Tag Archives: wynne godley

The Economist And Brad Setser On Current Account Surpluses

There is no branch of economics in which there is a wider gap between orthodox doctrine and actual problems than in the theory of international trade.

– Joan Robinson, The Need For A Reconsideration Of The Theory Of International Trade, 1973

Orthodox trade theory tells us that the “market mechanism” should work to resolve imbalances in the current account of balance of international payments. Although, the economics profession has conceded that Keynesianism is correct, it is still far from thinking clearly about international trade.

So it is a bit surprising that The Economist would say something unorthodox about this. In a recent article it complains about Germany:

The Economist On German Fiscal Policy And Trade Surpluses

link

This is the Post-Keynesian idea that surplus economies put a burden on deficit economies.

A fiscal expansion by the German government has the effect of raising domestic demand and imports and reducing the German current account balance of payments. This allows the rest of the world to grow both because of German imports and also because they are less “balance-of-payments constraint”.

Second, Brad Setser has a blog post on the current account surplus of the Republic of Korea (South Korea).

It’s impressive to see Setser get the causality right:

Fiscal policy alone doesn’t determine the current account (even if tends to be the biggest factor in the IMF’s own model). A boom in domestic demand, for example, would improve the fiscal balance and lower the current account surplus, just as a fall in private demand improves the current account balance while raising the fiscal deficit.

The current account balance, government’s budget balance and the private sector financial balance are related by an identity and sum to zero. But the identity itself shouldn’t be confused with causation.

The correct causation between the balances is between domestic demand and output at home versus abroad. This causality has been highlighted by Wynne Godley in the past. See more on this blog post by me here.

 

Link

New Bank Of England Paper On The Financial Balances Model For The United Kingdom

Stephen Kinsella is out with a new paper with co-authors Stephen Burgess, Oliver Burrows, Antoine Godin, and Stephen Millard published by the Bank of England.

From the paper:

Our paper makes two contributions to the literature. First, we develop, estimate, and calibrate the model itself from first principles as well as describing the stock-flow consistent database we construct to validate the model; as far as we know, we are the first to develop such a sophisticated SFC model of the UK economy in recent years.4 And second, we impose several scenarios on the model to test its usefulness as a medium-term scenario analysis tool. The approach we propose to use links decisions about real variables to credit creation in the financial sector and decisions about asset allocation among investors. It was developed in the 1980s and 1990s by James Tobin on the one hand, and Wynne Godley and co-authors on the other, and is known as the ‘stock-flow consistent’ (SFC) approach. The approach is best described in Godley and Lavoie (2012) and Caverzasi and Godin (2015) and underpins the models of Barwell and Burrows (2011), Greiff et al. (2011), and Caiani et al. (2014a,b). Dos Santos (2006) describes how SFC models incorporate detailed accounting constraints typically found in systems of national accounts. SFC models allow us to build a framework for the model where every flow comes from somewhere in the economy and goes somewhere, and sectoral savings/borrowings and capital gains/losses add or subtract from stocks of wealth/debt, following Copeland (1949). Accounting constraints allow us to identify relationships between sectoral transactions in the short and long run. The addition of accounting constraints is crucial, as one aspect of the economy we would like to model is the way it might react differently when policies such as fiscal consolidations are imposed slowly or quickly

4 Such models were popular in the past; for example Davis (1987a, 1987b) developed a rudimentary stock flow consistent model of the UK economy.

[The title of this page is the link]

Simon Wren-Lewis On Wynne Godley’s Models

Simon Wren-Lewis has an article on his blog on stock-flow consistent/coherent models by Wynne Godley. Unlike other articles, this has a more engaging tone and isn’t dismissive.

This is a  good thing but it has the tone “Oh, there’s hardly anything new” about stock-flow consistent modeling and the sectoral balances approach. 🤦. To me this is highly inaccurate, to say the least. None of the models outside SFC models —with one exception—come anywhere close to the important question about what money is and how money is created. Even in the Post-Keynesian literature, while there are various non-mathematical approaches, there’s hardly anything that comes close. That important exception is the work of James Tobin as is summarized in his Nobel Prize lecture Money and Finance in the Macroeconomic Process. Except that Wynne Godley’s model greatly improve upon the deficiencies of Tobin’s approach.

