Tag Archives: neochartalism

Neochartalists Shifting Positions

In a three part series, Bill Mitchell, makes the case against free trade. While this is most welcome – success and failure of nations depends on success in international trade via the principle of circular and cumulative causation – it’s quite a drastic change from what Neochartalists have claimed before. From “exports are a cost and imports benefits”, they have shifted their position. Mitchell goes on to concede:

These so-called ‘free trade’ agreements are nothing more than a further destruction of the democratic freedoms that the advanced nations have enjoyed and cripple the respective states’ abilities to oversee independent policy structures that are designed to advance the well-being of the population.

[emphasis: mine]

Neochartalists have always denied – till recently – that free trade can put a constraint on fiscal policy. They interpreted such critiques as an argument against fiscal expansion, instead of realizing that it’s possible to both argue for fiscal expansion and realize that it is constrained by balance of payments. One potential solution is import controls. Mitchell concedes that it’s required sometimes. He says:

In those cases, import controls may be justified to limit the damage to the less developed nation, despite the material benefits to the more developed nation being obvious.

[boldening: mine]

In another blog post as I noticed here, Mitchell says this while making proposals on reforming the international institutional framework:

2. Macroeconomic stabilisation – support for national currencies in the face of problematic balance of payments.

This function recognises that all nations should maintain sovereign currencies and float them on international markets but at the same time recognising that capital flows may be problematic at certain times and that some nations require more or less permanent assistance due to their export capacities and domestic resource bases.

There have been many critiques of Neochartalism but very few touch on this or give attention. But since international trade is the most important determinant of the rise and fall of nations, and that Neochartalism claims to be some fundamental theory of human interactions, its extreme position and shifting away from it should be noticed and critiqued, although welcomed.

In short, Neochartalism which is some sort of moral superiority on fiscal policy has accepted that free trade can put constraints on it. The solution of course is beyond the scope of this post but this shift should acknowledged when Neochartalism is discussed.

Another Admission

A few days back I posted a link to a paper written by a top advisor the US government admitting that economists in general got fiscal policy quite wrong before the crisis.

Now another admission, but this time from a non-orthodox economist.

In a recent blog post, Bill Mitchell writes (on reforming the international institutional framework):

2. Macroeconomic stabilisation – support for national currencies in the face of problematic balance of payments.

This function recognises that all nations should maintain sovereign currencies and float them on international markets but at the same time recognising that capital flows may be problematic at certain times and that some nations require more or less permanent assistance due to their export capacities and domestic resource bases.

The trouble with Neochartalism (Mitchell and his colleagues’ theory, also called “modern monetary theory” by themselves) is that what is correct is not original and what is original is incorrect. Despite repeated arguments of other non-orthodox economists, Neochartalists have continued to deny the existence of the balance-of-payments constraint. Still a long way to go from understanding the supreme importance of balance of payments on growth, but this is a good positive step.

It’s ironic that Neochartalists are followers of Hyman Minsky who talked of financial crises. While Neochartalists emphasize that crises can happen in financial markets, they have till now completely denied that it can happen in foreign exchange markets.

Neochartalists emphasize fiscal policy, as if problems start and end there. But the problems of this world can be solved not just by fiscal policy but also by industrial policy and in the international sphere via diplomacy.

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.

Is Floating Better? Is The Stock Of Money Exogenous In Fixed Exchange Rate Regimes?

I believe that the basic problem today is not the exchange rate regime, whether fixed or floating. Debate on the regime evades and obscures the essential problem … Clearly flexible rates have not been the panacea which their more extravagant advocates had hoped … I still think that floating rates are an improvement on the Bretton Woods system. I do contend that the major problems we are now experiencing will continue unless something else is done too.

– James Tobin, A Proposal For Monetary Reform, 1978

Frances Coppola has written a post saying that floating exchange rates are not the panacea. Although I agree with her point, there are however a few points in her article which has some issues. She says that money stock is exogenous in gold standard.

Under a strict gold standard, the quantity of money circulating in the economy is effectively set externally. The domestic money supply can only grow through foreign earnings, which bring gold into the country.

