One suggestion in the comments to the ongoing “short & simple” series is to cover the balance of payments. This will be covered at some point in the introductory series, but I am still considering how best to present it in brief, simple form. With that in mind, it seemed worth attempting a regular post on the topic. The post is still intended to be elementary in nature, but is perhaps at about the introductory university level. The post is also too long to qualify as “short”, even allowing for the fact that some recent parts of the series have already stretched the definition of “short” beyond what I would have preferred.
Components of the Balance of Payments
A national economy’s transactions with the rest of the world are recorded in the nation’s balance of payments. The balance of payments is a set of double-entry accounts grouped into three:
- the current account;
- the capital account; and
- the financial account.
In theory, the balances on the three accounts sum to zero, because every transaction between residents and non-residents will require both a credit (plus) entry and an offsetting debit (minus) entry somewhere within the accounts.
The current account records transactions between residents and non-residents that impact on income within the period (taken to be the financial year). Receipt of income from a non-resident results in a credit to the current account. Payment of income to a non-resident is recorded as a debit. Transactions that affect the current account include international trade in goods and services (exports and imports), giving the balance on goods and services, as well as income received or paid in such forms as interest, dividends and compensation of employees, which gives a balance on primary income. Record is also kept of current transfers, which give a balance on secondary income. Current transfers occur when a real or financial resource of a non-capital nature is transferred without anything of economic value being provided in exchange. Examples include foreign aid, whether in kind or in cash, and pensions paid by one national government to residents of another country. The sum of the balances on goods and services, primary income and secondary income gives the balance on current account.
The capital and financial accounts pertain to transference of ownership of assets between residents and non-residents.
The capital account records capital transfers, such as debt forgiveness or the change in ownership of a physical asset without a quid-pro-quo, as well as the disposal/acquisition of non-produced, non-financial assets, which include intangibles (e.g. copyright) and tangibles (e.g. embassy land). Transfers received by residents from non-residents are recorded as credits on the capital account. Transfers from residents to non-residents are recorded as debits. The sum of the entries gives the balance on capital account. The capital account is typically only small.
The financial account records transactions in financial assets and liabilities between residents and non-residents. Broadly speaking, the financial account is credited whenever there is an increase in net liabilities of residents to non-residents and debited whenever there is a decrease in net liabilities of residents to non-residents. To flesh this out a little, the financial account is credited when either (1a) a resident issues or sells a financial asset to a non-resident or (1b) a resident draws down savings to make payment to a non-resident. In either case, there is a transfer of ownership of financial assets from residents to non-residents and an increase in residents’ net liabilities to non-residents (or, equivalently, a reduction in residents’ net claims on non-residents). Conversely, the financial account is debited when either (2a) a resident purchases a financial asset from a non-resident or (2b) a resident accumulates savings as a result of payment received from a non-resident. In either of these cases, there is a transfer of ownership of financial assets from non-residents to residents and a reduction in residents’ net liabilities to non-residents (or, equivalently, an increase in residents’ net claims on non-residents).
In the financial account, financial assets/liabilities include shares, bonds, other securities, loans and trade credit. Transactions in these assets are grouped into five categories. Four of these categories pertain to foreign investment. To avoid possible misunderstanding, the term “investment” here is used in the accountant’s sense, not the economist’s sense. Much of what counts as foreign investment would be considered forms of saving in other economic contexts (such as when measuring Gross Domestic Product), because most of it does not entail productive investment in physical assets or inventories. The four categories of foreign investment are direct, portfolio, financial derivatives and other investment. Direct investment entails acquiring an interest in an enterprise of another country with an intent to exert significant influence on its management (taken to mean ownership of ten or more percent of ordinary shares or voting stock). Portfolio investment relates to transfer of equity and securities to a degree not constituting direct investment. Financial derivatives include currency swaps, interest-rate swaps and secondary securities. Other investment covers transactions impacting on trade credit, loans, holdings of currency and deposits. The fifth category in the financial account relates to transactions that cause changes in the reserve assets of the monetary authority (i.e. central bank or central banking system). Reserve assets are foreign currency assets controlled by the central bank, including currency, deposits and other financial assets denominated in foreign currency, as well as Special Drawing Rights, reserve position at the International Monetary Fund and gold. Apart from gold, reserve assets are claims on non-residents (the reserve position is a claim on the International Monetary Fund). The sum of the entries for these five categories gives the balance on financial account.
