Tag Archives: international investment position

Do US Trade Deficits Result In “Net Profits” For The US?

It’s frequently claimed that the US 🇺🇸 has trade deficits but since the US dollar has not collapsed, the ones saying that the US does not have a balance of payments constraint are all wrong.

Now there are several errors in this line of reasoning but going straight to the point: the balance-of-payments constraint is first a constraint on output. There’s a deflationary bias in the US output because of the imbalance in trade.

This article is written in response to a blog post Cumulative U.S. Trade Deficits Resulting in Net Profits for the U.S. (and Net Losses for China) at the blog macroblog by the Federal Reserve Bank of Atlanta. The article says:

The United States has run trade deficits for decades (1976 is the last year with a recorded surplus). To illustrate this, chart 1 depicts the cumulative U.S. trade deficit since 1980, which now surpasses $10 trillion. As a result, a drastic deterioration in the U.S. net foreign asset position—the difference between the amount of foreign assets owned by U.S. residents and the amount of U.S. assets owned by foreigners—has occurred. That is, as Americans borrow from the rest of the world to finance the recurring trade deficits, the national net worth goes deeply into the red. Not long ago, many commentators predicted that as a result of this increasing U.S. foreign debt, the U.S. dollar was set to collapse, which would trigger a stampede away from U.S. assets. Of course, this has not happened.

The wording of this itself is problematic. First some definitions:

Here’s from the IMF’s Balance of Payments And International Investment Position Manual (BPM6), pg 9:

The balance of payments is a statistical statement that summarizes transactions between residents and nonresidents during a period. It consists of the goods and services account, the primary income account, the secondary income account, the capital account, and the financial account. Under the double-entry accounting system that underlies the balance of payments, each transaction is recorded as consisting of two entries and the sum of the credit entries and the sum of the debit entries is the same.

What the US has is a positive balance in the secondary income account (more credits than debits) despite running large deficits in the primary account and despite having a large negative net international position. But “net loss” or “net profit” is bad wording to start with. Also the net international investment position itself is not “national net worth” because the latter includes non-financial assets owned by resident economic units and hence doesn’t make an appearance in the international investment position.

Now coming back to the point on output – If the US economy were to run under full capacity at all times with the current account deficit widening and the net international investment position deteriorating relative to gdp without limit, it can then be claimed that the US doesn’t have this problem and the economists worrying about US trade got it all wrong. But that is far from the case. Not only is the US economy not running under full capacity, but so much output has been lost since the beginning of the crisis starting in 2007.

Having an imbalance in trade means that output multipliers aren’t as high as it would have been the case otherwise. So the government expenditure multiplier and private expenditure multiplier are inversely related to the propensity to import and would have been higher if the propensity to import were less.

Usually economists talk about either trade or the financial aspect (i.e. either the current account or the financial account of the balance of payments) but not both together in a single unified framework. Most of the conclusions reached are due to lack of analysis which treat both of them simultaneously. Stock flow consistent models are an exception but other models are so messed up even for the closed-economy that it’s difficult in those models to make progress.

The fact that the US secondary income is in the US’ favour has led economists to draw any conclusion they want from their analysis. Let’s touch one aspect – the tipping point.

The tipping point

Let’s say you have assets worth $100 and earning at 6% annually (such as interest or dividend), and liabilities of $110 paying at 5%. So even though your liabilities are higher than assets, your income on assets ($6) is higher than what you pay on your liabilities ($5.5). So far, so good, so what? While this is not a bad situation, this is unlikely to remain the case forever. For example if your assets stay the same whereas liabilities rise to $130, then the net income is against your favour. You are earning $6 per year but paying $6.5.

The point of the above example is that even though the US earns more on assets held abroad than what it pays nonresident economic units on their financial assets, this process cannot continue forever. Sooner or later, the difference between the assets and liabilities (because of continuous trade deficits) will be so high that the secondary income in the current account in the balance of payments will be negative. So estimating the tipping point is estimating when this will happen.

Surely, if the US runs at full capacity and hence higher trade deficits because of higher national income and income effects on imports, the US will hit the tipping point sooner. At that point nobody can obfuscate the debate by saying that the secondary income balance in the current account of the balance of payments is positive. The international investment position will deteriorate at a much faster rate.