… This is evident from the quantity theory of money equation MV = PQ, which is fundamentally flawed in a fiat currency fractional reserve system but works admirably under a strict gold standard or equivalent.

Frances is critiquing Neochartalists there but ends up accepting their notion that macroeconomics is something different when a nation’s currency is not floating and there’s an exogenous stock of money in fixed exchange rate regimes. There is absolutely no proof that it is so. Money stock can grow if there’s higher economic activity due to rise in private expenditure relative to income or via fiscal policy. But why this obsession with Monetarism? It doesn’t work anywhere: whether the exchange rate is fixed or floating. All arguments made in Post Keynesian economics carry through to the gold standard. Indeed Robert Mundell himself realized this in 1961 [1].

Here’s a quote from the book Monetary Economics by Wynne Godley and Marc Lavoie, page 197, footnote 11:

It must be pointed out that Mundell (1961), whose other works are often invoked to justify the elevance of the rules of the game in textbooks and the IS/LM/BP model, was himself aware that the automaticity of the rules of the game relied on a particular behaviour of the central bank. Indeed he lamented the fact that modern central banks were following the banking principle instead of the bullionist principle, and hence adjusting ‘the domestic supply of notes to accord with the needs of trade’ (1961: 153), which is another way to say that the money supply was endogenous and that central banks were concerned with maintaining the targeted interest rates. This was in 1961!

Bretton Woods was the emperor’s new clothes and floating exchange rates are the emperor’s new new clothes. The important question is whether floating exchange rates offer any market mechanism to resolve balance of payments imbalances and the answer is that it doesn’t. In gold standard, current account deficits can be financed by official sale of gold in international markets and residents borrowing from abroad. In floating exchange rate regimes, it is financed by borrowing from abroad. Hardly much difference. So the main adjustment is left to movement of the exchange rate. One needs to suspend all doubt and believe in the invisible hand to think the movement of exchange rates can do the trick. The reason it is the emperor’s new new clothes is that the promises never worked. And similar promises were made by economists that there’s a market mechanism to resolve balance of payments imbalances in fixed exchange rate regimes.

To summarize, my argument is that the only point to debate is whether floating the exchange rate resolves imbalances as compared to fixed exchange rates, not about the endogeneity of money. Although there is a role because of the movement of the exchange rate, floating exchanges is not a panacea. Although I am not on the side of the Neochartalists in the debate, I thought I’d point this out: do not fall into the pitfall of your opponent.

  1. Mundell, R. (1961) ‘The international disequilibrium system’, Kyklos, 14 (2),
    pp. 153–72.

Heterodox Blogger On Neochartalism

The trouble with Neochartalism (and called “Modern Monetary Theory” by the Neochartalists) is that what is correct is not original and what is original is not correct.

A popular heterodox blogger writing under the pen name “Lord Keynes” and blogging at Social Democracy For The 21st Century has written a post Limits Of MMT

It’s good to see the blogger point that the main trouble with Neochartalism is the balance of payments constraint. He/she has said this in the past in posts while promoting it, so it’s good to see a special post for this. I don’t agree with many things with “Lord Keynes” but given the blog’s popularity, I think it’s a good thing to have happened.

There is one thing I would have liked to see differently. It is sometimes said that Neochartalism works for advanced/rich nations and not for poor nations. But this gives too much importance to Neochartalism. This is because the rise and fall of nations itself depends on competitiveness in international markets. Saying “MMT works for advanced nations” makes it look as if the success and failure of nations is to be explained elsewhere. It’s still true of course that advanced nations can expand domestic demand by fiscal expansion but they also have to look after the being being of firms selling products in international markets, to stay competitive and not lose edge. Similarly as the blogger Lord Keynes says, “What is needed for much of the Third World is heterodox development economics, not MMT.”

More generally a concerted action is needed by world political leaders in which fiscal policies are coordinated with a set of consistent balance of payments targets.

Neochartalism has confused people more than they were confused earlier. It has to be debunked.

Neochartalism, Balance Of Payments And Mainstream Economics

There have been many critiques of Neochartalism. Almost all of them, simply ignore the most important issue which makes Neochartalism the so-called “Modern Monetary Theory”, a chimera. A delusion.

