Monthly Archives: March 2012

Balance Of Payments: Part 1

Posted on by
Leave a reply

This is the first part of a series of posts I intend to write on the “rest of the world” accounts in National Accounts. This blog is about looking at economies from the point of view of National Accounts, Cambridge Keynesianism and Horizontalism. While various descriptions of balance of payments exist, most of them simply end up making money exogeneity assumption somewhere in the description!

In my view a careful description of balance of payments offers great insights on how economies work and what money really is. It is impossible to understand the success and failures of nations without understanding the external sector.

A description in terms of stocks and flows is the most appropriate for macroeconomics. Fortunately, national accountants have a good systematic approach to this.

Consider the following transaction: a government (or a corporation) raises funds in the international markets. The buyers can be residents as well as non-residents. The currency of the new issuance can be domestic as well as foreign. Does this by itself increase the net indebtedness of the nation as a whole?

The answer is No, and can be a bit surprising to the reader because the answer is the same whether the currency is domestic or foreign. The trick in the question is that an issuance of debt increases the assets and liabilities of the issuer!

(Note: the question was about the transaction, not on what happens after this)

Gross assets and liabilities vis-à-vis the rest of the world can be a bit more complicated and we need a more systematic analysis.

Consider another transaction. A government is redeeming a 7% bond with a notional of 1bn with semi-annual coupons. How much does the net indebtedness of the country change? Assuming that all the lenders are in the rest of the world sector, the net indebtedness changes by 35m. Does not matter if the currency is domestic or not. Why 35m? Because the semi-annual coupon has to be paid on redemption and the coupons are interest payments and this is recorded in the current account and this increases the net indebtedness. The principal payment cancels out the earlier liability – the bonds.

So between the start and the end of the period, foreigners earned 35m and this increased the net indebtedness of the nation who paid the interest. Of course there are other transactions which can cancel this out.

In another scenario, if all the bond holders were residents, the net indebtedness does not change – whether the bonds were in domestic currency or not.

The above was about financing. What about imports and exports? Exports provide income to a nation or a region as a whole and imports are opposite. If a nation is a net importer (more appropriately running a current account deficit), this means its expenditure is higher than income. When expenditure is higher than income, this has to be financed and this is via net borrowing. 

There is one important point worth stressing. Many people – including many economists (most?) – treat liabilities to foreigners in domestic currency as not really a liability at all – at least the government’s liabilities. The reason provided is that while usually the government is forbidden from making an overdraft at the central bank or have limited powers in using central bank credit, it can end up making a higher use of it than the limits allowed – in extreme conditions. This in my opinion, is a silly intuition.

While it is true that the governments of most nations (with exceptions such as the Euro Area governments) can make a draft at the central bank and this offers the government protection to tide over extreme emergencies, the government has to directly or indirectly finance the current account deficits and this can prove unsustainable. Despite this there is an advantage in having indebtedness to foreigners in the domestic currency because:

An indebtedness to foreigners in domestic currency prevents revaluation losses on the debt if foreigners continue holding the debt and if the currency depreciates against foreign currencies. If the debt is denominated in a foreign currency and if it depreciates, more income needs to be earned from abroad to service the principal and interest payments.

The discussion can be confusing because of the relative ease with which the United States has managed till now to finance its current account deficits because the US dollar is the reserve currency of the world and continues to do so and the holders are willing to accept liabilities of resident sectors of the United States, especially the government’s at low interest rates/yields.

James Tobin, who has provided the best description of the meaning of government deficits and debt said this in an article “Agenda For International Coordination Of Macroeconomic Policies” (Google Books link)

Nonzero current accounts must be financed by equivalent capital movements, in part induced by appropriate structure of interest rates.

