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.

Regards,
Peter

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.

Addendum

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

Thanks, Cullen.

Update

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.

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116 thoughts on “Controversy + Open Discussion on External Sector

  1. “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.)”

    Remind me peter, have you written anything on that point, because it’s an area I’d like to bottom as well.

    I can never make much sense of R’s points – particularly as China seems to represent clear evidence for the counter factual.

  2. Neil, I have written nothing on it, because I don’t like to express a viewpoint till I am confident (even if wrongly so) on my position.

  3. Hi Peter,

    “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.)”

    Here’s a line of thought for you to think.

    How many countries do you think have managed to truly float their currencies? There exists a genuine “fear of floating”. Even though many central banks claim they are floating, they regularly intervene in the currency markets. The Treasury and/or the Foreign Exchange Stabilization Fund issues debt in foreign currencies. You may not like it, but it IS reality. There is no escape.

    Basil Moore said this in “Shaking The Invisible Hand”

    So long as countries trade with the rest of the world, they must avoid all expansionary domestic policy that threatens external imbalance. Countries that engage in international trade must attempt to maintain expected future conversion rates of their currency at their current values. If the exchange rate is expected to fall, CBs must pay a risk premium to attract funds to compensate foreign portfolio holders for expected capital losses. Since currencies represent a store of wealth in asset portfolios, countries are doubly concerned about the current size of their foreign exchange reserves and the future value of their exchange rate. When a country’s current foreign exchange outflows consistently exceed its foreign exchange receipts, it has limited choices. It must either pay out foreign currencies from its reserves, borrow foreign currencies to cover its negative balance, let the exchange rate depreciate, or devalue its currency.

    Simple solutions to float doesn’t really work. The IMF puts regular pressure on nations to float their currencies but they don’t because they *cannot*.

    Here’s another exercise for you: list all countries which don’t intervene in the foreign currency markets, and which fully float their currencies and do not have foreign currency liabilities in the official sector’s books.

    Result: United States and … ?

    Even the Neochartalist claim that “There is no financial crisis so deep that cannot be dealt with by public spending” doesn’t work for Australia because the RBA had to borrow funds in US dollars from the Federal Reserve in 2008 to help relieve Australian Banks’ funding pressures.
    Australia was not saved alone by deficit spending in AUDs.

    The balance of payments constraint is straightforward consequence of “money=debt”.

    And how does the small group of nations who somewhat look like the “Modern Monetary Theory” idea of floating currencies are the way they are. The answer is that they have historically been strong on production. But in the last 15-20 years they have themselves run into troubles, facing both internal and external imbalances.

    Offering oversimplistic solutions just dilutes the case for fiscal expansion.

  4. That’s it. Now back to work (spreading the word and educating), EVERYBODY! 🙂

  5. “You may not like it, but it IS reality. There is no escape.”

    Yes there is. You counter attempts to manipulate your currency, and attempt to covertly manipulate everybody else’s to your advantage.

    In other words what happens now.

    “Australia because the RBA had to borrow funds in US dollars from the Federal Reserve in 2008 to help relieve Australian Banks’ funding pressures.”

    Did it have to, or did it choose to. It could have let the banks fail and put them into administration – since a central bank cannot be ‘lender of last resort’ in a foreign currency. The loss would then have been with the entity expecting payment in US dollars and the shareholders of a bank which tried to do maturity transformation in a foreign currency.

    The ‘constraints’ you suggest are voluntary. They are not an operational necessity.

    The solution is to design the systems to be able to handle these situations properly – failure to pay in a foreign currency = bankruptcy for private entities and government institutions should have nothing to do with liabilities in foreign currencies since it impossible for them to escape via bankruptcy.

    “Offering oversimplistic solutions just dilutes the case for fiscal expansion.”

    As does seeing problems where none exist. I just don’t see them.

    The only constraint that exists is that you can’t choose what you export. You can only choose what you import.

    Beyond that the aggregate issue is whether the aggregate exchange risk is domestic or foreign. And that seems to depend on whether you are an exporter or an importer. Net exporters like China do the net-currency exchange domestically – hoarding foreign currency, whereas net importers like the US push the net-exchange risk to the foreign side of the trade in aggregate.

    So are the only countries that struggle those that net-import but have to take the net-exchange risk domestically (ie they have to buy an excess of foreign currency)?

  6. I don’t want to interrupt the flow between Ramanan and Neil, but just let me state and ask some really simple things, leaving aside for the moment the issues raised so far.

    My limited understanding on the MMT position is that a sovereign currency issuer can always purchase what is available for sale in exchange for its own currency.

    Suppose for whatever reason that no imported raw materials or capital equipment are available to a particular government in its own currency.

    There is no question this has ramifications for living standards, but MMT seems to suggest that the government could, at the very least, still provide purely labor-intensive jobs for the otherwise unemployed through a job guarantee.

    Are we agreed on this?

    The additional demand of the JG workers could result in higher prices in the broader economy because of possible difficulties faced by the private sector in obtaining foreign currency to purchase imported inputs in an attempt to expand production.

    This could be handled, for example, by allowing the price rises to redistribute purchasing power from non-JG to JG workers. Or taxes could be raised on a segment of the community to dampen demand and price pressures, once again redistributing purchasing power.

    Are we agreed?

    If, instead of a JG, the government provided welfare payments of an equivalent amount, the effects would be the same as if the JG was purely labor intensive.

    Agreed?

    The way I see things at the moment – but as I said, I am not confident on the topic – is that in the case of developed economies the issues seem to be fairly minimal. For example, in Australia, the foreign currency value at various stages over the last fifteen years has been as high as on par with the US dollar (a little above) and as low as less than half the value of the US dollar. The impacts have been handled pretty seamlessly through alterations in spending patterns.

    There is an impact on living standards, no doubt, especially if what is available for sale in the government’s own currency is severely limited. And there may well be means of widening options, for example, through cooperative arrangements with other governments, and such approaches should be pursued provided they do not entail indebtedness in a foreign currency. But, as far as I can see at the moment, this does not negate the MMT position.

    Any thoughts?

  7. Ramanan, Peter,

    I think that the issues Ramanan has raised are valid and sometimes glossed over using deductive reasoning “from the axioms and first principles”. This seems to be a natural way of thinking for some “proper” economists but it is not natural for me.

    1. A central bank is generally unable to defend the exchange rate against an outflow of foreign capital. This even happened in the UK. But an individual Central Bank can always weaken the local currency provided that it doesn’t act against another Central Bank. A Central Bank cannot push but it can always pull.

    2. I believe that there can be cases when stimulating the aggregate demand in the local economy by deficit spending will lead to crowding out the import of capital goods needed for local production by the import of consumption goods – and therefore damage the productive economy. A similar effect could have happened in some of the Eastern Bloc countries in the 1970s. I think that this is the essence of your arguments for the thesis that not every country can implement MMT-inspired policies.

    3. There is a cure I believe – proven to work in Malaysia and to some extent China. Strict capital controls (a ban on currency speculation) combined with setting the exchange rate of the local currency at a low point to reduce the need for hedging agaist fx rate volatility (by “pulling” almost all the time – buying foreign currencies) seemed to work for them and allowed for the local expansion and export-driven growth. This is not MMT but their experience should probably be analysed. If capital controls are not enough then selective taxation may work even if tariffs cannot be used.

    Peter,

    Regarding the main topic that is the debate about Job Guarantee I think that looking from only the narrow GDP maximisation point of view there can be cases when Job Guarantee will not maximise the output. However we must ask ourselves the following wider question – should we aim at maximising production and wealth hoarding knowing that it leads to disastrous social consequences such as rising inequality and to accelerated destruction of non-renewable resources? We need to carefully redefine our metrics and goal function(s) before we run our optimisation process.

    (The following example is obviously oversimplified). Political correctness aside, I dare to say that in the era of outsourcing and robotics there may not enough jobs in Australia for the people who happen to have IQ=85. A century ago they would have worked on farms and their would have been almost as productive as people with IQ=115. This does not mean that these less talented people need to be denied an opportunity for a decent life now. Cranking up aggregate demand may lead to inflation before all these people are employed because they don’t have the skills which are in demand.

    Job Guarantee is the right approach – don’t ask any silly questions just organise work (not necessarily for monetary profit) for anyone who is fit and wants to work.

  8. Thanks for your thoughts, Adam (ak). We seem to have been composing our comments at the same time.

    I will hold off adding any more thoughts myself until I see what others have to say about the points raised in the thread so far. I really appreciate your in-depth comment. Cheers.

  9. Ram,

    Perhaps related, I would point out that there are Australian banking and their related entities that zealously and perhaps irrationally seek to acquire assets in the US so they may be working with the Australian exporters in that they tell the exporters to submit invoices in USDs and accept USDs in payment then the Australian banks change the exporters out and take the USDs over the US to buy US assets and operate them.

    Depending on how convoluted the Aus banks conduct/structure these activities, I could imagine they may end up having to go to the Fed if there were external shocks such as 2008.

    http://www.macquarie.com/mgl/com/mic

    So some of this may be voluntary…

    Resp,

  10. Ramanan,

    So long as countries trade with the rest of the world, they must avoid all expansionary domestic policy that threatens external imbalance. Countries that engage in international trade must attempt to maintain expected future conversion rates of their currency at their current values.

    As you may know I’ve had similar concerns about the balance of payment imbalances and the risks of floating a currency, but it is a topic I only weakly understand. As I wrote a paper about Georgia (the country) they had a floating currency that came under speculative attack once Russia started dropping bombs on the small nation and the IMF was called in to provide dollars to stop the panic, and ward off inflation due to far more expensive imports. I’ve been troubled by this episode, would I have advised them to ask the IMF for help? Is a small open economy like Georgia is it not possible to mobilize its population and distribute its resources that it commands at home any way that it likes? Do the rules that apply to the US differ from those the rest of the world? I believe the answer is yes, because unlike Georiga, the US doesn’t depend on international financial markets operating with some other nation’s currency. It means the US doesn’t need to accept the (often destructive domestically) demands of international creditors, but the US isn’t immune from harm foreigners can inflict.

    No matter what your FX policy, there are risks. By allowing China to acquire so many $NFA, they could easily dump USDs and buy Euros if we decided to limit their exports or got into a serious spat over Taiwan. Open economies foster mutual dependence. It’s too late to change that with US creditors, it exists, the immediate question is how to cope with it? How long will it last? Why? If it’s not going to last, what should be the policy response?

    So far my answer is simply it can go on for as long as people in other countries are willing to hold onto $NFA. They hold them in part because of financial instability (often generated in the US). $NFA are a cost for other countries, countries could have spent those US$ on imports helping the develop their country. They pick $NFA, because of self-reinforcing trust in the currency, because the US provides a source of demand for their exports, and US bonds are very unlikely to default unlike euro bonds.

    Most people worried about the US BOP deficit believe the correct response is to be “fiscally sound” which is code for austere. If this is done at the wrong time, it would result in higher unemployment, crumbling infrastructure, worse education, research, etc… Why not give other countries a reason to invest in America instead? It might preserve America’s role as a financial anchor and preserve America’s technological and scientific leadership. Doing this would entail putting into place sensible financial regulations, implementing policies consistent with full employment and price stability, and generally fighting back against the free market ideology that brought us to this crisis.

  11. “This could be handled, for example, by allowing the price rises to redistribute purchasing power among JG and non-JG workers. Or taxes could be raised on a segment of the community to dampen demand and price pressures, once again redistributing purchasing power.”

    Peter,

    AFAICT, the response to a ‘run out of foreign currency’ problem is the same as the ‘run out of people’ problem. You’ve hit the supply side constraint in the economy.

    If you do that then that means your income support level is too high – your domestic economy isn’t productive enough to sustain the level of income support you propose at the current taxation level (and possibly at any level for some countries).

    And that leads to the next question – can you have a sudden ‘run out of foreign currency’ problem that leads to a sudden deterioration in the domestic citizens standard of living and if you can how does that inform domestic policy to avoid such a thing.

  12. “By allowing China to acquire so many $NFA, they could easily dump USDs and buy Euros if we decided to limit their exports or got into a serious spat over Taiwan.”

    They could, but that would shove the Euro up causing European exporters a headache – primarily Germany.

    Therefore the ECB would be forced to buy the dollars to get the Euro back down and release the constraints on the Euro money supply.

    So it’s a risky strategy for China. They could end up losing their export markets and their dollar holdings for no benefit.

  13. Peter,

    Thanks for a longish reply. There are just too many issues here which makes it an endless debate. The reason I take so much interest in this is that if the nature of the current crisis is international and unless some strong action is taken to find a permanent solution to reach agreements to balance trade, the world economy is on an unsustainable path.

    The JG debate just misses this point. That is not necessarily an opposition of the program but just saying there are more pressing constraints on the path of full employment.

    Some commenters have very rightly pointed out that Neochartalists always talk of hypotheticals and this is so much true for the open economy case than for the case of a closed economy.

    Consider your statement

    “My limited understanding on the MMT position is that a sovereign currency issuer can always purchase what is available for sale in exchange for its own currency”

    This seems like seemingly straightforward conjecture to make but there are so many hidden assumptions here. What is sovereign currency? It is true for example that the Australian Dollar is more sovereign than the Euro but that anti-analogy doesn’t mean that since the AUD is not EUR, the Australian government faces no constraint.

