Controversy + Open Discussion on External Sector

My previous post seems to have been interpreted by some Modern Monetary Realists and supporters as a personal attack. Included among the offended parties appears to be Cullen Roche for whom I have much respect. Hopefully it is clear to readers here that I meant no offense in my post. In retrospect, I should have avoided any reference to politics, and kept strictly to the economic arguments that were my focus.

In an attempt to clarify my intent, I put up a comment [link no longer available] in the relevant thread at Pragmatic Capitalism. However, I was late to the party, so it could easily be missed. Rather than have ill feeling potentially simmer, I thought I would reproduce it here as well:

Hi Cullen,

I am sorry to see that you considered my recent post to be a personal attack. I can assure you that this was not my intention.

My argument – rightly or wrongly – focused on two aspects: (i) the effects of full employment on productivity; and (ii) the prospects of non-inflationary (true) full employment in the absence of a job guarantee or socialized investment.

I had hoped it would be clear that I was not criticizing your political perspective, whether right-leaning (as I incorrectly perceived) or centrist, which is of no concern to me in any case.

By way of clarification, in the term “right-libertarian” as per the Political Compass, the first word refers to economic stance and the second word refers to social stance. The term right-libertarian does not necessarily indicate Randian ideology, although extreme values on both scores might.

My (incorrect) impression of your political perspective was based on your previous statements that you were a fiscal conservative and social progressive. That tends to suggest the right-libertarian quadrant (though not necessarily) without in any way suggesting extremism. In fact, your “test result” indicates that, strictly speaking, I was only one square off the correct quadrant. 😉

Obviously, if I had my time over, I would not include any discussion of political perspectives in my post, as it only served to side-track the discussion.

More generally, given our political differences, which are due to my far left-libertarian tendencies in relation to the political center, it may not be readily apparent just how much in agreement we seem to be in many ways.

Correct me if my impressions are wrong, but based on my interpretation of your writings, we appear to have the following in common. We are both social progressives. We both think full employment or GDP measures do not necessarily ensure high quality of life. We both think there should be less emphasis on inflation, provided it is mostly moderate. We both accept the MMT insights on monetary operations, the importance of stock-flow consistency, and many other matters.

It may not be apparent that I also remain somewhat undecided on the external sector arguments, as discussed in the past by Ramanan, although I provisionally side with MMT. (I used to have to tutor on the “BOP constraint” in a former life, long before my exposure to MMT. It is a familiar idea in at least some lines of Post Keynesian thought.)

Anyway, I hope it is obvious that I have great respect for you and the major role you are playing in disseminating a correct understanding of monetary operations. I consider this to be the most important task. Once people understand that, they can make up their own minds on policy and politics.

On a personal note, I visit pragcap all the time. It is first rate.


In addition, perhaps I should stress for the benefit of newcomers that anything written here at heteconomist is not synonymous with Modern Monetary Theory. The views expressed in the posts are mine only, and I would imagine quite frequently at variance with the views – which I am not privy to – of the leading Modern Monetary Theorists. (See this post for more details.)

I hope this clarifies matters. Apologies to anyone who was offended.

Best wishes to all.


Cullen has kindly responded [link no longer available] to my comment. As he says, water under the bridge.

Thanks, Cullen.


I’ve amended the title of this post to draw attention to the involved discussion on external sector issues that has followed it. Thanks to everyone for their ongoing contributions.


116 thoughts on “Controversy + Open Discussion on External Sector

  1. Ramanan @ 9:05pm,

    “Yes I said it and you yourself quoted it at @1 February 2012 at 9:30 PM”

    I’m not seeing it there — i.e., a distinction made of the private sector’s debt (as opposed to government debt) and concerns about sustainability of cash flows — but it doesn’t matter — it’s been a long dialog and there’s probably a lot I missed or forgot.

    Also see my last comment to vimothy… it seems like you also saying the boom bust cycle is continuous and frequent in the context of international capital flows. That’s easy to understand if true, but I still consider that a little different from fundamental financial sustainability of trade flows.

    But, I see how even absent bubbles, a truly massive indebtedness to foreigners by a private sector could lead to sudden trouble in some situations.

    Thanks for the discussion and all the helpful history and references.

  2. hbl

    The trade and capital flows are related by a nations balance of payments (current account + capital account = BOP, and under floating exchange rates, BOP = 0). A current account deficit must be financed with foreign capital.

