Tag Archives: balance of payments

Limits To Growth, Part 3

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Digression

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

Limits To Growth?

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There has been a debate led by vicious attack by Paul Krugman that Bernie Sanders’ plans cannot achieve growth of 5.3%. And there have been replies by others.

Coming from a third-world country and seeing an annual growth rate of about 8% in the 10 years of the rule of the UPA government (mid 2004-mid 2014), —meaning real GDP more than doubling in 10 years — despite a global financial crisis and economic slowdown, it appears comical to me that Paul Krugman claiming such a thing is not possible for the United States.

I am a bit unsympathetic to those who quote historical data to try to sneak in an argument that 5.3% is possible. It sounds too apologetic.

If the U.S. fiscal policy was run with a restrictive bias since a long time, there is obviously a huge deflationary bias imparted by policy. So you cannot use that data to either argue one way or the other. The ones using data to try to show it’s possible are playing into the hands of economists such as Paul Krugman whose writing appears nothing but a support for Hillary Clinton.

For a closed economy, the only constraint to growth is the capacity to produce. The United States’ economy suffers no such constraint. At full employment, growth is constrained by rises in productivity and addition to the working population. But productivity itself is endogenous to production because of learning by doing. In addition, rises in incomes motivate people to work harder.

So imagine an economy in which the government’s fiscal stance is held constant for 10 years – i.e., the government expenditure and the tax rates are held constant. Output might fluctuate and even grow but finally the deflationary bias in fiscal policy will drag growth. But you cannot average out 10 years of economic data of hardly any growth to argue out that the economy cannot grow for the next n years.

But things are not easy. What surprises me is that in none of these discussions from either side, is there any discussion of the U.S. balance of payments. The U.S. does not have exports of just a couple of hundred billions and a GDP of some $16 tn. It has exports of about $2.5 tn and GDP of about $16 tn, meaning the GDP is a few multiple of exports. The United States is a net debtor to the rest of the world. So a rapid rise in growth by any means will come at the expense of terribly deteriorating balance of payments which cannot last long.

Of course the above doesn’t mean that things are as pessimistic. It depends on what is going on in the rest of the world and the United States being the economic center of world activity can convince others to boost their economies and there is no reason to assume that it cannot. if there is rapid growth in other economies, the U.S. balance of payments is not something to worry about.

The importance of balance of payments is seriously missing in all discussions. Use of historical data is so wrong here.

tl;dr summary: supply constraints cannot put a limit of some 5% on U.S. growth. It depends on policy makers’ decisions worldwide.

Neochartalism, Balance Of Payments And Mainstream Economics

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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?

y = x/π

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‘The rate of growth (y) of any developed country in the long run is equal to the growth rate of the volume of its exports (x) divided by its income elasticity of demand for imports (π)’, he [Anthony Thirlwall] explained.

Our eyes were fixed on the blackboard, attempting to digest the meaning and internalize the implications of this tri-legged animal. That job was not easy. For the animal distilled volumes of legendary work in economic development, encapsulating all of them in a small-sized anti-underdevelopment pill. The teaching of Engel’s law, which implies that the demand for primary goods increases less than proportionally to increases in global income; the Harrod foreign trade multiplier which put forward the idea that the pace of industrial growth could be explained by the principle of the foreign trade multiplier; the Marshall– Lerner condition which implies that a currency devaluation would not be effective unless the devaluation-induced deterioration in the terms of trade is more than offset by the devaluation-induced reduction in the volume of imports and increase in volume of exports; the Hicks super-multiplier which implies that the growth rate of a country is fundamentally governed by the growth rate of its exports; the Prebisch–Singer hypothesis which asserts that a country’s international trade that depends on primary goods may inhibit rather than promote economic growth; the Verdoorn–Kaldorian notion that faster growth of output causes a faster growth of productivity, implying the existence of substantial economies of scale; Kaldor’s paradox which observed that countries that experienced the greatest decline in their price competitiveness in the post-war period experienced paradoxically an increase in their market share and not a decrease; the literature on export-led growth which asserts that export growth creates a virtuous circle through the link between output growth and productivity growth – all of these doctrines were somehow put into play and epitomized within this small-sized capsule. Not only that but the capsule was sealed by the novel and powerful ingredient of the balance-of-payments constraint: ‘in the long run, no country can grow faster than that rate consistent with balance of payments equilibrium on current account unless it can finance ever-growing deficits which, in general, it cannot’.