    Yes, the government can buy a few things here and there and modern governments are big, so their contribution to total expenditure in any year is fairly big. But you cannot extrapolate that sentence and frame it the way Neochartalists do and say price rise constraint is the only constraint. If you start with an assumption which is framed as if there is no external constraint, you will never be able to see it.

    Back to what is “sovereign currency”. The assumption is that in order for a currency to qualify as sovereign the government (single as opposed to multiple such as the case of the Euro) should float the currency. It is a necessary condition. Absolutely necessary. And there are more which the Chartalists do not generally say upfront such as: the government and the central bank should not borrow in foreign currency etc since it somehow spoils the virginity of sovereignty.

    If these conditions are fulfilled – as if they will be fulfilled forever (!), there is a pretense that nothing can go wrong in the external sector. So when I mentioned that there are be runs due to balance of payments financing issues, I was told that these are extreme events. But a look at central banks’ balance sheets all around the world tells me that they hold a lot of reserves in foreign currency and there is a reason they are called “reserves”. Even the United States Treasury holds foreign currency reserves! Then are also capital controls in many nations. If things were so easy, why have capital controls at all?

    The hidden assumption is that there is an exchange rate at which there is a “clearing” and this assumption is very Friedmanite! Is this the lack of such clearing sometimes in the currency markets that central banks need to intervene and for many nations regularly. There seems to be a pretense among the Neochartalists the market will always “clear” and the central bank intervention in the fx markets is completely unnecessary.

    How does fiscal policy enter in all this? A relaxation of the fiscal stance brings in higher trade deficit. Some Chartalists seem to have issue with this but Randy Wray admitted it:

    “To sum up: a US government deficit can prop up demand for output, some of which is produced outside the US—so that US imports rise more than exports, especially when a budget deficit stimulates the American economy to grow faster than the economies of our trading partners.”

    http://www.neweconomicperspectives.org/2012/01/mmp-34-functional-finance-and-exchange.html

    For a different view see here:

    http://bilbo.economicoutlook.net/blog/?p=11527

    The reason Bill Mitchell doesn’t see a “statistical relationship” is that it depends on what the other nation is doing. So if there is a fiscal expansion in Australia and simultaneously in the rest of the world – at least in places Australia exports – increases both imports and exports.

    To summarize, an independent fiscal expansion has a spillover into trade deficits.

    So the government sector needs to both intervene in the foreign exchange markets and keep demand tight typically. Saying that the government can buy whatever is on sale is a highly misleading statement.

    Things would have been simple if the foreign exchange markets clear to eliminate the current account deficit, but with fx traders working with expectations and expectations of expectations, it does not bring anything in balance.

    Now Randy “figured out” the better question such why is a balance needed at all, everything is balanced etc …

    “Imbalances? What Imbalances” http://www.levyinstitute.org/publications/?docid=1478

    Again his analysis is highly dependent on a market clearing with no central bank intervention. He is a Minskyian – how does he hold a view that crisis can happen domestically but not in the currency markets 😉

    Is “modern monetary theory” so sensitive to the fact that if the government once picks up debt in foreign currency, the whole “paradigm” falls apart?

  14. Tschaff,

    “No matter what your FX policy, there are risks.”

    Exactly my point. I quoted this from James Tobin in a couple of places but let me quote again if you haven’t seen

    “I believe that the basic problem today is not the exchange rate regime, whether fixed or floating. Debate on the regime evades and obscures the essential problem.”

    My point is that the Neochartalists spend too much time about “floating”. It is *absolutely essential* in their “paradigm” that the currency *truly* floats in the sense meant by Milton Friedman in 1957.

    This is not a fixed versus floating debate. Flexible exchange rates certainly offer higher policy space but that cannot be extrapolated infinitely.

    I don’t know much about Georgia but yes in wartime, nations can have troubles. My point is that even in peacetime nations have issues.

    “They pick $NFA, because of self-reinforcing trust in the currency, because the US provides a source of demand for their exports, and US bonds are very unlikely to default unlike euro bonds.”

    Yes, the US dollar continues to be *the* reserve currency but don’t assume that it will last forever. At least the one in power cannot design policy using this assumption. Highly dangerous. If the US exploits this exorbitant privilege, it comes with continuing to pick up huge indebtedness to the rest of the world at a faster rate.

    Now there’s an argument that if someone dumps the dollar, someone else picks it up but it’s wrong to the core! Banks act in the fx markets as dealers not brokers as portrayed by the Chartalists (Billy Blog explicitly says banks act as brokers). There too it is operational realities which is working. If a foreigner repatriates funds, a US bank goes into debt in foreign currency and has to get rid of its open positions – i.e., attract funds. You can see these technicalities in discussions about Australian banks’ funding from foreign investors.

    Indebtedness to foreigners in domestic currency is better than indebtedness in foreign currency for a reason. The correct reason is not the one (“intuitive”) usually presented. The right reason is that if there is a depreciation of the domestic currency, it prevents a revaluation loss on the liability.

    “Most people worried about the US BOP deficit believe the correct response is to be “fiscally sound” which is code for austere.”

    Yes, but only most. Actually there are few who talk about it in public debate compared to people who mostly discuss the whole crisis as if the US is a closed economy. So the way to solve the crisis is by international means. There is a definite pretense that the problems of the United States can be solved in one month. Correct me if I am wrong – hasn’t Mosler gone on air saying this? Six months?

    About foreigners investing in the United States, I would comment on such a plan if there are more details but without it I can only say that the United States has enjoyed foreigners making next to nothing on their investments in the US and US citizens have made a killing in the past 10-15 years in their investments – both portfolio and FDIs – and this has certainly helped the US’s net indebtedness from rising to very high levels. A more globalized US will just increase its net indebtedness to the rest of the world.

    More importantly, the point I generally make is the US debate moves the discussion in a different direction. The US has more flexibility in all this which makes the argument harder. It is easier to look at other nations and then apply the logic to the US, rather than the other way round as usually done here.

    It is true that austerity is a bad policy, but a fiscal expansion has to be complementing with other policies as well.

  15. I should say I have little economics understanding but certain of the comments here seem to be odd or I am not understanding them so bear with me.

    First, it does not seem like a really good time to draw normative conclusions about a currency when bombs are falling.

    As China is concerned who will buy their dollars and what will they do with them? I think it is really unlikely that China would sell dollars for euros given that the eurozone is in crisis at the moment. And if they did, what would the buyer do with those dollars? Likely they would buy treasuries or invest them in the US. So I see no problem here, at least not now.

    And running out of foreign exchange is hitting a wall. If the country is that poor then they would likely need help or work off their own resources. If not, then perhaps you should scale back as you could be at the inflation wall. But beyond that are you assuming the import sector is a material proportion of GDP? That would seem really odd. Most countries could likely finance imports if they chose to. So I am not seeing the problem here.

    Finslly, I don’t know what is meant by redistributing purchasing power? If you work for money, makes no difference, the price is the same unless you mean some form of subsidy.

  16. “At least the one in power cannot design policy using this assumption. Highly dangerous.”

    My ideal policies would probably strengthen the US position as the reserve currency as a side effect, but I’m sure economists can put their imaginations to figuring out policy responses to a slow US dollar devaluation (which might be beneficial) or a rapid one that would collapse the global financial system.

    I think Mosler said a year? The direct job creation efforts of the 1930’s worked amazingly fast, I can’t find the number but in a matter of months they had hired 8-9% of the US labor force. Combine it with a FICA tax holiday and fiscal aid to states and you’re talking about a rapid increase in AD. Still, other many harms exist that need to be avoided. I try not to think about them all at once because it seems like an impossible. I hope some other country that is smaller and manageable can lead by example. The Scandinavian model is my favorite.

  17. I don’t think that this is just an economic question. It is also a national political question, as well as an international one. Governments are constrained by national and international political realities.

    One of the reasons that neoliberal could not work, even if its assumptions were correct, is political. There is a reason there are neoliberal (“capitalist”) economies, or any any socialist economies of note either, unless one considers Cuba and North Korea significant. Neither system work internally or externally. That is way we have mixed economies.

    There is also a reason for international organizations like the UN, the IMF, the World Bank, etc., and the G8, G20 and frequent summits. The world has learned from bitter experience that close coordination is required to deal with shared challenges as they arise instead of letting them festers into sources of conflict.

    So it is not just a theoretical matter, but what can actually work given the circumstances.

    I would argue on political grounds that it makes much mored sense to coordinate global economic policy so as to promote balanced trade insofar as possible. That said, the developed countries are in a far better position to absorb net imports than the emerging countries and they should do so in a coordinated way in order to speed and smooth transition to a global economy — which should be viewed as closed economy. This would prevent severe imbalances and reduce distortions.

    Theoretically a floating rate system works but the assumption is fairly equal participants in near perfect competition. That is not the case. So what is true for the US, for instance, may not be true for many other countries.

    Instead, nationalism is increasing, and international coordination is breaking down.

  18. “I would argue on political grounds that it makes much mored sense to coordinate global economic policy so as to promote balanced trade insofar as possible.”

    I would argue on political grounds that is impossible. China and Iran are not going to play ball. Or they will pretend to play ball while looking after their own.

    Even the US really only looks after its own.

    It’s the prisoner’s dilemma on a global scale.

    So you really need a competitive system that is ‘good enough’, rather than trying to achieve the unachievable.

  19. PeterC:

    Suppose for whatever reason that no imported raw materials or capital equipment are available to a particular government in its own currency.

    There is no question this has ramifications for living standards, but MMT seems to suggest that the government could, at the very least, still provide purely labor-intensive jobs for the otherwise unemployed through a job guarantee.

    I think this sums up the MMT position very clearly. I see it as a normative, long run argument that puts the build up of human capital before the defense of financial capital in the belief that that would follow naturally. Depending on one’s starting point, it’s hard to tell how long the run, nor how bumpy the ride will be, but I think it would be safe to say that politics, rather than economics, may be the limiting factor. A focus on human capital in such an inclusive and introverted way demands a shift in preferences that must first be brought about. The route of more international coordination could be done within the current ‘middle class’ paradigm and would probably render much smoother results in the short term. I also think the two are not necessarily mutually exclusive. But then, neither one nor the other seem praticularly workable in the current political climate – which is probably why we are where we are.

    So, assuming that we’re stuck with ‘each country on its own, but none bold enough to really do anything out of the ordinary’, I wonder: how realistic are capital controls for a country like the US or UK or Aus? What other means for allowing unliteral but controlled (i.e. without subsequent depreciation or deterioration of the CA) fiscal expansion are there that would not trigger trade wars and the like?

  20. “Is “modern monetary theory” so sensitive to the fact that if the government once picks up debt in foreign currency, the whole “paradigm” falls apart?”

    Until there is an agreed bankruptcy mechanism for nations, then all systems are sensitive to a government picking up foreign debt – as we can see with Greece.

    So the rule has to be ‘no government sector debt denominated in third party liabilities’ if you want a government with policy space to purse the domestic public purpose.

    “It is *absolutely essential* in their “paradigm” that the currency *truly* floats in the sense meant by Milton Friedman in 1957.”

    Where is that analysed in those terms? I’ve only seen the ‘let the currency float’ line, which I take to mean let the currency float as much as it can rather than actively trying to fix it to something.

    True float is never going to happen, but I haven’t seen anywhere where MMT ideas would struggle simple because the float is only ‘good enough’.

    Ultimately the sovereign nation is the monopoly controller of its fiat currency via its central bank. And that gives it the power to control any game played requiring fiat currency – because they all have to be cleared via the central bank.

    I see MMT’s foreign exchange regime derived from that simple fact. The only games that allowed to be played in the fiat currency are the ones allowed by the central bank.

    So if hoarding is a problem, you confiscate or accommodate. If interest payments to non-domiciles are a problem don’t pay them. If dumping is a problem you prevent or limit the transfer of those assets by that entity.

    ” If a foreigner repatriates funds, a US bank goes into debt in foreign currency and has to get rid of its open positions – i.e., attract funds.”

    Then don’t do that. Require matched exchange. If there isn’t an immediate counter-party then you can’t do the transaction.

    So it’s not an operational reality. It’s a operational choice based on the current liquidity of that market – much as the illusion of prior funding for governments is a choice.

    And if the US bank runs out of foreign currency due to bad management, then it should simply be put into administration. There needs to be a bankruptcy mechanism for banks that run out of cash flow in foreign currencies, which means that whichever foreign entity was expecting delivery of the foreign currency takes a loss.

    Banks can only be protected by the central bank from liquidity issues in the domestic currency.

    “The right reason is that if there is a depreciation of the domestic currency, it prevents a revaluation loss on the liability.”

    It doesn’t prevent it. It moves it to the counter-party. The risk is then with the ‘foreigner’ who has effectively joined your monopoly cult on that financial asset and therefore has to play by your rules.

    “Now there’s an argument that if someone dumps the dollar, someone else picks it up but it’s wrong to the core”

    It has to go somewhere. There is either a transfer of fiat currency at the central bank to some other entity with a central bank account, or there isn’t (in which case at worst it is a game in the credit circuit – with bankruptcy as the ultimate resolution).

    The question then is whether the fx games in the credit circuits are destabilising in a Minsky manner, and if they are can the monopoly supplier of a currency regulate the markets in its currency without involvement from anybody else.

    Because I just don’t see ‘international agreement’ in a sensible manner ever happening. Even Keynes didn’t get the system he wanted.

    So I would suggest the interesting fx questions apply to the credit circuit in a currency.