Of course reaching the tipping point itself is not apocalypse. Some countries do have a negative balance in the secondary income account of their balance of payments. The situation can continue as long as markets allow it to go on. When the busts, it will create a problem but nobody has a theory yet on when exactly some busts, although we’ve made progress on identifying unsustainable processes.

The point of the above analysis is that none of the arguments trying to claim directly or implicitly that “current account deficits do not matter” are erroneous.

No, the dollar won’t collapse but the US economy will run from full capacity to keep debts in check. Such as so much lost output in the last 9 years or so. To summarize, there are at least two scenarios here which are either confused or conflated or both by economic commentators:

  1. The US economy running closer to full capacity but with international investment position deteriorating fast and a threat to the US economy and the currency.
  2. Status-quo, where there’s deflationary bias to the US economy and hence consequences to output, employment and income for the bottom of the population but no immediate threat to the international investment position (although deteriorating) and in which there’s no dollar collapse.

The empiric of scenario 2 above cannot be used to argue that scenario 1 is benign because these two are different states of the world.

The solution is another scenario, a scenario 3 in which output is raises by fiscal expansion but the US government also works to address its balance of payments problems. For example, China’s strategy of exports is quite damaging to the US economy and it is important that the US establishment addresses this instead of just saying “it does matter” or that market mechanism will do the trick.

Last updated 15 Oct 2016, 1:21pm UTC – typo fixed. 

The UK’s International Investment Position

There’s one thing that slipped out of my mind in my recent post Sterling Flash Crash And The UK’s Balance Of Payments, i.e., the UK’s international investment position.

The Bank of England’s financial stability report from July has an interesting discussion on this with this chart.


UK’s net international position. Source: BOE.

with the comment:

The currency composition of the United Kingdom’s external balance sheet does not amplify risks associated with a sterling depreciation.

Currency mismatches in a country’s external balance sheet can amplify risks associated with a large current account deficit, if a depreciation of the currency leads to a deterioration of the external balance sheet position. Although there are no official statistics on the currency composition of the United Kingdom’s external balance sheet, estimates suggest that around 60% of the stock of external liabilities is denominated in foreign currency, compared with more than 90% of the stock of external assets. This means that, other things equal, a fall in the value of sterling should increase the value of external assets relative to liabilities, improving the United Kingdom’s net foreign asset position which was -6.7% of annualised GDP in 2016 Q1 (Chart A.11).

Of course, it is important to keep in mind that while this is true, large movements in liabilities in can affect corporations and systemic risks can arise if a large corporation fails. But at the same time, assuming risks are contained, the above is beneficial to the UK. Risks associated with Brexit and the fall in the value of the Sterling aren’t as bad as presented by economists 🤡 with the opinion that the UK should remain in the EU.

Abraham Ptachya Lerner, An Inconsistent Fellow

This quote of Abba Lerner from his article “The Burden of the National Debt,” in Lloyd A. Metzler et al.,Income, Employment and Public Policy (New York, 1948), p. 256 is frequently quoted in the Post-Keynesian blogosphere:

One of the most effective ways of clearing up this most serious of all semantic confusions is to point out that private debt differs from national debt in being external. It is owed by one person to others. That is what makes it burdensome. Because it is interpersonal the proper analogy is not to national debt but to international debt…. There is no external creditor. “We owe it to ourselves.”

This is unfortunately inconsistent with his “functional finance”. Abba Lerner clearly says that external debt can be problematic. However he probably never realized that if his advise is followed in running fiscal policy, a nation’s balance of payments will deteriorate and its international debt will increase (because current account balance adds to the net international investment position).

Public debt is not the same the negative of the net international investment position but it’s related as the external debt is directly or indirectly picked up by the public sector.

Sound finance is all junk science but Abba Lerner is not your friend to learn about money, debts, deficits and all that.

Getting Paid To Have A Trade Deficit?


Source: BEA.

Eric Lonergan has written an interesting post about US trade deficits on his blog Philosphy Of Money/Sample Of One. In the post Eric claims that the United States is not a debtor of the world but that she is a creditor of the world! Eric also says that a lot of talk of all this is conventional wisdom and in reality the United States is getting paid to have lunch.