The sectoral balances approach is a mini-version of stock-flow coherent modeling. Wren-Lewis seems to say there’s hardly anything great and don’t tell much. First, almost nobody was making a cri de coeur as much as Wynne Godley. Second, the approach makes it clear why a huge recession was coming. This is because US private expenditure was rising faster than private income and the US private sector was in deficit for long and the private sector was accumulating debt on a huge scale relative to income. It’s difficult to say when this would have reversed pre-2007, but had to reverse. Once this is reversed, i.e., when private expenditure slows relative to private income, so that the private sector goes into a surplus, output will fall as a result of a slowdown of private expenditure.

Moreover, the US economy had a critical imbalance in its trade with its current account balance of payments touching almost 6.5% at the end of 2005, hemorrhaging the circular flow of national income at a massive scale.

Wynne Godley’s argument was that because of the external imbalance, the US fiscal policy will be unable to expand output to full employment easily, once the US enters a recession. Hence, he proposed import controls for the United States.

None of anybody outside Wynne Godley’s circle came anywhere close to saying anything of this sort.

But these empirical analysis is a much more complicated discussion. At a simpler level, nobody has come closer to what stock-flow coherent models achieve. All we see is economists struggling with basic questions on how money is created, what role it plays and so on.

Wren-Lewis also criticises SFC models saying they have minimal behavioural hypothesis. Now, this is far from the truth. If you write stock-flow consistent models, which are more realistic, you’ll end up with having a lot of equations and parameters. Behaviour of each “sector” is articulated in these models. How money is created by the act of loan making by banks, to how households and firms accumulate assets and liabilities, to how firms making pricing decisions and how much they produce and how much households consume. In addition, the importance of fiscal policy is articulated: how governments make spending decisions, whether government expenditure can be thought of as exogenous and how in normal times—when politicians pay attention to how much the government’s deficit and debt it has—governement’s fiscal policy can be thought of as endogenous. And crucially, the supreme importance of the government’s finance in the financial assets/liabities creation process. While most economists stop at one time-step for the expenditure process, using stock-flow consistent models, you can see the full process. Moreover, the analysis highlights the correct direction of causalities. A good example is the direction of causation from prices to money.

I want to however highlight another important point. A lot about how the economy works can be understood without going too much into behaviour. Just national accounts, flow of funds and a minimal set of behavioural assumptions would be a great progress. The rest of the profession however struggles to even understand basic flow of funds. A lot can be understood because most of the times, economists are erring on basic accounting. Hence their story doesn’t add up and produces something completely unrelated to the real world. If only economists understood this, that’ll be a lot of progress. Stock-flow consistent models are rich in behavioral analysis but even without it, understanding flow of funds with a minimal set of assumptions is the right direction.

Steve Keen On BBC HARDtalk

Steve Keen was recently on BBC HARDtalk, interviewed by Steven Sackur. It’s a nice interview. Sackur asks Keen whether he’s contrarian just for the sake for it and Keen comes up with good answers and why economic “experts” cannot be trusted.

At around 11:00, Keen also quotes Wynne Godley and his article Maastricht And All That and calls it the most prescient article ever written.

Steve Keen HARDtalk

click the picture to watch the video on YouTube.

IEO On The Euro Area’s Balance Of Payments Problems

The IEO, Independent Evaluation Office of the IMF has come up with a report The IMF And The Crises In Greece, Ireland, And Portugal in which it discusses how the IMF rejected the possibility of a balance of payments crisis in a monetary union without a full political union such as in the Euro Area.

Ambrose Evans-Pritchard of The Telegraph quotes an important passage from the report in an article:

“The possibility of a balance of payments crisis in a monetary union was thought to be all but non-existent,” it said. As late as mid-2007, the IMF still thought that “in view of Greece’s EMU membership, the availability of external financing is not a concern”.

At root was a failure to grasp the elemental point that currency unions with no treasury or political union to back them up are inherently vulnerable to debt crises. States facing a shock no longer have sovereign tools to defend themselves. Devaluation risk is switched into bankruptcy risk.

The quote is in page 25 (page 33 of pdf) of the article, linked on top of this page.