  21. Here’s an interesting economic letter from the Fed on the US import share of personal consumption expenditure (from China and overal):

    “When total import content is considered, 13.9% of U.S. consumer spending can be traced to the cost of imported goods and services. This is substantially higher than the 7.3%, which includes only final imported goods and services and leaves out imported intermediates. Imported oil, which makes up a large part of the production costs of the “gasoline, fuel oil, and other energy goods” and “transportation” categories, is the main contributor to this 6.6 percentage point difference. ”
    http://www.frbsf.org/publications/economics/letter/2011/el2011-25.html

    I think MMT views FX markets as strictly transactional, in the sense that FX exchange mainly happens in the foreign trade markets and for long-term capital investments. I believe they are in favor of capital controls, which is quite reasonable since it is a fact that you cannot have independent policy, floating exchange rate and capital mobility.

    I fully agree that you could have a price-based crowding out of imported capital goods due to increased aggregate demand for imported consumption goods. The risks are quite different for developed countries (which have a large services sector and import prices have a small impact on the general price level) than developing countries (which usually have to pay a large part of their income for food and energy imports).

    One could say that each country group engages in a different policy mix. The developed countries usually have an external deficit and specialize in specific high valued sectors, while developing countries try to have an external surplus that will allow them to pay for immediate and pressing needs and also maintain a steady development path.

    The current situation seems to place the exporting nations on the ‘winning side’, while the importing nations are engaged in balance sheet recessions. Maybe Keynes was right after all (to have the surplus nations recycle their profits).

  22. jonf: I think your last paragraph is referring to my first comment in the thread. You wrote:

    I don’t know what is meant by redistributing purchasing power? If you work for money, makes no difference, the price is the same unless you mean some form of subsidy.

    What I was referring to is that the introduction of the JG would (presumably) give more income to people who were previously unemployed. If there are difficulties for the private sector in responding to the additional demand at current prices, because of a difficulty in importing productive inputs, there would be price rises in consumer goods, other factors equal.

    So one policy response by the government would be to allow the price rises. The effect of this would be to reduce the real wages (and real purchasing power) of workers employed in the regular economy relative to JG workers, which would enable the JG workers to obtain a greater share of the consumer goods. The JG workers would also be affected by the price increases, but they have at the same time received an increase in nominal income to the extent the JG wage is more than what they were receiving before its introduction.

    Another policy response would be to raise taxes on a segment of the community to take away some of the consumer demand coming from people not in the JG program (i.e. other workers, pensioners, rentiers, capitalists, etc.). This would keep prices from rising as much as otherwise while altering relative purchasing power of the different segments of the community.

    The point is simply that if output cannot increase much and we want to allow some members of the community to have more real income, then we will need to reduce the real purchasing power of others to make this possible.

    As Neil mentions, it is an example of hitting a supply constraint, although it is not an absolute one to the extent that there are domestic resources that can be put to use rather than relying on imported inputs.

  23. Ramanan,

    My guess is that you and the MMT academics are talking about different things when you disagree over external sector issues and the balance of payments constraint. Apologies if I’ve duplicated other comments (I have not been able to keep up), but consider this angle:

    1. Economic sustainability of trade balance =
    1a. Financial flow sustainability +
    1b. Domestic political sustainability (enough jobs?) +
    1c. Geopolitical sustainability (war cuts off essential imports, etc) +
    1d. Natural resource sustainability +
    1e. Risk of asset bubbles and resulting sudden adjustment of many asset prices, including currencies

    Could it be that you are talking about (1) overall while the MMT academics are talking more narrowly about (1a)?

    If I’m understanding correctly, I agree with the MMT academics that in nations with the sovereign currency attributes they describe, there should be no crisis related to (1a). That doesn’t mean the current account balance and currency value won’t both adjust over time — just that they should adjust gradually rather than via a sudden crisis spurred by (1a). Nor does it mean that factors (1b through 1e) don’t matter — they do!

    Regarding the “balance of payments constraint”, as I understand it… considered from the financial side alone (1a), it’s just one of the automatic stabilizers:

    – If GDP grows faster than government spending, taxes slow that growth, with the government budget deficit shrinking and playing an automatic stabilizer role

    – Similarly, if GDP grows faster than exports, imports slow that growth, with the trade deficit growing and playing an automatic stabilizer role

    (I’m picking deficit vs surplus examples that happen to match the US positions)

    In that light the trade deficit, like the budget deficit, is the *outcome* of a lot of broader economic factors that policy makers *should* worry about it, but like the budget deficit, they shouldn’t need to worry about the trade deficit for its own sake.

  24. hbl,

    Not sure where you are heading.

    “My guess is that you and the MMT academics are talking about different things when you disagree over external sector issues and the balance of payments constraint.”

    What the Neochartalists (and I guess almost all all Keynesians) miss is the following:

    In a closed economy, there is a State which has strong powers in creating debts. This gives it the ability to do demand management and this is not too difficult to understand. However in the case of open economies, the powers of the State are limited because of the balance of payments constraint. Of course that does not mean I am saying fiscal policy is useless or anything of that sort.

    I saw this old post http://bilbo.economicoutlook.net/blog/?p=8013 – named “Some Neighbours Arrive” which I hadn’t seen earlier.

    So there is a description of two kinds of business cards between two fathers who gets their respective kids to work and there is an innuendo that nothing can go wrong because of running trade deficits.

    What Bill Mitchell misses is that for trade to happen, nations should decide on how to settle debts. Just paying your own business cards to foreigners does not constitute a “settlement”.

    Earlier nations would settle debts in gold but then moved into other regimes. In his example, there is no bank just two governments employing kids, so foreigners kids selling products to local kids get paid in domestic business cards. However, foreigners cannot as a whole repatriate funds. So there is no “settlement” in his model – hence he finds that there is no problem.

    There is a lack of appreciation for the concept of convertibility in the Chartalist description. Hence they hold all the wrong views about the external sector. They even think money is non-convertible.

    Think of it this way. Let us assume that the banks are nationalized as the MMTers would love. :- )

    The US banking system is called Fed-Gosbank and the Australian RBA-Gosbank.

    An American firm selling goods in Australia will get paid in AUD (though in reality invoices are more in USD than in AUD). He will need his proceeds to be exchanged at RBA-Gosbank and RBA-Gosbank and Fed-Gosbank need to agree on how this is to be run. If the US exporter to Australia wants to convert his AUDs into USD and the agreement between the two will lead to the RBA-Gosbank running a USD liability because of this conversion.

    Now it should be obvious in this example that since the RBA-Gosbank starts seeing its USD liabilities increasing, something wrong is happening in Australia. Australia can respond by taking protectionist measures but that goes against the international rules and agreements of trade.

    Of course, with MMT taking a stand that imports are benefits, it will be hypocritical on their part to propose a protectionist measure!

    Actually we live in a market determined world so the above example is a bit abstract but it shows that the “modern monetary theory” description of two business card economies is wrong to the core!

    (On the other hand, if RBA-Gosbank doesn’t promise to convert, United States won’t export to Australia and then imports are truly benefits from Australia’s viewpoint!!!! – do you know what I mean?)

    I can move on to the market-determined world but I will save it for another day – I should get an acknowledgement from you that we are not talking past each other.

    Regarding your automatic stabilizers part with external sector included .. the foreign trade is unbalanced and hence as a result net indebtedness keeps rising!

  25. Okay Ramanan, now I think I might understand where you’re coming from. If by “There is a lack of appreciation for the concept of convertibility in the Chartalist description” you mean the practice of central banks accommodating the currency exchange demands of exporters as opposed to letting currency market forces do so, then I think you are correct that this adds some twists to the core chartalist argument.

    I don’t think it fundamentally alters the inherent financial sustainability of a trade imbalance, but it does add a larger than normal political dynamic and risk, as it sounds like a form of exchange rate intervention by central banks, with potential unpredictable future policy directions.

    “If the US exporter to Australia wants to convert his AUDs into USD and the agreement between the two will lead to the RBA-Gosbank running a USD liability because of this conversion.”

    I worked through this to be sure I understood. See below:

    Step 1 – US exporter wants to convert USD to AUD
    – American exporter asset: 10 AUD

    Step 2 – Currency exchange provided via central banks:
    – Fed-Gosbank asset: 10 USD Loan to RBA-Gosback
    – Fed-Gosbank liability: 10 USD (newly created)
    – RBA-Gosbank asset: 10 USD
    – RBA-Gosbank liability: 10 USD debt to Fed-Gosbank

    Step 3 – RBA-Gosbank sells USD to exporter:
    RBA-Gosbank asset: 10 AUD
    RBA-Gosbank liability: 10 USD debt to Fed-Gosbank
    American exporter asset: 10 USD
    (Side question: what is the spread on AUD interest earned by RBA-Gosbank vs USD interest paid out and under what scenarios does RBA-Gosbank care, if any?)

    So yes, it looks like determined central banks can prevent the exchange rate from directly responding to trade imbalances. Perhaps you are saying that such convertibility is written into international law. I think I’ve seen other say that is a misreading, but I don’t know enough to have an opinion.

    Okay let me try the market scenario:

    Alternate step 1
    Investor asset: 10 USD
    American exporter asset: 10 AUD

    Alternate step 2 – After market exchange:
    Investor asset: 10 AUD
    American exporter asset: 10 USD
    -> USD/AUD exchange rate pressured upward as exporter seeks to convert AUD to USD via markets
    -> US exporter becomes less competitive in Australia, net exports pressured down, limiting this dynamic in total

    On your last point: “Regarding your automatic stabilizers part with external sector included .. the foreign trade is unbalanced and hence as a result net indebtedness keeps rising!”

    I would say overall, so what? Again, the analogy is government debt that keeps rising and whether that is sustainable. Normally if government debt grows enough, then we’d expect it to trigger more private sector spending, which would act to put contractionary pressure on the government’s budget deficit and work toward REDUCING the debt, or at least working toward stopping its growth.

    Seems like the analogy would normally hold with the current account deficit being limited by exchange rate market forces. I think you are saying that convertibility agreements between central banks prevents this dynamic from fully playing out?

    If that is broadly true in the “real world”, then I question the sustainability of those government convertibility agreements more than I question the financial sustainability of the trade imbalances themselves. (Again, it comes down to the difference between sustainability of (1) and (1a) in my prior comment, with a new (1f) related to sustainability of convertibility agreements between central banks).

    Does that make sense? I know you’ve done way more reading on international trade issues than I have, so please correct me as needed.

  26. Two clarifications:

    – In “Step 1” above I meant “US exporter wants to convert AUD to USD”

    – In “Step 3” above, I assumed that a central bank exchanging currency on behalf of an exporter would somehow bypass the normal currency markets and avoid pressuring the currency (not sure why I assumed that… perhaps I read it into your comment). If that is NOT true, and this exchange in fact goes through the regular currency markets (?), then wouldn’t the original 3 steps (central banks getting involved) have the same exchange rate effects as the alternate steps (markets only)?

  27. Oops, confused myself in clarification #2. Please disregard. (If the central banks truly provide an unlimited offer to convert then it seems like that should be relatively neutral on exchange rates even if the conversion went through markets, so my prior comment wouldn’t have been wrong after all.)

  28. Neil: So you really need a competitive system that is ‘good enough’, rather than trying to achieve the unachievable.

    And history shows where that leads — to war.

    It is not by accident, I suppose, that the US hawks are preparing for war with Iran and later China. Of course, the Chinese know this and are preparing for war with the US. The Chinese know that time is on their side, and the US hawks do, too. They want to do China ASAP, after Iran, that is. They probably figure they can maneuver the Iranian gambit directly into a war with China, whose interests would be threatened.

  29. hbl,

    US exporter sells goods inside Australia. Australian importer pays US exporter in AUD.

    “US exporter wants to convert USD to AUD” should be the other way round. US exporter wants to convert AUD into USD.

    Also in Step 3, you should not have “RBA-Gosbank asset: 10 AUD” since its a reduction in liabilities. (minor point).

    I am not sure of an exchange rate market because in the example we have assumed a government dominated world.

    In the foreign exchange markets, the dealer (banks) set the exchange rate .. he is the price maker. Of course prices change often – every second. So I do not know how prices fluctuate in the absence of dealers. It has to be fixed by the authorities.

    In the example it has to be established by RBA-Gosbank and Fed-Gosbank.

    [In any case, there is no pressure down, pressure up etc. The foreign exchange markets move due to lots of things and trade flows due to exporters repatriating funds is just one of the aspects in “order flows”.

    The foreign exchange markets do not move to balance trade.]

    You’re right about law. If two nations want to trade one another – they have to decide on how to exchange their monies.

    So in the case where the banking system is under the authority of the government, they have to set the exchange rate.

    [If you had followed Volcker’s proposals, you would have seen that banks’ market making role in exchange markets haven’t been stipped off because it is impossible. It is proposed that their market making activity in other markets be banned. So they can act as dealers only in currency and government debt markets]

    What I am trying to say is that there cannot be a system in which banks can’t act as dealers in any system.

    So either you can a nationalized banking system in which case the central banks have to decide the exchange rate or you have a market system.

    (As a corollary, nationalizing banks is a horrible idea. It means the government sector picks up debt in foreign currency, a strict no-no around here.)

    My point is that if you hypothesise a two business card economies, you necessarily have to introduce “settlement”.

    “I would say overall, so what? Again, the analogy is government debt that keeps rising and whether that is sustainable. Normally if government debt grows enough, then we’d expect it to trigger more private sector spending, which would act to put contractionary pressure on the government’s budget deficit and work toward REDUCING the debt, or at least working toward stopping its growth.”