We will discuss this further in many posts and for now here’s a good illustration of how the balance of payments accounts are kept. This is from the Australian Bureau of Statistics’ manual Balance of Payments and International Investment Position, Australia, Concepts, Sources and Methods, 1998

(click to enlarge)

So, one starts out with the international investment position and records the transactions in the current account and the financial account. The difference is that the former records income/expenditure flows while the latter records financing flows. The current account includes items such as imports, exports, dividends, interest payments paid to/received from non-residents etc., while the capital account records transactions such as residents’ purchases of assets abroad, increase in liabilities to non-residents and so on. Since debits and credits equal, the balances in the two accounts cancel out. To calculate the international investment position, we add the financial account flows and calculate revaluations to reach the end of period international investment position.

The international investment position records assets and liabilities vis-à-vis the rest of the world. If the difference – the NIIP – is negative, it means the nation is a debtor nation. In the construction above, all transactions between residents and non-residents are recorded – whether in domestic or foreign currency. The numbers are then converted to the domestic currency according to the best rules prescribed by national accountants.

We will look into these in more detail – including all causalities of course – in later posts in this series. Till then, the summary is: imports are purchased on credit. 

€2.2 Trillion

Posted on by
Leave a reply

Found this graph at this hilarious blog which quotes Diapason Research. The graph plotted by the researchers uses cumulative current account balances from IMF’s data. I instead directly used the Net International Investment Position at the end of Q3 2011 from Eurostat.

The blue bars plot the net indebtedness of each EA17 nation (with signs reversed) and the red line is cumulative from left to right. It does not sum to zero because the Euro Area as a whole is a net debtor of the rest of the world.

The indebted European nations owe their creditors €2.2tn – which is almost 40% of the gdp of these nations as a whole.

An alternative way to plot the NIIP- in ascending/descending order as a percent of gdp. Readers of the Concerted Action blog will know that I love the NIIP! I just found a nicer way to plot this. The alternative graph is below:

Deutsche Bundesbank’s TARGET2 Claims

Posted on by
Leave a reply

Yesterday Wolfgang Münchau wrote an article in the Financial Times The Bundesbank has no right at all to be baffled in which he gave his opinion about Bundesbank President Jens Weidmann’s leaked letter to the European Central Bank President  Mario Draghi expressing concerns on the Bundesbank’s TARGET2 assets.

According to the Bundesbank December 2011 Monthly Report, its claims on the rest of the Eurosystem was around €476bn (and that it reduced somewhat in December!)

According to Münchau,

The Bundesbank initially dismissed the Target 2 balance as a matter of statistics. Their argument was: yes, it is recorded in the Bundesbank’s accounts, but the counterparty risk is divided among all members according to their share in the system. But last week, Jens Weidmann, president of the Bundesbank, acknowledged the Target 2 imbalances are indeed important, and an unacceptable risk. The Bundesbank has now joined the united front of German academic opinion.

and that:

One would assume that the best policies would be those that attack the root of the problem – the imbalances themselves. One of the deep causes behind this problem is, of course, Germany’s persistent current account surplus. The problem can thus easily be solved through policies to encourage Germany to raise its imports relative to its exports. You need policies that provide eurozone-wide backstops to the banking sector, and also policies to insure against asymmetric shocks. And you need to harmonise many aspects of structural policy to ensure imbalances do not become entrenched.

But there is no appetite for any of this in Germany. Instead, the Bundesbank prefers to solve the problem by addressing the funding side. Mr Weidmann proposed last week that Germany’s Target 2 claims should be securitised. Just think about this for a second. He demands contingent access to Greek and Spanish property and other assets to a value of €500bn in case the eurozone should collapse. He might as well have suggested sending in the Luftwaffe to solve the eurozone crisis. The proposal is unbelievably extreme.

This is indeed extreme but there are ones who argue that the Bundesbank’s (approximately) €476bn TARGET2 assets do not matter much – because the Bundesbank being the issuer of settlement balances of banks cannot go broke. This is from the Irish Economy Blog:

First, every national central bank in the Eurosystem currently has assets that exceed their liabilities and total Target2 credits equal Target2 liabilities. Thus, the most likely resolution of Target imbalances in the case of a full Euro breakup would be a pooling of assets held by Target2 debtors to be handed over to Target2 creditors to settle the balance. This may leave the Bundesbank holding a set of peripheral- originated assets that may be worth less that face value but this scenario would result in losses to the Bundesbank that would be far short of the current value of its Target2 credit.

