One thing that I notice on the blogs is that I don’t think I have ever seen anyone give a clear description of the external trade account of a country. Nor have I seen anyone give a clear explanation of what determines the value of a given currency. Now, I am sure that you can find some mainstream garbage where the external account always tends toward equilibrium and so forth. But that is obviously useless nonsense and anyone who has ever looked at the trade balances of countries and the currencies of those countries knows it.
Basically the mainstream theory states that if there is a trade deficit in a country two things will happen. First of all, interest rates will rise as the money supply contracts due to money ‘flowing out of the country’. Secondly, the value of the currency will fall in value as the domestic currency saturates foreign exchange markets. A combination of these two dynamics will reestablish equilibrium on the external account. The rise in interest rates will cause investment, GDP and, hence, imports to contract. While the fall in the value of the currency will decrease imports and increase exports.
There is so much wrong with this presentation that it would take a blog post in its own right to pick all the necessary holes in it. The most obvious error is the idea that interest rates would rise when these are obviously set by the central bank. In addition to this currency depreciations will not always correct the trade balance and trade imbalances will not always lead to currency depreciations. I could go on. I won’t.
Anyway, here I more so want to lay out a clear explanation of the external account and, in doing so, describe what determines the value of the currency in a floating exchange rate system like we have today. In fact, I do not need to do much of the heavy lifting here because G.L.S. Shackle has one of the clearest explanations of the external account that I have come across in his book Economics for Pleasure.
Since the book is hard to come by I’ve provided the chapter on the payments system here. I hope it will encourage people to seek it out because it is one of the best overviews of economic theory I have ever read. Shackle was a very gifted writer. Anyway have a quick read of the chapter, it is only a few pages, and then you should have a fair comprehension of the accounting involved.
I assume that you’ve now read the chapter. Good. Let’s turn to what determines the value of the currency in a modern system. The claims that foreigners make within the country that has a trade deficit can, as Shackle says, be either in the form of currency or securities. These are recorded in the capital account of the country running the trade deficit.
Let us break this down slightly. The trade balance is a flow. When the trade balance is in deficit more goods flow into the country than out of the country. A corresponding amount of claims flow out of the country into the hands of foreigners. Now, if the foreigners don’t want to hold these claims they may sell them and then convert the money they receive into money from their own country. This will drive down the price of the currency of the country with a trade deficit and drive up the price of the country with the trade surplus.
But we should be clear: this need not happen. There is every chance that the foreigners will hold the claims on the country running the trade deficit. If they do this there will be no effect on the value of the currency. Why might they do this? Any number of reasons really. Maybe they think that the country is a good investment. Or maybe the government of the surplus country wants to hold foreign reserves.
“But,” the reader might say, “these claims eventually have to be paid back and so the effect will eventually be felt on the currency.” Again, that is not altogether clear. For example, let’s say that all the claims are held in the form of stocks. Now let up say that these stocks were worth a total of $1bn. Basically what has happened is that foreigners have traded goods for these stocks. But what if these stocks half in value? Well then, the whole amount of the claim need not be ‘paid off’.
The key point to take away from this is that in order to understand trade dynamics in the modern world we must appreciate the financial dimension. Mainstream economists are altogether incapable of doing this and it completely blinds them to the real world. For them finance is just a veil. But for Post-Keynesians finance is very, very real. Most of the trade imbalances in the world today can only be understood by taking both finance and politics seriously. If you want to see how the mainstream prove unable to do this and why the Post-Keynesians give the only realistic view, check out this recent paper by Tom Palley.
Fixing the Economists 
The problem Post Keynesians have is that they don’t really seem to understand floating rate dynamics. Some of the stuff Tom comes out with for instance fails to get the causality relations anywhere near accurate. Certainly it never relates to how trade is actually done, and what an overall export overhang actual means for the finance dynamics of the country involved.
That chapter on the payments system is a fixed exchange rate system. Then the following chapter tries to add in the float *on the basis of the fixed exchange understanding*. That’s completely the wrong way of looking at things.
