Tag: international finance and trade

How to Think about the Balance of Payments

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. 

 

We’ve Always Had Free Trade with Eastasia

There’s nothing like trade to provoke full-throated defenses of economic orthodoxy. How many other topics are there where people would even use the phrase to mean what is correct, obvious, not to be questioned? For example,  Binyamin Applebaum in yesterday’s Times: On Trade, Trump Breaks with 200 Years of Economic Orthodoxy.

Donald J. Trump’s blistering critique of American trade policy boils down to a simple equation: Foreigners are “killing us on trade” because Americans spend much more on imports than the rest of the world spends on American exports. …

Add a few “whereins” and “whences” and that sentiment would conform nicely to the worldview of the first Queen Elizabeth of 16th-century England, to the 17th-century court of Louis XIV, or to Prussia’s Iron Chancellor, Otto von Bismarck, in the 19th century. The great powers of bygone centuries subscribed to the economic theory of mercantilism…

Etc. Restrictions on trade aren’t just mistaken, they’re  exotic, primitive, un-American, part of a dusty storybook world of kings and queens and whences.

I admit, this is an issue where I’m a bit of a heterodox bubble. I’ve been reading people like Ha-Joon Chang  so long, I forget how pervasive is the idea that the US has always practiced free trade (except for one terrible mistake in the 1930s.) I forget how unquestioned the myth of free trade is in the larger economic conversation. Because of course it is a myth. Here is Chang:

Between 1816 and the end of the Second World War, the U.S. had one of the highest average tariff rates on manufacturing imports in the world… The Smoot-Hawley Tariff of 1930, which Bhagwati portrays as a radical departure from a historic free-trade stance, only marginally (if at all) increased the degree of protectionism in the U.S. economy…

The following quote from Ulysses Grant, the Civil War hero and president of the United States from 1868 to 1876 clearly shows how the Americans had no illusions about [free trade]. “For centuries England has relied on protection, has carried it to extremes and has obtained satisfactory results from it. There is no doubt that it is to this system that it owes its present strength. After two centuries, England has found it convenient to adopt free trade because it thinks that protection can no longer offer it anything. Very well then, Gentlemen, my knowledge of our country leads me to believe that within 200 years, when America has gotten out of protection all that it can offer, it too will adopt free trade.”

Or here’s Paul Bairoch, whose book remains the esential reference on trade policy historically:

One should not forget that modern protectionism was born in the United States. In 1791, Alexander Hamilton, the first Secretaary of the Treasury, drew up his famous Report on Manufactures, which is considered to be the first formulation of modern protectionist theory. … The major contribution of Hamilton is the idea that industrialization is not possible wothout tariff protection. He was apparently the first to have used the term ‘infant industries.’ …

… from 1861 to the end of World War II was [a period] of strict protectionism … the tariff in force from 1866 to 1883 provided for import duties averaging 45% for manufactured goods… When the United States caught up with European industry, … [that] rendered obsolete the ‘infant industries’ agument… The Republican party based its case for introducing the Mckinley Tariff of 1890 on the need to safeguard the wage levels of American workers…

The McKinley Tariff, which raised duties to an average of 50 percent, became law, and its sponsor went on to be elected president. Applebaum might have mentioned McKinley. He might have mentioned Grant. He might have mentioned Abraham Lincoln, who as Chang points out, built his early campaigns as much on support for tariffs as on opposition to slavery. He might have mentioned Hamilton — I hear he’s really hot right now. But of course he didn’t: In America we’ve always practiced free trade. So instead we get Queen Elizabeth and Chancellor Bismarck.

What Is Foreign Investment For?

The top of the front page in today’s Financial Times shows Steve Forbes’ scowling face with the caption, “We want our money!” Really, that should be there every day — it could be their new logo.

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Further down the page, the big story is the election of the opposition candidate Mauricio Macri as president of Argentina. I’ll wait to see what Marc Weisbrot has to say before guessing what this means substantively for the direction of the Argentine state. What I want to call attention to now is the consistent theme of the coverage.

The front page headline in the FT is “Markets cheer Argentina’s new order”; the opening words of the article are “Investors hailed the election of Mauricio Macri….” After mentioning his call for the leaders of Argentina’s central bank to step down — the apparent unobjectionableness of which is evidence on the real content of central bank “independence” — the first substantive claims of the article are that “markets reacted positively” and that “Macri has promised to eliminate strict exchange controls” — evidently the most important policy issue from the perspective of the FT reporter.

Over the fold, we learn again that “Investors yesterday cheered the election of Mauricio Macri”; that “dollar bonds issued by Argentina … extended their winning streak”; and that “markets have hoped for an end to ‘Kirchnerismo’.” The only people quoted in the article other than Macri himself are three European investment bankers. One says that “Macri understands what the country needs to do to regain the confidence of international investors and get the country back on its feet” — presumably in that order. Another instructs the new government that “Argentina must normalise relations with the capital markets and start attracting the all- important foreign investors”.

The accompanying think piece explains that among the “most pressing issues” for Macri are that “the country is shut out of international markets by its long court case with holdout creditors” and that “the economy suffers from a web of distortions, including energy subsidies that can shrink a household’s monthly energy bill to the price of a cup of coffee.” (The horror!) It emphasizes again that Macri’s only firm policy commitment at this point is to remove capital controls, and suggests that “Argentina will need to have recourse to multilateral financial support.” The conclusion: “The biggest area where Macri needs to effect change is the investment climate. Investors have cheered his rise … but Mr Macri’s job is to convert Argentina into a destination for real money investment rather than hedge fund speculation … a decisive change for a country that … is unique in having lost its ‘rich nation status’.”

So that’s the job of the president of Argentina, making the country a destination for real money. Good to have that clear!

Now, you might say, if you don’t want to read every story through the frame of “Is it good for the bondholders,” then why are you reading the FT? Fair enough — but the FT is a good newspaper. (The Forbes story is fascinating.) Anyway, it’s worth being reminded every so often that in the higher consciousness of the bourgeoisie, nations and all other social arrangements exist only in order to generate payments to owners of financial assets. [1]

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The question I’m interested in, though, is the converse one — are the bondholders good for Argentina? The claim that foreign investors are “all-important” is obviously an expression of the extraordinary narcissism of finance. But is there a rational core to it? Are foreign investors at least somewhat important?

This is a question that critical economists need to investigate more systematically. Even among heterodox writers, there’s a disproportionate focus on the development of the financial superstructure and the ways in which it can break down. [2] The importance of this superstructure for the concrete activities of social production and reproduction is too often taken for granted. Or else we make the case against free cross-border financial commitments too quickly, without assessing what might be the arguments for them.

So, concretely, what is the benefit to Argentina of regaining “access to the markets,” to enjoying the goodwill of foreign investors, to being a destination for real money? To answer this properly would involve citing lots of literature and looking at data. I’m not going to do that. The rest of this post is just me thinking through this issue, without directly referring to the literature. One result of this is that the post is too long.

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Let’s start by distinguishing foreign direct investment (FDI) from portfolio investment.

