Scottish-born economist - Angus Deaton - recently published his new book - An Immigrant Economist…
I have noticed a few commentators expressing concern about the dangers that might arise if a nation runs a persistent current account deficit. There have been suggestions that this area of analysis is the Achilles heel of Modern Monetary Theory (MMT). I beg to differ. A foundation principle of MMT is that to be able to freely focus on the domestic economy, the national government has to be freed from targetting any external goals – such as a particular exchange rate parity. The only effective way for this to happen is if the exchange rate floats freely. In this sense, the exchange rate is the adjustment mechanism for external imbalances.
MMT is built on the foundation that the national government is a monopoly issuer of its own currency and is never revenue constrained. That means it can buy whatever is available for sale in that currency at any time of its choosing. Whether it is prudent to do that at any point in time is another matter and has to be considered on a case by case basis (depending what else is going on in the economy).
However, the fact it faces no financial constraints is not a sufficient condition for a sovereign government being able to advance public purpose. The latter goal relates to maximising domestic outcomes including environmentally-sustainable growth, low unemployment, real wages growth in line with productivity, and inclusive social policies.
To be able to freely focus on the domestic economy, the national government has to be freed from targetting any external goals – such as a particular exchange rate parity. The only effective way for this to happen is if the exchange rate floats freely.
To appreciate that point consider how a fixed exchange rate system operated.
Fixed exchange rates
The Bretton Woods System was introduced in 1946 and created the fixed exchange rates system. Governments could now sell gold to the United States treasury at the price of $USD35 per ounce. So now a country would build up USD reserves and if they were running a trade deficit they could swap their own currency for USD (drawing from their reserves) and then for their own currency and stimulate the economy (to increase imports and reduce the trade deficit).
The fixed exchange rate system however rendered fiscal policy relatively restricted because monetary policy had to target the exchange parity. If the exchange rate was under attack (perhaps because of a balance of payments deficit) which would manifest as an excess supply of the currency in the foreign exchange markets, then the central bank had to intervene and buy up the local currency with its reserves of foreign currency (principally $USDs).
This meant that the domestic economy would contract (as the money supply fell) and unemployment would rise. Further, the stock of $USD reserves held by any particular bank was finite and so countries with weak trading positions were always subject to a recessionary bias in order to defend the agreed exchange parities. The system was politically difficult to maintain because of the social instability arising from unemployment.
So if fiscal policy was used too aggressively to reduce unemployment, it would invoke a monetary contraction to defend the exchange rate as imports rose in response to the rising national income levels engendered by the fiscal expansion. Ultimately, the primacy of monetary policy ruled because countries were bound by the Bretton Woods agreement to maintain the exchange rate parities. They could revalue or devalue (once off realignments) but this was frowned upon and not common.
This period was characterised by the so-called “stop-go” growth where fiscal policy would stimulate the domestic economy, drive up imports, put pressure on the exchange rate, which would necessitate a monetary contraction and stifle economic growth.
Whichever monetary system of those that have been tried in the past – pure gold standard or USD-convertible system backed by gold – the constraints on the ability of government to advance public purpose were obvious.
The gold standard as applied domestically meant that existing gold reserves controlled the domestic money supply. Given gold was in finite supply (and no new discoveries had been made for years), it was considered to provide a stable monetary system. But when the supply of gold changed (a new field discovered) then this would create inflation.
So gold reserves restricted the expansion of bank reserves and the supply of high powered money (Government currency). The central bank thus could not expand their liabilities beyond their gold reserves (although it is a bit more complex than that). In operational terms this means that once the threshold was reached, then the monetary authority could not buy any government debt or provide loans to its member banks.
As a consequence, bank reserves were limited and if the public wanted to hold more currency then the reserves would contract. This state defined the money supply threshold.
Some gymnastics could be done to adjust the quantity of gold that had to be held. But overall the restrictions were solid.
The concept of (and the term) monetisation comes from this period. When the government acquired new gold (say by purchasing some from a gold mining firm) they could create new money. The process was that the government would order some gold and sign a cheque for the delivery. This cheque is deposited by the miner in their bank. The bank then would exchange this cheque with the central bank in return for added reserves. The central bank then accounts for this by reducing the government account at the bank. So the government’s loss is the commercial banks reserve gain.