    Doesn’t happen that way. A relaxed fiscal policy increases the current account deficit and makes the public debt rising forever when compared to GDP.

    In the government increases its expenditure, private expenditure also increases and the national income too. As a result, taxes also increase, as you say.

    It cannot however be assumed that the public debt/gdp stabilizes like you seem to assume – in fact keeps rising.

  30. hbl,

    I will mail you scans of two pages of Godley-Cripps on the scenario for public debt/gdp when government expenditure is increased etc in the case of open economies… similar to scenarios we are discussing.

  31. Here’s a complication in the issue. Under the present corporatism-managerialism model of capitalism which is controlled essentially by finance capital economically and politically, the developing situation is increasing corporate profit margins reflecting capture of increased productivity will workers’ compensation remains stagnant. Firms not only resist any margin compression but actually work to remove “wage rigidities.” Meanwhile, workers slide below the poverty line as the “working poor” increase and the number of unemployed and underemployed also increases.

    The MMT solution iaw sectoral balance approach and functional finance is to increase deficits to offset the demand deficiency introduced by this contemporary version of “capitalism” that is poised to dominate the global economy. At what point is it recognized that firm margins are being fed by government debt and what could be done about it before the global economy is increasing financed by sovereign debt, with the interest compounding to savers? This does not seem too much more sustainable than the presumption that private debt can grow forever, as it would have to if the private sector were to finance the spending necessary to purchase output.

    So we seem to be looking forward to a global economy that persistently underperforms, or one in which private debt grows until it become unsustainable with a resulting crash, or else virtually unlimited expansion of government debt.

  32. Ramanan,

    Regarding how the exchange rate is set, I agree that “the foreign exchange markets move due to lots of things”, but I’ve always understood trade flows as being able to move the exchange rate as part of that mix. You seem to be saying the exchange rate is set directly by banks and/or governments or in some other way is unable to respond to trade imbalances. That’s a big surprise to me. Can you point to evidence that this reflects the real world of non-pegged currencies? Do MMT academics agree with you on this one?

    Even the scans you just mailed me (which I don’t have time to fully digest) mention “The other is the probability that continuous external deficits will make the national currency less and less acceptable in currency markets, provoking rapid falls in the exchange rate for the currency.” (Though I’m not sure why it would be rapid unless the trade dynamics or government spending or GDP in general changed very rapidly).

    “Doesn’t happen that way. A relaxed fiscal policy increases the current account deficit and makes the public debt rising forever when compared to GDP.”

    Let’s say public debt to GDP did rise “forever.” What bad things would happen? If there is no adjustment mechanism to limit the growth, then how would it be different than an never-ending sports game where one team dominated and its points grew toward infinity? How would the high points some day cause sudden and unexpected damage? Even with some form of upwardly spiraling interest paid that pushed the points toward a higher order infinity?

    (Note again this is a focus on (1a) from my 5:14pm comment above, clearly other sustainability factors listed under (1) would come into play way before infinity).

    “It cannot however be assumed that the public debt/gdp stabilizes like you seem to assume – in fact keeps rising.”

    Are you sure? By my [possibly incorrect] calculations, if the fiscal multiplier is larger than the GDP/DEBT ratio, then the DEBT/GDP ratio will fall even in the context of increased government spending (whether that spending comes from interest payments or other spending programs).

    Thus the higher the DEBT/GDP ratio, the harder it is for new government spending to push that ratio up further — i.e., the only way the debt/gdp can keep rising is if the fiscal multiplier is really low (and progressively moving toward 0, as the debt/gdp ratio moves toward infinity).

    For example, if GDP/DEBT were 0.5 (which is about Japan’s scenario of 200% DEBT/GDP) then it should only take a multiplier of more than 0.5 on new government spending to raise GDP enough that the new DEBT/GDP ratio would be lower than the old one. In most economies today I think the fiscal multiplier on government spending is well over 1.0 (right?)

    I think that same dynamic should hold true with the current account deficit, though the multipliers are probably much lower because foreigners spending decisions may be driven more by their own domestic dynamics, plus there are many more countries’ goods and services they can spend their trade surpluses on than just the country they got them from.

    But if it’s valid to add in exchange rate adjustment in response to trade imbalances (which I still think is true, until I see evidence to the contrary), then trade imbalances would stabilize that much sooner.

  33. hbl,

    “You seem to be saying the exchange rate is set directly by banks and/or governments or in some other way is unable to respond to trade imbalances. That’s a big surprise to me. Can you point to evidence that this reflects the real world of non-pegged currencies”

    In the hypothetical economy example, governments have to set the exchange rate.

    In the real world, banks are market makers in the fx markets. While trade imbalance is one of the factors which cause exchange rates to move, there are other reasons they move as well. Only in the textbook Mundell-Fleming world do exchange rates move so as to reach a balance in trade.

    LRW from NEP MMP

    http://www.neweconomicperspectives.org/2011/11/mmp-blog-26-sovereign-currency-and.html

    “The reason is because those economists who had believed that exchange rates adjust to eliminate current account surpluses and deficits had not taken into account that an “imbalance” is not necessarily out of balance. As discussed previously, a country can run a current account deficit so long as the rest of the world wants to accumulate its IOUs. The country’s capital account surplus “balances” its current account deficit.”

    admitting that exchange rates do not move to bring about a balance in trade -if that is what you were looking for.

    “Though I’m not sure why it would be rapid unless the trade dynamics or government spending or GDP in general changed very rapidly”

    Well, if a government tries to pump prime Keynesian style, domestic demand rises faster than domestic output because the pump priming leads to higher imports.

    “Let’s say public debt to GDP did rise “forever.” What bad things would happen? If there is no adjustment mechanism to limit the growth, then how would it be different than an never-ending sports game where one team dominated and its points grew toward infinity? How would the high points some day cause sudden and unexpected damage? Even with some form of upwardly spiraling interest paid that pushed the points toward a higher order infinity?”

    You are assuming several things here. A nation’s liabilities are more acceptable to domestic citizens than foreigners. Since that is so, foreigners will shift to their own currencies. The nation as a whole has to attract foreigners by hook or crook.

    There is a general tendency here to think that “debt is not debt” and it’s the reason anybody and everybody here fails to see the problem. The reason is that one is trained around here with the intuition of US and China and with the US dollar being the reserve currency of the world, it’s easy for the US compared to other nations.

    Since it is difficult to see it this way one can look for real reasons (as opposed to monetary reasons) to see why it is so. A purchase of import by a citizen says something about the domestic producer versus the foreign producer. A citizen is buying a foreign product because of the relative weakness of the local producers. To some extent this is nice – domestic citizens get what domestic producers are unable to produce and the same for the foreign case. However if this continues forever, then clearly there is a problem.

    But if you do not look at indebtedness to foreigners as debt at all, you willl never see the problem. For example if foreigners shift their portfolios, this can lead to a high depreciation and the usual story applies – central banks intervene and debt is issued in foreign currency. You cannot assume that the currency will depreciate and things will be fine. Depreciation of a currency says something about its acceptability.

    “Are you sure? By my [possibly incorrect] calculations, if the fiscal multiplier is larger than the GDP/DEBT ratio, then the DEBT/GDP ratio will fall even in the context of increased government spending (whether that spending comes from interest payments or other spending programs).”

    And point me to a calculation for an open economy. Yours or others. Note its not so simple as you present. And I haven’t seen such a calculation – the one you mention – anywhere.

    (Btw, Japan is a creditor nation)

    Here’s a simple scenario. Trade deficit worsens every year by 1%. Since by sectoral balances,

    DEF=NAFA+CAD

    assuming NAFA is positive (else one has another unsustainable process in the game!)

    a rising CAD leads to a rising DEF which feeds into the PUBLIC DEBT

    I think you are assuming that since growth itself will increase GDP, PUBLIC DEBT/GDP will be prevented from rising.

    The error in such reasoning is that the growth scenario (keeping the rest of the world growth unchanged) worsens the trade deficit and hence the fiscal deficit and hence the public debt/gdp.

    Only in the work of Wynne Godley (and his collabrators) will you ever see this is in detail.

  34. “They even think money is non-convertible.”

    Money is non-convertible. It’s only exchangeable short of central bank intervention.

    The intermediaries are always the banks as they are in any triparty circuit model, and there are private banks with legs in each camp – ie a central bank account in two countries.

    The intermediary banks make markets in the currencies exactly as they would make markets in shares. Yet there is no suggestion that market makers can turn a share of Walmart into one in McDonalds.

    If the market maker bank is a regulated bank in a domicile then *it* can create credit money in the domicile in exchange for the foreign asset if it chooses – but only up to its capital limit. If that triggers a central bank reserve creation then it is a function of the loan system, not the exchange.

    That’s the basic system. The central bank’s swap system is allegedly to make that market more liquid, and if that is a problem from a float distortion point of view it can be instructed to stop doing that. Which would mean the market makers have to pre-fund.

  35. “And history shows where that leads — to war.”

    The past isn’t necessarily a guide to the future. There is no inevitability about that.

  36. “Depreciation of a currency says something about its acceptability.”

    But somebody had to accept it, and that means they are going to use it for something – or they wouldn’t have done the exchange.

    ITSM that all the objections here boil down to the basic belief that the system can force a central bank to convert the currency (ie literally reduce or increase the stock of fiat currency in existence).

    Are you sure you’re not confusing a stock with a flow here. A reduction in the flow of a currency against another currency is not destruction or creation.

  37. Ramanan,

    No time for a full reply but I should be able to within a half day. One quick response to the top of your comment… I was not claiming that exchange rates would shift to bring trade into BALANCE. Just that exchange rates could be impacted in part by trade imbalances which could in turn shift the trade imbalance. The shifted position would have no particular tendency to be balanced, so I agree with the LRW quote.

    More on the rest of your comment later.

  38. All,

    This is a good, and very important, discussion. I feel I should interject though. Ramanan has excellent instincts, but this,

    Only in the textbook Mundell-Fleming world do exchange rates move so as to reach a balance in trade.

    Is wrong. Exchange rates do not move to balance trade in the textbook Mundell-Flemming / ISLM-BOP model. (The fact that exchange rates do not do this is something that is probably emphasised in every course and textbook on the subject.) To claim otherwise seems to me to be a bad misreading of the model.

    A flexible exchange rate adjusts to keep BOP = 0, i.e., BOP equilibrium or a “balanced” BOP, i.e., total autonomous credits equal to total autonomous debits, NOT to ensure balanced trade.

  39. Ramanan @ 2:56am,

    “Well, if a government tries to pump prime Keynesian style, domestic demand rises faster than domestic output because the pump priming leads to higher imports.”

    Agreed, that’s an example of a change that could be rapid.

    “A nation’s liabilities are more acceptable to domestic citizens than foreigners. Since that is so, foreigners will shift to their own currencies. The nation as a whole has to attract foreigners by hook or crook.”

    Or by exchange rate adjustment? If not enough foreigners want to hold another currency, wouldn’t the price of that currency drop until they were willing to hold it, like with most asset markets? Wouldn’t that exchange rate shift in turn have some effect on trade competitiveness? (And again, this doesn’t imply a move to balanced trade!)

    “…However if this continues forever, then clearly there is a problem.”

    What problem, from the financial as opposed to broader economic side of things?

    “For example if foreigners shift their portfolios, this can lead to a high depreciation and the usual story applies – central banks intervene and debt is issued in foreign currency. You cannot assume that the currency will depreciate and things will be fine. Depreciation of a currency says something about its acceptability.”

    It seems true that if foreigners shift their portfolios in a large and sudden way that there could be problematic consequences and probably government intervention. But how likely are such large and sudden changes as a result of the trade-flow-driven financials alone? I would argue such sudden shifts result from other factors — political changes, popping of asset bubbles, etc.

    Perhaps your argument is that the result of a large drain of a nation’s financial assets via the import channel leaves it more vulnerable to other shocks outside the realm of the financial flows alone? I’d have to think it through more, but I might agree with that.

    “Note its not so simple as you present.”

    Yes, my mistake. My little GDP/DEBT multiplier rule was totally wrong — I was playing with the algebra recently and apparently mixed something up… managing to treat the government spending injection as one-off for debt purposes but perpetual for GDP purposes :O Sorry for the premature share of unchecked/unfinished thinking.

    Overall I think I understand better where you’re coming from and I’m a bit out of my depth without reading and thinking more, so I’ll stop here. I didn’t have any idea the discussion would get this involved, though it is useful to me (hopefully to others also).

    I will re-iterate my original point from Feb1 5:14pm — I still suspect that you are talking about broad economic sustainability that incorporates things like politics, institutional tendencies to react certain ways, etc, and that the academic MMTers may be talking about the purely financial sustainability side, and that perhaps you are talking past each other. If that’s the case, perhaps it is unrealistic of them to focus so narrowly even to make a theoretical point, with the real world being much more complex, even if they are technically correct within that narrow scope. But again, I’m out of my depth here, possibly already drawing the wrong conclusions, and should stop before I make more silly mistakes 🙂

  40. hbl,

    I think it’s simpler than you guys are making it seem.

    A current account deficit represents borrowing from the foreign sector. That is a position that has to be financed. If that financing is subject to sudden stops, then you end up with a currency crisis.

    Just because the govt of a country can run a sustainable ponzi with respect to the private sector doesn’t imply that a country can run a sustainable ponzi with respect to the rest of the world. Clearly, at some point, foreign creditors are going to look at the the size of a nation’s debt service relative to its income and start to think about getting out of there.