– Mohammed Nureldin Hussain, The Implications Of Thirlwall’s Law For Africa’s Development Challenges in Growth And Economic Development Essays In Honour Of A.P. Thirlwall, 2006 

U.S. Manufacturing Deficit

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The latest U.S. trade report is out and has data for the whole year 2015. Manufacturing deficit is something worth noting.

The U.S. manufacturing deficit is $831 bn.

U.S. Manufacturing Deficit

U.S. Manufacturing Exports/Imports

It is sometimes said that manufacturing has lost its importance and that countries in balance of payments difficulties should look to trade in services to put things right. However, while it is still true that manufacturing output has declined substantially as a share of GDP, the figures quoted above show that the share of manufacturing imports has risen substantially. The importance of manufacturing does not reside in the quantity of domestic output and employment it generates, still less in any intrinsic superiority that production of goods has over provision of services; it resides, rather, in the potential that manufactures have for expansion in international trade.

– Wynne Godley, A Critical Imbalance In U.S. Trade, The U.S. Balance Of Payments, International Indebtedness, And Economic Policy, September 1995.

Krugman’s 45 Degree Rule

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Recently, Paul Krugman reminded us of his “45 degree rule” on his blog Conscience Of A Liberal. This was a reference to his paper in 1989 which was a rediscovery of Thirlwall’s Law from 1979 [1] which states that the long run rate of growth of any country is constrained by the rate of growth of exports divided by the income elasticity of imports. Krugman rediscovered this law but interpreted the causality in the opposite way. This shouldn’t be surprising because in neoclassical economics, growth is explained by a production function and it is then difficult to interpret the causality in Thirlwall’s way. In an essay [2], John McCombie explains:

Krugman (1989) rediscovered Thirlwall’s Law, which he termed the 45-degree rule, as empirically ε/π = y/z or, when the (log) of the former is regressed on the (log) of the latter, the coefficient is unity or the slope of the line is 45-degrees. (Krugman provides some empirical evidence providing further confirmation of this empirical relationship). Like McCombie and Thirlwall (1994), he rules out sustained changes in the real exchange rate as a factor in bringing the balance of payments into equilibrium. Consequently, it is necessary to explain why the rule holds. The Keynesian explanation is that it is growth rates that adjust to maintain the balance of payments in equilibrium, but this is rejected by Krugman on “a priori grounds” that it is “fundamentally implausible.” He continues that “we all know that differences in growth rates among countries are primarily determined in the growth rates of total factor productivity, not differences in the rate of growth of employment; it is hard to see what channel links balance of payments due to unfavourable income elasticities to total factor productivity growth” (Krugman, 1989, p. 1037).

The Krugman article is instructive because it goes to the heart of the question about the direction of causation. Drawing on new trade theory, monopolistic competition, and the importance of increasing returns, he argues that faster growth leads to increased specialisation and the production of new goods for sale in overseas markets. Thus high “export elasticities of demand” are due to a dynamic supply side and rapid growth, rather than vice versa.

[x is the growth of the volume of exports, π is the domestic income elasticity of demand for imports, ε is the world income elasticity of demand for exports, and z is the growth of world income]

For a more forceful defence of Thirlwall’s Law, see McCombie’s paper.

In my opinion, the causality runs in both directions. However I am more sympathetic to Thirlwall and McCombie. And because the causality runs in both directions, there is still a balance-of-payments constraint. Complex economic dynamics still benefit richer nations and immiserate others. To an extent, this is already present in Kaldorian models. Growth brings in rise in productivity and this effects price competitiveness and hence beneficial to balance of payments generally. However, I also consider the income elasticity as being affected by growth at home and abroad.