The other implication of this system is that the national government can only increase the money supply by acquiring more gold. Any other expenditure that the government makes would have to be “financed” by taxation or by debt issuance. The government cannot just credit a commercial bank account under this system to expand its net spending independent of its source of finance. As a consequence, whenever the government spent it would require offsetting revenue in the form of taxes or borrowed funds.
Ultimately, Bretton Woods collapsed in 1971. It was under pressure in the 1960s with a series of “competitive devaluations” by the UK and other countries who were facing chronically high unemployment due to persistent trading problems. Ultimately, the system collapsed because Nixon’s prosecution of the Vietnam war forced him to suspend USD convertibility to allow him to net spend more. This was the final break in the links between a commodity that had intrinsic value and the nominal currencies. From this point in, governments used fiat currency as the basis of the monetary system.
As I have written in the past, elaborate institutional mechanisms have survived the collapse of the convertible currency system which make it look as if the government is funding its net spending by bond issues. The reality is that in a fiat currency system all the government is doing when it issues debt is draining reserves which it has created itself. I use the term – “its a wash”. The government really just borrows back what it has spent.
The important point is that the imposition of fixed exchange rates constrained the capacity of the government to pursue public purpose.
Flexible exchange rates
Many progressives think that flexible exchange rates is a neo-liberal policy because it was fiercely advocated by Milton Friedman during the 1960s. His advocacy for flexible rates was based on his view that all prices should be fully flexible so that markets can work. MMT advocates flexible exchange rates because it is the only way that the macroeconomic policy tools (fiscal and monetary) can be totally free to pursue domestic policy agendas. They do not become compromised by the need to defend a parity.
If progressives really understood this point they would be on much more solid ground when they argue for “Keynesian-style” expansionary policies.
The flexible exchange rate system means that monetary policy is freed from defending some fixed parity and thus fiscal policy can solely target the spending gap to maintain high levels of employment and other desirable policy objectives. The foreign adjustment is then accomplished by the daily variations in the exchange rate.
Please read my blog – Gold standard and fixed exchange rates – myths that still prevail – for more discussion on the differences between monetary systems.
Under flexible exchange rates, the sovereign government has more domestic policy space than the mainstream economists acknowledge. The government can make use of this space to pursue economic growth and rising living standards even if this means expansion of the Current Account deficit (CAD) and depreciation of the currency.
While there is no such thing as a balance of payments growth constraint in a flexible exchange economy in the same way as exists in a fixed exchange rate world, the external balance still has implications for foreign reserve holdings via the level of external debt held by the public and private sector.
It is also advisable that a nation facing continual CADs foster conditions that will reduce its dependence on imports. However, the mainstream solution to a CAD will actually make this more difficult.
Indeed, IMF lending and the accompanying conditions that are typically imposed on the debtor nation almost always reduce the capacity of the government to engineer a solution to the problems of inflation and falling foreign currency reserves without increasing the unemployed buffer stock. A policy strategy based largely on fiscal austerity will create unacceptable levels of socio-economic hardship.
Targets to reduce budget deficits may help lower inflation, but only because the “fiscal drag” acts as a deflationary mechanism that forces the economy to operate under conditions of excess capacity and unemployment.
This type of deflationary strategy does not build productive capacity and the related supporting infrastructure and offers no “growth solution”. And fiscal restraint may not be successful in lowering budget deficits for the simple reason that tax revenue can fall as the taxable base shrinks because economic activity is curtailed.
Moreover, the lessons of how the international crises of the 1990s and early 2000s were dealt with should not be forgotten: fiscal discipline has not helped developing countries to deal with financial crises, unemployment, or poverty even if they have reduced inflation pressures.
There are also inherent conflicts between maintaining a strong currency and promoting exports – a conflict that can only be temporarily resolved by reducing domestic wages, often through fiscal and monetary austerity measures that keep unemployment high. The best way to stabilise the exchange rate is to build sustainable growth through high employment with stable prices and appropriate productivity improvements.