    Having a sovereign currency issuing govt doesn’t necessarily help because although that gives the govt a certain amount leeway in determining nominal domestic income, 1, higher domestic income might just increase the CAD, and, 2, if the value of the currency falls after govt intervention that might precipitate the crisis.

  41. Vimothy,

    Thanks for the interjection.

    “A flexible exchange rate adjusts to keep BOP = 0, i.e., BOP equilibrium or a “balanced” BOP, i.e., total autonomous credits equal to total autonomous debits, NOT to ensure balanced trade”

    That is always true as a matter of accounting. Total credits are always total debits.

    According to Obstfeld, Mundell’s model is using the same specie-flow mechanism

    “Even in a world of rigid prices, Mundell argued, an “income-specie-flow mechanism” analogous to Hume’s price-specie-flow mechanism ensures long-run equilibrium in international payments.”

    Two things. Since debits=credits at all points in time and if a phrase “long-run” equilibrium is being used, I would assume it means a balance in the current account as opposed to anything else. If it is supposed to not mean balance in current account, it is hardly an equilibrium because given that an imbalance in current account, there is a rise in assets/liabilities relative to income which hardly qualifies as “equilibrium”.

    Second, if Mundell and Neoclassical theorists think that there is a specie-flow mechanism in Mundell’s model of floating exchange rates, then it’s the same old thing all over again – specie flow changing the money supply and thence wages/prices and leading to a balance in trade!

    Okay, one thing I would like to mention to you since you are a critical observer of MMT. The reason I take so much trouble in all this is that while they agree that international problems can be quite a tight reign on fiscal and monetary policy but under special conditions it is not even a reign. This condition is achieved when a nation truly floats its currency with some more conditions. No official sector liabilities in foreign currency etc. Spoils the virginity. To show this they present a few examples saying that some countries have achieved this state. But that is like showing a few alive people (never mind cancerous or not) to prove immortality. What do you think?

    It’s true that floating exchange rates provide more room for policy but the MMTers tend to go for the overkill.

  42. hbl,

    “Or by exchange rate adjustment? If not enough foreigners want to hold another currency, wouldn’t the price of that currency drop until they were willing to hold it, like with most asset markets? Wouldn’t that exchange rate shift in turn have some effect on trade competitiveness? ”

    Yes exchange rate adjustment is one way out. What I am saying is that the intuition that the currency drops till someone is willing to hold is wrong. It is for this reason central banks and the ESFs enter the currency markets.

    It’s not even true in asset markets. There can be runs where only a few speculators are willing to hold.

    Second, a drop in exchange rate certainly improves price competitiveness but hardly improves non-price competitiveness which is more important. A drop in INR is beneficiary to Indian exporters but India’s overall success in international markets is restricted by India’s competitiveness which has little to do with trade. To put it simply, India cannot make iPhones.

    “What problem, from the financial as opposed to broader economic side of things?”

    An increase in net indebtedness to the rest of the world. An imbalance in the current account adds to the net indebtedness of a nation.

    I am not sure about your points such as political risks etc. Yes, they are there.

    “But how likely are such large and sudden changes as a result of the trade-flow-driven financials alone?”

    Yes, there can be flows not due to imbalance in trade. A nation with a surplus can have portfolio shifts out of the nation but the more indebted the nation is the more likely it is to happen.

    “I still suspect that you are talking about broad economic sustainability that incorporates things like politics, institutional tendencies to react certain ways, etc, and that the academic MMTers may be talking about the purely financial sustainability side, and that perhaps you are talking past each other.”

    Not really. I am going to the very basic points.

    Consider a statement such as “imports *are* benefits”. Its completely untrue. A current account deficit is a leakage in demand. If there is no deficit or if the deficit had been low, that means domestic producers will produce more – seeing more demand for their products than otherwise. They will employ more people who consume more and this creates a nice positive feedback. A trade deficit produces higher unemployment. Only in a hypothetical world, they are “benefits”.

  43. Ramanan,

    The BOP is not always “balanced”. We can either have a surplus, in which BOP > 0 and total autonomous credits exceed total autonomous debits; or we can have a deficit, in which BOP < 0 and total autonomous debits exceed total autonomous credits.

    The key qualifier here is "autonomous".

    A BOP is in "equilibrium" (in Mundell-Flemmng / ISLM-BOP terms) when it is equal to zero.

    Normally we write the sum of autonomous transactions as,

    Current account balance + capital account balance + statistical discrepancy = Balance of payments (BOP)

    A second class of transactions is called “accommodating” or “compensatory”. These are official transactions taken for BOP purposes.

    Here we have,

    BOP = – Official settlements balance

    Under fixed exchange rates, the authorities maintain BOP surpluses or deficits by intervening in FX markets.

    Under flexible exchange rates, the currency appreciates or depreciates to keep BOP = 0. (I could flesh this out with an example, if you like). Trade is not brought to balance by flexible exchange rates–at least as far as the ISLM-BOP framework goes.

  44. Vimothy,

    I am fully aware of all this because I am familiar with the work of Godley and Lavoie and similar Post Keynesian work, so you don’t have to spend time to flesh it out in an example.

    If you check their G&L chapter, they use the notation OSA for the official settlement account and KABOSA.

    “Trade is not brought to balance by flexible exchange rates–at least as far as the ISLM-BOP framework goes.”

    Will check this from some standard reference. At least there is a specie-flow in the mechanism as Obstfeld points out.

  45. Vimothy@2 February 2012 at 4:22 PM,

    Didn’t see this comment earlier.

    Fully agree.

    More generally, in addition to the constraint of borrowing from foreigners, a current account leads to a leakage in demand and is doubly problematic.

    The people here seem to assume that there are no sudden stops.

  46. R,

    No worries. Figured you knew all this already. Just different names in different frameworks.

    For anyone else who might not follow, the issue is that if I want to acquire some foreign asset, someone needs to acquire a deposit denominated in the domestic currency, which is how I pay for the asset.

    The question–but why the hell should anyone want to do that?–is a question about what is the equilibrating variable that ensures that autonomous debits equals credits in the BOP and autonomous demand for deposits denominated in the domestic currency equals supply. That variable is the exchange rate.

    R–one other thing, in response to your question, re the issue of a BOP constraint. I agree very much that net indebtedness to the rest of the world is a constraint on policy, even with floating exchange rates, and even if the govt is a sovereign curreny issuer.

    I think because MMT has a particular way of looking at govt solvency, it makes sense to try to apply that way of thinking elsewhere.

    The idea that the govt faces no solvency constraint rests on the idea that it issues currency. So, a natural question to ask is: does the nation also face a solvency constraint with respect to the rest of the world, if that nation is a sovereign currency issuer?

    And the answer to that is yes, it does face a solvency constraint. It faces a solvency constraint because there will always be inherent uncertainty about its ability to repay its foreign creditors. Why uncertainty? Because there is no guarantee that foreigners are going to be willing to hold the domestic-currency-denominated assets at an acceptable exchange rate.

    Thought about from an MMT perspective, perhaps one might say that foreigners do not have a natural and plastic tax-driven demand for the domestic currency that can be exploited by policy makers.

    But whatever the case, the ability to issue a currency is not going to help if foreigners decide that they no longer wish to hold assets denominated in that currency, and they might decide that for a whole variety of reasons, none of which are obviously mitigated by the power of a sovereign to issue currency.

  47. Vimothy @ 4:22pm (& Ramanan too),

    Thanks for trying to clarify.

    “If that financing is subject to sudden stops, then you end up with a currency crisis… Clearly, at some point, foreign creditors are going to look at the the size of a nation’s debt service relative to its income and start to think about getting out of there.”

    This is what I find it difficult to envision happening. I suppose the analogy is the “bond vigilantes” scenario for government debt. Bond market sudden stops don’t exist for US-style countries because it is not possible for a self-fulfilling crisis of confidence to force insolvency because the government can always fund itself either directly or indirectly… that is not true for countries such as Greece, of course.

    I suppose it does seem theoretically possible that a self-fulfilling prophecy of a collapsing currency could take hold and that a country without sufficient foreign reserves could not defend its currency, thus allowing the self-fulfilling prophecy to take hold in the first place.

    It doesn’t seem very probable to me, but if that’s the point you and Ramanan are making, I see how it might be accurate.

    I know these currency collapses have happened before, but my understanding is they were always with pegged currencies of some sort, and the collapse occurred as a self-fulfilling prophecy took hold that the “unnatural” peg would be broken, so it was.

    Are there other asset markets where self-fulfilling prophecies of price collapses have taken hold? Commodities? Real estate? Equities? I’ve never heard of such a thing… unless of course the scenario is a bursting bubble of overvaluation (e.g., Minsky-related dynamics). Thus it seems like the possibility for default (i.e., loss of principle in discrete chunks decided upon by the originator of the asset, rather than via market forces) is a distinguishing factor.

    It’s possible I’m still not understanding you, in which case I should definitely be done (sorry). If I am understanding, I’m still skeptical, but perhaps see your point.

  48. R,

    Forgot to add .. with stocks of assets and liabilities falling or rising, hardly qualifies as equilibrium.

    Definitely not in the sense of a dynamic “stock-flow” steady state like in Godley and Lavoie’s models–which reminds me of something that I’ve been meaning to ask you:

    I’d be really interested to see how G&L type models perform “out of equilibrium”. In particularly, I

  49. Ramanan @ 5:16pm,

    My comments to Vimothy I think apply in response to your comment, also. One other point though:

    “Consider a statement such as “imports *are* benefits”. Its completely untrue…”

    I disagree. The statement “imports are a NET benefit” would be untrue, or at least not true in all scenarios. However, imports are a benefit, even if the drawbacks might outweigh the benefit(s).

    That said, I think it would be more precise of MMTers to say “imports are a material benefit” or “imports are a benefit with respect to the consumption to work ratio” or something else a little less ambiguous.

  50. [Sorry, pressed the damn submit button by accident]

    …I’d be really interested to see how G&L type models perform “out of equilibrium”. In particular, I’d like to see the model subjected to stochastic shocks to see what sort of business cycle dynamics it generates. Do you know of any papers / researchers working in this vein?

  51. “Because there is no guarantee that foreigners are going to be willing to hold the domestic-currency-denominated assets at an acceptable exchange rate.”

    The MMT argument is that you balance the desire to save in the non-government sector.

    So if the foreign entities don’t want to save in the domestic currency then they will swap it with some other entity that does – or some entity that wants to spend in the domestic currency. The change in the direction and strength of that flow influences the exchange rate.

    If that reduces the overall desire to net-save in the domestic currency, then MMT automatically withdraws sovereign support for the excess savings.

    So I would say you have the causality backwards. The sovereign support is to replace the leakage of the domestic financial liabilities to foreign holdings *after* those foreign holdings have happened.

    It’s never a question of whether foreigners will accept the money. By definition they already have and the sovereign is just topping the flows back up by accommodating them.

  52. Vimothy,

    Nice exchange. I missed your qualifier “autonomous” when I looked at your comment.

    Btw, regarding “accomodating flows” the point I made briefly here and in some other places as well is that the banks’ books (more generally, the financial sector’s books) accommodate some of the flows.

    “But whatever the case, the ability to issue a currency is not going to help if foreigners decide that they no longer wish to hold assets denominated in that currency, and they might decide that for a whole variety of reasons, none of which are obviously mitigated by the power of a sovereign to issue currency.”

    Good point.

    In fact, the point I am trying to make is that in a model world one can imagine, everyone is born “sovereign” in the Neochartalist sense. However, the financial sector forces nations to give up this sovereignty.

    For example, if there are sudden stops, a nation with a “sovereign currency” will be forced to issue debt in foreign currency and in this story, a nation starting being a “sovereign currency issuer” becomes non-sovereign in MMTspeak.

    (Because in MMT rules, government issuing debt in foreign currency is a strict no-no).

    So the implicit risk MMTers do not realize is that a/the nation they are describing can fall out of their description!

  53. hbl,

    “I disagree. The statement “imports are a NET benefit” would be untrue, or at least not true in all scenarios. However, imports are a benefit, even if the drawbacks might outweigh the benefit(s).”

    Okay partially agree. Everyone enjoys foreign products. Most products I buy are foreign. So there is some hypocrisy in my arguments 😉

    But the MMTers give no qualification to this statement whatsoever and places where one finds these are full of innuendos that it is harmless.

  54. hbl,

    “I know these currency collapses have happened before, but my understanding is they were always with pegged currencies of some sort, and the collapse occurred as a self-fulfilling prophecy took hold that the “unnatural” peg would be broken, so it was.”

    Hungary is a recent example with a floating exchange rate but then the typical argument one can come up with is that the Hungarian government has debt in Euros (without mentioning that the central bank of Hungary has reserves in Euros too!).

    Another example. Australia too faced huge issues in 2008 and the Australian banks faced huge pressure in meeting their funding requirements. This put a lot of pressure on the exchange rate. The RBA had to borrow from the Federal Reserve to lend Oz banks – else they would have faced a day of reckoning.

  55. hbl,

    Forgot to add. Its difficulty to fully float (“fear of floating”) which is important. While most currency crisis happens with non-floating regimes, that doesn’t mean they had they floated they would not have had issues. This is because, the alternative does not exists. They cannot float.

  56. Where I have a problem is that theoretically something can sound good, but practically it can present problems socially and politically as well as economically, I think that this may be the case with certain MMT solutions without applying corrective measures (which may be only implicit).