Second, as Gavyn Davies discusses in this interesting FT article, central bank balance sheets are simply not the same as normal private sector balance sheets. It is unwise for central banks to go around printing money to purchase worthless assets so it is generally appropriate to insist that a central bank’s assets at least equal the value of the money it has created.

That said, should the Bundesbank end of losing a bunch of money because its Target2 credit was worth less than stated, there would be no earthly reason why the German public would need to give up large amounts of money to ensure that the Bundesbank remained “solvent”.

In a post-euro world, the Bundesbank would be one of a select number of central banks that could be counted on to print a currency likely to retain its value. Weidmann could write himself a cheque, stick it in the vaults and declare the Bundesbank to be solvent without any need to call on the German taxpayer.

I had written on this sometime back in the post Who is Germany? so I refer the reader to the post. Briefly my argument is that the TARGET2 balance is an important item in Germany’s International Investment Position. If there is a breakup of the Euro Area, then Germany’s wealth reduces. Indeed Karl Whelan has somewhat changed his position – from arguing it doesn’t matter to arguing that there will be a demand for settlement!

Matters can get worse in case there is a dreadful scenario in which the financial firms do a panic selling of assets in the Euro Area but held outside Germany and make a “flight to quality” to Germany. This by itself does not change Germany’s net international position (only gross items in IIP) but if the breakup results in a default by the “periphery”, Germany’s wealth erodes (among other assets, TARGET2 claims vanish overnight) and it can become a net debtor of the rest of the world from being a net creditor!

National Balance Sheet

In one of my recent posts, I went into the concept of “National Saving”. The stock counterpart of this is the “Net Worth”. It is calculated by first taking the nonfinancial assets within a nation’s boundary (defined appropriately on what is counted and what is not). Then one adds financial assets and liabilities. The claims within sectors of an economy cancel out because every asset has a counterpart liability and one is left with assets and liabilities with the rest of the world.

This is the SNA concept of net worth. It is done for example for the case of Australia in the following manner by the Australian Bureau of Statistics. (Link to the full release Australian System of National Accounts 2010-11)

So if a nation’s external assets are impaired for whatever reason, its wealth reduces. It doesn’t matter if it is the central bank whose assets are impaired. This is counter-intuitive because no sector immediately may “feel the pinch” due to the central bank’s loss of assets held abroad.

That’s a bit of Mercantilism. It is true that Mercantilist policies “injures everyone alike” as argued by Keynes himself and later by many Post Keynesians (such as Basil Moore whom I quoted in this post). However, it cannot be argued that a potential asset impairment of the Bundesbank’s TARGET2 balance does not cost the German taxpayer. So the Bundesbank would indeed go behind debtor nations and ask them to settle claims!

Needless to say, this is no defense of Weidmann’s position!

Recycling Old Posts

Here are some related posts on basics of TARGET2 and the Eurosystem: The Eurosystem: Part 1, Part 2, Part 3, Part 4, & Part 5.

Ya He Averiguado Lo Que Es La Economía

Posted on by
Leave a reply

– es la ciencia de confundir los stocks con los flujos.

Or …

I have found out what economics is; it is the science of confusing stocks with flows.

– A verbal statement by Michal Kalecki, circa 1936, as cited by Joan Robinson, in ‘Shedding darkness’, Cambridge Journal of Economics, 6(3), September 1982, 295–6 and quoted in Monetary Economics written by Wynne Godley and Marc Lavoie. And that’s how Chapter 1 starts and the authors aim to straighten out the messes of the profession and set the confusions straight!

Javier López Bernardo has translated the book in Spanish and here’s the publisher’s website for the book. The publisher’s preview is here.

The author has also implemented the models in Microsoft Excel and you can find them here. I try do that myself but it’s not in such a neat form.