First, it’s no conventional wisdom. Most of standard macroeconomics is simply denying the importance of balance of payments. It is held that market mechanisms will correct imbalances, if only the government does its job. So there’s no conventional wisdom worrying about the trade deficit of the United States of America. It is exactly the opposite – a heterodox view.

Second, there is no “free lunch”. Imports put a drain on demand and output and because of the imbalance of the U.S. trade, full employment has been a distant dream. With so much of unemployment (especially in the crisis) and the slow recovery, one cannot claim that the U.S. has some free lunch. Only if there is full employment and that too remaining sustainable, can one claim that there’s some “free lunch”. A smaller point is that one needs the correct counter-factual: if the U.S. trade deficit had been lower, interest income (one of Eric’s main points) would have been even higher. So one more reason to avoid the phrase “free lunch”.

Moving to more important points. Eric claims that net return of FDI is high and hence BEA’s numbers are not right. Specifically he claims:

So here’s the crux: American generates a high positive net income from its net international asset position – which implies its net external asset position is a positive number. Despite running permanent current account deficits, the US has accumulated net external assets. this sounds less counterintuitive if you think that all it means is that US assets oversees are more valuable than foreign holdings of US assets.

To highlight how significant the difference is, BEA measures of US net external liabilities are around $7trn, if we simply value the net income on a PE multiple of 14x, the net external assets of the US are around $2.7trn!

An inconsistency this large seems extreme, but consider the valuation of foreign direct investment (FDI). According to the BEA, net FDI of the US has a value of less than $1trn, although the US earns $424bn on its overseas FDI and foreign FDI in the US only earns $153bn. If we value both income streams on 14x earnings, the US has net FDI assets of $4.2trn – the BEA ‘market value’ estimates are out by $3trn.

Now, that is not a correct way to approach this. To see the error, assume the stock of outward FDI is $100 and the stock of inward FDI is also $100 at market prices. Suppose investment receipts is $10 and income paid is $9. So it looks like the United States is earning $1 on a net FDI of 0. So according to this argument, the return is infinite!

It is better to look at the actual numbers:


Outward FDI: $6,695bn

Inward FDI: $6,196 bn.


Direct investment income: $776bn

Direct investment payments $592bn.

There is nothing drastically wrong about these numbers. Perhaps, it can be argued that direct investment in the US by foreigners will take time to pay off, or that foreigners are satisfied with this or something else. These numbers do not appear wrong.

Netting inward and outward and comparing returns to the net stock is an invalid argument, as I showed above with an example of inward/outward FDI of $100.

In addition, on Twitter Eric says a DCF (discounted cash flow) model also supports his thesis that the United States is a net creditor. The loophole in this argument is that it holds assets and liabilities vis-à-vis foreigners fixed. But because the United States runs current account deficits, liabilities rise faster than assets attributable to the deficit. So even if the U.S. earns interest income, net, from abroad, this effect will catch up.

There’s other way of saying all this. If is return on assets and are assets and liabilities.

rA > rL

rA ·A > rL·L

is not inconsistent with

A < L

Second, using subscripts, 0 and 1 for now and some point in future,

rA0 ·A0 > rL0·L0

does not imply automatically that

rA1 ·A1 > rL1·L1

because liabilities can rise faster than assets (because of current account deficits) and even if return on assets is higher than return earned by foreigners on U.S. liabilities, net interest income can turn negative.

Anyway, the point of this post is that while netting is a good concept, one cannot blindly net accounting numbers. The example, a net FDI of $0 earning a net income of $1 and hence infinite return(!) is not a valid way of doing accounting. BEA’s numbers look correct.

Last edited: 26 Mar 2016, 6:35 pm UTC

Limits To Growth, Part 3

[For previous discussions, see my posts Limits To Growth? and The Full Employment Assumption]

Brian Romanchuk has written a post as a response to my post Limits To Growth? referred above. In that his tone seems to be that the U.S. does not face an external constraint fundamentally, and that trade acts as a drag only because politicians have an impression that there exists a constraint.