A low wage, export-led growth strategy sacrifices domestic policy independence to the exchange rate – a policy stance that at best favours a small segment of the population.
Is a current account deficit a problem?
We continually read that nations with current account deficits (CAD) are living beyond their means and are being bailed out by foreign savings. This claim is particularly potent in the current US-China context.
In MMT, this sort of claim would never make any sense. A CAD can only occur if the foreign sector desires to accumulate financial (or other) assets denominated in the currency of issue of the country with the CAD. This desire leads the foreign country (whichever it is) to deprive their own citizens of the use of their own resources (goods and services) and net ship them to the country that has the CAD, which, in turn, enjoys a net benefit (imports greater than exports). A CAD means that real benefits (imports) exceed real costs (exports) for the nation in question.
There are complications where one currency (USD) is a reserve currency widely used throughout the world in resolving trade. But ultimately, this is only a complication.
A CAD signifies the willingness of the citizens to “finance” the local currency saving desires of the foreign sector. MMT thus turns the mainstream logic (foreigners finance our CAD) on its head in recognition of the true nature of exports and imports (see below).
Subsequently, a CAD will persist (expand and contract) as long as the foreign sector desires to accumulate local currency-denominated assets. When they lose that desire, the CAD gets squeezed down to zero. This might be painful to a nation that has grown accustomed to enjoying the excess of imports over exports. It might also happen relatively quickly. But at least we should understand why it is happening.
Sterilisation enters the scene here as well. It is often erroneously thought that financial inflows (corresponding to the CAD) via the capital account of the Balance of Payments boost commercial bank reserves. Mainstream economists who operate within the defunct money multiplier paradigm think this might be inflationary because it will stimulate bank credit creation.
The flawed logic is – increased bank reserves -> increased capacity to lend -> increased credit -> excess aggregate demand -> inflation.
You might like to read the following blogs – Money multiplier and other myths – Building bank reserves will not expand credit and Building bank reserves is not inflationary – to understand why that is totally at odds with the way the credit creation system operates.
The claim is that the central bank can “sterilise” this impact by selling government debt via open market operations. However, if there is excess capacity in the economy, the central bank might refrain from sterilising and allow aggregate demand to expand.
But think about what a CAD actually means. I always argue that it is essential to understand the relationship between the government and non-government sector first. A common retort is that this blurs the private domestic and foreign sectors. My comeback is that the transactions within the non-government sector are largely distributional, which doesn’t make them unimportant, but which means you don’t learn anything new about the process net financial asset creation.
In the case of CAD, what mostly happens is that local currency bank deposits held say by Australians are transferred into local currency bank deposits held by foreigners. If the Australian and the foreigner use the same bank, then the reserves will not even move banks – a transfer occurs between the Australian’s account in say Sydney, to the foreigner’s account with the same bank in say Frankfurt.
The point is that the AUD never leaves “Australia” no matter who is holding it. The same goes for the USD and all the fiat currencies.
If the transactions span different banks, the central bank just debits and credits, respectively, the reserve accounts of the two banks and the reserves move.
What happens next depends on the approach the commercial banks take to the reserve positions. We know that excess reserves put downwards pressure on overnight interest rates and may compromise the rate targetted by the central bank. The only way the central bank can maintain control over its target rate and curtain the interbank competition over reserve positions is to offer an interest-bearing financial asset to the banking system (government debt instrument) and thus drain the excess reserves.
So sterilisation in this case merely reflects the desire of the central bank to maintain a particular target interest rate and is not discretionary. The alternative is to offer a return on excess returns equivalent to the target rate.
Should CADs be prevented?
The other implication of the mainstream view is that policy should be focused on eliminating CADs. This would be an unwise strategy.
First, it must be remembered that for an economy as a whole, imports represent a real benefit while exports are a real cost. Net imports means that a nation gets to enjoy a higher living standard by consuming more goods and services than it produces for foreign consumption.
Further, even if a growing trade deficit is accompanied by currency depreciation, the real terms of trade are moving in favour of the trade deficit nation (its net imports are growing so that it is exporting relatively fewer goods relative to its imports).