References

  1. Thirlwall, A. P. (1979) ‘The Balance of Payments Constraint as an Explanation of International Growth Rate Differences’, Banca Nazionale del Lavoro Quarterly Review, March.
  2. McCombie, J.S.L. (2011) ‘Criticisms and defences of the balance-of-payments constrained growth model: some old, some new ‘, PSL Quarterly Review, vol. 64 n. 259 (2011), 353-392. (Can be previewed on Google Books here)

Sergio Cesaratto On TARGET2 Balances

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Sergio Cesaratto has posted a reply on Matias Vernengo’s blog, replying to a paper by Marc Lavoie on economic problems of the Euro Area

For previous discussions, see the citations in that post or see my previous post on this.

Marc’s point is that because TARGET2 allows unlimited and uncollateralized credit/debit facilities between Euro Area NCBs and the ECB, the troubles facing the Euro Area are not balance-of-payments in origin.

As mentioned earlier, this however is not the thing to look at. One should look at counterparts to the intra-ESCB (TARGET2) debts. Intraday overdrafts, marginal lending facility, MRO, LTRO, ELA … none of these can rise without limit. At some point, a crisis occurs and foreigners’ help is needed.

Greece, Portugal, Ireland, Spain, Cyprus all have high negative net international investment positions. No wonder these nations have seen the most troubles.

I echo Sergio’s example (on Calabria) with a similar example of my own. If nations in a monetary union cannot face a balance-of-payments crisis, why not have the whole world join the Euro Area and adopt the Euro as their currency and have the ECB as the central bank of the world and guarantee all government debts without any condition? Surely, that should be the solution to the problems of the world! Not!

Surely austerity has been high and the ECB can help to keep government bond yields in check and allow for expansionary fiscal policies. It had its “OMT”, which has never been used as the annoucement effect itself has kept government bond yields low. But Greece has faced difficulties despite this.

The ECB alone cannot resolve the crisis.  Attempts to boost domestic demand with fiscal policy will bring higher imbalances within the Euro Area. The Euro Area needs a central government with high powers to tax and spend. Regional imbalances will be kept in check via fiscal transfers and regional policies of the government. And the powers of the government won’t be limited with this. There are many other things such as wages which need to be coordinated at the federal level, for example. Euro Area balance-of-payments cannot be neglected.

Sergio Cesaratto’s Debate With Marc Lavoie On Whether The Euro Area Crisis Is A Balance-Of-Payments Crisis – II

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This is a continuation of the post from the end of 2014, although reading that isn’t necessary. 

In a new paper, Marc Lavoie continues his debate with Sergio Cesaratto on whether the Euro Area crisis is a balance-of-payments crisis or not. For the sake of completeness, here’s the list of papers, with references copy-pasted from Marc’s latest paper. Not all links are final versions and some may not be available to read in full).

  1. Cesaratto, S. 2013. “The Implications of TARGET2 in the European Balance of payments Crisis and Beyond.” European Journal of Economics and Economic Policy: Intervention 10, no. 3: 359–382. link
  2. Lavoie, M. 2015. “The Eurozone: Similarities to and Differences from Keynes’s Plan.” International Journal of Political Economy 44, no. 1 (Spring): 3–17. link
  3. Cesaratto, S. 2015. “Balance of Payments or Monetary Sovereignty?. In Search of the EMU’s Original Sin–Comments on Marc Lavoie’s The Eurozone: Similarities to and Differences from Keynes’s Plan.” International Journal of Political Economy 44, no. 2: 142–156. link
  4. Lavoie, M. 2015. “The Eurozone Crisis: A Balance-of-Payments Problem or a Crisis Due to a Flawed Monetary Design?” International Journal of Political Economy 44, no. 2: 157-160. (abstract)

As mentioned in my part 1, referred to on top of this post, I agree with Sergio Cesaratto.

sergio-and-marcSergio Cesaratto with Marc Lavoie (picture credit: Matias Vernengo)

Marc Lavoie’s main point in the final paper seems to be that, “Eurozone countries can never run out of TARGET2 balances, which can take unlimited negative values, so that the evolution of the balance of payments cannot be the source of the crisis”.