To hold that claim Brian should to able to defend the dynamics which is likely if that were the case: the U.S. public debt and the net international investment positions deteriorate without limit (relative to gdp). Not sure at the moment if he thinks that debt/gdp ratios can grow without any limit.

That is the financial aspect of his argument. From the trade perspective, Brian says:

In any event, the U.S. could get away with strong GDP growth without causing external difficulties right now. There is plenty of spare global manufacturing capacity, so rapid U.S. growth would be accommodated by exporters. After awhile, there would be a self-reinforcing global growth spurt, which will reduce the pressure on the U.S. trade balance.

There are two things. One is capacity constraint and the other competitiveness.  Both I and Brian agree there is no need to worry about the former. (Unlike neoclassical economists who are worried about the former!). It is about the latter where the debate is. This is in addition to the financial aspect mentioned in the previous paragraph.

The U.S. having plenty of spare manufacturing capacity has little impact on competitiveness. At a micro level, one can think of a firm with lots of idle resources but the sales team not being able to win projects for the firm. So two things—capacity and competitiveness—need to be studied separately. If the rest of the world does not expand, there is not much U.S. firms can do. If they produce more stuff, it will just be left as additional inventories forcing a clearing sale in domestic markets at the year end. So presence of spare capacity cannot make U.S. exports grow if domestic demand rises, either due to rise in private expenditure or via fiscal policy. In addition, there’s no self-reinforcing global growth because exports won’t take off to begin with.

To be more technical, there is one way in which U.S. exports may rise. If production rises, then via the Kaldor-Verdoorn process, U.S. productivity will also rise and this affects pricing of products and U.S. exporters may get some price advantage.

So rise in production can lead to a rise in competitiveness.

But this effect is quite negligible in the short run because competitiveness is both about non-price competitiveness and price competitiveness. 

There is an additional effect. U.S. production rising means rise in national income and rise in imports. This implies a rise in global output and demand and helping U.S. exports. Again, this effect is small and doesn’t prevent a deterioration of balance of payments and international investment position. So U.S. production rising helps exporters a bit but not much.

What the world needs is a coordinated policy to raise output by fiscal policy and putting limits on balance of payments imbalances.

Whoever becomes President of the United States has to not only take care of domestic policies but also act as a leader in world wide policy.

All this is about the future. But it’s not that the U.S. balance of payments hasn’t mattered in the past. Because of imbalances in trade, the U.S. fiscal policy could not save the U.S. i.e., could not bring the economy back into full employment quickly. It has taken about 9 years and there is still not full employment. So much has been lost. The critical imbalance in U.S. trade is the numero uno reason for the lack of a quick recovery. It could be said that the U.S. could have expanded fiscal policy and that is quite true but it would have put the U.S. debts on unsustainable path.


It is sometimes said, such as by a commenter in Brian’s blog that “balances balance”, so there is no need to worry about them. There is no imbalance as per an economist. This is a dubious argument. Surely the private sector can be in deficit for long and it is matched by items in the financial account of the system of national accounts. But surely private sector deficits for long is unsustainable as agreed by everyone around here. So “balances balance” is no argument.

United States’ Net Wealth

The latest release of the Federal Reserve Statistical Release Z.1, Financial Accounts of the United States – Flow of Funds, Balance Sheets and Integrated Macroeconomic Accounts or just “flow of funds” has a new table B.1: Derivation of U.S. Net Wealth.

According to the release:

A new table on the derivation of U.S. net wealth (table B.1) has been added to the summary section of the “Financial Accounts.” The calculation of U.S. net wealth includes the value of nonfinancial assets (real estate, equipment, intellectual property products, consumer durables, and inventories) held by households and nonprofit organizations and noncorporate businesses. For the federal government and state and local governments sectors, only structures, equipment, and intellectual property products are included; values for land and nonproduced nonfinancial assets are not available. The measure of U.S. net wealth also includes the market value of domestic nonfinancial and financial corporations, and is adjusted to reflect net U.S. financial claims on the rest of the world. This definition of U.S. net wealth differs from the sum of the net worth of sectors shown in the Integrated Macroeconomic Accounts (IMA). A forthcoming FEDS Note will provide additional information.

United States Net Worth

click to expand, and click again to zoom

According to it, the United States net wealth was $79.69 trillion.