The case for FDI is essentially that there are productive processes that can be carried out successfully only if owned and managed by foreigners. Now, obviously there are real advantages to the ways in which production is organized in rich countries, which poorer countries can benefit from adopting. But the idea that the only way this technical knowledge can reach poorer countries is via foreign ownership rests, I think, on racism, that simple. The claim that domestically-owned firms cannot adopt foreign technology is contradicted by, basically, the entire history of industrialization.

A more plausible advantage of foreign ownership is that foreign companies have more favorable access to markets and supply networks. It would be at least defensible to claim that Polish manufacturing has benefited from integration into the German auto industry — not because German management has any inherent superiority, but because German car companies are more likely to source from their own subsidiaries than from independent Polish firms. I don’t see this kind of argument being made for Argentina. When we hear about “regaining the confidence of international investors,” that pretty clearly means owners of financial wealth considering whether to include Argentine assets in their portfolios, not multinational corproations considering expanding their operations there. In other words, we are interested in portfolio investment.

So what are the benefits that are supposed to come from attracting portfolio inflows? I wonder if the people quoted in the FT piece, or the author of it, ever even ask this question. This may be a case where the debate over what “capital” means is not just academic. If financial wealth is conflated with concrete means of production, then it’s natural to think that the goodwill of the owners of the first is all-important, since obviously no productive activity can take place without the second. But purchasers of Argentine stocks and bonds are not, in fact, providing the country with new machines or software or engineers or land. (For this reason, I prefer to avoid the terms “capital flows” and “capital mobility”.) What then are the bond buyers providing?

Macroeconomically, it seems to me that there are really only two arguments to be made for portfolio inflows. First, they allow a current account deficit to be financed. Second, they might allow the interest rate to be lower. Beyond macro considerations, we might also want to keep international investors happy because of their political influence, or because they control access to the international (or even domestic) payments system. And of course, if a country is already committed to free financial flows then this commitment will only be sustainable if net financial inflows are kept above a certain level. But that just begs the question of why you would make such a commitment in the first place.

Let’s consider these arguments in turn.

‘The first benefit, that portfolio inflows allow a country to have a deficit on current account, is certainly real. I think this is the only generally credible macroeconomic story for the benefits of capital account liberalization.

In a world with no international financial flows, countries would have to a balanced current account (or in practice balanced trade, since most income flows are the result of past financial flows) in every period. But there might be good reasons for some countries. to have transitory or persistent trade imbalances If a country’s trade balance moves toward deficit for whatever reason, the ability to reduce foreign assets and increase foreign liabilities allows the movement back toward balance to be deferred. If faster growth would lead to higher import demand (which cannot be limited otherwise) or requires specific imported intermediate or capital goods (that cannot be financed otherwise) then the foreign exchange provided by portfolio inflows can allow faster growth than would otherwise be possible.

There are good reasons to be skeptical about the practical value of portfolio inflows as finance of current account deficits. But there’s nothing wrong with the argument in principle. If that is the argument you are making, though, you have to be clear about the implications.

First, if this is your argument, then saying that Argentina has suffered because of its lack of access to foreign capital markets, is equivalent to saying that Argentina suffered because of its inability to run a trade deficit. I don’t think this is what people are saying — and it would not be plausible if they were, since Argentina has had a large trade surplus over the whole Kirchner period. No help from foreign investors would have been needed to reduce that surplus.

Second, if the benefit of portfolio flows is to finance current account imbalances, then only the net flows matter. There is no purpose to the large offsetting gross flows — you could just as well have the central bank alone borrow from abroad, and then sell the resulting foreign exchange at the market price (or distribute it in some other way). That would deliver all the macroeconomic benefits of international financial flows and avoid one of the major costs — the central bank’s inability to act as lender of last resort or resolve financial crises when financial institutions have liabilities that cannot be settled with central bank’ money.

Again, the only unambiguous macroeconomic reason to support capital-account liberalization, or to make attracting portfolio inflows a priority, is if you want to see larger current account deficits. In an undergraduate textbook, this is the whole story — to say that international lending permits countries to substitute present for future expenditure, or to raise investment above domestic saving, are just different ways of saying it permits current account deficits. If you think larger current account imbalances are unnecessary or dangerous, then, it’s not clear what the macroeconomic function of portfolio investment is supposed to be. The only thing that portfolio investment directly provides is foreign exchange.

The second possible macroeconomic benefit is that foreign portfolio investment allows the interest rate to be lower than it otherwise could be. This is certainly possible as a matter of logic. Let’s imagine a firm with an investment project that will generate income in the future. The firm needs to issue liabilities in order to exercise claims on the labor and other inputs it needs to carry out the project. Wealth owners must be willing to hold the liabilities of entrepreneur on terms that make the project viable; if they demand a yield that is too high, the project won’t go forward. But there may be some foreign intermediary that is both willing to hold entrepreneur’s liabilities on more favorable terms, and issues liabilities that wealth owners are more willing to hold. In this case, the creation of financial claims across borders is a necessary condition for the project to go forward. Note that this case covers all the macroeconomic benefits of diversification, risk-bearing, etc. — the ability to hold an internationally diversified portfolio may be very valuable to wealth owners, but that matters to the rest of us only insofar as that value allows real activity to be financed on more favorable terms.

That story makes sense where there is no domestic financial system, or a very underdeveloped one; it’s a good reason why financial self-sufficiency is not a realistic goal for small subnational units. But it’s not clear to me how it applies to a country with its own banking system and its own central bank. Is it plausibly the case that in the absence of financial flows, the Argentine central bank would be unable to achieve an interest rate as low as would be macroeconomically desirable? Is it plausibly the case that there are productive enterprises in Argentina that are unable to secure domestic-currency loans from the local banking system even given expansionary policy by the central bank, but would be able to do so from foreign lenders?  [3]

If this is your argument, you should at least be able to identify the kinds of firms (or I suppose households) that you think should be borrowing more, are unable to secure loans from the domestic banking system, but would be able to borrow internationally. (Or that would be able to borrow more from domestic banks, if the banks themselves could borrow internationally.)

It’s hard for me to see how a reasonably developed banking system with a central bank could be constrained in its ability to provide domestic-currency liquidity by a lack of portfolio inflows. And I doubt that’s what the gentlemen from Credit Suisse etc. are saying. On the contrary, the usual claim is that portfolio flows reduce the feasible range of domestic interest rates. Of course the people saying this never explain why it is desirable — the ability to conduct financial transactions across borders is just presented as a fact of life, to which policy must adapt. [4]

In any case, my goal here isn’t to dispute the arguments for the importance of portfolio inflows, but to clarify what they are, and their logical implications. Do you think that the benefits of portfolio flows are that they finance current account deficits and allow easier credit than the domestic bank system could provide? Then you can’t, for instance, turn around and blame the euro crisis on current account deficits and too-easy credit. Or at least, you can’t do that and still hold up “free movement of capital” as one of the central virtues of the system.