    Think about what happens when an American exporter sells some goods to an importer in the UK. The sale of the goods gets recorded as a credit in the US current account (and a debit in UK CA). The exporter receives a bank deposit in the UK in payment. This is recorded in the US capital account as a debit: capital “flows out” of the US and “flows in” to the UK, where it is recorded as a credit in the KA.

  3. hbl,

    Not sure where you are headed. But I guess what you are thinking is that suppose political processes run smoothly, there are no natural disasters and so on then what happens.

    Now I am still not sure how open to my comment that most nations don’t even have a choice … maybe you are still unsure … but lets leave those nations aside.

    Now consider a nation such as Australia. Recently exports are doing well so the nation is running a trade surplus but a current account surplus due to income payments such as interest payments etc.

    Suppose Australia’s exports suffer for some reason. Now in MMTosphere, there is no issue because this is compensated by a fiscal expansion. Let us suppose the Australian government does a massive fiscal expansion and somehow the private sector’s balance is brought into positive.

    But … Australia’s trade is deteriorating in this scenario.

    So use the sectoral balance identity


    NAFA is slight positive so the private sector is doing well in one sense.

    The trade is deteriorating and soon interest payments to foreigners start exploding. At any rate, the current account deficit is widening due to trade imbalances alone.

    Since PSBR is also growing because of the sectoral balances identity, someone has to take this debt and foreigners will have to absorb this debt at a massive scale because the domestic private sector does not have enough funds to finance the PSBR.

    You will say, its okay. I will set interest rates to zero and so on so forth. So the Australian government finances its deficit by having the banks hold the reserves. Foreigners are net creditors. So they holding huge amounts of bank deposits (the counterpart to increase in reserves) in addition to financing the domestic Australian private sector.

    But bank deposit rates are also zero. So foreigners are not impressed. So they shift the deposits out the country. Now go to my comment on comment at 3 February 2012 at 4:54 PM and how they transfer funds or repatriate and the balance sheet changes.

    Lets put some numbers for the stock counterpart to the flows.

    Domestic private sector net financial assets = 40% of GDP.
    Government debt = 300% of GDP
    Foreign sector holding of Australian liabilities = 260% of GDP.

    .. and still rising…


    (exaggerating to prove a point but from an MMT viewpoint no issues).

    Either foreigners are continuously transferring funds abroad and banks find themselves indebted in foreign currency. So they have to attract funds from abroad inducing them to hold bank liabilities in AUD so that they do not have net open positions. For this they need to pay interest.

    Also needless to say there are counterparty exposure limits.

    (This is not an imaginary scenario. Australian bank rely on huge foreign funding for funding domestic currency liabilities even in reality).

    Else the RBA can hike rates to 1%. This will induce foreigners to hold some Australian government bonds.

    However, the government debt needs to be attractive to foreigners.

    So who is funding whom? Is the Australian government funding foreigners as Mosler says

    or are the foreigners funding the Australian government?

    Do you think that such a scenario won’t lead to a speculation of the Australian dollar?

    Now this is a very hypothetical scenario but it is extremely difficult to believe in a situation in which foreigners are absorbing debt continuously.

    The alternative is to bring trade into balance (or the current account to be precise) by international means because market mechanism does not lead to a balance.

  4. Oops

    “Recently exports are doing well so the nation is running a trade surplus but a current account surplus due to income payments such as interest payments etc.”

    Recently exports are doing well so the nation is running trade surpluses but current account deficits due to income payments such as interest payments etc.

  5. Neil,

    I am not sure about what you proposal for the banking system is. Read this:

    The purpose of this note is to consider the prudential aspects of banks’ foreign exchange activities. It is not directly concerned with the restrictions that countries may place on their banks’ foreign exchange business for exchange control, monetary or other macroeconomic reasons. In exercising prudential control over this area of banks’ activities, however, supervisory authorities need to take into account the role of the banks as “market-makers” in foreign exchange. This role has two aspects. Firstly, banks have to quote rates to their customers (including other banks) at which they stand ready to buy and sell currencies. Secondly, by themselves taking open positions in currencies, banks (as well as non-banks) help to ensure that the foreign exchange markets are balanced at any point of time without
    excessive and erratic exchange rate fluctuations. In other words, supervisors have to weigh prudential considerations against the need to enable the banks to play their part in the smooth and efficient functioning of the exchange markets. Whatever may be the exact balance struck between these considerations, supervisory authorities must seek to ensure that the risks assumed by banks in their foreign exchange operations are never so large as to constitute a significant threat either to the solvency and liquidity of individual banks, or to the health and stability of the banking system as a whole.

    i.e, if you attempt to strip away this function of banking, you will have even more erratic exchange rates. Also its a huge change in the way the banking system works.

