Saturday, 20 July 2013

Trade Deficits and Current Accounts. Is Mercantilism Inevitable?

In the past few days, a substantial amount of articles has been aiming at either defending (or better semi-defending since most arguments do not really prove or disprove anything) or attacking mercantilism. Thus, I decided I'd give my (rather lengthy) view of the subject.

To begin with, mercantilism is "the economic doctrine that government control of foreign trade is of paramount importance for ensuring the military security of the country. In particular, it demands a positive balance of trade." The system flourished in the 16th-18th century in Europe, although lighter forms of it appeared after World War II in several countries, where tariffs and taxes were imposed. Mercantilism is obviously not a system which can be sustained if every country in the world assumes it since in order for one country to have a positive balance of trade other countries need to have a negative one (on aggregate, this is a zero-sum game). The system favours domestic corporations and puts barriers on foreign ones, although in lighter forms of mercantilism many foreign companies have managed to successfully establish their presence in a country. The economic rationale behind these policies is that trade deficits matter; not only do they matter but they are of great importance to a country's well-being. So, do they?

As usual, economists are divided on the subject. Monetarists, echoing the words of Milton Friedman and following the rationale of David Hume state that a country could not permanently gain from exports because the income from exports would make prices rise in the country, thus making exports less attractive and imports more attractive. On the aggregate and in the long-run, countries' trade balances would balance out. On the most extreme form, Frédéric Bastiat asked the following question: "If I send $50 of wine abroad, sell it for $70, buy coal from the foreign country at that price and import and sell it in mine for $90 imports would be higher than exports (Imports=$70, Exports=$50) yet the trader would be richer." Using reductio ad absurdum Bastiat pointed out that a trade deficit is an indicator of a successful economy not a deteriorating one. A similar thesis is held by most mainstream economists today, with Gregory Mankiw stating that "Trade Can Make Everyone Better Off" in his "10 Principles of Economics".

On the other end of the spectrum, Keynesians state that the balance of trade matters. This is why Keynes had proposed the International Clearing Union and the Bancor at the Bretton Woods Conference; in cases of severe crises occurring governments could control the flow of capital and trade to their best interest. Similar proposals have arisen ever since the 2008 crisis, notably by Zhou Xiaochuan the Governor of the People's Republic of China which prompted an IMF analysis on the subject. (For details on Keynes's proposal

The above can also

Nevertheless, after examining some of the existing data what makes the US different from the Eurozone lies in a sentence in page 11 of the .pdf file (or page 313 if you prefer) "Put another way, each state indirectly subsidizes or is being subsidized by the other states". This means that specific states would never run out of money as long as the whole nation is prospering (that is, its citizens will not witness deflationary pressure) since states are assisting one another.


  1. As important as the trade balance is (and normally the trade balance represents the bulk of the current account balance), what really matters, in the final analysis, is the current account. The following formula is not explicitly addressed in this article:

    Current account deficit = capital imports
    Current account surplus = capital exports

    A current account surplusser (i. e. Germany) has no choice but to export capital. That’s why German banks were involved in just about every international financial bubble (except Bernie Madoff, that is…). Greece could only incur horrendous current account deficits because it could attract foreign capital.

    The national economy with its own currency works exactly like a family in its cross-border transactions. When it spends more foreign currency than it earns abroad out of operations, it needs to borrow and/or attract foreign investment. A current account deficit is nothing other than the transfer of national wealth to the rest of the world. It is the ‘cross-border cash flow from operations statement’ of a national economy.

    There is nothing necessarily wrong with an island in the South Sea which produces nothing and imports everything it needs. As long as it generates enough income from tourism to pay for all the imports, they are ok. However, the trade balance has an impact on domestic employment. When a national economy imports products which it could also produce domestically, it ‘exports’ jobs, wage/income taxes and social contributions (i. e. revenue for the state). If the trade deficit is offset by a surplus in the services balance and the current account is balanced overall, it is still a question of whether the services surplus creates enough jobs to offset the loss caused by the trade deficit.

    Why can the US run the kind of current account deficits which it has run for decades? Because the US has a seemingly unlimited ability to attract foreign capital as loans and/or investments. At the end of the day, this could mean that all of S&P, half of Manhattan and much of Florida is owned by foreigners. No big sweat really, except that the income on such investments now flows to foreigners instead of Americans.