    For example, MMT economists argue that imports of are benefits. But Marshall Auerback points out that this is only true at full employment since the cost is demand leakage and unemployment (as Ramanan observes above). MMT economists counter that the demand leakage can be countered by expanding the deficit in offset. This presents a situation where in creating more demand to expand domestic employment, the nation further encourages an expansion of the trade deficit, so that plugging the hole in demand results in massive virtual immigration as the country supports more and more foreign workers as twin deficits increase.

    Moreover, thinking that this solutioncan be accomplished seamless is myopic, it seems to me. There will be political pushback from conservatives concerned with lack of fiscal discipline, from labor forced to compete with the ROW when foreign workers’ compensation is much lower, etc.

    And I have already mentioned how an asymmetrical global economy will not tend toward a stable equilibrium of its own through free trade, free capital flows, and floating rates without international coordination including international control of translational firms in a socially and politically practical way.

    Similarly, in attempting to achieve full employment and price stability domestically independent of a CAD, the government offsets demand leakage with increased deficits, a JG, etc. However, this does not address the issue of firms capturing an increasing share of gains in productivity, with wages stagnating or falling as firms resist margin compression, so that if workers manage to negotiate a higher wage, the firm passes that increased cost to consumers to maintain profit margin, or else moves the work to places where labor is less costly. What happens as a result is that the increased deficit spending simply goes to supporting a system that is inherently dysfunctional without addressing the issues relative to dysfunction.

    If MMT were simply an economic theory, there would be no difficulty. But MMT economists have posited that macroeconomics is policy-oriented. Economic policy cannot ignore social and political realities. In embracing institutionalism MMT economists admit this.

    However what I see lacking is a comprehensive presentation of MMT as a policy instrument that addresses the practical issues in addition to the theoretical one. Of course, the theory has to be sound to provide a foundation, but that is not enough to make a convincing argument that the policy is feasible under particular circumstances.

    For example, what I hear Ramanan saying is that certain MMT solutions may work for the US as long as conditions remain favorable (superpower, world’s largest economy, USD as global reserve, etc.), but the same policies may not work elsewhere. That is not always made clear in asserting MMT policy solutions.

    There are pieces of a larger solutions scattered about. For example, Warren has advanced some reform proposals for banking, the financial sector, and health care. However, without a unified and integrated proposal for an MMT-based economic policy, it is difficult to counter criticism of specific MMT policy solutions. For instance, the commonly heard criticism from the left is that MMT perpetuates a dysfunctional system that is aligned against workers by allowing firms to preserve their margins at public expense while throwing a subsistence wage safety net to workers. And the right complains that the solutions continue to feed the beast, potentially growing government without limit.

  57. Vimothy,

    “I’d be really interested to see how G&L type models perform “out of equilibrium”. In particular, I’d like to see the model subjected to stochastic shocks to see what sort of business cycle dynamics it generates. Do you know of any papers / researchers working in this vein?”

    Yes most of their models are simple. But they do simple analysis like shocking government expenditures, propensity to consume, changes in asset allocation, changes in wage-bargains and all that. It’s more of a framework than anything else. As they claim in their intro, they are not claiming they are experts in some sort of investment function …

    “We are not writing as experts with special knowledge concerning, say, the investment or consumption functions.”

    However its the crudeness of the models which I am really attracted to and the intuition of the authors is the reason I read and reread their book.

    You can try to find some papers by Lance Taylor who also got into SFC a bit and he does some kind of analysis you may be interested in but I haven’t read his papers though.

    You can read Taylor’s review of the book here which has some similar points with some references:

    http://mulestable.net/file/ramanan-20100615T083857-gsl2drg.pdf

  58. Neil,

    It’s never a question of whether foreigners will accept the money. By definition they already have and the sovereign is just topping the flows back up by accommodating them.

    But this isn’t true. If what you claim followed logically then we wouldn’t need fixed exchange rates–or floating exchange rates for that matter, because there wouldn’t be any need for the currency to appreciate or depreciate.

    But clearly, currencies do appreciate and depreciate. So…

    Again, it comes back to the question of what happens if we increase the supply of domestically denominated bank deposits on FX markets. No one is forced to to buy your pound denominated bank deposit at current exchange rates, and no one is forcing other holders of pound denominated bank deposits to trade them at current rates.

    Either there is demand for those new deposits at current exchange rates or there is not. If there is, well and good. If not, then then foreign currencies will appreciate against our own until the owners of portfolios are happy and demand again equals supply.

    Now, that’s no big deal, in and of itself. But it is the mechanism.

  59. Vimothy and Ramanan

    Nice exchange. Ramanan, you said this

    “In fact, the point I am trying to make is that in a model world one can imagine, everyone is born “sovereign” in the Neochartalist sense. However, the financial sector forces nations to give up this sovereignty.”

    To me, being truly sovereign is not just a “financial” thing, it also involves real things. To be truly sovereign one must be able to live completely off what one can produce using only domestically obtained raw products. The US meets these requirements as does China, Australia, and Europe and probably Russia.

    Mosler, Mitchell and co know this. Virtually all discussion in these blog posts revolves around the US economy and US dollar, and there is no doubt that the US is truly sovereign. We choose to import certain stuff not because we need to but because its easier, in a sense. Involving yourself with the rest of the world IS a net positive but it does put some constraints on your ability to “do whatever the heck you want” which, admittedly, it seems is contrary to what MMT is saying. You can only do whatever you want if you are living in total isolation, which no one seems to be advocating.

  60. Greg,

    Thanks.

    Yes I agree that nobody can live in isolation. So protectionism is not the way out.

    Mervyn King said while discussing global imbalances

    http://www.bankofengland.co.uk/publications/speeches/2011/speech473.pdf

    that

    “But, to borrow a phrase, in order to be tough on protectionism, we need also to be tough on the causes of protectionism.”

    Globalization is very important but there is a balance. Because of the free trade doctrine nations have found themselves being forced to agree on the rules of international trade, GATT etc.

    The point is that when world leaders meet on discussing policies the infernal muddle on how the world operates leads to policies which are beneficial to some and harmful to the rest.

    MMT says that is opposed to free trade but looks for fair trade (as in better working conditions and so on), and while these are very important matters, but I believe the problems are more fundamental than that.

  61. hbl,

    All good comments and you’ve obviously given this quite a bit of thought.

    So let’s think about the US in particular for a moment. Here we’re trying to understand the nature of what constraints if any policy makers face under a variety of hypothetical scenarios—not suggest that the US is about to undergo a currency crisis.

    Now, it’s certainly true that (pace the Eurozone’s ongoing conflagration), BOP or currency crises are things that happen to (relatively) crappy little economies with (relatively) fixed exchange rates. (Although, did I mention Europe yet?)

    Obviously the US is not very much like Mexico in 1994 or Malaysia in 1997 or Russia in 1998.

    However, as Ramanan alludes to above, a “true” float is very rare—like perfect competition, it’s an ideal. In reality there is a continuum between totally fixed and totally floating, and most countries lie somewhere in between. If the dollar started to nose-dive with great speed tomorrow, I would be very surprised if the Fed did not intervene to prevent a collapse. And why should the US care if the value of the dollar falls on FX markets? Because it pushes up the cost of imports, which lowers the US standard of living, and it makes financing the CAD more difficult.

    To reiterate, I don’t think that the US is about to undergo a currency crisis. Nor am I claiming that servicing foreign held debt is currently a huge problem. But one shouldn’t infer from that the idea that current trends are ipso facto sustainable or that it is impossible for these issues to constrain US policy choices or outcomes in the broader US economy.

    What we want to know is, under what conditions would these things begin to bite? Well, one reason is that the CAD could become very wide, and demand for dollar deposits might fall. Why should the CAD become large? Let’s say that Warren Mosler becomes president and raises nominal income to unprecedented levels. The economy is booming! The CAD is huge! Imports are a real benefit, remember, so you want to maintain the real terms of trade and keep US standards of living high. But how do you do that given that the supply of dollar deposits in FX markets has also exploded?

    Well, one method would be to intervene in foreign exchange markets to try to keep the dollar pegged around some level. And there you have a dynamic that could build into a BOP crisis. The fact that you want to avoid a BOP crisis clearly implies a constraint on policy choices. (BTW, I’m not claiming that any particular policies will lead to this. Merely that such a thing is possible).

    Another thing to consider is what proportion of the national income is lost to servicing foreign debt. If it is big, that is probably bad, and if it is small, that is probably good. But it is not no thing; an irrelevance; something that can be ignored. If the govt were to try to deal with issue this by increasing the deficit, to raise national income, say, that might simply widen the CAD and exacerbate the issue. So there is again is a possible constraint on US policy makers, arising from the nature of the international economy.

    And of course, I should add that the US is a very special case. Most countries do not have the freedom afforded to the US in terms of its ability to ignore these issues, which is less than total.

    The point that I am trying to make is just that these things matter and are worth worrying about and factoring into your models, not that they are necessarily significant constraints today (or that they are not!).

  62. Ramanan: I believe the problems are more fundamental than that

    Interesting. Care to elaborate. Or have you elsewhere?

  63. It seems to me that the US has the economic space to pursue free trade as in its national interest, although the political space is shrinking with persistent unemployment. Through free trade the US gets inexpensive foreign labor, resources, and goods, and this also contributes to development of emerging markets that US firms can penetrate. Furthermore, it opens up opportunities for investment in the emerging economies, where the bulk of accelerating growth is coming from and will for the foreseeable future. The cost is chiefly higher domestic unemployment, which may not be sustainable politically. But there don’t seem to be any currency issues on the horizon even though there are a lot of Cassandras ranting about it.

  64. “But this isn’t true. If what you claim followed logically then we wouldn’t need fixed exchange rates–or floating exchange rates for that matter, because there wouldn’t be any need for the currency to appreciate or depreciate.”

    It is. You’ve misunderstood what I said.

  65. vimothy @ 8:37pm,

    Don’t worry, I didn’t interpret your comments as ringing alarm bells about the US today! All good constructive comments.

    You say “a “true” float is very rare—like perfect competition, it’s an ideal” and Ramanan says at 7:10pm some regimes “cannot float”.

    That seems to me a fundamental departure from the view point of the MMT academics. The implication I read from them is that every country has the realistic and sustainable option to float. To be clear, I have no idea which view point is correct, or if I’ve misunderstood. I also don’t have enough expertise to comment on the countries that you and Ramanan both listed as examples.

    So let’s say many currencies don’t have true floats because those regimes find such an arrangement beneficial… or perhaps out of necessity as I think you and Ramanan might be saying.

    Again I would separate the concept of “financial sustainability” from other types of sustainability. That would call into question for me the sustainability of the currency arrangement (peg, partial float, or whatever it is), not the inherent financial sustainability of a trade deficit. If that currency arrangement is somehow inevitable for those nations, what is it about the nation that “forces” such a situation? Lack of real resources? Something else? Is there REALLY no other alternative, or is the currency arrangement just politically convenient in some way?

    Again I have the feeling that with enough precision in defining the two opposing viewpoints they would turn out to not be in conflict after all… but I could also still be missing the point.

  66. “For example, if there are sudden stops, a nation with a “sovereign currency” will be forced to issue debt in foreign currency ”

    What’s the problem with sudden stops?

    Every time anybody mentions this sort of thing it usually involves somebody in the economy doing something stupid and the country refusing to let that entity go to the wall.

    Probably because there is no catch system to handle the fall-out of the deleveraging.

    I don’t see how you can get ‘sudden stops’ on your external trade if you’re managing your exports and imports properly. By definition the exports are earning foreign currency to be used on the appropriate imports.

  67. Neil,

    Fair enough!

    As long as exchange is voluntary then it seems to me that you can’t guarantee that anyone will take the other side of the transaction. This applies to FX markets as well.

    Ah, sod it. I’m going to try that example. This might be unnecessarily convoluted and not news to anyone. In which case, please ignore. 😉

    Consider the following hypothetical transaction:

    Foreign exchange market is in equilibrium at e_0 = $2/£1.

    British resident buys a bond from a US firm using a check for £1000.

    If the US firm wants to hold that £1000 asset, it deposits it in a bank in London, and demand for pound-denominated deposits is unchanged.

    In the US BOP, the capital account is credited and debited $2000.

    Now say instead that the firm doesn’t want the pound-denominated deposit, and sells it to its NY bank in return for a $2000 deposit. If e_0 is still the equilibrium exchange rate, then, by definition, someone (perhaps one of the bank’s other customers) is content to hold the new pound denominated deposit, and total demand for pound denominated deposits is again unchanged.

    In other words, portfolio owners are content to hold the new quantity of pound-denominated deposits at the initial exchange rate, so that autonomous demand for pound-denominated deposits equals the quantity available.

    But say instead that at the current interest rates and (expected & forward) exchange rates, no one wants to hold the extra £1000 pound-denominated deposit. In this case, e_0 is no longer the equilibrium exchange rate.

    Now, either the authorities must intervene to keep the exchange rate at e_0 or the exchange rate must shift to bring the BOP into balance. Let’s ignore the case of fixed exchange rates and focus on what happens when the exchange rate changes freely.

    Here, the firm will be willing to sell its pound-denominated deposit for less than $2000. The pound depreciates against the dollar. Say it moves to a new equilibrium rate at e_1 = $1.80/£1.