    About your thoughts on importing and exporting, I think you are adding water to your wine.

  6. hbl,

    Anyway I am writing a lot of stuff but the point I am trying to make is that if one doesn’t see indebtedness to foreigners as debt at all (even holding of public sector debt by foreigners in the domestic currency), then its a bit difficult to agree with me and the discussion can be endless. So enuf said from my side for now.

  7. Ramanan,

    I agree that indebtedness to foreigners is debt — as made explicit in the giant scoreboard example, all financial assets are debt. And I agree that there are limits to how much debt is sustainable.

    My difficulty in understanding seems to be on why big discontinuities should arise and why the market mechanism should fail to limit the overall process before it reaches an abrupt crisis stage. Earlier you said “If I carry a board on my head saying my net worth is minus $10m, and have gross assets worth just $5,000 nobody will accept my liabilities – that is the bank won’t accept my IOU (loan) to give me its IOU (deposits). “ I’m not sure how the lenders and markets would have let you get to the minus $10m net worth in the first place.

    If it’s possible to make the argument that trade imbalances are inherently and unavoidably subject to irrational momentum and bubble dynamics (with a handful of notable exceptions like the US), then I think your argument would be easier for me to follow. In that event, one could say that trade imbalances are frequently not *financially* sustainable because they invoke unsustainable bubble pricing dynamics leading to currency crashes, central bank interventions, etc. But for most of this discussion I have been thinking of bubble dynamics as their own separate non-inevitable scenario. And I realize this might not be the basis of your argument anyway.

    I’m afraid some of the implications of your scenarios are still lost on me until I can revisit them with more time to fill in the gaps in my knowledge on these topics. Thanks though, and I’m sure others should find them helpful.

    Any observers still around who are better able to digest all this should feel free to weigh in… I need to wrap up here. (I said that before… how did I get drawn in again for so long?? 🙂

  8. I fail to see how a country borrows from another country on credit wrt a trade deficit. A trade deficit seem to me to imply a deferred exchange of real goods. For instance, Chinese companies sell goods to US companies. US companies pay in USD, which can only be spent in the US. The Chinese company can 1) save the dollars at a US bank (not permitted by China), or lend the USD to the PBOC, which holds them either in its deposit or savings account at the Fed, 2) excahnage the USD for another currency it prefers, 3) buy goods in the dollar zone with USD, or 4) invest in the dollar zone using USD.

    What is “owed” to China when the stuff has already been paid for in USD which the Chinese companies were willing to accept. If anything is “owed,” it is simply the right to use the USD received in exchange to purchase goods in the US or invest in US assets.

    If Chinese do not want to hold USD, then they could either curtail exports or exchange their USD, which would drive down the value of the USD if in quantity greater than market demand. This would devalue the USD, making imports more expensive thereby reducing the volume of imports. In either case, the trade deficit would shrink.

    The risk anyone has in holding a non-convertible floating rate currency is domestic inflation and external devaluation. Everyone understand this, and makes decisions based on expectations of future domestic inflation or currency devaluation.

    MMT economists recognize this and say that monetary and fiscal authorities have to take both into consideration in economic policy. Fiscal deficits are infinitely expandable operationally but that does not imply that they are practically. The limit is ability to expand production at full employment.

    I am not aware of what MMT economists say about the limiting factor wrt trade deficits, however, other than concern with the fx rate. In the case of domestic policy, the fix is to cap the fiscal deficit at the point at which inflation (continuous rise in price level) would occur. The corresponding factor would be 1) trade changes in fx rate and 2) unemployment due to demand leakage if the fiscal deficit was insufficient to counter act it. The problem I see here is that growing the fiscal deficit to counteract employment effects would also stoke demand for more imports, thereby increasing unemployment and potentially affecting the fx rate. So this does not seem to be an infinitely expandable solution practically, even through there is no operational constrain on the size of the fiscal deficit or the ability to service it.

    Thus, it seem that inflation and devaluation as two sides of the same coin (declining purchasing power of the currency ultimately leading to aversion) are the limiting factors.

  9. hbl,

    Yes will end for now and catch on this at some other point. No need for you to reply but just clarifying one point.