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There are two other non-macroeconomic arguments you sometimes hear for the importance of foreign investors, focused less on what they offer than with what they can threaten. First, the political importance of international creditors in the US and other states may allow them to use the power of those states against government they are unhappy with.

Historically, this is the decisive argument in factor of keeping foreign investors happy. Through most of the period from the 1870s through the 1950s, the possible consequences of a poor “investment climate” included gunboats in your harbor, the surrender of tariff collection and other basic state functions to creditor governments, military coups, even the end of your national existence. [5] (Let’s not forget that the pretext for the war in which the United States claimed half of Mexico’s territory was the mistreatment of American businessmen there.)

That sort of direct state violence in support of foreign creditors has been less common in recent decades, though of course we shouldn’t exclude the possibility of its revival. But there are less overt versions. The extraordinary steps taken by the Judge Griesa on behalf of Argentina’s holdout creditors go far beyond anything the investors could have done on their own. If the point of the FT pieces is that Argentina needs to settle with its creditors because otherwise it will face endless, escalating harassment from the US legal system, then they may have a point. I’d just like them to come out and say it.

A related argument is that failure to get on good terms with finance as a cartel of asset owners, will mean loss of access to finance as a routine service. The version of this you hear most often is that defaulting on or otherwise annoying foreign investors will result in loss of access to trade finance. So that even if the country has a current account in overall balance, its imports and/or exports will be restricted by a sudden need to conduct trade on a pure cash basis. I’ve seen this claim made much more than I’ve seen any evidence for it — which doesn’t mean it’s wrong, of course. But who are the providers of trade finance? Are they so resolutely class-conscious that they would refuse otherwise profitable transactions out of solidarity with their investor brethren? It doesn’t seem terribly likely — if foreign investors are willing to continue buying sovereign bonds post-default, as they unequivocally are, it’s hard to see them refusing this basic financial service to private businesses. Or coming back to Argentina, is there any evidence that the demand for Argentine exports was reduced by the default, or that Argentina was unable to convert its foreign exchange earnings into imports because foreign exporters couldn’t finance the usual 60- or 90- or whatever-day delay before receiving payment?

Another version of this argument — which Nathan Cedric Tankus in particular made in the case of Greece — is that a country that breaks with its creditors will lose access to the routine payment system — credit cards and so on — since it is all administered by foreign banks. In the case of a eurosystem country this may have some plausibility, at least as an acute problem of the transition — over a longer term, I can’t see any reason why this is a service that can’t be provided domestically. But leave aside how plausible they are, let’s be clear what these claims mean. They are arguments that foreign investors matter not because of anything of value they themselves provide, but because of their ability to provoke a sort of secondary strike or embargo by other segments of finance if they don’t get what they want. These are political arguments, not economic ones. In the longer view, they also support Keynes’ argument that finance should be “homespun” wherever possible. If trade finance really is so critical, and so readily withdrawn, wouldn’t it be wise to develop those facilities yourself?

The final argument is that, if you have committed yourself to permitting the free creation of cross-border payment commitments, you will be unable to honor those commitments without a sufficient willingness of foreign units to take net long positions in your country’s assets. [6]

This one is correct. If, let’s say, banks in Argentina have accumulated large foreign currency liabilities (on their own, or more likely, as counterparties to other units accumulating net foreign asset positions) then their ability to meet their survival constraint will at some point depend on the willingness of foreign units to continue holding their liabilities. And unlike in the case of a bank with only domestic-currency liabilities, the central bank cannot act as lender of resort. In other words, the central bank can always maintain the integrity of the payment system as long as its own liabilities serve as the ultimate means of settlement; but it loses this ability insofar as the balance sheets of the domestic financial system includes commitments to pay foreign moneys. [7]

This, probably, is the real practical content of stories about how important it is to maintain the goodwill of footloose capital. If you don’t honor your promises to foreign investors, you won’t be able to honor your promises to foreign investors. The weird circularity is part of the fact of the matter.

 

[1] Needless to say, not every political development is covered this way. The fact that the bondholder’s view of the world so dominates coverage of Argentine politics is evidently related to the specific way that Argentina is integrated into the global circuits of capital.

[2] I really wish people would stop talking about “the crisis” as some kind of watershed or vindication for radical ideas.

[3] I emphasize domestic currency. Of course domestic banks cannot provide foreign -currency loans. But again, this is only a macroeconomic issue if the country is running a trade deficit. Otherwise, the foreign exchange needed for imports will, in the aggregate, be provided by exports. The same goes for arguments that portfolio flows allow the central bank to target a lower interest rate, as opposed to achieving one.

[4] It would be worth going back and seeing what positive arguments the original framers of the policy trilemma made in favor of “capital mobility.” Or is it just treated as unavoidable?

[5] In the 19th century, “default might even be welcomed as a way of enhancing political influence.”

[6] It would be more conventional to express this thought in the language of capital mobility or international financial flows, but I think the metaphor of “capital” as a fluid “flowing” from one country to another is particularly misleading here.

[7] The capacity of the central bank to maintain payments integrity by substituting its own liabilities for impaired institutions’ is preserved even in the case of foreign-currency liabilities insofar as the central bank’s liabilities are accepted by foreign units. So the development of unlimited swap lines between major central banks represents, at least potentially, an important relaxation of the external constraint and a closer approximation of at least the rich-country portion of the global economy to an ideal closed economy. I’m glad to see that the question of swap lines is being taken up by MMT.

Lessons from the Greek Crisis

The deal, obviously it looks bad. No sense in spinning: It’s unconditional surrender. It is bad.

There’s no shortage of writing about how we got here. I do think that we — in the US and elsewhere — should resist the urge to criticize the Syriza government, even for what may seem, to us, like obvious mistakes. The difficulty of taking a position in opposition to “Europe” should not be underestimated. It’s one of the ironies of history that the prestige of social democracy, earned through genuine victories by and for working people, is now one of the most powerful weapons in the hands of those who would destroy it. For a sense of the constraints the Syriza government has operated under, I particularly recommend this interview with an unnamed senior advisor to Syriza, and this interview with Varoufakis.

Personally I don’t think I can be a useful contributor to the debate about Syriza’s strategy. I think those of us in the US should show solidarity with Greece but refrain from second-guessing the choices made by the government there. But we can try to better understand the situation, in support of those working to change it. So, 13 theses on the Greek crisis and the crisis next time.

These points are meant as starting points for further discussion.  I will try to write about each of them in more detail, as I have time.

Continue reading Lessons from the Greek Crisis

New-Old Paper on the Balance of Payments

Four or five years ago, I wrote a paper arguing that the US current account deficit, far from being a cause of the crisis of 2008, was a stabilizing force in the world economy. I presented it at a conference and then set it aside. I recently reread it and I think the arguments hold up well. If anything the case that the US, as the center of the world financial system, ought to run large current account deficits indefinitely looks even stronger now, given the contrasting example of Germany’s behavior in the European system.

