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.

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