It’s important to understand how this is reached. Normally we divide the world in various sectors: households, production firms, the financial sector, government and the rest of the world. In real life one adds more nuances to all this. So for example, in the table above, we have a sector “non-financial non-corporate businesses”.

Now, there are two types of assets: non-financial assets and financial assets. Non-financial assets are things such as houses, machines and so on. Financial assets are things such as currency notes, bonds, equity securities and so on.

In the system of national accounts (e.g., the 2008 SNA), all financial assets have a counterpart liability. So financial assets = liabilities for the world as a whole. It’s of course not true for a nation because assets and liabilities between residents and non-residents do not cancel out.

There is one complication, however: equity securities. The 2008 SNA treats equity securities as liabilities of corporations, just like debt securities. This is despite the fact that a company isn’t bound by law to pay dividends to holders of equity, unlike the case for debt securities or loans (for which interest is needed to be paid periodically and also the principal upon maturity).

All economic units have a net worth. This is the difference between assets and liabilities. So,

Assets = Liabilities + Net Worth.

Since equities are treated as liabilities in the 2008 SNA, the net worth of firms can in fact turn negative. This might happen if the price of equities is high.

So it is easy to derive the net worth of a nation. Resident economic units’ liabilities held by resident economic units cancel out and one is left with non-resident units’ liabilities to residents (i.e., resident units’ assets “held abroad”) and residents’ liabilities to non-residents.  This is the net international investment position.

So, as per the 2008 SNA (and the Balance of Payments Manual, 6th Edition),

Net Worth of a nation = Non-financial assets held by residents + Net International Investment Position

The Federal Reserve however does not do the same for flow of funds. It does not treat equities as liabilities.

But one has to be careful about double counting. It’s easy to sum up non-financial assets of all economic units, such as as done by the SNA. But in the flow of funds, with the special treatment on equities, we shouldn’t use corporate businesses’ non-financial assets. If you read the explanation and see the table B.1 carefully, corporate businesses’ assets have not been added, only “non-corporate businesses'” non-financial assets have been added. Since equities are not treated as liabilities in the sense of debt securities, the market value of corporations is needed to be added. This is line 13 in Table B.1.

There is one complication however. Even though equities is not treated as liabilities, that held by foreigners is treated as liabilities. Otherwise, one can have a source of inconsistency. Suppose equities held by a non-resident economic units is not treated as liabilities. Suppose foreigners sell $1bn of equities and purchase T-bills with that. This will mean that the net wealth reduces. Which doesn’t make sense. Hence, one is forced to treat foreigners’ equity holdings as liabilities. So the foreign aspect of the whole calculation is the same as as done in the SNA and one needs to include the net international investment position of the United States which is line 24. (minus $5.47 trillion).

So that basically summarizes the calculation of the United States net wealth as per the Federal Reserve flow of funds report.

How does this compare with the SNA measurement? Some tables in the report are only updated to 2014. So let’s use those numbers.

Flow of funds’ net wealth for 2014 = $77.89 tn (Table B.1, line 1).

Now, go to Table S.2.a. These tables use SNA definitions. Add lines 76-81.

This gives us a value of $87.34 trillion.

However the Z.1 report has an error in the way SNA/IMA way of calculating net worth. Line 77 in Table S.2.a is incorrect. There’s double counting. It uses the SNA/IMA concept of net worth but instead calculates it using the FoF concept. One should subtract line 29 in table B.101 which is $10.04 trillion. Hence the US net worth in the SNA definition is $87.34 trillion minus $10.04 trillion which is $77.30 trillion.

So in short, the net worth of the United States as per the flow of funds definition at the end of 2014 was $77.89 trillion and according to the SNA/IMA it was $77.30 trillion.

What does all this mean? Hmm. Not to easy to answer, except saying that familiarity with the system of measurement helps in understanding how the economy works. Which measurement is better – the new table B.1 or S.2.a? Doesn’t matter.

I am thankful to commenters in this blog post by Steve Randy Waldman, especially JKH and Marko.