As already noted, in principle the balances on the current, capital and financial accounts sum to zero. In practice, there is error due to mismeasurement and non-measurement. This is recorded as net errors and omissions.
For our purposes, we can focus on the theoretical point that, conceptually, the three accounts balance. For simplicity, we can also consolidate the non-current accounts into the capital and financial account.
In principle, then, we have:
Current Account Balance + Capital and Financial Account Balance = 0
This is an accounting identity, meaning that it is true by definition.
Implications of a Current Account Transaction for the Capital and Financial Account
An implication of the accounting identity is that any payment affecting the current account will have mirror implications for the consolidated capital and financial account.
As an example, consider what happens to the UK balance of payments when a UK firm receives a payment from a US firm either in exchange for an export or as primary or secondary income. This is a credit on the UK current account and must have a mirror implication (must result in a debit) on the consolidated capital and financial account (more specifically, the initial debit will be on the financial account). There are numerous ways the scenario could play out, but they all have the same basic implication. We can distinguish the initial impact on the capital and financial account from subsequent portfolio decisions.
Focusing on the initial impact first, the payment might be in US dollars or in pounds sterling, depending on the arrangements in place between the two firms. If the US firm makes its payment in US dollars, the funds will be credited to the UK firm’s US dollar-denominated bank account. This is a UK resident’s claim on a US bank, resulting in a debit to the UK financial account. If, instead, the US firm makes its payment in pounds sterling, it could do so by (a) purchasing pounds sterling from a UK resident or (b) borrowing pounds sterling from a UK resident or (c) drawing down external savings denominated in pounds sterling (whether these external savings are the firm’s own savings or those of an external supplier of pounds sterling in the foreign exchange market). If, as in (a), a UK resident supplies the pounds sterling in exchange for US dollars, the US dollars credited to the resident’s bank account are a claim on a US bank and recorded as a debit on the UK financial account. If, as in (b), a UK resident lends pounds sterling to the US firm, the loan is a claim on the US firm and once again a debit on the UK financial account. If, as in (c), the US firm obtains pounds sterling from a non-resident, there will be a running down of foreign savings denominated in pounds sterling. This is a reduction in liabilities of UK residents to non-residents, which likewise is a debit on the UK financial account.
We have just described some possible initial impacts. The composition of assets and liabilities held by UK residents can change after that. Basically, a UK resident who receives payment in US dollars has various options. The funds can simply be left in a bank account denominated in US dollars. Or the funds can be used to purchase financial assets denominated in US dollars, which will be a form of foreign investment. Or the UK resident holding the US dollars might exchange them for pounds sterling, perhaps with a bank, in which case the bank will face similar options. Or the bank might subsequently exchange the US dollars for pounds sterling at the Bank of England (the UK central bank). This would increase ‘reserve assets’ held by the Bank of England. The Bank of England could leave these funds in a reserve account at the Fed (the US central banking system) or switch the funds to a US treasury account, also at the Fed.
Such changes in the composition of US dollar-denominated assets held by UK residents do not directly impact the balance on the consolidated capital and financial account, because these external transactions involve both a credit and an offsetting debit within the account. For example, when the Bank of England switches funds from reserve balances to US treasuries, this results in a debit to the Bank of England’s reserve account at the Fed (a credit in the UK financial account) and a credit to its treasuries account at the Fed (a debit in the UK financial account). Over time, though, the composition of foreign assets held by UK residents can affect the balance on the capital and financial account. Portfolio choices, by affecting future interest and dividend income, affect the current account (in particular, the balance on primary income), with mirror impacts on the consolidated capital and financial account.