Bill Mitchell has written a post on his blog about the balance-of-payments constraint, which among other things makes fun of physical appearance of Nicholas Kaldor. In that he correctly recognizes Nicholas Kaldor as the main proponent of this idea. Mitchell rightly represents Kaldor’s views:

In fact, Kaldor thought that exports were the only true ‘exogenous’ source of income growth, given that household consumption and business investment are considered to be ‘endogenously’ driven by fluctuations in (national) income itself.

In the post, Bill Mitchell doesn’t offer any argument as to why the literature behind it is supposedly wrong. He quotes Australia’s example but doesn’t recognize that Australia’s growth rate fits Thirlwall’s law. Had Australia grown much faster, its international indebtedness would grow to a much bigger size than now, which means its growth is limited by the balance of payments constraint.

Instead, Mitchell’s main point is:

While Thirlwall adopted a Keynesian position, the ‘balance of payments constraint’ he defined has underpinned the obsession with export-led growth strategies. It is a case where the IMF and others have co-opted the ‘Keynesian’ literature to impose neo-liberal solutions on nations.

In part, this is because ‘Keynesian’ literature was flawed.

Supposedly, its the Kaldorians who succumb into policies of the IMF because of their confusions! This is quite funny, given that Nicholas Kaldor was quite opposed to free trade which imposes a huge constraint on nation’s fortunes. In fact Kaldor and his colleagues at Cambridge were advocating import controls for Britain, which is obviously not a right-wing solution and was opposed by all.

One of my favourite articles is Foundations And Implications Of Free Trade Theory by Nicholas Kaldor, written in Unemployment In Western Countries – Proceedings Of A Conference Held By The International Economics Association. At Bischenberg, France. 

Nicholas Kaldor On Free Trade

Nicholas Kaldor on free trade


Kaldor main point in the essay is a major opposite to the doctrine of free trade. Free trade is a policy of international organizations such as the IMF. So it’s not Nicholas Kaldor and others who are being fooled by the IMF, but Neochartalists themselves who think that if nations simply float their currencies, they get rid of their external constraint.

Here’s Kaldor:

Owing to increasing returns in processing activities (in manufactures) success breeds further success and failure begets more failure. Another Swedish economist, Gunnar Myrdal called this’the principle of circular and cumulative causation’.

It is as a result of this that free trade in the field of manfactured goods led to the concentration of manufacturing production in certain areas – to a ‘polarization process’ which inhibits the growth of such activitiesin some areas and concentrates them on others.

So as you see, there is an opposition to the “consensus” view. But according to Neochartalists, there is no problem with free trade: just expand domestic demand by fiscal policy. Imports are benefits, exports are costs according to them!

The main point of the post is that it is Neochartalists whose views are orthodox, not other Post-Keynesians following the work of Nicholas Kaldor. It’s funny of them to assert the other way. Look at it this way: opposition to free trade requires import controls, tariffs and things such as that. Is that the mainstream view – to put tariffs? However it is funny if you see a Neochartalist arguing against free trade as it would mean an inconsistency. If fiscal policy alone can bring full employment, why oppose free trade?

Monetary Mysticism

Normally, I’d give such things a pass. But there are monetary mysticists – the Neochartalists (“MMTers”) – who make a big issue of a few monetary things. In a post on banking, Eric Tymoigne such mystical things:

Throughout this blog I will not the use the words “loan” “lender” “borrower” “lending” “borrowing” when analyzing banks (private or Fed) and their operations. Banks don’t lend money, and customer don’t borrow money from banks. Words like “advance” “creditor” “debtor” are more appropriate words to describe what goes on in banking operations.

The word “lend” (and so “borrow”) is really a misnomer that has the potential of confusing—and actually does confuse—people about what banks do.

So banks do not make loans?

But that’s not the main point in my post. It is the other claim:

  • Point 2: The Fed does not earn any money in USD

When the Fed receives a net income in USD it is not receiving any money/cash flow, i.e. its asset side is not going up. What goes up is net worth.