Last edited 8 Oct 2015, 2:22pm UTC. [Error in Fed’s Z.1 report pointed out and my own fixed]

Update: Part 2 of this post/afterthought here United States’ Net Wealth, Part 2

Interest Rate, Growth And Debt Sustainability

Frequently, discussions about debt sustainability have discussions about the importance of the interest rate and growth in debt sustainability analysis. See for example, today’s Paul Krugman’s post on his blog. It is concluded that as long as the rate of interest is below the rate of growth, the ratio public debt/gdp doesn’t explode. Unfortunately, this result is erroneous.

John Maynard Keynes’ biggest disservice to the profession is to not start with the open economy. In my view, debt sustainability is tightly connected to balance of payments.

Imagine a nation whose exports is constant. If output rises, it will have adverse effects on the current account balance of payments because of income induced increase in imports. This will have an adverse effect on the international investment position of the nation: the net international investment position will keep deteriorating unless output is slowed down or some measure is taken to improve exports. In the case of rising exports, there is a similar constraint, except it is weaker but dependent on the rate of growth of exports.

If the ratio net international investment position/gdp keeps deteriorating, either the public debt to non-residents or private indebtedness to non-residents or both have to keep rising, all unsustainable.

There are some complications. A nation’s balance of payments also depends on how assets held abroad and liabilities to foreigners affect the primary income account of balance of payments. Also, the exchange rate can depreciate (or be devalued in fixed-exchange rate regimes) improving exports and reducing imports. However assuming that exchange rate movements do the trick is believing in the invisible hand. Foreign trade doesn’t just depend on price competitiveness but also on non-price competitiveness. These complications are highly interesting but do not affect the fundamental fact that a nation’s success is dependent on the success of corporations to compete in international markets for goods in services.

Even the conclusion that the government should contract fiscal policy and aim for a primary surplus in its budget balance or else the ratio public debt/gdp keeps rising if the rate of interest is greater than the rate of growth is erroneous. Consider a closed economy. An expansion in fiscal policy will automatically raise output and gdp and hence tax collections to prevent the ratio public debt/gdp from exploding. The public sector balance may hit primary surpluses but not due to contraction of fiscal policy or targeting a primary surplus in its budget balance.

In short, although the rate of interest and the rate of growth are important in debt sustainability analysis, it is not as easy as is usually presenting in macroeconomics textbooks and in the blogosphere. For a more detailed analysis see the reference below.


  1. Godley, W. and B. Rowthorn (1994) ‘Appendix: The Dynamics of Public Sector Deficits and Debt.’ In J. Michie and J. Grieve Smith (eds.), Unemployment in Europe (London: Academic Press), pp. 199–206

Updated 8 Apr 2015, 6:52 am UTC.

The U.S. Net International Investment Position At The End Of 2014 [Updated]

The U.S. Department of Commerce’s Bureau of Economic Analysis today released accounts for the United States’ international investment position. The U.S. is sometimes called the world’s biggest debtor and its net international investment position is now (at the end of 2014) minus $6.9 trillion.

Here’s the chart from the BEA’s website. U.S. Net International Investment Position 2014A few points. The importance of the U.S. balance of payments and international investment position is quite neglected in analysis of the crisis. The United States’ economy went into a crisis (and the rest of the world with it) because a huge rise in private indebtedness led to a fall in private expenditure relative to income when the burden of the debt started pinching. This caused a drop in economic activity and was saved partly due to automatic stabilizers of fiscal policy as tax payments fell due to a drop in economic activity and partly due to a relaxation of fiscal policy itself by the U.S. government and governments abroad. But the huge rise in the U.S. government debt meant that resolving the crisis by fiscal policy alone would have been difficult. This is because a huge fiscal expansion would have meant that the U.S. trade deficit would have risen much faster into an unsustainable path.

See Wynne Godley’s article The United States And Her Creditors: Can The Symbiosis Last? from 2005 here arguing such things.

Back to the international investment position. There are a lot of interesting things about it. Although the U.S. in a huge debtor to the rest of the world, the return on assets held by resident economic units of the United States earn more than paying on liabilities to nonresidents. So according to the BEA release U.S. International transactions 2014, investment income in the full year was about $813 billion while income payments was about $586 billion. (More complication arises from “secondary income”).BEA-2014-U.S.-International-Transactions

In addition, revaluations of assets and liabilities also affect the international investment position and revaluations of direct investment held abroad has acted in the United States’ favour.