    The US BOP will record a $1800 capital account credit for the “export” of the bond, and a $1800 capital account debit for the “import” of the pound-denominated bank deposit. Total autonomous credits equals total autonomous debits / BOP = 0.

    Nothing here forces people in the US to hold the pound deposit. But if they do not want it, they will sell it and that will put downwards pressure on the exchange rate, unless the authorities intervene.

  68. The primary dealers are the market makers that take the opposite sides of trades in tsys to ensure that the market clears, accumulating when the public desires to save less and distributing when the public’s saving preference increase. I would assume that the central bank (as market maker) would perform a similar function wrt the fx market to maintain a liquid market in its currency without disruptive volatility. Where problems arise is when the cb doesn’t have sufficient foreign reserves to defend against attacks on the currency.

    Is cb market making any more intervention than the market making of the PDs?

  69. Any thoughts on how some of this analysis pertains to Iran at the moment? Their current brew of fx concerns and sovereign currency revulsion seems like an interesting real world experiment with regard to some of the issues being discussed here.

  70. hbl,

    The issue with the sustainability of the trade deficit is that it has to be financed by foreigners. A govt deficit is always sustainable because it is financed with dollars the Fed issues, and the govt can generate demand for that money by levying taxes denominated in dollars. There is no comparable mechanism WRT the foreign sector. So there’s a categorical difference the two.

  71. hbl,

    “Again I would separate the concept of “financial sustainability” from other types of sustainability. That would call into question for me the sustainability of the currency arrangement (peg, partial float, or whatever it is), not the inherent financial sustainability of a trade deficit.”

    These are interrelated.

    A current account deficit is the difference between residents’ expenditure and income. Since globally income=expenditure, this appears as foreigners’ surplus and as a result, the net accumulation of financial assets of the foreigners to the country we are discussing. (Or Net Lending in modern national accounts terminology).

    Now foreigners may not wish to hold these assets and the nation as a whole has to attract foreigners by hook or crook.

    If a nation keeps running a current account deficit, it is increasing its indebtedness to the rest of the world and is susceptible to moods of foreigners.

    Exchange rate pegs usually see a “speculative attack” – typically when the central bank is losing reserves when it needs to intervene in fx markets. The reason the central bank is doing so is to “clear” so that the currency doesn’t lose its value. When is it more likely to happen? When a nation is more indebted to foreigners who are making portfolio shifts for various reasons.

    The foreigners accumulated these assets since “t=0” on a net basis because of the current account deficits.

    No wonder – when a nation faces a crisis in the external sector, it is called a “balance of payments crisis”.

  72. Tom,

    “Ramanan: I believe the problems are more fundamental than that

    Interesting. Care to elaborate. Or have you elsewhere?”

    When a nation is running a current account deficit mainly due to the trade deficit, it has to keep demand from rising because it will create a situation of higher deficits. As a result, it results in higher unemployment, less production and hence less productivity.

    Now, its easy to wave hands and say just deficit spend but I am afraid such an intuition is wrong to the core!

    Many nations have found themselves unable to expand because of “free trade” unable to control the imports by other means. This has led to a situation where they face a lower quality of living.

    So much for “imports are benefits”!

  73. Vimothy@2 February 2012 at 8:37 PM,

    Perfect.

    Let me add that in my opinion even the United States faces this issue now and it is for this reason Timothy Geithner keeps visiting China.

    The US does not face a balance of payments financing issue now but definitely has a problem with its current account. Any attempt by the US government by fiscal policy – as you mention – brings back a huge deficit and a huge indebtedness to foreigners. It can continue to finance them on terms favourable to it for some time but while doing so, its indebtedness keeps increasing.

    Unlike Mosler who thinks there cannot be a run on the dollar any time in the future .. the more this process continues the higher the chance of a trouble in the external sector … except for mildly possible scenarios where the dollar depreciates smoothly to bring the current account in balance.

    So the United States does have a problem with the current account itself not with financing so far. It also restricts the ability of the government to reach full employment by fiscal means alone because of the huge leakage in demand. This is imagine if the US didn’t face this problem of a high current account deficit. A fiscal expansion would have solved the problems somewhat more easily.

  74. Ramanan,

    On the first page does Adam (ak) make the same point that you make? If so, that’s the first time I’ve ever actually understood your argument.

    As an aside I agree with Neil on the “good enough” float – all things in moderation & take politics into consideration of the goals at the time.

  75. Senexx,

    Somewhat agree with Adam (ak) but unsure as to what “crowding out” is in his mental model.

    Some Post-Keynesians such as Anthony Thirlwall repeatedly stress that the greatest disservice Keynes did to the economics profession is that he didn’t start with an open economy.

  76. “British resident buys a bond from a US firm using a check for £1000.”

    Why would the US firm accept the check for £1000. What good is it to them?

    Why would the bank accept the check and handover $2000 if they can’t get the money back for it?

    If nobody wants to hold the £1000 check then the initial transaction wouldn’t happen in the first place.

    Which means everything that you suggest follows is moot.

    The causality is the wrong way around. The buying of the bond is that last thing that happens, not the first.

  77. Thirwall basically boils down to this

    You can’t buy stuff priced in a foreign currency if you haven’t got any foreign currency.

    Which aggregated up turns into you can’t import stuff paid for in a foreign currency unless you’ve already earned some foreign currency with exports paid in a foreign currency

    And you can’t choose what you export.

    I wonder whether in MMT terms foreign currency should be seen as a ‘commodity’ item sat in the real circuit rather than sitting in the nominal circuit.

    It seems to me that whenever you see foreign currency you should substitute ‘iridium’ or some other commodity.

  78. Ramanan,

    You’re position seems to be that the the policy freedom which appears to exist for the government of an open economy with a floating currency is illusory. That in effect the economy still has to be run as if were on a gold standard. Is that a fair assessment? If so, I’d prefer to take my chances will a permanent trade deficit.

  79. jms grmwd,

    Yes fiscal policy in purely floating exchange rates has more space.

    However, … The success or failure of a nation depends on how its producers compete in international markets and the propensity to import… and its ability to float as well!

  80. Ram,

    Thanks. And thanks for the ref earlier too. I’ve actually already read that paper (quite a while ago), but I’ll give it another look.

    hbl,

    Forgot to address this:

    The implication I read from them is that every country has the realistic and sustainable option to float.

    That’s true to an extent, but the cost of floating is that the value of your currency is determined by the market. Changes in the value of the currency have implications for the real terms of a nation’s trade with the rest of the world, its real net indebtedness and the real cost of servicing that debt. And that’s without even getting into the microeconomic effect of exchange rate movements on individual actors and industries in the economy.

    In practice, most countries aren’t prepared to live with a totally freely floating / unmanaged exchange rate, which is why it is relatively rare. The question is more, how much will we float, than will we float.

  81. vimothy @ 9:39pm,

    While there are differences, I believe the external deficit and the government deficit are analogous in at least one important way. And in both cases, portfolio transactions are subservient to real economic transactions.

    A government deficit involves net worth flowing from government to non-government. MMT makes clear that when the government issues bonds, it is just facilitating a change in portfolio composition — “where will all the bond buyers come from?” is the wrong question when looking at a growing deficit.

    An external deficit involves net worth flowing from the domestic sector to the external sector. Similarly, decisions about the currency (and currency-denominated asset type) in which to hold the asset side of that net worth increase are subservient to the transfer of net worth. Outside of Minsky-style bubbles, the market prices of portfolio choices tend to shift gradually rather than rapidly.

    Ramanan seems to be saying that currency markets are special in some way… that they don’t typically respond to these portfolio decisions in a smooth and continuous way, but then are subject to sudden large spikes or crashes as sentiment changes all at once. Or that it is somehow a fundamental feature of international trade that some regimes will be forced into currency arrangements that interfere with the market-based currency pricing mechanism. While recognizing these things might be true, these assertions don’t yet make sense to me.

  82. To be more precise, my previous comment should have referred to a transfer of “financial net worth” rather than “net worth”… (Though in the case of trade of goods the two are closer to matched than in the case of services).

    Ramanan @ 9:40pm,

    Thanks for your reply. I think my last comment to vimothy addresses your comment as well. Also, I’m still not sure what to make of “by hook or crook”.

    vimothy @ 3:13pm,

    Thanks… this again sounds to me like an argument that certain trade and currency related policy choices are practically inevitable for most countries, and that therefore financial sustainability (with respect to trade flows) and political sustainability cannot be separated. My prior point was that I think MMT academics take pains to separate those two concepts of what is sustainably, rightly or wrongly.

  83. hbl,

    Let me offer a “microstructure” approach of the exchange rate markets, roughly like Vimothy’s description.

    Unlike people around thinking of business card economies, I see the world as a system of interconnected banking systems.

    People here know roughly what happens when payments are made for either goods or services or purchases of financial securities and how the funds flow within the banking system.

    For the international case as well payments/funds transfers affect banks’ balance sheets.

    When I transfer funds say INR50,000 from a local bank to another person’s account with another bank but denominated in USD, I send in a request to my bank to transfer funds to a foreign account and the bank uses the correspondent account network to settle.

    In the first instance my bank ends up with an additional liability to its correspondent of $1,000 (assuming an exchange rate of $1=INR50).

    During the day, there are transactions happening in all directions and banks typically would like to not keep open positions in other currencies due to regulations imposed by the regulators or self. The banking system has to attract funds from abroad (in the opposite direction) so that it does not have a net open position.

    In the BOP accounting, this affects the item “Other Investment”. In the MMT world, this item doesn’t even exist.

    I have seen the same mistake made by good fx theorists such as Paul de Grauwe.

    Also, at the same time, banks act as dealers/market-makers in the foreign exchange markets. MMT says banks act as brokers.

    So as their role as dealers, banks are quoting bid-ask rates to their customers and needles to say, these change within a second. Even for fixed exchange rates, these fluctuate but less so.

    Banks are receiving order flows every moment and they accept this at the quoted rate. Depending on the direction of the order flows, banks would like to initiate trades themselves because they are managing their “inventories” actively and they may have undesired inventories. This leads to an initiation of order from the bank which some other dealer is likely to accommodate. The next person is also faces the same issue and this leads to a “hot potato effect”.

    This explains why trading in the fx markets is so high about $4T of daily turnover. Against the usual portrayal that these are speculative.

    Now consider a fixed exchange rate regime.

    Suppose a nation imports a lot. Foreigners get paid and shift their funds out the country. If the central bank does not intervene, banks will see their liabilities in foreign currencies rising because of these order flows and this puts a downward pressure on exchange rate. The central bank has to intervene to sell foreign currency in the markets which the banks acquire and reduce their indebtedness in foreign currency.

    Now in the BOP accounting, this can be seen as two steps

    1. Debit in the current account and a credit to “Other Investment” in the financial account. (For the purchase and payment of goods)
    2. Once the foreigner shifts funds abroad, it again affects “Other Investment” and then because of banks retiring their indebtedness to the foreign bank “Other Investment” in the opposite direction. (If the central bank’s counterparty is a foreign bank, it affects “Reserve Assets” too).

    Technical, but the net result is losing of fx reserves and this answers the vague notion of “paying for imports by fx reserves”

    At a more technical level, its not even required for the central bank to intervene as long as it thinks banks’ open positions are not huge. Banks can fund their positions in the interbank markets.

    However, if the central bank starts losing reserves, it has to increase interest rates to attract foreigners and the central bank can purchase foreign reserves while there are financial flows in the inward direction.

    Now consider a floating exchange rate. Even here, its about the same except that the central bank doesn’t intervene and there is a depreciation to the point which attracts “hot money” leads to a point where the depreciation stops. (Of course during the day, there are other financial transactions happening).

    All this first increases “Other Investment” and then “Portfolio Investment” and “Other Investment” in the opposite direction.

    Refer to the table on page 13 of the pub here (“20 of 179”) http://www.ons.gov.uk/ons/rel/bop/united-kingdom-balance-of-payments/2011/bod-pink-book-2011.pdf

    To be more precise, trade credit is also affected by I am assuming payments are instantaneous.

    Now except for a few nations, pure floating is a myth. (Which of course doesn’t mean their fiscal stance is not reigned by external factors).

    It may happen that the currency depreciates and there is no inflow via portfolio investment which means other investment keeps rising and the currency keeps depreciating. The central bank then has to intervene by either selling fx reserves or ask the government to issue government debt in foreign currency. Else it will be difficult for the banks to decrease their net open position.

    (If things go wrong, you see a “twin crisis”).

    Such things are managed by a coordination of the CB and the ESF.

    So when there is a “capital flight”, you see the item “Other Investment” keeps rising. So sudden stops arise when there is some loss of confidence such as due to an announcement of the current account deficit by the statistical agency, typically the central bank.

    So much for the MMT intuition that “we do not borrow from foreigners”, a deeper look shows how this is wrong. Also imagine if the central bank sets the interest rates to zero, there will be portfolio shifts out of the country!

    Another thing the central bank can do is to attract foreigners by increasing interest rates. This induces foreigners to sell their currency to domestic banks and reallocating their portfolio.

    The typical example of China buying US Treasuries is just a special case because the US dollar is a reserve currency. In most other countries exporters are repatriating funds. To reverse the flows, one has to attract the foreigners.

    The main reasons some here are misled is due to the “intuition” that indebtedness in one’s own currency is not really debt, just technically a debt and “reasons” along those lines. Well, that’s wrong but the main reason indebtedness in one’s own currency is better is that it prevents revaluation losses on liabilities and less needs to be earned abroad to pay off the liabilities!