    1. The formula you are referring to is not really absolute since a Current Account deficit may be due to high imports of goods and services and have nothing to do with capital imports. For example the US had a high CA deficit after 2000 and yet there were no significant capital imports in the country. In comparison, during the dot-com bubble there was a large inflow of capital to the United States, although the CA was still in the red. (Data can be found in this Ben Bernanke speech:

      A current account surpluser may export capital but can also use it to fund projects at home, depending on how much the expected return would be. That was why there was a flow of funds to the emerging markets during the past decade. Still you have a point on German banks and their involvement in bubbles due to too much liquidity (although I am positive that every bank would have done the same)

      The US can afford to have large CA deficits because it can actually print more money if it ever runs out. It does attract foreign capital but like it used to do. The balance of payments for the US is negative. Yet, since this is spread over many years it does not show too much of an effect. Still, the ability of a country to issue its own currency matters on whether it can sustain a large CA deficit. (Obviously this does not mean that a country which does not have any income can sustain large imports. It may need tourists or industry but it needs some exports to sustain imports)

    2. I respectfully disagree because this is not an issue of economics but of mathematics, instead. The Balance of Payments must balance for mathematical reasons. The BoP consists of the current account and the financial account. Thus, a net plus in one must be offset by a net minus in the other.

      Yes, the US has the nearly unique advantage that it can print the currency in which it has all its foreign debt. But that's not the reason why the US can have large current accout deficits. They could/can only do that because foreigners accepted that currency on US promissory notes. And buying Treasuries on the part of foreigners is nothing other than an export of capital to the US.

      But I think the most important reason for the seemingly infinite US ability to run current account deficits is that the country is viewed as an excellent place for investment.

      You say that a current account surpluser MAY export capital but it could also invest that capital at home. True, but if Germany had done that during the 2000s, the rest of the world (e. g. Greece) would have had less capital to finance a current account deficit (and Germany would have had much more domestic demand). I grant you that this is a bit of a chicken-and-egg process where one cannot say clearly which comes first. But, as you said in the article, current accounts are a zero-sum game world-wide. So if all the surplusers would break-even their current accounts, the rest of the world would have to do he same.

      "A Current Account deficit may be due to high imports of goods and services and have nothing to do with capital imports" - there is a confusion of terms here. The current account DOES NOT include capital imports (all those are in the financial account). The current account includes exports, imports, services, current transfers and capital transfers (like EU subsidies). Put differently, everything which is considered to be part of a country's cross-border operating activities. Loans, investments, etc. are in the financial account.

    3. I am referring to the trade balance not the balance of payments. You are right that the BoP must balance by construction.

      Yes many foreigners seek to buy Treasuries as a safe investment. Nevertheless bond buying by foreigners is also happening in Germany, a country with a very large CA surplus.

      Reputation obviously is very important when it comes to the macro level.

      My argument is that a country with a large export sector could possibly do that, yet I am not arguing that it has. It depends very much on external conditions as well as the state of the domestic economy.

      Yes, that was a typo. It should read, "has nothing to do.." You are referring to the BoP accounting identity right? I thought you were referring at what constitutes the current account.

    4. I am afraid we are talking a bit past one another. One has to differentiate between what happens WITHIN a BoP (i. e. surpluses in current account must be offset by identical deficits in financial account and vice versa), and what happens WITHIN the current account and the financial account. What happens within the latter must be seen on a net basis (and you see gross transactions).

      The US is definitely a net importer of capital. Notwithstanding this, the US is also a major exporter of capital, particularly foreign investments. That is gross. But the capital imports exceed the capital exports and, thus, the net balance is negative.

      Germany, on the other hand, is a net exporter of capital. Notwithstanding this, Germany also borrows abroad. That is gross. But Germany's capital exports exceed by far its capital imports.

      Picture it this way: the place where you see Germany's current account surplus is the aggregated balance sheets of German banks. Those banks build up liquidity, as you said in your article. That liquidity must be 'exported' by the German banking sector because, if not, the rest of the world would not have enough liquidity to buy German exports. And, as you said, if German banks did not export that liquidity, the rest of the world would have less liquidity to buy German exports and Germany's current account surplus would decline in a hurry.

    5. I think we are saying the same thing, using a different approach. I have specified that I did not consider the balance of payments in the article and neither in the comments (although I agree with your comments on it). The main point for the article was mercantilism and whether trade deficits matter; these are mere parts of the BoP yet they are important (in my opinion at least).