This is not accurate in my view. Although the rules of the Eurosystem allow unlimited and uncollateralized credit facility between the Euro Area NCBs and the ECB, one has to look at the counterpart to the T2 imbalances. If an economic unit transfers funds across border from country A to country B, this first results in a reduction of balances of banks in country A at their NCB and may result in an intraday overdraft (“daylight overdraft” in U.S. language), usage of the marginal lending facility with the NCB, an MRO, or an LTRO and finally ELA in late stages of a crisis (if capital outflow is large).

Marc himself mentions this point in his latest paper:

If a Eurozone country is running a current account deficit that banks from other Eurozone members decline to finance, or if it is subjected to capital outflows, then all that happens is that the national central bank of that country will be accumulating TARGET2 debit balances at the ECB. There is no legal limit to these debit balances. The national central bank with the debit balances, which pay interest at the target interest rate, has as a counterpart in its assets the advances that it must make to its national commercial banks at that same target interest rate. And the commercial banks can obtain central bank advances as long as they show proper collateral. Why would the size of current account deficits or TARGET2 debit balances worry speculators? There might be a problem with the quality of the loans that have been granted by the banks, or with the size of the government debt, but that as such has nothing directly to do with a balance-of-payments problem.

[italics: mine]

But that is the case! It’s because of balance-of-payments. Nations who had high indebtedness to the rest of the Euro Area saw more capital flight. This is because in times of crisis, there is a home bias and international investors are likely to sell securities abroad and repatriate funds home. Large current account imbalances lead to a large negative net international investment position. (It’s of course also true that revaluations are important, and this is what happened in the case of Ireland). So when non-residents sell securities to domestic investors, banks are likely to get into a bad situation because they have to accommodate these transfer of funds and are losing central bank balances on a large scale.

It is precisely nations which had worse net international investment positions which were affected as charted in my previous post on this.

Now moving on to definitions: what is a balance-of-payments problem? The simplest definition is the problem for residents in obtaining finance from non-residents. Greece precisely has been struggling to obtain funds from non-residents.

So I do not agree with Marc’s view that:

Cesaratto, as others, is adamant that the Eurozone crisis is a balance-of-payments crisis, whereas I believe, as others do, that this is a side issue.

Marc Lavoie also says that the people arguing for this view are implicitly assuming some kind of “excess saving” view on all this:

In discussions with colleagues who support a “current account deficit” view of the Eurozone crisis, I sometimes get the impression that they are also endorsing a kind of “excess saving” view of the economy. They tell me that current accounts deficits are unsustainable within the Eurozone because the core Eurozone countries will refuse to lend to the periphery and will thus prevent these countries from financing economic activity. This seems wrong to me.

I disagree with this. It’s precisely because residents’ liabilities are large compared to their financial assets that they have to rely on non-residents/foreigners. And during the crisis a lot of capital outflow has happened and this precisely shows that non-resident private investors are unwilling to lend again on the same scale as before. This obviously means that to obtain finance, governments of nations affected have to take the help of the official sector abroad, such as from governments, the ECB and the IMF. If TARGET2 alone could do the trick, is the Greek government foolish to go abroad?

It is of course true that the design of the Euro Area was faulty. But that still leaves open the question about why Germany is not facing a crisis as severe as Greece. The design view cannot explain this. Any country (or all countries) in the Euro Area could have faced a crisis. There is a pattern here and that is where balance-of-payments comes in.

This debate is an interesting one. Both Sergio Cesaratto and Marc Lavoie agree on almost everything, except this BIG thing.