Second, CADs reflect underlying economic trends, which may be desirable (and therefore not necessarily bad) for a country at a particular point in time. For example, in a nation building phase, countries with insufficient capital equipment must typically run large trade deficits to ensure they gain access to best-practice technology which underpins the development of productive capacity.
A current account deficit reflects the fact that a country is building up liabilities to the rest of the world that are reflected in flows in the financial account. While it is commonly believed that these must eventually be paid back, this is obviously false.
As the global economy grows, there is no reason to believe that the rest of the world’s desire to diversify portfolios will not mean continued accumulation of claims on any particular country. As long as a nation continues to develop and offers a sufficiently stable economic and political environment so that the rest of the world expects it to continue to service its debts, its assets will remain in demand.
However, if a country’s spending pattern yields no long-term productive gains, then its ability to service debt might come into question.
Therefore, the key is whether the private sector and external account deficits are associated with productive investments that increase ability to service the associated debt. Roughly speaking, this means that growth of GNP and national income exceeds the interest rate (and other debt service costs) that the country has to pay on its foreign-held liabilities. Here we need to distinguish between private sector debts and government debts.
The national government can always service its debts so long as these are denominated in domestic currency. In the case of national government debt it makes no significant difference for solvency whether the debt is held domestically or by foreign holders because it is serviced in the same manner in either case – by crediting bank accounts.
In the case of private sector debt, this must be serviced out of income, asset sales, or by further borrowing. This is why long-term servicing is enhanced by productive investments and by keeping the interest rate below the overall growth rate. These are rough but useful guides.
Note, however, that private sector debts are always subject to default risk – and should they be used to fund unwise investments, or if the interest rate is too high, private bankruptcies are the “market solution”.
Only if the domestic government intervenes to take on the private sector debts does this then become a government problem. Again, however, so long as the debts are in domestic currency (and even if they are not, government can impose this condition before it takes over private debts), government can always service all domestic currency debt.
How do deficits and the external sector interact?
MMT shows that fiscal deficits result in net injections of banking system reserves that due to common (voluntarily imposed) arrangements are drained through sales of government debt either in the new issue market (by Treasury) or through open market sales (by the central bank).
If these (unnecessary) voluntary arrangements which force governments to match $-for-$ their net spending with bond sales were abandoned then the central bank would start accumulating treasury assets (maybe via formal bond sales but more sensibly via some numbers in an accounting ledger to keep record of the transactions).
International financial markets would immediately (and erroneously) believe that this accumulation of represents “monetisation of the deficit”, and that this contributes to inflationary pressures, although the empirical evidence is scant. Some selling off of the currency might occur as a consequence of investors forming this expectation.
If there is inflationary pressure, it would result from the government spending, not from the bond sales that drain excess reserves.
Problems are greatly compounded if the nation has issued foreign-currency denominated debt. If this debt is issued by private firms (or households), then they must earn foreign currency (or borrow it) to service debt. To meet these needs they can export, attract FDI, and/or engage in short-term borrowing. If none of these are sufficient, default becomes necessary.
There is always a risk of default by private entities, and this is a “market-based” resolution of the problem as noted above.
If however the government has issued (or taken over) foreign currency denominated debt, default becomes more difficult because there is no well delineated international method. Often, the government is forced to go to international lenders to obtain foreign reserves; the result can be a vicious cycle of indebtedness and borrowing.
Since international lenders request austerity, domestic policy becomes hostage. For this reason, it is almost always poor strategy for government to become indebted in foreign currency. By contrast, a sovereign government can never face insolvency in its own currency.
What would happen if the government issued no debt?
When it credits the bank account of any recipient of its spending (whether this is for purchases of goods and services or for social welfare spending), the central bank simultaneously credits the bank’s reserve account. If this leads to excess reserves, these are then exchanged for treasury debt. While the IMF and other mainstream financial analysts criticise sales of treasury debt to the central bank (or corresponding accounting entries), it actually makes no difference whether treasury sells the debt to private banks. In effect the sales directly to the central bank simply bypass the bank “middlemen”.
If you think there is a difference between treasury debt being sold the central bank or to the commercial banks then you do not understand reserve accounting which is at the heart of MMT.
