Tag Archives: Balance of Payments

internal and external economic adjustment

July 12, 2016 By in Balance of Payments, currency effects, currency markets, economics, Uncategorized Tags: , , , , , Leave a comment

This is ultimately about the euro and the EU.  Today’s post is about creating a framework for thinking about this issue.

It’s a condensed version of a longer post I wrote six years ago on Balance of Payments (actually, a series, for anyone who’s interested).   Although a big simplification of what is actually going on in the world, it highlights what I believe is a central structural issue facing the EU and Japan today   …and potentially the US, at some point.

 

imports and exports

The residents of any given country typically don’t consume only items made in that country.  They buy imported goods as well.  In fact, the marginal propensity to consume imports is normally higher than the marginal propensity to consume, meaning that as spending increases imports rise at a faster rate.

paying for imports

The country as a whole gets the money to pay for imports in one of a number of ways:  it can make things to sell to foreigners, it can use accumulated savings, it can sell assets to foreigners or it can borrow.

imbalances

In an ideal world, every country would make and sell exactly enough goods and services through export to pay for the imports it purchases.  That’s seldom the case, however.

chronic deficit

Consider a country that, year after year, buys more from foreigners than it can pay for with the proceeds from what it sells.  To continue consuming foreign goods at the same rate, such a country has to either sell assets, like land or companies, or borrow from foreigners.  At some point, however, it will reach the limits either of what it has that others want to buy or the amount foreigners will lend.

This situation sets the stage for a potential foreign currency/trade/economic growth crisis.

internal/external adjustment

Here’s where we get to internal/external adjustment.

There are two ways of dealing with this issue:

internal

–the government can slow down overall consumption (essentially, create a recession) by raising interest rates/taxes by enough to decrease consumption of foreign goods and services

–domestic industries can voluntarily restructure themselves, with/without government help, to improve quality and lower prices so they make more things foreigners will want (unlikely to happen on a large scale)

–the government can erect tariff or regulatory barriers to imports, to try to redirect consumption to domestic goods (almost always a bad idea:  look at the US auto industry since the mid-Seventies)

None of these actions are likely to win unanimous applause from voters.  And if legislative action produces negative results, it will be completely clear who is to blame.  So politicians everywhere, and particularly in badly-run countries, tend to not to want to choose any one of them.  Instead, they most often opt for the external adjustment route.

external

–This means to encourage or embrace a decline in the local currency versus that of trading partners.  That simultaneously makes foreign goods more expensive for locals and local goods cheaper for foreigners.  Devaluation will encourage exports and inhibit imports, achieving the same end as rising interest rates, but without the sticky legislative fingerprints attached.  It’s those horrible foreign exchange markets instead.

 

More tomorrow.

 

 

 

 

 

 

Balance of Payments (II): internal and external structural adjustment

March 25, 2010 By in Balance of Payments, Basic Concepts, currency effects, economics Tags: , , , , , , , 1 Comment

The BoP accounts should balance

In the long term, the balance of payments accounts for a given country is supposed to balance, that is, net out to zero.

a simple example

This is a common sense notion.  It’s easiest to see if we take a simple, theoretical example.  Assume a world where there are only two countries, A and B, where all exports are priced in the local currency and all imports are priced in the foreign currency. (Everyone knows the first assumption isn’t true, but in the real world the second one isn’t, either.)

Further, call the currency of A the $ and the currency of B the @.  Let’s take the initial exchange rate as $1 = @1.

a trade/current account deficit…

Let’s take the case where country A produces $1 billion of goods that it exports to B, but still has an annual trade deficit of $100 million.  It gets @1 billion for the goods and services it exports to B but it still has to get another @100 million from B to pay for the extra $100 million of imports it purchases.

Where does this extra @100 million come from?  Not from today’s income-earning activities in country A.  Looking at the other balance of payments accounts, the other @100 million might come from dividend or interest payments from abroad.  If it doesn’t–and this is the most likely case–country A has to sell things to B to get the extra @100 million.  This “selling” can come either in the form of promises to pay, i.e. bank loans or corporate/government bonds, or in physical assets like commercial or residential real estate or manufacturing plant and equipment.

…isn’t sustainable forever

This situation can’t go on forever.  If nothing else, at some point country A will run out of assets that country B will desire to buy.   In our simple world, country B will then be piling up loads of $ that it doesn’t particularly want.  Initially, it will “recycle” extra $ into country A’s bonds to get some interest income.   But there’s a limit to that, as well.  Sooner or later, the debt will reach a level where country B will get worried about the possibility that A may not be able to repay.

The level of country B’s concern will depend to some degree on its analysis of the character of A’s economy and of its imports.  If country A is importing, for example, machinery it will use to develop new export-oriented or import-competing businesses, B will be less worried.  So, too, if it sees that some purely domestic industry has immense potential to develop into an exporter.  But if the imports are mostly of consumer items that will generate no future income–like TVs or building materials for McMansions–concern will rise a lot faster.

In any event,  a persistent trade (and current account) deficit will sooner or later cause downward pressure on country A’s currency.  Country B will demand a premium for continuing to hold $.  What happens then?

intervention

One possibility is that country A intervenes in the currency market to buy up the “extra” $ that are sloshing around.  That is, the government of A takes action to defend the $1 = @1 exchange rate.  It may also have help from country B in doing so, since the government of B may be satisfied with the status quo.  In the real world, this is not a good solution, since the big international commercial banks, who would be the most worried about the present situation and who may well be leading a trading attack on the $, have far greater market power than any set of governments.

Two possibilities remain–external structural adjustment or internal structural adjustment.

Internal adjustment means slowing down the purchase of imports, particularly of imported consumer goods.  In practical terms, this means the government raising interest rates and inducing a recession.  How so?  The problem country A faces is typically that government economic policy is too stimulative.  As a result, the country is living beyond its means.  Most of the “extra” economy energy is going into consumption, and a disproportionately large share of that is going into consumption of imported goods.

The practical issue with internal adjustment is that politicians find this very difficult to do, since the change in economic policy is very visible.  It’s also very clear to voters exactly who has taken away the punchbowl.

External adjustment means standing aside and letting the currency markets achieve a new equilibrium.  In other words, in our example, country A allows the $ to devalue to what is, for now anyway, a new equilibrium level.

This is the solution almost all countries opt for, even though it leaves internal structural problems unaddressed.  Why this path?  It’s easier politically.  Local citizens will likely not realize the large loss of national wealth that devaluation entails–unless they travel abroad.  And to the degree that citizens do notice that the local price of imported goods has increased, anger can easily be directed against “greedy” currency speculators or foreign industrialists.

In academic theory, adjustment through currency devaluation is an illusory process.  The economy reverts to its prior state of disequilibrium, only with inflation at a higher level.  For smaller countries, I think that this is true in reality as well.  In the case of large countries like the US, the reality is more complicated.  More about this in later posts.