Some economists clearly saw it coming. Here’s Wynne Godley from his 1991 article Commonsense Route To A Common Europe for The Observer:

… But more disturbing still is the notion that with a common currency the ‘balance or payments problem’ is eliminated and therefore that individual countries are relieved of the need to pay for their imports with exports.

Quite the reverse: the existence or a common currency makes a country more directly dependent on its ability to sell exports and import substitutes than it was before, particularly as it will then possess no means whereby it can (in the broadest sense) protect itself against failure.

Why doesn’t it happen to a state in say the United States? This is because, there’s a federal government which is engaged in automatic fiscal transfers. Weaker states as a whole will receive more from the government than what it sends as taxes, especially during downturns. This has the effect of stabilizing the current account balance of payments of the whole region and prevents its indebtedness from exploding relative to its economic output. The Euro Area clearly does not have it.

MoneyWeek Interviews Steve Keen

In this interview, Steve Keen talks of Europe post the UK EU Referendum (“Brexit”).

Steve Keen talks of various things such as the importance of manufacturing etc. In the first four minutes, he also refers to Wynne Godley’s 1992 LRB article Maastricht And All That.

Steve Keen MoneyWeek Interview

click the picture to see the video on MoneyWeek’s website. 

Nice interview.

A few complaints. Although Steve Keen is correct about the importance of debt, he is still holding on to his equation, “aggregate demand = gdp + change in debt”. Also in the interview Keen talks of quantitative easing is about banks selling bonds to the Fed. Although banks in their role as primary dealers do sell the bonds to the Federal Reserve, the counterfactual is not banks holding all the bonds.

I also do not believe in debt jubilees (except in exceptional case such as farmers with huge debt in India). Debt jubilee is unfair to the people who didn’t go into debt. Good initiatives are things such as forgiving medical debt as done by John Oliver.

Krugman’s Envelope

Paul Krugman has an article each on his blog and for NYT Opinion on Donald Trump’s claim that he’ll take protectionist measures to improve U.S. manufacturing, especially on China.

The debate is around a paper Import Competition and the Great US Employment Sag of the 2000s by Daron Acemoglu, David Autor, David Dorn, Gordon H. Hanson and Brendan Price.

From the abstract of the paper:

Even before the Great Recession, US employment growth was unimpressive. Between 2000 and 2007, the economy gave back the considerable employment gains achieved during the 1990s, with a historic contraction in manufacturing employment being a prime contributor to the slump. We estimate that import competition from China, which surged after 2000, was a major force behind both recent reductions in US manufacturing employment and—through input-output linkages and other general equilibrium channels— weak overall US job growth. Our central estimates suggest job losses from rising Chinese import competition over 1999–2011 in the range of 2.0–2.4 million.

Now Paul Krugman explicitly agrees with this claim:

I basically agree with this conclusion, at least when we’re talking about manufacturing employment. But I’m troubled by some conceptual issues, which I think are important for interpreting the results.

As the second line of the quote shows, Krugman is reluctant to accept this. This shouldn’t be surprising. Krugman has been a champion of free trade and it will be difficult for him to accept that he has been wrong all around.

Krugman says:

… it all depends on offsetting policies. If monetary and fiscal policy are used to achieve a target level of employment – as they generally were prior to the 2008 crisis – then a first cut at the impact on overall employment is zero

First, the United States didn’t have full employment before the 2008 crisis. So fiscal policy wasn’t offsetting enough. Instead if the U.S. had taken measures to protect manufacturing, unemployment would have been lower for the same fiscal stance. But that is not enough. Even if fiscal policy had offset all loss of employment due to trade, such a policy would not have been sustainable as it would mean that U.S. public debt and the net international investment position keep deteriorating relative to gdp.

So the U.S. could have been better off taking some measures such as non-selective protectionism as recommended by Wynne Godley in 1999 in his article Seven Unsustainable Processes.

Second Krugman’s claim is that instead of purchasing manufactured imports, U.S. economic units would have non-manufactured imports. That is partly true, if the protectionism measure was selective. But even here, output would have been higher even if total imports were the same, non-manufactures instead of manufactures. In other words, what is more important is the import propensity, not imports itself.