[highlighting: mine]

Such things are also closely related to claims by the Neochartalists that “taxes don’t fund government expenditure” or “taxes don’t fund anything”. The claim “the Fed does not earn any money in USD” is quite silly.

If you were to ever do an honest-to-goodness calculations with such things, you’ll notice that items accounts receivable and accounts payable are important things. In the simplest example, the Federal Reserve holds government bonds as assets and has bank reserves or settlement balances of banks and currency notes on liabilities. So the Fed is accruing interest on bonds it holds and has payables on interest on banks’ settlement balances. The system of national accounts 2008, has a nice explanation on para 7.115:

The accrual basis of recording

Interest is recorded on an accrual basis, that is, interest is recorded as accruing continuously over time to the creditor on the amount of principal outstanding. The interest accruing is the amount receivable by the creditor and payable by the debtor. It may differ not only from the amount of interest actually paid during a given period but also the amount due to be paid within the period.

So the Federal Reserve’s assets can indeed go up along with net worth because of interest income. It will reflect in accounts receivable in assets. When an actual interest payment is received, it is a transaction in the financial account of the system of national accounts. Then, accounts receivable falls and so do liabilities but net worth doesn’t change. More generally, the Fed may also make advances to banks as the banking system as a whole can lose reserves for paying interest. There is absolute no need for the kind of mysticism that Neochartalists do.

Edit 1, Jan 23, 2016, 2:19pm UTC :  detail about transaction in the financial account added. 

Strong Assertions

In a recent article (from last month), Warren Mosler makes strong claims. He says:

I reject the belief that economy is strong and operating anywhere near full employment. I also reject the belief that a zero-rate policy is inflationary, supports aggregate demand, or weakens the currency, or that higher rates slow the economy and reduce inflation.

What I am asserting is that the Fed and the mainstream have it backwards with regard to how interest rates interact with the economy. They have it backwards with regard to both the current health of the economy and inflation, and, therefore, their discussion of appropriate monetary policy is entirely confused and inapplicable.

Furthermore, while I recognize that raising rates supports both aggregate demand and inflation, I am categorically against raising rates for that purpose.

The problem with the mainstream credit channel is that it relies on the assumption that lower rates encourage borrowing to spend. At a micro level this seems plausible- people will borrow more to buy houses and cars, and business will borrow more to invest. But it breaks down at the macro level. For every dollar borrowed there is a dollar saved, so any reduction in interest costs for borrowers corresponds to an identical reduction for savers. The only way a rate cut would result in increased borrowing to spend would be if the propensity to spend of borrowers exceeded that of savers. The economy, however, is a large net saver, as government is an equally large net payer of interest on its outstanding debt. Therefore, rate cuts directly reduce government spending and the economy’s private sector’s net interest income.

I don’t understand why as a heteredox author, Mosler simplifies his analysis so much.

This post is not about discussion about whether it is time to raise interest rates in the United States. It’s not the time. It is about Mosler’s claim that monetary policy works opposite to what is usually assumed.

This oversimplification can easily be debunked. If the central bank raises the short term interest rate to say 15% from 0.25%, it will obviously lead to a reduction in borrowing. Firms will reduce investment and stock building as higher rates will require them to pay higher interest and the expectation that the economy will slow down will dampen production. Households may postpone plans for purchases of new houses and take out lesser loans and those with existing loans on floating interest rates are likely to reduce consumption when faced with a higher debt burden because of higher interest payments. Further, raising rates from say 0.25% to 15% may bankrupt a lot of firms because interest payments on debt may become very high. There are also feedback effects: a slowdown of output will lead to higher unemployment and less consumption and so on. It can be argued that interest payment by one economic unit is income for another so one needs a model to see how all this works: complications such as consumption propensities of interest payers and receivers.

Of course this effect may not be so strong if the short term interest rate is raised from 0.25% to say 2% but asserting that there is no effect and that the effect is exactly the opposite is too simplified a claim.

Does that mean that rising short term interest rates is always accompanied by a lower output? No. Monetary policy is only one channel. It is possible that while the central bank is raising interest rates, other things that affect aggregate demand conditions are working to raise output. For example, the government may be raising pure government expenditure while the central bank is raising rates, or exports are rising.