I’ve put the paper up as a working paper at John Jay economics department site. Here’s the abstract:

Persistent current account imbalances need not contribute to macroe- conomic instability, despite widespread claims to the contrary by both mainstream and Post Keynesian economists. On the contrary, in a world of large capital inflows, a high and stable level of world output is most likely when the countries with the least capacity to generate capital inflows normally run current account surpluses, while the countries with the greatest capacity to generate capital inflows (the US in particular) normally run current account deficits. An emphasis on varying balance of payments constraints is consistent with the larger Post Keynesian vision, which emphasizes money flows and claims are not simply passive reflections of “real” economic developments, but exercise an important influence in their own right. It is also consistent with Keynes’ own views. This perspective helps explain why the crisis of 2008 did not take the form of a fall in the dollar, and why reserve accumulation in East Asia successfully protected those countries from a repeat of the crisis of 1997. Given the weakness of the “automatic” mechanisms that are supposed to balance trade, income and financial flows, a reduction of the US current account deficit is likely to exacerbate, rather than ameliorate, global macroeconomic instability.

You can read the whole thing here.

What Has Happened to Trade Balances in Europe?

It has gradually entered our awareness that the Greek trade account is now balanced. Greece no longer depends on financial markets (or official transfers, or remittances from workers abroad) to finance its imports. This is obviously important for negotiations with the “institutions,” or at least it ought to be.

I was wondering, how general is this shift toward a positive trade balance. In the FT last week, Martin Wolf pointed out that over the past five years, the Euro area as a whole has shifted from modest trade deficits to substantial trade surpluses, equal to 3 percent of euro-area GDP in 2013. He does not break it down by country, though. I decided to do that.

Euro area trade ratios, 2008 and 2013. The size of the dots is proportional to total 2008 trade.

Here, from Eurostat, are the export-import ratios for the euro countries in 2008 and 2013. Values greater than one on the horizontal axis represent a trade surplus in 2008; only a few northern European countries fall in that group. Meanwhile, in seven countries imports exceeded exports by 10 percent or more. By 2013, the large majority of the euro area is in surplus, while not a single country has an excess of imports over exports of more than 5 percent. The distance above the diagonal line indicates the improvement from 2008 to 2013; this is positive for every euro-area country except Austria, Finland and Luxembourg, and the biggest improvements are in the countries with the worst ratios in 2008. The surplus countries, apart from Finland, more or less maintained their surpluses; but the deficit countries all more or less eliminated their deficits.

So does this mean that austerity works? Yes and no. It is certainly true that Europe’s deficit countries have all achieved positive trade balances in the past few years, even including countries like Greece whose trade deficits long predated the euro. On the other hand, it’s also almost certainly true that this has more to do with the falls in domestic demand rather than any increase in competitiveness.

This is shown in the second figure, which gives the ratio of 2013 imports to 2008 exports on the vertical axis, and 2013 exports to 2008 imports on the horizontal axis. (This is in nominal euros.) Here a point on the diagonal line equals and equal growth rate of imports and exports. Most countries are clustered around 15% growth in imports and exports; these are the countries that had balanced trade or surpluses in 2008, and whose trade ratios have not changed much in the past five years. Only one country, Estonia, has export growth substantially above the European average. But all the former deficit countries have import growth much lower than average. (As indicated by their position to the left of the main cluster.) It’s evident from this diagram that the move toward balanced trade in the deficit countries is about throttling back imports, not boosting exports. This suggests that it has more to do with slow income growth than with lower costs.

Again, the sizes of the dots are proportional to 2008 trade volumes.

Still, the fact remains, trade deficits have almost been eliminated in the euro area. Liberal critics of the European establishment often say “not every country in Europe can be a net exporter” as if that were a truism. But it’s not even true, not in principle and evidently not in practice. It turns out it is quite possible for every country in the euro to run a trade surplus.

The next question is, with whom has the euro area’s trade balanced improved? Europe outside the euro, to begin with. The country with the biggest single increase in net imports from the euro zone is, surprisingly, Switzerland, whose deficit with the euro area has increased by close to 60 billion. Switzerland’s annual trade deficit with the euro area is now 75 billion, about a quarter of the area’s overall trade surplus. Norway and Turkey have increased their deficits by about 15 billion each. The rest of the increase in net exports are accounted for by increased surpluses with Africa (26 billion), the US (27 billion), and Latin America (35 billion, about half to Brazil), and a decreased deficit with Asia (135 billion, including a 55 billion smaller deficit with China, 30 billion smaller with Japan and 20 billion with Korea). Net exports to Australia have also increased by 10 billion.

Why do I bring this up? One, I haven’t seen it discussed much and it is interesting.

But more importantly, the lesson of the Europe-wide shift toward trade surpluses is that austerity can succeed on its own terms. I think there’s a tendency for liberal critics of austerity to assume that the people on the other side are just confused, or blinkered by ideology, and that there’s something incoherent or self-contradictory about competitiveness as a Europe-wide organizing principle. There’s a hope, I think, that economic logic will eventually compel policymakers to do what’s right for everyone. Personally, I don’t think that the masters of the euro care too much about the outcome of the struggle for competitiveness; it’s the struggle itself — and the constraints it imposes on public and private choices — that matters. But insofar as the test of the success of austerity is the trade balance, I suspect austerity can succeed indefinitely.

UPDATE: In comments Kostas Kalaveras points to a report from the European Commission that includes a similar breakdown of changes in trade balances across the euro area. There’s some useful data in there but the interpretation is that almost all the adjustment has been structural rather than cyclical. This is based on estimates of declining potential output in the periphery that I think are insane. But it’s interesting to see how official Europe thinks about this stuff.

The Call Is Coming from Inside the House

Paul Krugman wonders why no one listens to academic economists. Almost all the economists in the IGM Survey agree that the 2009 stimulus bill successfully reduced unemployment and that its benefits outweighed its costs. So why are these questions still controversial?

One answer is that economists don’t listen to themselves. More precisely, liberal economists like Krugman who want the state to take a more active role in managing the economy, continue to teach  an economic theory that has no place for activist policy.

Let me give a concrete example.

One of Krugman’s bugaboos is the persistence of claims that expansionary monetary policy must lead to higher inflation. Even after 5-plus years of ultra-loose policy with no rising inflation in sight, we keep hearing that since so “much money has been created…, there should already be considerable inflation.” (That’s from exhibit A in DeLong’s roundup of inflationphobia.) As an empirical matter, of course, Krugman is right. But where could someone have gotten this idea that an increase in the money supply must always lead to higher inflation? Perhaps from an undergraduate economics class? Very possibly — if that class used Krugman’s textbook.

Here’s what Krugman’s International Economics says about money and inflation:

A permanent increase in the money supply causes a proportional increase in the price level’s long-run value. … we should expect the data to show a clear-cut positive association between money supplies and price levels. If real-world data did not provide strong evidence that money supplies and price levels move together in the long run, the usefulness of the theory of money demand we have developed would be in severe doubt. 