In all, putting tariffs on trade can be highly expansionary for the U.S. economy and employment. China’s economy has expanded massively and has damaged the U.S. economy. China is in a position to expand output by boosting domestic demand rather than relying on exports because its international investment position is quite solid and it need not worry about balance of payments problems if it does so. Instead, China has a massively undervalued exchange rate and it gives unfair advantage to China. It is sometimes said that China should float its currency freely in the foreign exchange markets. Although this step would be great, it still relies on the market mechanism to solve problems and is not guaranteed to work. Who knows how much China’s currency would appreciate? Maybe it just appreciates 10% and not more. Moreover, it is not just China. U.S. faces competition from various other nations as well. So a non-market mechanism is needed such as non-selective protectionism. This will help the U.S. expand output without its debts rising in an unsustainable way.

Krugman’s back-of-the-envelope calculations are not really something which are obvious and the first cut to a right answer. The flawed ideology of free trade is behind Krugman’s numbers.

Needless to say, all this is not an endorsement of Trump. Strange times, when we defend politicians whose ideology we do not like. Even Bernie Sanders is not pro-free trade, although he hasn’t been as explicit as Trump.

Finally, on manufacturing versus services, Krugman says:

No matter what we do on trade, America is going to be mainly a service economy for the foreseeable future. If we want to be a middle-class nation, we need policies that give service-sector workers the essentials of a middle-class life.

I don’t understand what economists dislike so much about manufacturing. “Going to be” is different from whether it is correct to be and not do anything about manufacturing. It’s not a logical argument to say, “Oh! we are a service economy, manufacturing has lost its importance”. Because the U.S. manufacturing deficit was $831 bn in 2015.

Wynne Godley On The EU

In the previous post, I highlighted Nicholas Kaldor’s view on the EU. I want to quote Wynne Godley’s views as well. Wynne Godley was highly influenced by Nicholas Kaldor so it is not surprising his views were similar.

In an article Wynne Godley Asks If Britain Will Have To Withdraw From Europe, written for London Review Of Books, written in October 1979, Godley writes:

The implications for Britain of EEC membership are rapidly becoming so perversely disadvantageous that either a major change in existing arrangements must be made or we shall have, somehow, to withdraw.

I strongly support the idea of Britain’s membership of the Common Market for political and cultural reasons. I would also support co-ordinated economic policies which were mutually advantageous to all the member countries. But this is not what we have got at the moment.

So we are all to be losers. The taxpayer through the Budget contribution, the consumer through higher food prices, the farmer through costs rising more than selling prices, and the manufacturer through rapidly rising import penetration.

… And if we may also take into account the dynamic effects, our balance of payments would be better by several thousand million pounds than it is at present. This would by itself have had a favourable effect on real national income and output, but, more important, it would have enabled the Government to pursue a less restrictive fiscal and monetary policy. According to preliminary estimates, the real national income could have been at least 10 per cent higher than at present and the rate of price inflation several points lower than if we had never joined the EEC.

The UK Should Leave The EU

It’s the United Kingdom European Union membership referendum tomorrow. In my opinion, the UK should leave the EU.

When discussing the Euro Area, it is emphasized frequently that Euro Area governments do not have the power to make expenditures by making drafts at the central bank as argued by Wynne Godley in 1992:

It needs to be emphasised at the start that the establishment of a single currency in the EC would indeed bring to an end the sovereignty of its component nations and their power to take independent action on major issues. As Mr Tim Congdon has argued very cogently, the power to issue its own money, to make drafts on its own central bank, is the main thing which defines national independence. If a country gives up or loses this power, it acquires the status of a local authority or colony. Local authorities and regions obviously cannot devalue. But they also lose the power to finance deficits through money creation while other methods of raising finance are subject to central regulation. Nor can they change interest rates.

The Euro Area was formed because Europeans wanted to come together and create a union which is big and powerful enough to be not affected by financial markets. The original intent was right but soon the whole idea came to be influenced by neoliberalism. The thing which was hugely missing (“the incredible lacuna” in Wynne Godley’s words in the above cited article) was the absence of central government of the Euro Area itself, which will have the power to collect taxes from Euro Area economic units and make expenditures. After some years of boom, the Euro Area found itself in crisis and could not deal with it well because there was no central government and fiscal policy to the rescue. The European Central Bank tried to save the monetary union but isn’t as powerful enough as a central government. More importantly, the Euro Area was brought into existence with the idea of free trade. Not only was power taken away from relatively economically weaker nations such as Greece but free trade was imposed by bringing their producers compete in the common market. In summary, there were two reasons why some Euro Area nations suffered.