Now reconsider Mosler’s point quoted above:

For every dollar borrowed there is a dollar saved, so any reduction in interest costs for borrowers corresponds to an identical reduction for savers. The only way a rate cut would result in increased borrowing to spend would be if the propensity to spend of borrowers exceeded that of savers.

Not sure what that means. Dollar is not fixed in quantity. Further an economic unit may be both a net borrower and a saver. To see this think of a simple example: Your disposable income is $1mn, your consumption is $200,000 and you borrow $4.2mn to buy a house for $5mn. Your saving is $800,000 and your net borrowing is $4.2mn. You are both a saver and a borrower. Also, I am not sure how “propensity to spend of borrowers” means, as long as one is talking of borrowing to not make purchases of financial assets: all that is borrowed is spent, so this propensity is always equal to 1.

Perhaps Mosler has in mind the debt/income ratio. In the above example, your debt/income has risen but it isn’t necessarily the case with firms as investment is self-financing. Firms may borrow more in response to a fall in interest rates. But this needn’t cause a rise in debt/income as investment is also a source of income for firms as a whole. So firms’ debt/income may actually improve.

Mosler discusses the net lending of the private sector when he is talking of “net saving” (saving less investment expenditure), which is identically the net lending. Even if the private sector as a whole sees a deterioration of their net lending position it isn’t necessarily problematic in the short run. There is no reason that this is a constant relative to output or income which Mosler implicitly is assuming.

Finally the point about interest income on government bonds: it is true that if interest rates are higher, the private sector is receiving more income from the government and this is one factor to consider among all factors which affect aggregate demand. But there is no reason to assume that this effect is always higher.

In stock-flow consistent models, one sees the long run output depend positively on interest rates. But short term, this effect isn’t always positive except in simple pedagogic models.

Mosler gives the example of Japan to show what he says vindicates him. Low rates in Japan hasn’t helped Japan. The analysis is oversimplified because output depends on so many other things than monetary policy. There is no need to make simplistic assertions. Heteredox economists will be be seen as simpletons because of analysis such as that of Mosler. Mosler’s idea of writing was perhaps to stress the importance of fiscal policy and that mainstream economists underplay the positive role of fiscal policy and exaggerate the role of monetary policy. It can be said directly instead of claiming “the mainstream have it backwards with regard to how interest rates interact with the economy.”

Massive Overstatement Of Profits?

In an article, The Profits’ Conundrum, Marshall Auerback uses Kalecki’s profit equation analysis (which is just a simple rearrangement of terms of the sectoral balances equation) to claim that corporate profits have been overstated in the United States.

Now consider the US deficit and explain how on earth we can still have profits as a record percentage of GDP.  There is no way that we can have had a fall in the fiscal deficit to GDP ratio from ten percent to three percent (we are in the middle of fiscal yr 2014 remember) without some kind of significant decline in the profit share of GDP.

But NIPA says there is no such fall.   All the people who use this sectoral balance analysis keep saying that the profit decline is coming which of course is nonsense.  If it is to be it is here and now; we are dealing with an identity.  This cannot be ignored, but it is by virtually every single Wall Street analyst.

This does pose the real possibility that we have a massive overstatement of profits.

While it is possible this is the case, I don’t see how this follows from the usage of Kalecki’s profit equation or the sectoral balances equation without any dynamical analysis thrown in.

While the government deficit has fallen, the household sector saving has fallen too and there has been a big rise in firms’ investment expenditure in recent times. So let us look at the data but before that derive the profit equation.

From sectoral balances we know that net lending (in the language of the U.S. Z.1 Flow of Funds report) of all sectors should add to zero.

Firms’ undistributed profits FU is the sector’s saving. So firms’ net lending is:

FU − If

where Iis firms’ investment expenditure.

This should be the sum of net borrowing of all the other sectors – households, government and the rest of the world: Household net borrowing + Government net borrowing + Rest of the World net borrowing

Or, in the more usual language,

FU = If  + Government deficit − Household Net Lending + CAB

where CAB is the current account balance of international payments.