      What do you mean by net basis? As in whether the CA is positive or negative? I do consider that in the article and the comments.

      Regarding capital imports and exports: We reach the same conclusion, albeit from a different angle. A trade surplus and subsequently (although not necessarily) a CA surplus, leads to increased liquidity thus a flight of capital from e.g. Germany to places where the return on investment is higher (or for other reasons, which is irrelevant to this analysis). I agree that this boosts liquidity and allows foreigners to buy even more German products, yet there is another way to purchase: print new currency, and that is what I was specifying in the article. You need the CA surplus back to the importer if you do not have a domestic currency but (although it would be very helpful) it is not that needed if the importer can print to finance its imports.

    6. Regarding the 'net basis': suppose the current account is minus 100, then the financial account must be plus 100.

      But the current account is the net of pluses (exports, etc.) and minuses (imports, etc.). A current account deficit means that the minuses exceed the pluses (thus, it is a 'net').

      The same goes for the financial account. It consists of pluses (incoming loans, investments) and minuses (outgoing loans, investments).

      So, in the above example, it may very well be that capital of 1.000 was exported but then capital of 1.100 must have been imported to make the BoP balance.

      Suppose the current account is +/- zero. Then the financial account must be +/- zero. What if the state needs to borrow money abroad? How can that work when the financial account has to be +/- zero? It works because then there will be (rather: have to be) capital outflows which match the capital inflows.

      The above applies to a local currency country. Since FX is not a valid currency in that country, whatever enters the country as FX must leave the country as FX (because there is zero use for it domestically). Let me give you the pre-Euro Austria as an example.

      Post-WW2 Austria had no oil and built no cars. But Austrians wanted to have cars and cars run on oil derivatives (and oil is needed elsewhere, too). In order to buy oil and cars, Austria needed FX. Through exports alone, there was no chance that Austria could have gotten enough FX. Thus, Austria focused on tourism to generate the necessary FX. However, even that was not enough to close the gap. So Austria had no alternative but to follow the following strategy: keep the state financials in good order so that it could borrow abroad and make Austria attractive for foreign investment.

      All of this is different with a Euro country because the Euro is both, a legal local currency as well as the currency of other countries where one buys imports. All of a sudden, imported capital (the former FX) could also be used domestically as payment. The country could no longer print its currency; instead, it had to import it. Even though Greece was madly wasteful in the 2000s (current account deficit of 199 BE 199UR!), the reckless financial sector lent it even more; as much as 283 BEUR! Thus, Greece not only overspent 199 BEUR of the borrowed money but it also increased domestic money supply by 84 BEUR (because it had littly by way of outgoing loans/investments). Result: more money; asset and other prices go up; incomes go up; inflation goes up; competitiveness is wiped out; productive industry is wiped out; unemployment would have exploded if the state had not hired so many people (again paying them with borrowed money).

    7. You are talking BoP again then. I have been considering net current account in the article as far as I remember. The question is whether (economically not mathematically) we can have a country with a positive BoP (i.e. it's hoarding money)...

      You are right about Greece. Too much credit expansion and reckless handling of public finances caused high inflation and low productivity, although the latter is also to blamed on the incentives, structure and the institutions of the country.

      This is why I have mentioned in the article that EZ countries should be extra careful with their finances. Unlike your example of pre-euro Austria, Greece cannot afford a currency devaluation (although to be fair the drachma was severe devalued before the euro introduction; the drachma-euro rate was 340) and it cannot borrow abroad given its reputation and the fact that most of its creditors are in the EU and cannot provide it with FX reserves (which it cannot use since it's in the EZ).

    8. Regarding last question of first paragraph, my point would be that a local-currency country cannot have a positive BoP. Since FX is not legal tender in a local currency country, any FX which enters the country must, by definition, leave it.

      A USD will eventually always have to be in a bank account in a country where the USD is legal tender. It may be that Juan has his USD in a USD account of a Buenos Aires bank and that bank may have its USD in an account in London, but at the end of the day those USD will be in an account with as US bank. No way around that.

      Obviously, a current account surpluser can still export capital and hoard it at he same time. All it would have to do is to deposit it with the Fed and call it 'FX reserves'. Against those it could print local currency without any inflationary risk (I believe).