  1. The monetary arrangement
  2. The common market.

Typically the former is emphasized more than the latter. Perhaps the reason is simple. It is easier to explain the former than the latter. In my experience, the latter is more difficult for people to understand and appreciate. Very few have emphasized it. Few exceptions are: Nicholas Kaldor, Wynne Godley.

Because economic growth is “balance of payments constrained”, free trade is devastating. The Euro Area could have had free trade if it had a central government which keeps imbalances in check because of fiscal transfers and regional policies.

Which brings us to the European Union itself and Britain’s membership. Although the UK government neither didn’t surrendered its sovereignty to make drafts at the central bank nor irrevocably fix the exchange rate in 1999, the nations’ producers still compete in the common market. It is better off leaving the European Union and have powers to impose tariffs on imports. Free trade is destructive to trade and one needs a lot of protection – at least the power of the optionality to impose such things any time a nation needs.

It was surpising to see less heterodox noise on this.

Nicholas Kaldor wrote a lot on this in the 1970s before the United Kingdom European Communities membership referendum in 1975. In his Collected Economics Essays, Volume 7, Nicky wrote (Introduction, page xxvi, October 1977) :

The final section of this volume, Part III, reproduces papers written in the course of the “Great Debate” on the question of British Membership of the Common Market in 1970 and 1971, and includes as a postscript a lecture on Free Trade written in 1977. As this debate came to an end when Britain entered the market, a decision which was later confirmed in popular referendum with a 2:1 majority, the reproduction of these papers may strike as otiose and serving little purpose other than somewhat ignoble one of self-vindication in the eyes of future historians. However, if the long-run effects of our membership turn out to be as disastrous as I feared they would be in 1971—and nothing that has happened has caused me to change my views—I think it is of the utmost importance that the true arguments against membership should be accessible to successive generations of students, the more so since the political debate continues to be dominated by issues (such as our effects of membership on the cost of food, on our agriculture, or the net budgetary cost of membership) which I regard as secondary and which could be brushed aside if the long-run effects on Britain’s manufacturing industry and on our capacity to provide employment were favourable.

[page xxviii] … the last essay of this volume, “The Nemesis of Free Trade”, which recounts the arguments in the great debate on Free Trade and Protection conducted at the beginning of this century between Herbert Asquith and Joseph Chamberlain. The points made on both sides seem to have lost none of their freshness or relevance in the intervening years. What has changed is our freedom to act. In 1905 we were free to decide whether to continue with the policy of free imports or to protect our industries. In 1977 the choice is no longer open to us, except at a political cost of withdrawing from the Common Market, an act which few people would contemplate seriously so soon after accession.

But after so many years, here is the chance to undo all this and withdraw from the EU. The UK should leave the EU.

Output At Home And Abroad

It’s fairly common for economists to confuse accounting identities and behavioural relationships.

Question: What is the best way to find it?

Answer: The behaviour of output (at home and abroad) is not discussed in their analysis.

It’s not always the case that it’s true but a good way to find – check whether the economist is talking of the effect of changes in stocks or flows on output.

It’s also of course important to discern what someone is literally saying and what that person is trying to say. Economists aren’t the best communicators. For example, consider the sentence: “(fiscal) deficits increase growth and surplus reduces it”. This is far from accurate because the fiscal deficit is an output of a model (and everyone has a model implicitly), not an input. It’s better to state whether the fiscal policy under discussion is expansionary or contractionary. So let’s say that private expenditure rises relative to income for whatever reason, such as expectations of the future. This leads to a rise in output and hence taxes and the fiscal deficit will reduce and we have a rise in output coincident with a fall in fiscal deficit. But neither fiscal deficit or surplus caused that growth. At the same time, one should also try to check what the narrator is trying to say. So if someone says “deficit spending is needed”, he or she is actually trying to say, “an expansionary fiscal policy is needed”.