A Closer Look at Importing
Concern is often expressed in public debate over the implications of current account deficits. There is a notion, for instance, that the US, in running a current account deficit, is beholden to China. From the perspective of Modern Monetary Theory (MMT), these concerns are misplaced.
To consider the issue, it may help to focus in a little more detail on the example of an import. Specifically, we can consider the case of a US company importing output that is produced in China. Let’s say that, expressed in yuan, the per-unit price of the output is ¥1000 and that 100 units of the product are to be imported. The trade will involve a payment equivalent to ¥100,000. It is possible that the Chinese company wants to be paid in US dollars. But it is also possible that it wants to be paid in yuan. We can consider each possibility in turn.
Payment in Dollars. If payment is to be made in dollars, we need to know the exchange rate at which the two currencies trade. Currently the rate of exchange is ¥1 = $0.15. (At the moment, the Chinese government fixes the exchange rate at this level.) So the US company will need to pay $15,000 for the transaction to take place. In doing so, the US company will end up with 100 units of the product. This is a real benefit for the US company that comes at a financial cost of $15,000. In exchange, the Chinese company trades 100 units of its product (a real cost to the Chinese company) in exchange for a financial benefit of $15,000.
For the Chinese company to be paid in US dollars, it needs to have an account denominated in US dollars. In payment for the imports, the bank account of the US importer will be debited and the bank account of the Chinese exporter credited. Unless the Chinese exporter has an account at the same bank as the US company, $15,000 will be debited from the reserve account of the US company’s bank, held at the Fed. The same amount of $15,000 will be credited to the reserve account of the Chinese company’s bank. None of this alters the net position of the Fed (or the US government), since there is no net change in reserve balances held at the Fed, and so no change in the Fed’s total liabilities.
In terms of the balance of payments, the US import to the value of $15,000 is a debit on the current account, since it involves a payment to a non-resident. This is matched by a $15,000 credit on the consolidated capital and financial account, because a Chinese company now has a US dollar deposit, which is a financial claim on the US banking system. The Chinese company has a portfolio decision over where to place the $15,000. If it leaves the funds in its bank account, this is matched by reserve balances of the same amount, which is a liability of the Fed. If the Chinese exporter chooses to hold some of the funds in the form of US currency (notes and coins), this again is a liability of the consolidated US government. The Chinese company might exchange the US dollars for yuan at a bank, and the bank exchange the US dollars for yuan at the People’s Bank of China (China’s central bank). If so, the People’s Bank of China’s reserve account at the Fed will be credited. If the People’s Bank of China prefers US treasuries, the Fed will debit the reserve account and credit a treasuries account. This is just a swap of one Fed liability for another. As before, the net position of the Fed is unchanged.
All this has been under the assumption that the Chinese exporter wanted to be paid in US dollars. We can also verify that nothing of much consequence changes in the case where the Chinese exporter wants to be paid in yuan.
Payment in Yuan. In order for the US importer to pay in yuan, either it needs to draw down yuan-denominated savings or purchase yuan with US dollars in the foreign exchange market. If the US importer draws upon residents’ savings denominated in yuan to pay for the import (either through a purchase in the foreign exchange market or by drawing on a bank account), this is recorded as a credit in the US financial account. If yuan is obtained from a non-resident in the foreign exchange market, a non-resident will end up holding the US dollars used to pay for them, and this too is recorded as a credit in the US financial account. The recipient of the US dollars can hold them as currency, leave them in a bank account or purchase financial assets denominated in US dollars. Whether the US dollars are held as currency, reserves or financial assets, the direct impact on Fed liabilities will be the same.
Private Debt Can be Problematic But is Not the Direct Responsibility of the American Public
If any US debt is incurred in orchestrating the trade, it will actually be a private debt of the US exporter (and perhaps of a foreign-exchange trader). It is not a debt owed by the American public. For example, to purchase the imported goods, the US firm may borrow. It is quite likely that the loan will be from a US bank. If so, any debt used to finance the purchase of the import will not be foreign, but domestic. The US firm will owe a US bank, just as it would owe a US bank if it had borrowed to purchase a domestically produced good. If, instead, the US firm takes out a foreign loan to purchase the imported goods, there will be a debt owed to a foreign creditor rather than a US bank. But, in any event, the debt is private.