… 

Sharp swings in inflation rates [are] accompanied by swings in growth rates of money supplies… On average, years with higher money growth also tend to be years with higher inflation. In addition, the data points cluster around the 45-degree line, along which money supplies and price levels increase in proportion. … the data confirm the strong long-run link between national money supplies and national price levels predicted by economic theory. 

… 

Although the price levels appear to display short-run stickiness in many countries, a change in the money supply creates immediate demand and cost pressures that eventually lead to future increases in the price level. 

… 

A permanent increase in the level of a country’s money supply ultimately results in a proportional rise in its price level but has no effect on the long-run values of the interest rate or real output. 

This last sentence is simply the claim that money is neutral in the long run, which Krugman continues to affirm on his blog. [1] The “long run” is not precisely defined here, but it is clearly not very long, since we are told that “Even year by year, there is a strong positive relation between average Latin American money supply growth and inflation.”

From the neutrality of money, a natural inference about policy is drawn:

Suppose the Fed wishes to stimulate the economy and therefore carries out an increase in the level of the U.S. money supply. … the U.S. price level is the sole variable changing in the long run along with the nominal exchange rate E$/€. … The only long-run effect of the U.S. money supply increase is to raise all dollar prices.

What is “the money supply”? In the US context, Krugman explicitly identifies it as M1, currency and checkable deposits, which (he says) is determined by the central bank. Since 2008, M1 has more than doubled in the US — an annual rate of increase of 11 percent, compared with an average of 2.5 percent over the preceding decade. Krugman’s textbook states, in  unambiguous terms, that such an acceleration of money growth will lead to a proportionate acceleration of inflation. He can hardly blame the inflation hawks for believing what he himself has taught a generation of economics students.

You might think these claims about money and inflation are unfortunate oversights, or asides from the main argument. They are not. The assumption that prices must eventually change in proportion to the central bank-determined money supply is central to the book’s four chapters on macroeconomic policy in an open economy. The entire discussion in these chapters is in terms of a version of the Dornbusch “overshooting” model. In this model, we assume that

1. Real exchange rates are fixed in the long run by purchasing power parity (PPP).
2. Interest rate differentials between countries are possible only if they are offset by expected changes in the nominal exchange rate.

Expansionary monetary policy means reducing interest rates here relative to the rest of the world. In a world of freely mobile capital, investors will hold our lower-return bonds only if they expect our nominal exchange rate to appreciate in the future. With the long-run real exchange rate pinned down by PPP, the expected future nominal exchange rate depends on expected inflation. So to determine what exchange rate today will make investors willing to holder our lower-interest bonds, we have to know how policy has changed their expectations of the future price level. Unless investors believe that changes in the money supply will translate reliably into changes in the price level, there is no way for monetary policy to operate in this model.

So  these are not throwaway lines. The more thoroughly a student understands the discussion in Krugman’s textbook, the stronger should be their belief that sustained expansionary monetary policy must be inflationary. Because if it is not, Krugman gives you no tools whatsoever to think about policy.

Let me anticipate a couple of objections:

Undergraduate textbooks don’t reflect the current state of economic theory. Sure, this is often true, for better or worse. (IS-LM has existed for decades only in the Hades of undergraduate instruction.) But it’s not much of a defense, is it? If Paul Krugman has been teaching his undergraduates economic theory that produces disastrous results when used as a guide for policy, you would think that would provoke some soul-searching on his part. But as far as I can tell, it hasn’t. But in this case I think the textbook does a good job summarizing the relevant scholarship. The textbook closely follows the model in Dornbusch’s Expectations and Exchange Rate Dynamics, which similarly depends on the assumption that the price level changes proportionately with the money supply. The Dornbusch article is among the most cited in open-economy macroeconomics and international finance, and continues to appear on international finance syllabuses in most top PhD programs.

Everything changes at the zero lower bound. Defending the textbook on the ground that it’s pre-ZLB effectively concedes that what economists were teaching before 2008 has become useless since then. (No wonder people don’t listen.) If orthodox theory as of 2007 has proved to be all wrong in the post-Lehmann world, shouldn’t that at least raise some doubts about whether it was all right pre-Lehmann? But again, that’s irrelevant here, since I am looking at the 9th Edition, published in 2011. And it does talk about the liquidity trap — not, to be sure, in the main chapters on macroeconomic policy, but in a two-page section at the end. The conclusion of that section is that while temporary increases in the money supply will be ineffective at the zero lower bond, a permanent increase will have the same effects as always: “Suppose the central bank can credibly promise to raise the money supply permanently … output will therefore expand, and the currency will depreciate.” (The accompanying diagram shows how the economy returns to full employment.) The only way such a policy might fail is if there is reason to believe that the increase in the money supply will subsequently be reversed. Just to underline the point, the further reading suggested on policy at the zero lower bound is an article by Lars Svennson that calls a permanent expansion in the money supply “the foolproof way” to escape a liquidity trap. There’s no suggestion here that the relationship between monetary policy and inflation is any less reliable at the ZLB; the only difference is that the higher inflation that must inevitably result from monetary expansion is now desirable rather than costly. This might help if Krugman were a market monetarist, and wanted to blame the whole Great Recession and slow recovery on bad policy by the Fed; but (to his credit) he isn’t and doesn’t.

Liberal Keynesian economists made a deal with the devil decades ago, when they conceded the theoretical high ground. Paul Krugman the textbook author says authoritatively that money is neutral in the long run and that a permanent increase in the money supply can only lead to inflation. Why shouldn’t people listen to him, and ignore Paul Krugman the blogger?

[1] That Krugman post also contains the following rather revealing explanation of his approach to textbook writing:

Why do AS-AD? First, you do want a quick introduction to the notion that supply shocks and demand shocks are different … and AS-AD gets you to that notion in a quick and dirty, back of the envelope way. 

Second — and this plays a surprisingly big role in my own pedagogical thinking — we do want, somewhere along the way, to get across the notion of the self-correcting economy, the notion that in the long run, we may all be dead, but that we also have a tendency to return to full employment via price flexibility. Or to put it differently, you do want somehow to make clear the notion (which even fairly Keynesian guys like me share) that money is neutral in the long run. That’s a relatively easy case to make in AS-AD; it raises all kinds of expositional problems if you replace the AD curve with a Taylor rule, which is, as I said, essentially a model of Bernanke’s mind.

This is striking for several reasons. First, Krugman wants students to believe in the “self-correcting economy,” even if this requires teaching them models that do not reflect the way professional economists think. Second, they should think that this self-correction happens through “price flexibility.” In other words, what he wants his students to look at, say, falling wages in Greece, and think that the problem must be that they have not fallen enough. That’s what “a return to full employment via price flexibility” means. Third, and most relevant for this post, this vision of self-correction-by-prices is directly linked to the idea that money is neutral in the long run — in other words, that a sustained increase in the money supply must eventually result in a proportionate increase in prices. What Krugman is saying here, in other words, is that a “surprising big” part of his thinking on pedagogy is how to inculcate the exact errors that drive him crazy in policy settings. But that’s what happens once you accept that your job as an educator is to produce ideological fables.