Of course this also spills over to policy proposals. Marc Lavoie believes that the European Central Bank can guarantee that all nations can have independent fiscal policies (by promising to buy all government debt which the financial markets isn’t interested in purchasing). Sergio Cesaratto is clear on this (and I agree very much) – in another paper Alternative Interpretation of a Stateless Currency Crisis:

A more resolute role of the ECB as lender of last resort accompanied by fine-tuned expansionary fiscal policies can only be imagined in a different political and institutional framework, quite close to that of a political union.

Let’s consider what happens if there is no federal government and if the ECB is the main supranational authority (ignoring other supranational institutions which have limited powers). Suppose the ECB were to guarantee the debt of governments of all Euro Area nations. There’s nothing to prevent, say, the government of Finland to increase the compensation of its employees every year by a huge percentage and thereby affecting Finnish corporations’ compensation of its employees. This will result in a reduction of competitiveness of Finnish producers and Finnish resident economic units will rely more on goods and services produced abroad. This will raise Finland’s net indebtedness to the rest of the Euro Area and the world. If someone believes that this debt is not a problem, how about the inflationary impact of this rise in demand on the rest of the Euro Area?

So the solution lies in bringing down the balance-of-payments imbalances (both negative and positive ones such as that of Germany). This requires a supranational institution, which is a central government. National governments would have rules on their budgets but the central government — since its goals and objectives are different — wouldn’t be bound by any rules. Wage rises would need to be coordinated. And as I argue in this post, fiscal transfers also plays a role of keeping imbalances in check.

Of course there are many other economists who also argue that the Euro Area problem is a balance-of-payments problem, but with a different motive. Their argument is to blame the nations in crisis instead of taking a humanist approach.

To summarize, the Euro Area problem wouldn’t have been a balance-of-payments problem had the official sector promised to act as a lender of the last resort to national Euro Area governments without any condition. As long as there are conditions, it is a balance-of-payments problem. One cannot pretend that the European Central Bank has or can be given such powers to lend without any condition. And hence the Euro Area crisis is a balance-of-payments problem.

Economists Can Be So Wrong

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Oh boy! Krugman could not have been more wrong about Macroeconomics than what he said recently in his blog The Conscience Of A Liberal for The New York Times. In a blog post, Competitiveness And Class Warfare, he concludes:

International competition is a mostly bogus notion; …

In a sense it is not surprising. Paul Krugman has done enough to push free trade. With that position, one is forced to take a position that competitiveness doesn’t matter (or that free trade will lead to a convergence between successful and unsuccessful nations).

The notion that balance of payments does not matter is as old as Monetarism. If it is understood that competitiveness does matter and that for a nation it hurts domestic producers and hence one needs some sort of protectionist measures goes against the notion of free trade. For neoclassical economists other than Paul Krugman, competitiveness does matter but in a different sense. They would argue that it there is divergence in performance of nations because of “loose fiscal policy” or “fiscal profligacy” and so on and that once the government balances its budget and behaves the way as per a standard textbook model, there’ll be convergence in performance because market mechanisms will do the trick. But Krugman is different. During the crisis, he has understood that fiscal policy is important and that it is not impotent as claimed by his colleagues.

There are of course other factors at play in the examples Krugman provides. Japanese producers are highly competitive but at the same time, the government of Japan didn’t expand domestic demand by fiscal expansion and so the performance of the economy of Japan has suffered. But that doesn’t mean that the competitiveness of Japanese producers doesn’t matter. Had they been less competitive, Japanese exports would have been lower than otherwise and Japan would have imported more because foreign producers would beat them at their home. Moreover, a weaker current account balance of payments would have led to a bigger government deficit and the Japanese government would have (incorrectly) tightened fiscal policy in response, with the result that both balance of payments and fiscal policy would have reduced domestic demand and hence output.

So while there are other factors affecting economic performance, none of it ever means that competitiveness doesn’t matter.

Cambridge economists were clear on this. Here’s Wynne Godley in a 1993 article Time, Increasing Returns And Institutions In Macroeconomics, in S. Biasco, A. Roncaglia and M. Salvati (eds.), Market and Institutions in Economic Development: Essays in Honour of Paolo Sylos Labini, (New York: St. Martins Press), page 79:

… In the long period it will be the success or failure of  corporations, with or without active help from governments, to compete in world markets which will govern the rise and fall of nations.