    If you do your visualizer exercise for open economies using the Pink Book BOP table, you may start believing what I say.

  84. Ramanan,

    I appreciate the detailed explanation but unfortunately am unable on two readings to understand the implications and interconnections of all of it. I would like to revisit it when I can spend the time to look up unfamiliar concepts, study the pink book, etc.

    It seems like part of what you are saying is that in order for households or businesses in a nation to hold foreign currency denominated assets, they have to do it through their own nation’s banking system, which results in that banking system having some mix of foreign currency assets and/or liabilities that requires regular intervention from their central bank (for either regulatory or practical reasons). And that this somehow can set the preconditions for capital flight / sudden stops to occur.

    There’s a good chance I have misunderstood even that much, and I know there was more to what you said. Thanks for the effort and I’ll let you know when I revisit this at some point.

  85. hbl,

    In Krugman’s “canonical” currency crisis model, you have a fixed exchange rate that the authorities wish to defend and a shadow price of the currency, which is the market price satisfying supply and demand, steadily increasing in the background. At the moment that the market calculates that the authorities do not have sufficient reserves to defend the parity there is a discontinuous jump in the exchange rate to the shadow price and the peg is broken.

    It seems clear that a freely floating exchange rate won’t be subject to such discontinuities.

    Rather than respond immediately to the rest of what you wrote, I’d like turn it around a little bit, because I’m not really certain what the source of the disagreement is. Say that we agree that a budget deficit is always sustainable as long as the debt is denominated in the currency of issue. It doesn’t follow, as far as I can tell, that a current account deficit is always sustainable. Since you appear to think otherwise, I’d like to see you defend this position a little. Why is a CAD always sustainable? Thanks.

  86. vimothy @ 5:55pm,

    That Krugman model sounds entirely logical to me.

    “Why is a CAD always sustainable?”

    I don’t believe it is always ECONOMICALLY sustainable, just that it is always FINANCIALLY sustainable. See my first comment on this thread. As I’ve defined them, the financial is a subset of the economic.

    However, I get the impression that you and Ramanan don’t believe it’s possible to separate the financial sustainability component from the others. If that’s an accurate representation of your position, I’m undecided on whether I agree, but my weakly held instinct is disagreement, i.e., that it is fair to think of financial sustainability as an independent phenomenon.

    Apologies if I’m defining my own terms here and messing with the established terminology of this knowledge domain, with which I am not as familiar as I should be to be continuing to engage in this discussion (!)

  87. hbl,

    I don’t have any problem with you defining those terms in that way. It seems consistent and makes sense to me.

    But I still don’t understand why it is always financially sustainable. Can you explain a bit more?

  88. vimothy,

    “But I still don’t understand why it is always financially sustainable. Can you explain a bit more?”

    I guess I just can’t think of what in the realm of financial net worth “moving” between nations and portfolio mixes being adjusted would force an inevitable endpoint or crisis in that process. Yes, I recognize that there are correlated factors such as potentially insufficient domestic employment levels that could come to a head, but the way it’s arranged in my mind is that those other sustainability factors and the financial flows both arise from the same underlying trade dynamic, but that the financial flows themselves don’t CAUSE the other potential sustainability crises to hit. i.e., they are correlated secondary effects to a shared underlying economic trade dynamic. Policy *could* treat these correlated but independent outcomes of the underlying dynamic in differing ways.

    Picture a giant electronic scoreboard hovering in the air above every country. Each country has a distinct color for the points corresponding to financial assets denominated in its currency. All financial assets are just debt… no gold standard or anything underlying these points. Trade flows and market-driven portfolio adjustments result in points “moving” around between the scoreboards of different countries. Why does this process have to end in something bad just because one country’s scoreboard has an unusually large number of points in another country’s color? If there was only one entity controlling the points on each country’s scoreboard, it’s easier to worry about sudden massive shifts in sentiment by that one entity happening all at once. But it’s harder for me to picture that when the points are collectively “owned” by millions of separate households and businesses each with their own mostly independent trading and portfolio adjustment dynamics. Even government institutions such as central banks wouldn’t (I think) hold a large enough percentage of the foreign points on a given scoreboard to matter… unless they enacted interventionist policy like issuing unlimited points in their own currency to peg its value relative to other currencies.

  89. hbl@3 February 2012 at 5:41 PM,

    The underlying point is that imports are purchased on credit not for free.

    Chinese don’t export to India for doing charity. Etc.

    Continuous current account deficits leads to higher net indebtedness and if foreigners are not impressed by the terms favourable to them, they will shift their portfolios. Foreigners anyway have bias to allocate their portfolios in domestic assets i.e, there is imperfect asset substitution.

    So that’s what I meant when I use “by hook or crook”. Given these foreigners have to be attract to hold assets denominated in the domestic currency.

    One may wave hands and say that the exchange rate depreciates etc but that is pure hand-waving.

  90. hbl,

    “Picture a giant electronic scoreboard hovering in the air above every country. Each country has a distinct color for the points corresponding to financial assets denominated in its currency”

    “Why does this process have to end in something bad just because one country’s scoreboard has an unusually large number of points in another country’s color?”

    Public debt is not the debt of a nation. The latter is captured by the Net International Investment Position.

    I know where this intuition that nothing can go wrong comes from – the Japan example with public debt of 200%. But Japan as a nation is a net creditor of the rest of the world.

    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).

    In the same way, a nation’s currency can become unacceptable in the international markets.

  91. Ramanan @ 7:24pm,

    “if foreigners are not impressed by the terms favourable to them, they will shift their portfolios.”

    This makes me wonder if you are thinking of residents of a country as if they share a hive mind. Perhaps part of our difference of opinion is the extent to which people have abrupt herd-like behavior when it comes to financial markets. I know it does happen in some scenarios, I’m just not convinced it happens in this context.

    “One may wave hands and say that the exchange rate depreciates etc but that is pure hand-waving.”

    Are you and vimothy disagreeing on this point or am I misunderstanding one of you? For example he says at 5:55pm, “It seems clear that a freely floating exchange rate won’t be subject to such discontinuities.” Maybe it comes back to your point about true free floating currencies being so rare in real life, but I read you as saying the exchange rate doesn’t respond even in free floating currencies.

    [just now reading your next reply…]

    Ramanan @ 7:38pm,

    “In the same way, a nation’s currency can become unacceptable in the international markets.”

    I think I understand! If so, you are suggesting that a nation (private sector and government combined) can become effectively insolvent in the eyes of its “creditors” — potentially unable to keep up with its interest obligations to the rest of the world…?

    If that’s it I wish you’d just said it that way in the first place 🙂 Perhaps you did and I failed to notice.

    Yes, at least on my initial consideration, I would agree that this could lead to unsustainable financial flows if the private sector’s debt was a very large chunk (since the government sector CAN always meet its interest obligations when its debt is issued in its own currency). I’m not sure how common or likely that dynamic is in the real world, and whether a nation’s government would be sure to avert crisis by “bailing out” its private sector’s cash flow obligations in some sense, but the concept makes sense now.

  92. hbl,

    Thanks. I’d like to try to tie your response in to something in Ramanan’s comment. R. notes that obviously it wouldn’t make sense to think in that way when talking about individuals. (Or at least, if I’m wrong you need to introduce me to your bank manager).

    You seem to be saying that the nation in international markets should be considered as being like a sovereign govt in domestic markets, in that there’s never any question as to the sustainability of its borrowing. (I think I) understand MMT’s arguments with respect to sovereign govts. But I don’t understand why the same should be true of net debtor nations.

    What’s the reason or reasons that makes any amount of net borrowing from the foreign sector sustainable? Why is the nation more like a govt than a household or an individual?

  93. “Technical, but the net result is losing of fx reserves and this answers the vague notion of “paying for imports by fx reserves””

    Only because regulations are allowing that. So don’t allow it.

    The central bank can let the commercial banks know that they will not back stop the foreign currencies and the commercial banks then have to fund in the market – which will include pre-funding if necessary to cover the risk positions.

    And the net result of that policy structure would be that the repatriation of domestic funds by foreign entities (ie swapping it into their own currency at the current exchange rate) could not happen until there was a matching transaction in the opposite direction.

    So again its a matter of policy. Maintaining the floating exchange rate may very well require domestic entities match funding imports by finding an exporter in the same boat when they are dealing with invoices in a foreign currency.

    Foreign entities wanting to sell on the domestic market would then have the option of accepting the domestic currency in payment, and carrying the risk that they would be stopped from repatriating their funds due to a lack of currency.

    Of course that could be solved by the foreign central bank issuing the foreign currency and swapping the domestic currency payment for foreign currency – getting the foreign entity off the hook. Which is exactly what China does with US dollars, Euros and every other currency they deal with.

    So the policy trick is lock foreign entities desperate to sell their wares by paying them in your currency. Where a foreign entity gets locked in your currency, then it for the foreign central bank to free the logjam.

    Beyond that no matching export, no deal.

  94. vimothy @ 8:03pm,

    “What’s the reason or reasons that makes any amount of net borrowing from the foreign sector sustainable? Why is the nation more like a govt than a household or an individual?”

    Maybe when you commented you hadn’t seen my 7:55pm reply to Ramanan?

    One further thought… it seems counter-intuitive to me that thousands or millions of entities holding a different country’s liabilities could collectively embark on a herd-driven loss of confidence in that other country’s liabilities based on some sort of analysis of the thousands or millions of foreign private sector entities that issued those liabilities…

    It seems more intuitive to me that a country with lots of liabilities to foreigners could be more vulnerable to exogenous shocks… such as a famine destroying a lot of an agrarian country’s productive infrastructure. In that case the trigger of the currency crisis isn’t financial but the state of vulnerability is.

  95. Yes, I was still writing my commented when you posted!

    Looks like we all agree after all 🙂 Been a good discussion.

    It does seem counter-intuitive that the outcome of the interaction of all of these individually rational investors should be herding and bubbles. But on the other hand, it looks like international capital flows do actually behave like that, at least some of the time. These things do happen, are not infrequent and are costly.

    It’s interesting to read about previous currency crises. (Krugman actually wrote a nice little book on them). There you tend to see massive capital inflows leading to booms, real estate speculation, busts, and then massive capital outflows. It’s hard to see how these capital flows can be explained purely in terms of underlying economic factors.

    You can see some of this dynamic at work in the 08 financial crisis: you’ve got massive capital inflows lowering interests rates in the US and setting off an unsustainable real estate boom.

  96. “If that’s it I wish you’d just said it that way in the first place Perhaps you did and I failed to notice.”

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

    On the household-government analogy, I know Wynne Godley used to mention about this household-government analogy to the Thatcher government but he considered the nation as a whole as a corporation. Saying a growing debt leads to a growing burden of serving the debt and this could run unsustainable.

    I am unsure why you keep mentioning natural disasters etc and so on. Yes these are trigger events and a nation with higher net indebtedness is more likely to face an issue.

    (Remember though the JPY started appreciating last year leading to G7 central banks threatening to intervene ;- )

    But Mexico whose currency floats saw its currency plummeting in 2008 as crisis hit the US and there was a flight to quality into US government securities… and was forced to go to the IMF for rescue.

    About your points on exogenous shocks, I partly agree on trigger events but central banks are afraid of “unknown unknowns”.

    However what I am saying is that those cases are for considerations for a few nations such as the US, UK, Canada and Australia. Even Australia had an issue in 2008 as I mentioned.

    Most nations face miniruns on the currencies frequently. It is for this reason they are unable to truly float.

    The GBP was once the reserve currency but GB itself faced a lot of balance of payments crises in the 1970s even when floating.

    One example where a simple fiscal expansion leading to a boom and a bust was the “Heath Barber boom” of the 1970s – even after Keynes predicted that Britain was better off after 1971 here:

    “Keynes celebrates the end of the Gold Standard”
    http://www.youtube.com/watch?v=U1S9F3agsUA

    The US is a reserve currency of the world but once used to be the world’s largest debtor. Slowly it’s position has worsened over the years. However because since it is a highly productive nation, its creditworthiness is unquestioned.

    I don’t know much about the history of Canada’s external sector.

  97. “The US is a reserve currency of the world but once used to be the world’s largest debtor”

    Sorry meant once the biggest creditor and now the world’s biggest debtor.

  98. vimothy @ 8:51pm,

    “It does seem counter-intuitive that the outcome of the interaction of all of these individually rational investors should be herding and bubbles.”

    I did identify bubbles early on (from my list,
    “1e. Risk of asset bubbles and resulting sudden adjustment of many asset prices, including currencies”) as a risk factor for currency crises, but I don’t remember the discussion returning to them until now. Now it seems like you and Ramanan are suggesting these bubble dynamics are common, which is a proposition I might have agreed with from the start! But I still would have separated them from my category of “financial sustainability” of trade flows. But perhaps the two are inseparable if capital inflow bubbles are as frequent as the remainder of your comment seems to suggest.

    Thanks for the discussion.

  99. 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.

  100. 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.

  101. 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

    PSBR = NAFA + CAD

    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…

    Possible?

    (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 http://moslereconomics.com/mandatory-readings/the-innocent-fraud-of-the-trade-deficit-whos-funding-whom/

    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.

  102. 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.

  103. Neil,

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

    http://www.bis.org/publ/bcbsc132.pdf

    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.

  104. 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.

  105. 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?? 🙂

  106. 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.

  107. 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.

  108. “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.

  109. “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.

  110. 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.

  111. 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.

  112. “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).

  113. “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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