    I should have rather said something like this:

    If my current expenditure pattern relative to my income does not change, my net worth will soon turn negative and is projected to fall to minus $100,000 in the medium term and minus $10m in the long term. At this rate, sooner or later my IOUs will become unacceptable and I better do something to change my pattern of expenditure/income.

  10. “Chinese companies sell goods to US companies. US companies pay in USD,”

    The assumptions under this should be made clear.

    – That on balance the contracts for these good transfers are settled in USD.
    – That there is a market banking system willing to exchange those USD for something else for the Chinese.

    There is also one other thing the Chinese exporter/Chinese banking system can do, which is to take the USD currency asset off the exporter and exchange it for new Yuan so that the Chinese central bank controls the USD currency asset.

  11. “I am not sure about what you proposal for the banking system is.”

    It’s very simple. It follows from the ‘thou shalt not get into foreign debt if you can’t easily go bankrupt’ rule.

    The domestic central bankmust not and will not be the lender of last resort in a foreign liability come what may. And if that means a bank goes down due to lack of liquidity, then that is what needs to happen ‘pour l’encouragement des autres’

    Ultimately if a foreign exporter has assets in your domestic currency and their repatriation is blocked due to a lack of a particular foreign currency available in exchange for the domestic currency then the foreign central bank can unblock that transaction if they so choose.

    That is the approach China takes to support its exporters. It therefore makes very good policy sense that an import nation should do its level best to retained earned foreign currency assets to purchase required imports only available priced in a foreign currency. That is the basis of the Thirlwall limit.

    The exchange risk for discretionary imports should be pushed onto those entities from nations using the export surplus strategy to support their economy. That economy will then make sure there is enough of their currency available to unblock repatriations and the foreign central bank will end up owning your domestic financial assets.

    Once your domestic financial assets are safely in the custody of the foreign central bank, they can be replaced in the domestic flow with more deficit spending.

    No doubt over time, as this strategy plays out, the central banks will contact each other and do ‘hostage exchanges’ – writing out the currencies they hold against each other.

  12. Neil: There is also one other thing the Chinese exporter/Chinese banking system can do, which is to take the USD currency asset off the exporter and exchange it for new Yuan so that the Chinese central bank controls the USD currency asset.

    As I understand Michael Pettis on this, Chinese companies were not allowed to save USD in US banks although that has recently been relaxed a bit but not a great deal. Chinese companies cannot exchange USD for yuan in the fx market and cannot repatriate yuan directly.

    What actually happens according to my understanding of Pettis is that the PBOC borrows the USD from Chinese exporters and keeps it on reserve at its Fed deposit (reserve) or savings (tsys) account. This is one way that China controls its currency to maintain the peg within the desired range.

  13. Tom Hickey…can you direct me to the books of Pettis’ that you recommend? BTW Satyajit Das has also said what Pettis has, so that’s just another source to confirm how they maintain their peg. BTW, your comments above brought an end to my desperation of watching ramanan/vimothy/hbl talk to each other…and in another sense you also explained the importance of why it’s not as if these foreign countries have a domestic industry to sell their wares to, there would simply be no reason whatsoever for them to not accept our dollars, they simply couldn’t afford it unless they want more riots like what they saw in CHina when the financial crisis first erupted.

  14. “What actually happens according to my understanding of Pettis is that the PBOC borrows the USD from Chinese exporters and keeps it on reserve at its Fed deposit (reserve) or savings (tsys) account.”

    The effect is that it is the Chinese state that owns and controls the reserves.

    Does anybody know if the PBOC has an account at the Fed, or if they use an agent US bank.

    That’s quite important because if the PBOC has an account at the Fed, then they can literally lock the reserves away from the other US banks (by refusing to lend them in the interbank markett).

  15. “If my current expenditure pattern relative to my income does not change, my net worth will soon turn negative and is projected to fall to minus $100,000 in the medium term and minus $10m in the long term. At this rate, sooner or later my IOUs will become unacceptable and I better do something to change my pattern of expenditure/income.”

    If the pattern of expenditure facilitates the production of more real wealth, one is better able to service the obligations in real terms. You are too fixated on the nominal in this respect, somewhat similar to focusing on book value while being unaware of the real value. You are also using a household analogy. When one views a debtor, one does not look at what the debtor is making in terms of income (perhaps GDP). One takes a look at the debtor’s worth in bankruptcy. Even taking net worth at book value is incomplete and inaccurate as it will not express market value. And even NIIP does not portray this as it is concerned with the net external .

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