There are many payments between countries — trade in goods and services, profits and interest paid to foreign capitalists, portfolio investment, FDI and bank lending, transactions between governments. All of these payments must balance out one way or another.
International-finance orthodoxy since David Hume has been about identifying an automatic mechanism that ensures that all these flows balance. This mechanism should take the form of a price adjustment, whether of the price level, the exchange rate, or the interest rate.
An alternative Keynesian approach is to make aggregate income the adjusting variable that maintains the balance of payments equality, just as it is in maintaining the domestic savings-investment balance. This is the idea behind balance of payments constrained growth.
Balance of payments constrained growth is certainly an improvement on the price adjustment mechanisms of orthodoxy. But I think it would be even better to consider both as items on a menu of things that may happen when a payments imbalance develops. The beginning of wisdom here is to recognize that there is no general mechanism that maintains payments balance. Changes in relative prices, exchange rates, interest rates or incomes may all play a role, depending on the timeframe we are considering and on the countries involved and the source of the imbalance.
Our theory of balance of payments adjustments should not begin with the universal logic of either orthodox or b.o.p.-constrained growth models, but with a concrete historical enumeration of the various sources of payments imbalance and the various kinds of adjustment in response to them.
We also need to consider other kinds of adjustment mechanisms, in particular, accommodation by buffers. This will always be the dominant mechanism if we are considering a short enough period. In the first instance, payments balance is maintained because there are some actors in the system who will passively take the other side of any open foreign exchange positions. The familiar example of this is a central bank that holds foreign exchange reserves: When it intervenes in the foreign exchange market, it passively allows its reserve position to adjust to accommodate whatever net demand there is for foreign currency. But there are also private buffers. In particular, there’s not nearly enough recognition of the special role of banks in the payments system, which requires them to take open foreign exchange positions when other units engage in cross-border transactions. An inflow of foreign investment, for instance, will in the first instance always result in a an increase in foreign assets in the banking system of the receiving country and foreign liabilities in the banking system of the investing country. How large are the imbalances that can be buffered in this way, and how long the banking system will passively maintain its open position without some other adjustment mechanism coming into play, are open questions. But there is no question that in the short run, the balance of payments is maintained through this sort of passive buffering, and not through any adjustment of either prices or incomes.
We also need to recognize the role of active policy in maintaining payments balance. We tend to think of policy “interventions” as modifications or “shocks” to an underlying structure of payments, but official actions may be an important adjustment mechanism by which that structure is maintained in the first place. This includes both bilateral or multilateral actions that generate offsetting official financial flows in the face of imbalances (important even in the19th century, in the form of central bank cooperation) and unilateral actions to limit outflows, including capital controls, import restrictions and so on.
The right starting point, I think, is to think of the various financial and trade flows as evolving essentially independently. If they happen to more or less balance, then the available buffers and whatever limited price adjustment is possible will be enough to maintain balance. If they don’t happen to balance, then the expected outcome is a crisis of some sort, ending with state intervention and/or a change in the “fundamental” parameters. There is no automatic mechanism that maintains balance. Where we see smooth payments balance over a long period time, it is probably because international payments are being actively managed by the authorities, or because productive capacities, import demands, asset preferences of foreign investors and so on have evolved to fit the existing pattern of payments, rather than vice versa.
The classic case is the London-centered gold standard system of the 19th century. Despite what someone like Barry Eichengreen will tell you, price flexibility was not an important element in the stability of this system. While prices and wages did rise and especially fall more freely before World War One, they almost always did so in parallel across trading partners, not in the opposite way that would offset trade imbalances. Instead, the system depended on the following institutionally specific features.
1. A large fraction of non-British savings, especially from Latin America and other less-developed countries, were held in London. This meant that many “international” payments simply involved a transfer from one British bank account to another, with no cross-border settlement required.
2. British foreign investment primarily funded purchases of British capital goods, so that financial outflows and exports naturally rose and fell together without the need for price adjustments.
3. The capital goods so purchased (for railroads especially) were largely used to produce exports to Britain, offsetting interest and divided payments back to London.
4. Slower growth in Britain was associated with lower interest rates there. So the slowdown in import payments abroad (due to lower incomes) was offset by an increase in foreign lending, which was quite interest-sensitive.
5. Within Europe central banks actively cooperated to offset any payments imbalances that did occur. On several occasions where there a net flow of gold from London to Paris seemed to be developing, the Bank of France made large loans to the Bank of England so that no actual gold had to move. In addition, the belief that gold convertibility would be maintained, or if suspended soon restored at the old parity, meant if a payments imbalance led to a deviation of the market exchange rate from the official parity, it would generate large speculative flows toward the depreciated currency.
6. Outside of Europe, crises and defaults were integral to the operation of the system. While interest-sensitive foreign lending meant that for England (and to some extent other European countries, and later the US), imports and financial outflows tended to move in opposite directions, higher interest rates could not reliably generate financial inflow for peripheral countries. Instead, the normal adjustment process for large imbalances was a catastrophic one in which large deficits periodically led to suspension of convertibility and default.
7. Over the longer run, the “fundamentals” in the periphery were shaped to produce payments balance at prevailing prices, rather than prices adjusting to fundamentals. Foreign investment financed development of export industries suiting the needs of the investing country, with higher-wage countries specializing in higher-value products. In settler colonies, migrant flows strengthened trade and financial links with the mother country.
Bottom line: there was no adjustment mechanism. Stability depended on the contingent fact that the prevailing “shocks” had roughly balanced effects on payment flows. Small imbalances were absorbed by buffers (which in the pre-WWI system included the cost of transporting gold). Large imbalances were actively managed or else led to the system breaking down, either locally, or globally as with the war.
For the gold standard era, I think the best statement of this perspective is Triffin’s “Myths and Realities of the So-Called ‘Gold Standard’.” Alec Ford’s The Gold Standard 1880-1914: Britain and Argentina is also very good (as is Barry Eichengreen’s discussion of it.) Peter Temin makes essentially this argument in his Lessons from the Great Depression — that the gold standard worked before World War I but broke down in the 1920s not because prices were more flexible before the war, but because in the prewar period it did not have to deal with big imbalances in trade and financial flows as developed after. Keynes makes the same larger point, as well as all seven of the specific points above, but at scattered places in his writing and correspondence rather than — as far as I know — in any single text. This perspective is in the same spirit as the “surplus recycling mechanism” that Varoufakis talks about in The Global Minotaur and elsewhere, the idea that there is no price mechanism that tends to bring about payments balance and so some specific institution is needed to offset persistent surpluses and deficits. (Though of course Varoufakis is focused on the more recent period.) The point that productive capacities are shaped by relative prices, rather than vice versa, was made by development economists like Arthur Lewis — it’s stated very clearly in his Evolution of the World Economic Order.
Obviously, the specifics will be different today. But I think the same basic perspective on the balance of payments still applies. Where payments balance exists, it is because of institutional factors that tend to generate offsetting disturbances to trade and financial flows, and because the international structure of production has evolved to generate balance at existing relative prices, rather than because prices have adjusted. And when imbalances do develop, they are accommodated first by passive buffers, and then either actively managed by authorities or else produce a breakdown in the system.
Note: I wrote most of this post in February 2015 and then for some reason never put it up. It really should have links, but given that it’s already sat around for over year I decided to just put it up as-is. Since the original post was very long, I’ve split it into two parts. The second half is here.