What Do People Need to Know About International Trade?

On the first day of my trade class, we read Paul Krugman’s article “What Do Undergrads Need to Know About Trade?” In an admirably succinct four pages, it captures all the important things that orthodox trade theory claims to tell us about trade policy. I don’t think orthodox views on trade policy have changed at all in the 20 years since it was written. [1]

So what’s Krugman’s answer? What undergrads need to know, he says, is just what Hume and Ricardo were saying, 200 years ago: If relative costs of production are different in two countries, then total world output, and consumption in each individual country, will always be greater with trade than without, and prices will adjust so that trade is balanced. Free trade is always beneficial for all countries involved.

Krugman’s additions to this Ricardo-Hume catechism are mostly negative — a list of things we don’t need to talk about when talk about trade.

Don’t worry about development. The idea that a country can benefit from changing the sectors or industries it specializes in is, he says “a silly concept.” Yes, we look around the world and see workers in rich countries producing things like airplanes and software, which are worth a lot, and workers in poor countries putting the same effort into producing agricultural goods and textiles, which are worth much less. But

Does this mean the rich country’s high standard of living the result of being in the right sector, or that the poorer country would be richer if it tried to emulate the other’s pattern of specialization? Of course not.

Of course not. This blanket dismissal is rather odd, since the work Krugman won the Nobel for explicitly supports an affirmative answer to both questions. [2] It’s a case of esoteric versus exoteric knowledge, I guess — some truths are not meant for everyone. Or as Krugman delicately puts it, “the innovative stuff is not a priority for undergrads.”

Don’t worry about demand. In debates over policy, “the central issue is employment” in the arguments on both sides. But this is wrong, he says:

The level of employment is a macroeconomic issue, depending in the short run on aggregate demand and depending in the long run on the natural rate of unemployment, with policies like tariffs having little net effect. Trade policy should be debated in terms of its impact on efficiency…

It’s not immediately obvious why the claim that employment depends on aggregate demand is inconsistent with the claim that trade flows have important employment effects. After all, net exports are a component of demand. The implicit assumption is evidently that the central bank (or some other domestic policymaker) is maintaining the level of demand at the full-employment level, and will offset any effects from trade. [3]

Don’t worry about trade deficits, and the financing they require. “The essential things to teach students are still the insights of Ricardo and Hume. That is, trade deficits are self-correcting…”

The whole piece is frankly polemical — it’s clear that the goal is not to educate in the normal sense, but to equip students to take a particular side in public debates. This is not specific to Krugman, of course. If anything, most contemporary textbooks are even worse. [4] One  reason I am using Caves and Frankel in my class is that it has less obnoxious editorializing than other texts I looked at. But less is still a lot.

Enough Krugman-bashing. What’s the alternative? What should people know about international trade? Matias Vernengo has one good alternative list. Here is mine.

There are three frameworks or perspectives in which we can productively think about international trade. The questions we ask in each case will depend on whether we are thinking of trade flows as the adjusting variable, or as reflecting an exogenous change to which some other variable(s) must adjust.

1. Trade flows are part of aggregate expenditure. On the one hand, a good way to predict trade flows is to assume that a fixed fraction of each dollar of spending goes to imported goods. As Joan Robinson and others have stressed, in the short run at least, adjustment of trade balances comes mainly or entirely through income changes. (This is also the perspective developed in Enno Schroeder’s work, which I’ve discussed here before.) On the other hand, if we can’t assume there is some level of full employment or potential output to which to which the economy always returns, then we have to be concerned with trade flows as one factor determining the level of aggregate income. This might be only a short-run phenomenon, as in mainstream Keynesian analysis, or it might be important to economic growth rates over the long run, as in models of balance of payments constrained growth.

2. Trade flows are part of the balance of payments. In a capitalist world economy, there are many different money payments and obligations between countries, of which trade flows are just part. In a world of liquidity constraints, certain configurations of money payments or money commitments are costly, or cannot be achieved at all. That is, a country in the aggregate cannot in general borrow unlimited amounts at “the” world interest rate. The tighter the constraints on a country’s financial position, the more positive a trade balance it must somehow achieve. On the other hand, for a given level of financing constraint, a more positive trade balance allows for more freedom on other dimensions. This interaction between trade flows and financial constraints is central to the balance of payments crises that are such a prominent feature of the modern world economy.

3. Trade flows involve specialization. Thinking now in terms of baskets of goods rather than money flows, the essential thing about international trade is that it allows a country’s consumption and production decisions to be made independently. Given that productive capacities vary more between countries than the mix of consumption goods chosen at a given income and prices, in practice this means that trade allows for specialization in production. If we take productive capacities as given, it follows that trade raises world output and income by allowing countries to specialize according to comparative costs. This is the essential (and genuine) insight of Ricardo. On the other hand, if we think that inherent differences between countries are small and that differences in productive capacity arise mainly through production itself, then international trade will lead to a historically contingent pattern of international specialization in which some positions are more advantageous than others. If causality runs from trade patterns to productive capacities and not just vice versa, then there is a case for including activity trade policy in any development strategy.

The orthodox trade theory has legitimate value and deserves a place in the curriculum. As we’ll discuss in the next post, simple textbook models of the Ricardo-Mill type can be used to tell stories with more interesting political implications than the usual free-trade morality tales. But they are only part of the picture. Much of what matters about trade depends on the fact that it involves flows of money and not just exchanges of goods.

[1] Have Krugman’s views changed since he wrote this? As reflected in his textbooks, no they have not. As reflected in his blog, seems like sometimes yes, sometimes no. Someone should ask him.

[2] For example, one of Krugman’s more widely cited articles is this one, which develops a model in which an innovating region (“the North”) develops new products, which it exports to a non-innovating region (“The South”). In the model,

Higher Northern per capita income depends on the quasi-rents from the Northern monopoly of new products, so the North must continually innovate not only to maintain its relative position but even to maintain its real income in absolute terms. 

This is hard to distinguish from the arguments for industrial policy that Krugman dismisses as silly.

[3] What’s especially odd here is that orthodox theory says that in a world of mobile capital, the only tool the central bank has to maintain full employment is changes in the exchange rate. In standard textbooks (including Krugman’s own), it is impossible for monetary policy to boost employment unless it improves the trade balance.

[4] For example, David Colander’s generally undogmatic intro textbook includes a section titled “If trade is so good, why do so many people oppose it?”The answer turns out to be, they’re just confused.

International Trade: What Are the Questions?

This semester, I’m teaching an upper-level class at Roosevelt on international trade. Trade is an interest of mine, but not something I’ve ever taught. So it will be a learning experience for me at least as much as for the students.