Each term is a flow and has a time subscript such as −1 or 0 or 1 but I will avoid it. Now let’s compare 2013 and 2009.

We need the numbers highlighted in yellow to check what’s going on from the Fed’s Z.1 report:

Table F.8, Z.1 Q4 2013 Highlighting Corrected

(click to expand and see clearly)

Government deficit is the negative of net lending and between 2009 and 2013 this has reduced by $776.5bn. However, private investment has increased by $704.4bn and household net lending fell by $216.2bn. The change in current account balance over the period is small (line 42). So the rise in private investment and the fall in household net lending (and change in the current account balance) more than offsets the fall in the government deficit.

Also remember, reported profits is the sum of undistributed profits and distributed income of corporations. Table S.1.a has data only till 2012 but it shouldn’t be difficult to get a feel for the numbers.

Table S.1.a, Z.1 Q4 2013

(click to expand)

So the change in distributed income also has been high.

And add complications of taxes to the numbers (pre-tax vs. post-tax), the difference in profits in the last few years is even higher.

Why this exercise if you can get the profits numbers directly? To show that things do add up except for small discrepancies which are always present.

So pure rearrangements of terms of sectoral balance identity doesn’t prove the overstatement of profits as claimed by Auerback. Of course it still leaves the possibility of dynamics which lead to a contraction of aggregate demand and hence profits but Auerback’s claim is that this is purely due to accounting identities and this claim is erroneous.

Last Updated: 14 Oct 2016, 7:51am UTC – broken link updated to archive from web.archive.org.

Neochartalism, Original Sin And The Backfire Effect

[This post is a sort of part 2 of the previous post Indebtedness And Liability Dollarization]

In the Neochartalist blogs, one frequently comes across the notion of monetary sovereignty, together with the notion of a “sovereign currency” – their notions of such things. One also sees an admission that countries whose governments have debt in foreign currency are constrained in boosting domestic demand to increase output and employment.

So this blog post by Bill Mitchell Defaulting on public debt as a way to progress has a few things to say about it.

Today I consider the idea that governments which have surrendered their sovereignty either by giving up their currency issuing monopoly, and/or fixing their exchange rate to the another currency, and/or incurring sovereign debt in a foreign currency might find defaulting on sovereign debt to be their best strategy in the current recession. I consider this in the context that any government that has surrendered their sovereignty is incapable of pursuing policies across the business cycle that serve the best interests of their population. While re-establishing their currency sovereignty may not require debt default, in many cases, default will necessarily be an integral part of the move back to full fiscal sovereignty. This is especially the case for nations that have borrowed in foreign currencies and/or surrendered their currency issuing capacities to a common monetary system. So here are some thoughts on when default is a way for a nation to progress.

[boldening: mine]

and then goes on the present the “balance-of-payments constraint” story as a mainstream economics story.

Now, it is clear from the above quote that Mitchell admits that nations with government have a constraint on fiscal policy. But the more troublesome fact is that he presents it as if the government doing this had some full volition to not have been indebted in foreign currency.

Incidentally Randy Wray writes a post – his latest and admits nations face a balance-of-payments problem and makes it look as if he has not shifted his extreme views:

I am not flippant about the many real constraints faced by a poor, developing nation. At an early stage of development, imports are very hard to get. The national currency faces little external demand. The world doesn’t want the nation’s produce, so it cannot export. Borrowing foreign currency can easily lead to excessive debt service and financial collapse.

Neither floating nor fixing is going to easily resolve these problems. That MMT does not have an easy solution to them does not, in my view, prove that MMT is flawed. My suspicion is that floating the currency and taking advantage of the sovereign’s ability to spend domestically is a step in the right direction. Capital controls are probably necessary—even more so if the country does not float. Foreign aid is probably necessary to finance needed imports.

[emphasis: mine]

Oh yeah doesn’t prove that the muddle which has come to be known as “modern monetary theory” is flawed? Wow!

But let’s get back to government borrowing in foreign currency. The original sin hypothesis is that many nations actually do not have a choice but to borrow in foreign currency. Now I won’t repeat the argument of the originators but present my own to argue that the hypothesis is roughly right. But the originators’ solution – creating policies to increase the size of financial system is far from a good solution.