    9. From what i have seen Germany has had positive BoP ever since 2010. Yet, why print local currency against the FX reserves when it does not really have to? Printing money always has some inflationary risk (if they are spent that is and not held in the bank's vaults) thus it would not be a good idea print if they wish to avoid inflation. Nevertheless, they could do it if they wish to keep the currency at low levels (much like China is doing at the moment). Thus, it is to Germany's best interest that troubles in the EZ are keeping the euro low. Would like to see what would happen if the euro strengthens against other currencies and German exports fall...

    10. I specifically referenced a 'local currency country', which Germany is no longer. Germany cannot print Euros.

      I agree with you regarding the risks entailed with Germany's obsession of being the 'export world champion'. Ever since WW2, the German economy has produced much more than Germans could consume, and they considered that as part of their exceptionalism. Only during the years after unification, Germany had to spend (gigantically) more domestically. This led to an increase in imports and a current account deficit. Since the Euro, they are back into current account surpluses.

      The German economy can only employ its people because it has so many customers in the rest of the world. Should somehing ever happen to those customers, German unemployment will skyrocket.

      Yes, the German export industry (not the German citizens!) has benefited from the value of the Euro which was/is lower than the value of a DM would be today. Whether or not that is good for the structure of the German economy, I am not sure. What we are seeing more and more is that tax payers are paying the bills of German exporters and not Greece & Co.

      The highest DM value against the USD (during DM times) was equivalent to a Euro/USD exchange rate of 1,85. Once, when the Euro hit 1,60, it came raher close to that. I think the bottom line is: the Euro is too weak for Germany and too strong above all for France.

      Getting back to a local currency country's printing local currency. When it does so against FX reserves it is more or less the same thing as printing local currency against gold reserves. I see nothing wrong with that. Printing local currency is then nothing other than replacing the local currency which went into FX reserves and/or gold.

    11. What happens in Germany is rather astonishing politically and economically: it is to the country's best interest to keep the crisis going (i.e. keep the Euro low), since this would assist her economy, yet it is to her partners' cost since they are bearing the problems of unemployment and poverty. It appears that there exists an incentive compatibility problem in the Eurozone.

      You have a good point on German dependency on her foreign counterparts. Paraphrasing an article I read yesterday, the importer has a much greater power over the exporter than we often believe.

      To be fair, if the German exporters got benefits from low EUR values then some Germans citizens also had to benefit from it (albeit not all as we wrongfully generalize from time to time).

      I doubt that when countries "print" money they do it just against foreign reserves. I am not arguing that they might do it, yet it very often is the case that they do not, even if that means a devaluation. I am not a proponent of the gold standard to be honest, thus the same rationale would hold in printing just against foreign reserves: I believe that it is too rigid and too deflationary, especially at times when demand is falling and crises emerge.

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  2. I agree with you (and am glad that we finally reached agreement...).

    Before the Euro, a country like Austria had its local currency on one hand and FX on the other. Politicians knew that they could print local currency but not FX, thus they tended to be careful with FX.

    When Austria joined the Euro, even I as a banker thought that we had just switched from one local currency to another. Little did I realize then that we had switched from a local currency to FX.

    A country like Greece might have been better off if it had entered a monetary union with the US instead of the Euro. In case of trouble, Greek political leaadership could have negotiated with political leadership on the other side. With the Euro, Greek political leaders really have no one to negotiate with (unless you consider the EU political leadership of Europe...) and those who run the show (ECB) had the mandate not to listen to politicans.

    Looking back, it seems to me that not only I but a lot of political leaders thought that they were just changing one local currency against another when they joined the Euro (Margaret Thatcher excluded!).

    1. Heh, we would have eventually I think!

      Yes your analogy perfectly expresses the situation. Although at first one may consider the euro to be a "domestic" currency, it is in fact nothing of the kind since it cannot be issued by any Eurozone member at its will.

      The only difference a monetary union with the US would have made is that the US could, without having to ask anyone's permission, print more USD to support Greece (doubt that it -see Detroit- would but this is for the sake of argument). Whether the ECB follows its mandate not to listen to politicians is another issue, yet I consider the "all have to agree to print" a tremendous obstacle in the conduct of EU monetary policy, with no change visible in the near future.

      You have a point in your last paragraph as well: we all (or at least most of us) thought that having the euro would be like having a domestic currency, drifted by European integration slogans and comments. The fact that the economy was also doing very well did much to blur our perception of the subject. The UK was correct in not abandoning the pound although it is still rather stuck to EU economic policy.