One way to organize a class like this is to start with the orthodox approach and then present the various heterodox alternatives. I don’t know if that’s the best way to do things; but it is what I am doing. So we divide things up:

1. Orthodox trade theory. Orthodox approaches to trade (the first half of any standard textbook; we are using Caves and Frankel) treat trade as an exchange of goods for goods. We assume that trade is always balanced and that all resources are fully employed, and show how specialization by different countries in their preferred activities leaves everyone better off. We can divide this approach into Ricardian models, which treats countries preferred activities as dictated by inherent differences in productive capacities, on the one hand; and on the other, the Heckscher-Ohlin models that regard countries as having the same productive technology but different “endowments” of (a relatively small number of) “factors of production.” As far as I can tell, these two kinds of models are not associated with distinct schools of thought in any larger sense; but it seems to me that the tension between them is one of the more interesting things in the orthodox theory.

2. Keynesian approaches. Here the important thing is the systematic relationship between income-expenditure and trade flows. On the one hand, we think a predictable fraction of incremental expenditure will fall on imports, and on the other, net exports are a form of autonomous demand boosting income. The short-run version of this approach used to be fully respectable; one very good presentation is Dornbusch’s 1980 textbook, Open Economy Macroeconomics. [1] The long-run version of the Keynesian approach is Thirlwall’s model of balance-of-payments constrained growth. I don’t know that this has ever been respectable but I think it’s useful and sensible and, I hope, teachable.

3. New trade theory. The starting point here is that while orthodox theory says that the biggest gains come from trade between countries that are most different (in terms of productive capacities or factor endowments), what we see in the real world is that most trade is between basically similar industrialized countries. The explanation, according to this approach, is that most trade is not in fact driven by comparative advantage, but by increasing returns, which reward specialization even in the absence of any inherent differences between countries or regions. This is the stuff Paul Krugman got his prize for. One puzzle about the new trade theory is that its practitioners almost all endorse the same free-trade policy orthodoxy underwritten by the old trade theory, even though the substantive content would seem to undermine it. What the new theory says is, first, that the pattern of specialization between countries is in some important respect arbitrary and at least potentially shaped by choices; and second, that the global distribution of income is a function of who ends up with which specialty. in this sense, there is some affinity between the new trade theory and Marxist theories of imperialism, dependency and unequal exchange. I’d wondered for a while if anyone had written about this connection. The answer turns out to be yes: Krugman himself. He even cites Lenin!

4. Development, dependency and unequal exchange. There is a large body of radical theory here, which I admit I have not quite got my arms around. For current purposes, let’s think in terms of two strands of analysis — or at least two sets of questions, which may or may not correspond to different schools or bodies of theory. First, there is the relationship between trade and economic development. Historically, we could put this at the very beginning of the list, since it seems that many of the earliest writers on what we now call economics were centrally concerned with this question. But for our purposes, we are interested in the tradition that runs from Hamilton to Friedrich List to Gerschenkron to Dani Rodrik and Ha-Joon Chang. These mostly pragmatic analyses, associated politically with rising rivals to the current hegemon, include a mix of infant industry/”import protection as export promotion” arguments, and trade restrictions as devices to expand the domestic policy space (the positive side of mercantilism emphasized by Keynes.) Second, there are the various theories that go under the names of dependency and unequal exchange. The key claim here is that there is a systematic movement of prices that favors the North and disfavors the South. We may further subdivide these theories into Prebisch-Singer and related approaches, and more Marxist analyses from Hobson, Lenin and Luxembourg through Baran to Frank, Wallerstein, Amin and Emmanuel.

Another way of looking at this: Among the assumptions of the orthodox theory are that all resources are fully employed, that prices always adjust so as to balance trade (or equivalently, that goods trade directly for goods), and that countries’ productive capacities can be taken as exogenous and determine the pattern of trade. Keynesian approaches reject the first two of these assumptions, the new trade theory rejects the third; the various development/dependency approaches also reject the third assumption and in some versions the first two as well.

There reason I’m posting this here is I’d like to integrate my teaching more with this blog. So the hope is to have a bunch of posts about all this over the next few months. I’m sure I’ll get a lot of things wrong; maybe the readers of the blog can correct some of them.

[1] On the other hand, this contemporary (and very admiring) review of the Dornbusch book does chide him for starting with 

a nonmonetary “Keynesian” model with rigid prices, fixed exchange rates, and unemployment … The basic consideration is short-run full employment; long-run problems of allocation and prices are left in the background. Economists with a more “classical” turn of mind may be a little disconcerted to find tariffs introduced as instruments to raise employment and to see real wages explained by the “claims” of trade unions. They would probably prefer to start out with the long-run picture, linking monetary aspects firmly to the pure theory of international trade. 

So maybe it wasn’t ever fully respectable. One thing I’d like to understand better is exactly when and to what extent “Keynsian” theory was accepted among academic economists.

Exchange Rates and Trade Flows in Asia

A bit more on shifting trade flows following the 1997 Asian Crisis.

Enno Schroeder, whose decomposition  of European trade flows I’ve mentioned here before, was kind enough to do a similar exercise for the four Asian crisis countries. His results are here; below I present them in graphical form below.

The conventional story, as we all know, is that relative prices drive trade flows. The Asian countries, in this view, moved from deficits to surpluses after 1997 because abandoning their currency pegs and devaluing made their exports cheaper and their imports more expensive. I’ve been suggesting a different story: Relative prices were relatively unimportant in the post-1997 move to surpluses, with the improved trade balance mostly or entirely a matter of lower imports resulting from the deep fall in income in the crisis. Looking at the picture in more detail suggests a more complex but in some ways even stronger version of my earlier story.

Some context: Suppose a country reduces its total import bill. As a matter of accounting, this reduction can be broken up into some mix of lower total quantity of goods bought, a smaller fraction of those goods being imports, and a lower price of the imported goods. Similarly for exports, any increase can be broken up into higher incomes in a country’s export markets, a greater market share there for our exports, and higher export prices. So the overall trade balance — here expressed as the ratio of total export value to total import value — can be decomposed into the change in relative expenditure growth, the expenditure switch between the home country’s goods and the rest of the world’s; and the change in the relative price of home goods compared with foreign ones. (Note that relative price presumably affects trade volumes, but it also affects trade value directly — for given trade volumes, if a country’s imports are more expensive it will spend more on imports.) The cumulative contribution of each of these components is shown in the figures below, along with the nominal exchange rate. (The exchange rate is the nominal rate for July of each year, from the BIS.)

The heavy black line is the actual trade balance. Again, since the balance here is expressed as the ratio of exports to imports, a value of 1 means balanced trade. The other three solid lines show the cumulative contributions of each component to the changes in trade flows after 1996; the values represent how the trade ratio would have changed from that factor alone. Yellow is expenditure switch, from the rest of the world’s goods to the home country’s; this includes both home country switch from imports to domestic goods, and foreign country shift toward the home country’s exports. Green is income growth in the country’s trade partners relative to the home country. The solid red line is the terms of trade. The dotted red line shows the cumulative change in the nominal exchange rate; this isn’t directly a contribution to the change in trade flows, but it’s useful to know how closely the change in the terms of trade tracks the exchange rate.

It’s convenient to think of the difference between the black line and the green line as the change in competitiveness.