Of course this cannot always be the case. Take a simple example: Suppose an economic unit’s assets is $100 and liabilities is $150 and suppose assets earn 8% every year and interest paid on liabilities is 5%. So even though the economic unit has a net indebtedness of $50, it is earning

$100 × 8% − $150 × 5% = $0.5

However, if liabilities rise to $160 and beyond the net return turns negative.

In a similar way, there is a tipping point, beyond which the net primary income of the current account of balance of payments turns negative. Because the United States has a negative current account balance and the deficit adds to the net indebtedness every year, at some point in the future, the international investment position may reach a tipping point.

All this sounds as if domestic demand and output are unrelated. This is of course not the case. Imports depend on domestic demand and exports depend on economic activity abroad. Hence the constraint on output at home because if output were to rise fast, the net indebtedness of the United States will also rise fast.

Of course the concept of a tipping point may itself be misleading. Indebtedness can keep rising even if net primary income turns negative without any trouble in financial markets because it all depends on how the financial markets see the problem. But it may be said that once a tipping point is reached, the debt will start to rise much faster than now. My article here hasn’t gone into any analysis here with numbers but I will leave it for another day.

Cyprus Rescue

Cyprus has recently received the attention of academicians and financial professionals in recent weeks. Need I say that?

So national bankruptcy is to be resolved by winding down a bank, moving guaranteed deposits (i.e., upto €100,000) to another and as per the latest Reuters article on this, big numbers (anywhere ranging from 20 to 40 per cent loss on deposits on amounts over €100,000) are quoted.

Martin Wolf has a good summary:

The current plan is closer to what one would wish to see in an orderly bank resolution. Laiki Bank is to be split into good and bad banks. Deposits of less than €100,000 in the bank and assets worth €9bn – the sum owed to the central bank as part of its liquidity support – will be transferred to Bank of Cyprus. The remainder will be wound down. Those with claims to deposits in excess of €100,000 will obtain whatever the value of the bad bank’s assets turns out to be.

Meanwhile, savers at the Bank of Cyprus with deposits of more than €100,000 will have their accounts frozen and suffer a “haircut” of still unknown size. That reduction in value is likely to be large: perhaps 40 per cent. Finally, temporary exchange controls are to be imposed.

Why are the reasons for such huge numbers?

The reason is that the nation has accumulated huge net indebtedness to foreigners over years and this has been financed by banks raising deposits from foreigners, so that if debt traps are to be avoided, foreigners are to be required to take losses.

The following is the international investment position of Cyprus at the end of Q3 2012 (source: Central Bank of Cyprus)

Cyprus - International Investment Position Q3 2012In the balance of payments literature, banks’ position is referred as Other Investment. Also, the above refers to a Financial Account but it really means net IIP. Ideally it would have been better if this data had been updated but the above information is useful nonetheless.

As a percent of gdp, the net IIP position (with the opposite convention to standard usage) was 81.1% (Source: Eurostat) which is big in itself but very much lower than the now famous banks’ liabilities to foreigners/Russians! (the second red box above).

If a nation wants to resolve bankruptcy, it is better to do it by imposing losses on foreigners – especially if an international lender of last resort is available! And if this is to done it in the optimal way, best to do it once – rather than keep doing it. The ratio of two red boxes in the table – i.e., net liability as a proportion of gross bank liabilities to foreigners is 24.56%.

So Cyprus needs to wipe out about this amount as a percent of deposits roughly. It is not necessary to reach a position of zero indebtedness but something low such as 10% of gdp is ideal. Some buffer is needed because there will be leakages in spite of capital controls – requiring fire sale of foreign assets (and subsequent losses) by banks or borrowing from the ECB which may want to ensure that banks have good collateral for the ELA. Foreign deposits below €100,000 shouldn’t be hit. So “net-net”, as a percentage, this may be higher than 24.56%. All this depends on the latest situation and the distribution of foreign deposits and also the distribution between residents and foreigners but 24.56% of deposits is a good starting point – it gives a rough estimate of the order of magnitude of the problem.

At any rate, losses imposed on foreigners have to be big for the ECB and Euro Area governments to stand behind.