It doesn’t harm to be accurate or try to be accurate.

One of the worst mistake of this kind being discussed is using the identity (in the case of a closed economy):

G − T = S − I

where G, T, S and I are government expenditure, taxes, private saving and private investment respectively.

A careless look at this would led one to conclude that “deficits reduce investment”. What the economist who claims this is saying is that an fiscal expansion (rising government expenditure and/or reduced tax rates) decreases investment. The error in this is that, saving is thought to be constant. However, using a Keynesian stock-flow consistent model, it is not difficult to see that a fiscal expansion has an expansionary effect on output which will raise private investment and also private saving (assuming saving propensities are constant).

More generally, the equation is:

G − T + CAB = S − I

in the general case of the open economy. In the above CAB is the current account of the balance of payments. Also balance of payments accounting tells us that current account balance is equal to the net lending to the rest of the world. In the old balance of payments terminology, this is equal to the negative of the capital account balance.

So we have:

CAB + KAB = 0

Or

NL = CAB

in the modern balance of payments terminology, where NL is the net lending of resident economic units to the rest of the world.

This has led to various theories about how what causes trade imbalances. A careless conclusion which can be drawn by looking at the last equation is that an increase in private saving or a reduction in the government expenditure reduces the trade balance. Although in this case it’s true, this happens via a reduction of output.

Another strange hypothesis is to say that it’s net borrowing (the opposite of net lending) from the rest of the world which causes current account deficits. Some authors such as Michael Pettis have taken this to extreme.

Wynne Godley was one economist who made heavy use of the accounting identity.

G − T + CAB = S − I

In his view, the causal relationship linking the balances is via output at home and abroad. 

In his 1995 article, A Critical Imbalance in U.S. Trade he says:

… an accounting identity, though useful as a basis for consistent thinking about the problem can tell us nothing about why anything happens. In my view, while it is true by the laws of logic that the current balance of payments always equals the public deficit less the private financial surplus, the only causal relationship linking the balances (given trade propensities) operates through changes in the level of output at home and abroad. Thus a spontaneous increase in household saving or a spontaneous reduction in the budget deficit (say, as a result of cuts in public expenditure) would bring about an improvement in the external deficit only because either would induce a fall in total demand and output, with lower imports as a consequence.

In this post, I want to highlight how capital flows can impact trade balances using my experience with experimenting with stock flow consistent models. Before that, it’s important to note a few things which are often forgotten.

An import by a resident economic unit is a decision to purchase a good or a service produced by a non-resident producer. Similarly exports of a nation is indicative of the relative competitiveness of producers at home in international markets. It cannot be said to be caused solely by capital flows. But it’s not so simple. Imports for example depend on incomes of resident economic units and capital flows can have an impact on imports because they can affect output and income.

But it’s vacuous to say that current account imbalances are caused solely by capital flows as many economic commentators claim implicitly or explicitly.

It’s easy to commit the mistake and think that imports depend solely on prices of goods and services.  The world is not so simple. If every good or service is exactly the same, then it’s all about prices. However, producers produce thousands of different goods and services. So both price and non-price factors matter in determining imports. Even for similar goods, such as cars, consumers tend to prefer foreign produced cars over domestically produced ones even if the former is much more expensive simply because consumers are not just looking at the price but also quality, durability, looks and design and so on.

So both price competitiveness and non-price competitiveness are important. The way these things are modelled in literature is by using price and income elasticities. Imports depend on price via terms involving price and price elasticities and on income via terms involving income and income elasticities.

Where can we then look for causal connection of impact of capital flows on trade balance?

Before this it is important to keep in mind that gross capital flows can be compensated gross flows in the other direction. So to look for a causal connection in the accounting identity:

NL = CAB (or “CAB + KAB = 0″)

is silly to begin with.

So here are some ways in which capital flows can cause have an impact on trade balances.