In trying to defend the importance of fiscal policy, some economists such as Paul Krugman become forceful in their views about the way the world works and underplay the importance of matters such as international competitiveness. They seem to falsely believe that this strategy would work for them because accepting the importance of competitiveness would give enough chance for their opponents to argue against worldwide fiscal expansion.  It is a sad and counterproductive strategy.

Federal Government And Regional Balance Of Payments

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The Financial Times has a column titled Europe’s Fiscal Union Envy Is Misguided. The author echoes a recent article in The New York Times (referred here in my blog). According to the FT columnist, in the United States,

… The bulk of the risk-sharing happens through credit and capital markets – that is to say, private lending, borrowing and investment returns do most of the job of evening out regional shocks.

and,

… The best thing the eurozone can do to promote risk-sharing is to stop flirting with its own disintegration: as long as investors suspect politicians might let the currency unravel, they will hunker down behind national borders. Next, get cracking on developing the capital markets union – where there is much more reason to envy the Americans.

In addition, the FT author presents the following graph.

FT Image 20 July 2015Now, there are several things wrong with this. It’s true that risk-sharing happens through credit and capital markets, the argument ignores that fiscal transfers improve the net indebtedness of regions. Financial markets may improve risks by the way they work, but they cannot change net indebtedness of regions in significant ways. Borrowing is not comparable to fiscal transfers. It’s vague what “capital income and insurance flows” is.

Let’s see how a federal system works.

There are regions with local governments but there is also a federal government which raises taxes from economic units of all regions and spends on the units. Some regions will be net recipients of such flows of funds — the government expenditure toward these regions is higher than what it receives in taxes — while others will pay more taxes than what they receive from the government. These needn’t sum to zero, as the federal government may be in a deficit.

There is one peculiar thing in the way such accounting is done. The federal government is outside all regions when studying balance of payments of each region. However for the whole group, the federal government is inside. The Sixth Edition of the IMF’s Balance Of Payments And International Investment Position Manual (BPM6) does this in a similar way for monetary unions, such as for the Euro Area. In that case, the European Central Bank and the European Parliament and other such supranational institutions are considered to be outside each nation when nations’ balance of payments statistics is produced, but inside when the balance of payments of the whole region is studied.

Now, some regions may see an improvement in their balance of payments compared to the case where there is no federal government. There are four kinds of flows which are important here when thinking about the current account balance of payments of a region:

  1. Exports
  2. Imports
  3. Federal government expenditures and transfers
  4. Federal taxes and transfers.

Of course, expenditure of the federal government in the region itself may be thought of as an export, so exports in the list above is meant to exclude that and include transactions such as a private sector producer selling a car to a household in another region.

So one can roughly identify surplus regions as ones which have higher exports than imports in the definition above and others as deficit regions. These transactions of course also affect the capital and financial accounts of the balance of payments and the “regional investment position”.

Usually, one thinks of “fiscal transfers” as affecting aggregate demand. But from the above analysis, it should be clear that it also affects the regional investment position. Economic units in deficit regions also see an improvement in their net asset position. Economic units in deficit regions in aggregate will typically receive more federal government payments than what they send in taxes. The counterpart to this in the capital and financial account of the balance of payments is an improvement in their net acquisition of financial assets and net incurrence of liabilities, as compared to the case where there is no federal government. This is turn improves the regional investment position.

Of course there is still a possibility that the private sector of a union with a federal government as a whole may turn unsustainable but at least there is a regional mechanism of improvement compared to the case when there is no federal government.

To summarize, the point of the above analysis is that the financial sector as a whole cannot achieve this on its own. It takes a federal government to not only affect demand in all regions but also keep their debts in check. The workings of finances of a federal government affects the asset and liability positions of any region as a whole. The financial sector cannot take up the task of a federal government.