What a floating rate exchange system does is add a separate financing transaction to the process of creating a deal. Not only must the customer want the goods/services provided by the supplier, but the customer must be able to settle the debt with what they want to settle the debt in, and the supplier must receive a settlement in the form they want the settlement in.
If both chains are not in place, then the deal *never happens*.
The finance system evolves to allow more and more of those sort of deals to happen – and the finance system earns an income from that process.
There is never any ‘imbalance’ as such, because no such thing can arise in a floating rate system. Everything is always in balance. Everybody interacts and gets what they want – customer, supplier and banking system.
“Why might they do this?”
Because ultimately they don’t have any choice if they want to sell stuff in a floating rate endogenous system. To get a deal you have to provide the customer with what they want – goods/services they like *and* the ability to buy them with their tender of choice.
The ‘external sector’ isn’t one thing. There are lots and lots of countries and companies all competing for that business. The one that makes it easiest for the customer to buy gets the business.
For export led nations that leads to vendor financing, liquidity swaps and an aggregate level of forced saving they can never use that comes about from the finance system interacting in the exchange markets to keep the value of their currency down. Import nations can persist *as a consequence* of the export nations driving their own policies. A clever import nation would help the export nation achieve their goal – and would get rewarded with the surplus goods and services then generated by that production system.
The whole concept of the ‘external sector’ I think leads to bad thinking. It is an over-abstraction just as bad as the mainstream ‘veil over barter’ nonsense. It leads to thinking that the external sector is capable of operating with one voice. As if the Russians and the US would agree on anything! We need to get rid of the external sector and start working with mental models that have sets of domestic/government sectors grouped as currency areas, and the currency areas grouped as the one closed world that we have.
Always have a minimum of three currency areas, so that everybody has an alternative choice. For me that helps visualise the feedback effects between export and import more genuinely.
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“Basically what has happened is that foreigners have traded goods for these stocks. But what if these stocks half in value? Well then, the whole amount of the claim need not be ‘paid off’.”
Yup. Net foreign assets of a country can go down even as that country continues to accrue current account surpluses, due to changes in the market value of those foreign assets. Switzerland is one example of this phenomenon:
Click to access sr283.pdf
Hélène Rey, for instance, did a lot of work on cross-border capital flows.
One important point that Palley highlights, that doesn’t tend to appear in mainstream analysis, is the impact of globally mobile capital. For example he mentions that a lot of Chinese exports are actually from foreign owned corporations.
This creates its own dynamic. Say the Chinese subsidiary of a US parent sells goods to US consumers for $100 and pays $50 in wages to Chinese workers. Often it is possible to achieve a low effective rate of tax on the $50 of gross operating profit. However, this then forces the US parent to keep the $50 offshore to avoid US taxation on repatriated low taxed foreign earnings. They end up with an offshore subsidiary sitting on $50 which they ideally want to hold in the form of high quality liquid US dollar assets. So the sale of $100 of goods creates the demand for $50 of dollar financial assets.
These offshore cash pools are huge and they have played an important role in how global financial flows have developed, including the shaping of shadow banking. But they can’t be explained in terms of simple optimisation, without taking into account the intricacies of the global tax system, so they don’t tend to figure in mainstream analysis.
That is an interesting point. It didn’t stand out to me in the paper but you are correct, this is a very important dynamic. It gives a whole new meaning to the phrase ‘taxation drives the demand for currency’!
Although, hang on a moment. If the profits were repatriated wouldn’t the effect be the same? I mean, they would have to be converted from yuan into dollars thus propping up the demand for the dollar regardless, no?
In terms of the exchange rate, then yes – it doesn’t make any difference whether the profits are repatriated or held offshore. It only impacts on the current account deficit, since a dividend is a current flow. So it’s more a question of explaining how large deficits can be happening and who is buying the dollar assets to fund them. And the accumulation of large cash piles matters for other reasons, notably availability of credit.
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