From the perspective of the US firm, whether its debt is owed domestically or internationally, it is still a debt that needs to be repaid. The debt, like all private debt, can become problematic, because unlike a currency issuer, currency users are financially constrained. If, in addition, the firm has exposed itself to exchange-rate risk, by borrowing in a foreign currency, this will further complicate matters for the firm, but again has no direct implications for the American public.
It is true that the Fed pays interest on outstanding US treasuries. The Fed does this by crediting accounts. This is simply a matter of typing in numbers on a spreadsheet, and in itself has no impact on the American public. When a treasury matures, the Fed debits the treasury account and credits the reserve account, including for the interest due. If the saver continues to desire treasuries, the treasury account is once again credited and the reserve account debited. In this way, any US treasuries held by the Chinese will yield interest. But, in terms of potential implications for the level of future taxes, which would relate to a possible impact on future demand for US output, not any difficulty in the Fed making interest payments, this is no different than if the treasuries were held by residents. The outstanding US dollars and treasuries on issue are simply the accumulated difference between the amount of dollars the US government has spent into existence and the amount that it has taxed out of existence. Whenever government spending exceeds taxes, the resulting US dollars will be held either as currency, reserve balances or outstanding government bonds.
The level of government net spending can potentially (though it is unlikely) affect future taxes if the interest payments on US treasuries, which are income for the recipients, ever became so high, relative to GDP, that it induced the recipients into excessive spending. This is the case irrespective of whether the source of the excessive spending is domestic or foreign. This unlikely outcome is easily avoided by the Fed creating conditions in financial markets such that the rate of interest on treasuries (and hence interest income) is kept low. For instance, in the period following the financial crisis, government deficits have been accompanied by low interest rates, as a matter of policy. Since the Fed’s capacity to create reserves is infinite, there is no limit to its capacity to maintain financial conditions conducive to a low rate of interest on US treasuries.
From the MMT perspective, the US government’s deficit is a result of a non-government desire to net save (maintain a financial surplus, spending less than it receives) in US dollars. If there were no desire within the non-government to maintain a financial surplus in US dollars, the government would not be able to spend more dollars into the economy than it subtracted in taxes. If, for whatever reason, the non-government decided to save less of its US dollars, that would at the same time be a decision to spend more on US goods and services. The government deficit would automatically narrow as taxes (for given tax rates) rose endogenously with income. If the Chinese, in particular, decided that they did not want to earn US dollars anymore, either to save in dollars or to import from the US, they would stop exporting to the US, and the US current account (or at least the US trade balance with China) would move toward, or into, surplus. Similarly, if the Chinese decided that they would rather spend the dollars they earn rather than save them, US exports would increase, the US current account would move toward, or into, surplus and the US government deficit would narrow.
To the extent any of that would matter, it would be due to the implications for inflation, not a supposed public debt burden. There is an inflation risk inherent in any spending, whether public or private, and whether the source of the spending is domestic or foreign. Chinese spending on US goods and services is no different, in this respect, than any other spending. In the meantime, the way to contain any inflation risk associated with government deficits is to maintain low rates of interest on US treasuries (or, better still, stop issuing treasuries and just let reserves mount at zero interest). As a rule of thumb, so long as the rate of growth in nominal income (GDP measured at current prices) exceeds the nominal rate of interest on government-issued treasuries, ongoing government deficits are consistent with low, stable rates of inflation.
Warren Mosler – The Innocent Fraud of the Trade Deficit: Who’s Funding Whom?
Bill Mitchell – Do Current Account Deficits Matter?
L. Randall Wray – MMT and External Constraints
Scott Fullwiler – Interest Rates and Fiscal Sustainability
Neil Wilson – Savings are an Export Product
Ellis Winningham – Tadpoles and Trade Imbalances