The reality is that the end result will be the same: the distribution of treasury debt holdings between the central bank and the private sector will depend on portfolio preferences of the private sector. These preferences are reflected in upward or downward pressure on the overnight interest rate. To hit its target, the central bank must accommodate private sector preferences by either taking the debt into its portfolio, or by selling the debt to reduce bank reserves.
The only complication is that the treasury can issue debt of different maturities. Very short-term treasury debt is equivalent to bank reserves that earn interest. Long term treasury debt is not a perfect substitute because capital gains and losses can result from changes to interest rates.
Hence if there is a lot of uncertainty about the future course of interest rates, trying to sell long-term treasury debt to private markets can affect interest rates and the term structure. For example, selling long-term debt that is not desired by the private sector will lead to low prices and high interest rates for that debt. In this case, it is not really the case that budget deficits are affecting interest rates, but rather the decision to sell debt with a maturity that is not desired by markets. The solution would be to limit treasury debt to short-term maturity.
An important point to be made regarding treasury operations by a sovereign government is that the interest rate paid on treasury securities is not subject to normal “market forces”. The sovereign government only sells securities in order to drain excess reserves to hit its interest rate target. It could always choose to simply leave excess reserves in the banking system, in which case the overnight rate would fall toward zero or whatever support rate on reserves was being offered.
When the overnight rate is zero, the Treasury can always offer to sell securities that pay a few basis points above zero and will find willing buyers because such securities offer a better return than the alternative (zero).
This drives home the point that a sovereign government with a floating currency can issue securities at any rate it desires – normally a few basis points above the overnight interest rate target it has set.
There may well be economic or political reasons for keeping the overnight rate above zero (which means the interest rate paid on securities will also be above zero). But it is simply false reasoning that leads to the belief that the size of a sovereign government deficit affects the interest rate paid on securities.
When the central bank desires to target a non-zero interest rate, budget deficits will thus lead to growing debt and increased interest payments. However, the interest rate is a policy variable for any sovereign nation which can increase its deficits and its outstanding debt while simultaneously lowering its interest payments by lowering interest rates.
A non-sovereign government faces an entirely different situation. In the case of a “dollarised” nation, the government must obtain dollars before it can spend them. Hence, it uses taxes and issues IOUs to obtain dollars in anticipation of spending.
Unlike the case of a sovereign nation, this government must have “money in the bank” (dollars) before it can spend. Further, its IOUs are necessarily denominated in dollars, which it must incur to service its debt. In contrast to the sovereign nation, the non-sovereign government promises to deliver third party IOUs (that is, dollars) to service its own debt (while the US and other sovereign nations promise only to deliver their own IOUs).
Furthermore, the interest rate on the non-sovereign, dollarised government’s liabilities is not independently set. Since it is borrowing in a foreign currency, the rate it pays is determined by two factors. First there is the base rate on the foreign currency. Second, is the market’s assessment of the non-sovereign government’s credit worthiness. A large number of factors may go into determining this assessment. The important point, however, is that the non-sovereign government, as user (not issuer) of a currency cannot exogenously set the interest rate. Rather, market forces determine the interest rate at which it borrows.
One commentator recently wrote:
However, the external sector has other dollar-denominated assets as well such as equities, corporate bonds and mortgage backed securities and the question is what about the rates with which such numbers grow? If a stock is held by a household, the dividend goes to it and the household may consume a part of it and it flows back to the producer. If the external sector holds the stock, it just goes to it and doesn’t flow back to the domestic sector. The US government can increase its fiscal stance but what if all the expansion goes to the external sector? In other words, there is a scenario in which the fiscal expansion improves short term demand, but doesn’t do much in the long term (for countries such as the US with a huge external debt, though denominated in the local currency).
First, the dollars never leave the country. Yes, an external holder of a USD income stream can use that stream to purchase goods and services elsewhere given the reserve status of the USD. But what is the problem? Ultimately, the holder of the USD can only realise these holdings by buying goods and services (or assets) denominated in US dollars.