The immediate effect of a devaluation is to make the home country’s goods cheaper in the rest of the world, and the rest of the world’s goods more expensive in the home country. The direct effect of this is to move the trade balance further toward deficit — a descending red line in the figures below. But in the conventional story, the change in price leads to a more than proportionate change in quantity — a rise in exports and/or a fall in imports — so that the overall trade balance improves. This should show up here as a rise in the yellow line steeper than the fall in the red one. Income growth doesn’t really come into the conventional story, so the green line should be flat.

This is not what we see. Even in terms of this simple decomposition, the post-crisis experience of each of the four Asian NICs was different, but none of them fit the standard story. Devaluations don’t reliably translate into changes in the terms of trade, and changes in the terms of trade don’t reliably translate into changes in trade flows. The income-trade balance link, on the other hand, looks quite reliable. In terms of the debate taking place elsewhere in econ blog land, this is a case where “hydraulic Keynesianism” looks pretty good.

Thailand is the clearest picture.

In the 1997 devaluation, the baht lost about a third of its value; the fall in the terms of trade — the price of Thai exports relative to imports — was less than proportionate, but still substantial. You can see this in the red lines at the bottom. But there was no expenditure switch at all. The flat yellow line shows that expenditure on foreign goods out of a given Thai income, and expenditure on Thai goods out of a given income elsewhere, did not change at all in the ten years after the crisis. (More precisely, expenditure in Thailand shifted toward domestic goods, while Thailand lost ground in its export markets; the two effects approximately canceled out.) Given that Thai goods were getting cheaper relative to foreign goods, the lack of net expenditure switch toward Thai goods should have led to deeper deficits. The only reason Thailand moved from deficit to surplus, is the decline in expenditure in Thailand relative to expenditure in its trading partners. The close match between the black and the green line in the figure, means that essentially the whole change in Thailand’s trade balance is explained by the change in relative growth rates; there was no net switch toward Thai goods from foreign goods.

Indonesia is in some ways even a starker example:

Here we see a very deep devaluation, but again only a moderate change in the terms of trade, and an even smaller response of trade volumes. As in Thailand, the trade balance basically tracks relative income growth. The difference between these two cases is where the devaluation-trade flows link fails. In Thailand, the devaluation did reduce the price of exports relative to imports, but demand was not price-elastic enough for the change in prices to improve the trade balance. (In other words, the Marshall-Lerner-Robinson condition appears not to have been satisfied.) In Indonesia, the even larger devaluation — the rupiah lost almost 80 percent of its value — failed to change relative prices of traded goods, so demand elasticities did not come into play. This is partly because of high inflation in Indonesia following the devaluation, but not entirely – the rupiah fell by nearly half in real terms. But there was no change in the price of Indonesia’s exports relative to its imports. If you want an example of a devaluation not working, this is a good one.

Korea, by contrast, looks superficially like the devaluation success story.

As I mentioned in the previous post, Korea was the only one of these countries where export growth in the decade after 1997 was as fast as in the decade before. And as the figure here shows, there was a substantial shift expenditure toward Korean goods following the crisis; alone among the four countries, Korea achieved its immediate post-crisis improvement in trade balance mainly through favorable expenditure switch rather than solely through a fall in income (though that contributed too.) But over time, Korea’s terms of trade continued to deteriorate, without any further favorable expenditure switch; meanwhile, Korean growth slowed relative to its trade partners. By 2007, expenditure shares were back at 1997 levels; to the extent that Korea’s trade balance was more favorable, it was only because spending was lower relative to its trade partners. Of course the surpluses it had run in the meantime had allowed the accumulation of substantial foreign exchange reserves. But if the goal is to use a lower exchange rate to achieve a permanent shift in trade balances, Korea post-1997 cannot be considered a success.

I should emphasize here: Slower relative expenditure growth in Korea does not mean slow growth in absolute terms. In fact, Korea (and, to varying degrees, the other three) did enjoy strong post-crisis recoveries. But because by far the largest trading partner for these countries is China — taking about 25% of their exports — even fairly strong growth translated into low relative growth. In other words, rapid growth in China implied growing exports in the NICs even in the absence of any competitiveness gains.

Finally, the one country that did achieve a lasting improvement in competitiveness, Malaysia.

In the immediate crisis period, Malaysia looks like Thailand and Indonesia: A deep devaluation fails to pass through to the relative prices of traded goods, and there is no expenditure switching; instead, the entire burden of raising the trade balance falls on slower growth in domestic expenditure. In the case of Malaysia, domestic expenditure fell by an astonishing 28 percent in 1997, a collapse in economic activity that has few precedents — neither the US in the 1930s nor any Euro-crisis country comes close. But in the case of Malaysia, unlike the other three countries, growth subsequently accelerated relative to its trade partners, reflected in the downward sloping green line; at the same time, there was a continued expenditure switch in favor of Malaysian goods, reflected in the upward slope of the yellow line. What’s especially striking about this competitiveness success story is that the favorable expenditure switch happened despite a rising price of of Malaysia’s exports relative to its imports.

To continue with this analysis properly, one would want to disaggregate imports and exports by sector or industry. And would want to study, for each country, the institutional and legal changes that influenced trade flows in the decade after 1997. But failing that, it’s at least worth understanding what the aggregate numbers are saying. It seems to me that they are saying this:

Even a very deep devaluation, as in Indonesia, is not guaranteed to change the relative prices of a country’s imports and exports.

Even if a devaluation is passed through to relative prices, as in Thailand, price elasticities may not be large enough to produce a favorable change in the trade balance.

Even if a devaluation moves relative prices, and demand is price-elastic enough for the price change to move the trade balance in the right direction, as in Korea, a short-term improvement in competitiveness may not persist.

When countries do achieve a long-term improvement in competitiveness, like Malaysia, they don’t necessarily do so through a relative cheapening of exports compared to imports. On the contrary: If the Marshall-Lerner condition is not satisfied, then a relative increase in the price of a country’s exports will raise export earnings. In the case of Malaysia, improved terms of trade (that is, a rise in the price of its exports relative to its imports) account for about half the long-run improvement in its trade balance.

The Asian precedent does not make a Greek (or Spanish, or Portuguese, or Irish) devaluation look like an obviously good idea.

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One other thing, if even real exchange rate changes are not passed through to traded-good prices in the destination country, then they must be showing up as changes in exporter profit margins. This shifts the focus from demand responses to supply responses, which I would argue are  more institutionally mediated. As you can tell if you’ve read this far, I am sympathetic to the “elasticity-pessimist” strand of Post Keynesian thought. But on the other side Robert Blecker has a strong argument for a strong effect of exchange rate changes, focusing on the role of export-industry profits in financing investment. Blecker’s paper, in my opinion, is more convincing the straightforward “prices matter” view of exchange rate changes. But it also suggests a certain asymmetry: low profits induce exit from tradable sectors, especially for countries with Anglo-American market-based financial systems, more reliably than high profits encourage entry.

UPDATE: The fact that even large exchange rate changes produce relatively small movements in the relative prices of traded goods is well-known in the empirical trade literature. See for example here. I should have made this clearer.