Here’s how: What determines the trade balance? Imports depend on income and the income elasticity of demand for imports and exports the same but different elasticities. Now, there is also a price angle to this, but without much argument for now, Post-Keynesians argue that non-price factors are more important. Roughly this is because price is just one aspect of why the ultimate economic unit (consumers/households and producers purchasing machines for example) buys what it buys.

In neoclassical theory, absolute advantage any producer has doesn’t last long and is eliminated presumably because of the “price mechanism” and it is only comparative advantage which matters. And there is a market mechanism which resolves imbalances supposedly. But in a world full of giant corporations based in a few nations, this is hardly a good assumption. Worse, comparative advantage story is the reason used to push free trade agreements between nations. And since imbalances are rarely resolved by price adjustments, neoclassical economists start blaming the government – as if governments cannot solve the problem by coordination.

And the “income elasticity of demand for imports” is what non-price competitiveness is about. It is true price adjustments have a role to play but this has been massively exaggerated by economists.

That’s a model way of saying that competitiveness is important and that in a world of free trade, if domestic demand is boosted and if exports aren’t growing sufficiently fast, a fast rise in output will lead to an income-induced effect on imports and the balance of payments will deteriorate.

Ignoring revaluation gains/losses, a current account deficit implies a rise in net indebtedness to foreigners (or a fall in net international investment position in general). Non-residents are continuously making choices on their portfolio allocation and based on their preferences allocate their wealth into various assets including the liabilities of resident economic units of the nation we are discussing. In general they prefer a mix of assets in domestic and foreign currencies and such things depend on a lot of things such as expected returns on assets, expectations of the movement of the exchange rate and so on. At one extreme is the case where all liabilities of residents to non-resident are denominated in the domestic currency. If this increases, the exchange rate may move to clear the supplies of assets and liabilities. But it is possible that no movement of the exchange rate – while still maintaining external stability – may clear the market and only if the government adjusts its liabilities in various currencies so that the stocks of assets and liabilities are consistent with international investors’ portfolios will it lead to some stability in the foreign exchange markets. In practice the adjustment is also from the asset side: central banks sales of foreign currency in the foreign exchange market. So with the risk that the exchange rate may become unstable, central banks or the government Treasury – sometimes via their “exchange stabilization fund” issue debt in foreign currency. And unable to take protection for trade in goods and services, they suffer when balance of payments deteriorates.

So the Neochartalist story that somehow the government shouldn’t borrow in foreign currencies is vacuous. Only a few nations have the ability to attract investors to purchase their debt in domestic currency and typically these nations are successful in international trade. But this by no means guarantees continued success – if net indebtedness to foreigners keeps rising relative to output because trade in international markets for goods and services turns weak, then output gives in. And a shift in investors’ portfolio preferences also can lead to the original sin, even if one starts with zero government debt in foreign currency.

In general however, success in international trade leads to further success and failure leads to more failure. And the latter are unable to increase domestic demand by fiscal or monetary policy. Hence we see the massive differences in the national income of nations.

The culprit of all this is of course free trade. Economists now admit they had been incorrect on things such as capital controls (ie their pre-crisis notion that capital controls are bad) that but nobody wants to change the current rules of the game in international trade in goods and services. If anything more free trade is imposed.

Now the backfire effect: in the “modern monetary theory” blogs, examples such as those of Pakistan are presented as if it was Pakistan’s policy makers huge error to have borrowed in foreign currency and to their fans this appears to strengthen the view that in the supposed world which the Neochartalists fantasize, there is no balance-of-payments constraint. And the error is the failure to recognize that “money” has an international aspect in addition to what it has to do with the government and banks.

At present, the solution is for the world leaders to provide a coordinated fiscal expansion and induce the creditor nations to increase domestic demand and hence increase latter’s level of imports. But the long term solution is to move away from a system of free trade. And that is far from the “MMT” overkill description of the world and overly simplified solutions.

Updated: 25 Feb 2014, 3:12 AM UTC