  1. Capital flows cause exchange rates to move. With floating exchange rates, the exchange rate is the price which clears the supply and demand for assets of currencies. Note, in a correct model of exchange rates, supply and demand for all assets should be included not just “money” or “currency”. Exchange rate movement impact prices of goods and services. Since imports and exports depend on prices of goods and services (among other things), capital flows impact trade balance. It’s of course important to keep in mind producers’ own pricing behaviour: If the Japanese Yen appreciates by 30% against the US dollar, it’s not necessary that Japanese producers will raise prices of their goods in the U.S. market by 30%. They might raise the price only by 10%. But this is a digression, the important point being that capital flows cause changes in prices of imports and exports and hence the trade balance.
  2. Long term interest rates are both due to expectations of short term interest rates and portfolio preference for assets such as government bonds with long maturities. Long term Interest rates have an effect on aggregate demand which has an effect on output and income and hence imports.
  3. Capital flows can cause asset price booms, such as a stock market boom and via the wealth effect, cause changes in output and income and hence imports.
  4. There’s a further complication. Suppose there’s a large capital inflow into equities. This can cause switch of resident holders of equities (issued by resident economic units) into newly produced houses. This has an effect on aggregate demand and output and hence income and imports. This mechanism is slightly different from the wealth effect in point 3. It’s more a flow effect. Also in my opinion, it’s not easy to model this because one has to keep in mind gross capital outflows in balance of payments as well.
  5. Purchase of new houses by non-residents: Depending on regulations in the land, foreigners can directly purchase houses – such as a vacation house in Greece or to speculate on house prices such as in London. There can even be foreign investment funds which can speculate by buying houses and commercial property. This has the effect on aggregate demand and output and income and hence imports.
  6. Securitization allows banks to package loans on their balance sheet and sell it to investors. This allows banks to reduce risks and because of this they can make more loans which they may not have made without securitization. More lending means higher aggregate demand and output and income and affects imports.
  7. Direct investment: Direct investment is a more complicated example. Direct investment can raise output by various means, such as causing rising business domestically, employing people. They not only have an effect on the trade balance because of their international nature but also because their profits affect balance of payments. Also one has to be careful: sometimes direct investment is confused with the in the identity: G − T + CAB = S − I. Needless to say, this is confusing the different meanings of “investment”.
  8. Large capital outflows can cause a large depreciation of the currency and impact a nation’s fiscal policy. If there are large gross outflows, a government may be forced to deflate domestic demand and output to reduce imports. The flip-side is that large capital flows can keep a bubble from busting for long.

On Twitter, T Srinivas mentioned to me that desire to accumulate reserves may cause nations to depress demand and hence lead to lower exports for other nations, citing the example of events following the Asian Crisis in the late 90s. This is partly included in 8. Although I don’t disagree, my points are more about flows caused due to changes in investor preferences themselves.

Of course it touches an important point. Low domestic demand and output in “surplus” nations leads to a positive net lending to the rest of the world. It’s more accurate to say that the current account deficit of “deficit” nations is because of low domestic demand and output than because of capital inflows to those “deficit” nations. So it’s not “saving glut” but demand shortage, beggar-my-neighbour policies.

In conclusion it is counterproductive to use the accounting identity

NL CAB

(or the same identity in the slightly misleading language CAB + KAB = 0) to claim a causation from capital flows to current account balance.

An example is this paragraph from Michael Pettis:

… This is one of the most fundamental errors that arise from a failure to understand the balance of payments mechanisms. As I explained four years ago in an article for Foreign Policy, “it may be correct to say that the role of the dollar allows Americans to consume beyond their means, but it is just as correct, and probably more so, to say that foreign accumulations of dollars force Americans to consume beyond their means.” As counter-intuitive as it may seem at first, the US does not need foreign capital because the US savings rate is low. The US savings rate is low because it must counterbalance foreign capital inflows, and this is true out of arithmetical necessity, as I showed in a May, 2014 blog entry.

It’s an extreme viewpoint. During the crisis, there was a large foreign demand for US public debt but this didn’t cause a rise in U.S. imports. Similarly, a central bank intervening in the foreign exchange market and buying U.S. dollars from U.S. resident economic units doesn’t cause U.S. imports to rise in the few seconds. (Accounting identities also hold for time periods of seconds!) It’s balanced by gross U.S. capital outflows.

Capital flows can impact trade balances but it has really nothing to do with this identity. The causal link is still output and home and abroad (and some due to price changes of goods and services due to exchange rate movements).