Second, the advantage of fiscal policy is that it can be targetted to alter the composition of output as well as the level of output. So one of the first policies I advocate is the introduction of a Job Guarantee which would focus the public spending on the domestic economy and deliver domestic (non-tradeable) outputs. It is very hard to see a high proportion of this expansion going out of the country.
Third, more generally, the government can always buy what is for sale in its own currency. Every country has a well-developed non-tradeables sector which offers many goods and services that can be procured for the advancement of public purpose. Why would we be concerned if the government improves mental health care by increasing the educational outlays for these professions and employing increasing numbers of the graduates? Perhaps, the new workers will buy some imports. What exactly is the problem?
Fourth, all private sector decisions are made on a voluntary basis with the best knowledge that is available. If private firms are selling financial claims to foreigners they are doing this voluntarily. What is the problem? It just means the external leakage is greater and there is more space for domestically-orientated injections, without compromising the stable price objective.
The same commentator then noted:
If the dollar devalues because of market forces, the position of various domestic sectors of the US improves because the values of their external assets increases. They export more as well and this increases demand as well. However, the US dollar has been artificially high or one can say that the others have pegged theirs to lower values. The manufacturers in the US have great production capacity and products, are competitive and have good selling skills. In spite of this, manufacturing has weakened a lot in the US. The answer to why this has happened may only be in the monetary economics related to the external sector. One can say that the US government should have just increased the fiscal deficit but that would have increased the trade deficit – who wins the race ?
First, while there is some debate about the value of the import and export price elasticities, it is generally believed that a depreciating currency does have the impacts you mention. Competitiveness is enhanced without a harsh austerity drive to drive down domestic wages. This is the mechanism the EMU nations are sorely missing at the moment (among others). This stimulates exports (usually but not always) and reduces imports.
Is that a good thing? Not in itself because exports impose costs and imports provide benefits. But it may be that the aggregate demand injection boosts local jobs which is a good outcome. All these judgements depend on what happens.
Second, it is clear that China is buying US financial assets and this is having the effect of keeping their currency weak. Although recently they have let the currency follow a peg (and appreciate a little). But the Chinese can hardly liquidate its holdings of foreign currencies because then they would strengthen their own currency and undermine their own trade plan.
So their option is to buy US dollar-denominated financial or other assets to keep their own currencies weak and maintain their export competitiveness. All they are doing is depriving their own citizens of development opportunities.
Third, it is clear that the US dollar remains the safe haven and this has impacts on the competitiveness of its manufacturing sector. But that has nothing much to do with the effectiveness of the public deficits nor of the current account that the US is running. It has to do with the relative attractiveness of other currencies, most recently the Euro.
Fourth, the statement “The manufacturers in the US have great production capacity and products, are competitive and have good selling skills. In spite of this, manufacturing has weakened a lot in the US” is counter to the facts. If they were competitive (by which we mean internationally competitive) then they wouldn’t be losing market share.
The logic of the market is that consumers will demand what they think is best. It is clear that they no longer think US production fits that category. That might be heart-wrenching for the dying manufacturing towns – as it was as agriculture waned some decades earlier and communities vanished – but I doubt that you want to argue for protection where the rest of the US consumers subsidise the jobs of a few who can no longer produce attractive enough products in their own right.
Further, while manufacturing in the US has declined (as it has in most advanced nations), the high productivity manufacturing jobs have stayed in the US. The low wage jobs have been exported to China, India and elsewhere.
Finally, I don’t think this has anything to do with the effectiveness of fiscal policy.
The following graph is taken from the RBA statistics and shows in the left-panel the AUS/USD exchange rate since 1969 and in the right-panel the relationship between the exchange rate (horizontal axis) and annual inflation rate (vertical axis).
The left-panel shows you how much of a roller coaster the Australian economy is on with respect to its exchange rate. Within a decade it has gone from below 50 cents USD to nearly parity. The sky hasn’t fallen in.
The right panel shows that there is no intrinsic relationship between domestic inflation and the exchange rate. If anything it is the reverse of that which the fear mongers claims exists.
For those who think the change in the exchange rate matters, the following graph demonstrates that it doesn’t. Quarterly changes in the left-panel and annual in the right-panel.
That is enough for today!