This post was occasioned by a reader’s (Alejandro Calve Seferian) query: Why do I presume that an accelerating US trade deficit required an offsetting tsunami of net capital flows, from the Rest of the World to the US, in order to ‘close the loop’ and, thus, provide long term aggregate demand to the Rest of the World (which is the hypothesis of my Global Minotaur)? Taking my cue from Alejandro’s question, this post compares and contrasts the relationship between trade and capital flows between (a) the US and the Rest of the World and (b) within the Eurozone.
Alejandro’s question: I am aware that the media continuously bemoans an assumed US dependence on foreign capital, but a recap of the actual transactions involved seems to reveal the reverse. Take the example of a US consumer buying a German car. If the consumer pays cash for it, the consumer’s checking account in a US bank is debited and the German carmaker’s account is credited, thereby increasing foreign savings of USD financial assets. Total deposits in the US banking system remain unchanged. If the consumer borrows to buy the car, the bank makes a loan to the consumer, which results in a loan on the asset side of the bank’s balance sheet and a new deposit on the liability side (loans create deposits). After the car is paid for the German car company has the new bank deposit. Consumer borrowing increased total bank deposits and funded foreign savings of USD. That’s what the finance behind the trade gap is all about – foreigners desire to net save USD financial assets and sell goods and services to the US to obtain those assets. Following the above transaction, the foreign holder of USD bank deposits may instead desire to purchase US Treasury securities. At the time of purchase, the seller of the Treasury security becomes the new holder of the bank deposit, and the foreigner the new holder of the Treasury security. (If the foreigner buys securities directly from the Treasury the result is the same.) The US government is now said to have foreign creditors, and the US is said to be a debtor nation. While this is true as defined, a look past the rhetoric at what the US government actually owes the holder of the Treasury security is revealing. What the government promises is that at maturity the foreigner’s security account at the Fed will be debited, and his bank’s reserve account at the Fed will be credited for the balance due. In other words, the US government’s promise is only that a non-interest bearing reserve balance will be substituted for an interest bearing Treasury security. This is not a potential source of financial stress for the government. Moreover, there is no foreign cash that flows into Wall Street for the loop to close. Your thoughts and comments on the above would help me as I am not an economist and admire your work very much. What I am missing?
My answer: What I think Alejandro missed is the role played by Central Banks, in the case of this example the Fed and the Bundesbank. Let me explain:
Suppose that Jill, a US resident with an account at BoA, buys a VW for $20k. This is how the transaction will be effected:
- When Jill buys a VW for $20k Jill’s BoA account is debited $20k
- BoA’s liabilities in BoA’s Fed account is reduced by $20k
- BoA instructs the Fed to deduct $20k from its account, with the Fed, and send the funds to VW’s Bank in Germany
- Reduction in BoA’s deposit account with the Fed reduces the Fed’s liabilities by $20k
- The Fed increases its liabilities with the Bundesbank
- The Bundesbank receives either a $20k credit to its $ assets or a $20k reduction in its $ liabilities depending on which of the two central banks has a deficit with regard the other
- Offsetting this $20k improvement in its balance sheet, the Bundesbank credits VW’s Bank’s reserve account (with the Bundesbank) a sum in DM equivalent, at the given exchange rate, to $20k in this manner increasing the German bank’s assets in DM.
- VW’s Bank finally credits VW’s deposit account the relevant DM sum.
From the point of view of Jill and VW something simple has happened: $20k went from Jill’s BoA account into VW’s German account, after the sum was converted from $ to DM. It is, of course, quite true that the Fed’ assets have not changed but the liability side shows $20k less in reserve accounts and the equivalent more in DM liabilities to the Bundesbank.
For the $-DM exchange rate to be in equilibrium, the Fed’s total liabilities and assets vis-à-vis the Bundesbank must balance out. For this to happen, if the US is in a trade deficit with Germany, it must be in surplus regarding the capital flows. Thus my Global Minotaur metaphor is predicated upon the parallel ever-expansion of (a) America’s trade deficits and (b) the net capital flows that came into the US in order to close the ‘loop’.
A note on the peculiar Eurozone arrangement
The fact that the Eurozone is a common currency area does not mean that when Maria, an Athens resident, buys a VW, the financial process resembles what would have occurred within a unitary country, with a single Central Bank. Instead, the same steps as above are followed, except for a ‘small’, rather peculiar, difference coming in after Step 5.
Indeed, Steps 1 to 5 are identical, as above, after substituting the Central Bank of Greece (CBG) for the Fed, dollars for euros and, say, Alpha Bank for BoA. The difference comes at Step 6 where a new category of CBG liability comes into play, one called Intra-European Liabilities (IEL):
6. The Bundesbank receives either a €20k credit to its assets or a €20k reduction in its liabilities depending on which of the two central banks has a deficit with the other – thus, we can take it for granted that the Bundesbank realises an increase in its assets!
7. Offsetting this €20k improvement in its balance sheet, the Bundesbank credits VW’s Bank’s reserve account (with the Bundesbank) a of €20k in this manner increasing the German bank’s euro assets.
8. VW’s Bank finally credits VW’s deposit account with the sum of €20k.
The difference with the US-German trade deficit case above is that, within the Eurozone design, the market-based, exchange rate mediated, balancing out of $ and DM liabilities is replaced by an administrative balancing of IELs, also known as Target2. Eurozone countries with IEL liabilities are charged interest on these liabilities at a rate reflecting the ECB’s overnight rate of refinancing (currently 0.75%) and these interest payments pile up with the ECB and then sent to the Eurozone Central Banks whose IEL accounts are in the black.
Trade imbalances require offsetting capital flows regardless of whether the trading nations have their own currencies or whether they are part of the Eurozone. In both cases, free marketeers hope (against hope) that the financial system will provide these flows automatically.
In the case of US-German trade, for instance, mainstream economists’ hope is that a persistent trade deficit will cause the dollar to fall, as capital will be demanding an increasing high return to flow into the US, thus limiting the deficit. Similarly, in the case of intra-Eurozone trade, a persistent German trade surplus with a Peripheral country, like Spain or Greece, should, in theory, automatically be limited by offsetting capital financial flows occasioned by sound banking decisions both in Germany and in Greece. .
Alas, neither happens in reality. In the case of the US trade deficits, for reasons that I try to explain in the Global Minotaur, the deficit can grow and grow without any counteracting forces limiting it from the side of capital flows. (And what a boon that proved to be, per-2008, from the perspective of net exporters, like Germany, that it did not, as the growing US trade deficit kept their factories humming!)
Alas, neither happens in reality automatically. In the case of the US trade deficits, for reasons that I try to explain in the Global Minotaur, the deficit can grow and grow without any counteracting forces limiting it from the side of capital flows. (And what a boon that was from the perspective of net exporters, like Germany, that it did not, as the growing US trade deficit kept their factories humming!) Similarly, in the Eurozone periphery, capital kept flowing in as if there were no tomorrow, oozing out of Germany’s and France’s banks which were, in City and Wall Street fashion, minting their own toxic money for years. And when the Credit Crunch hit in 2008, these capital flows were instantly reversed, causing the asset value bubbles that had built up in the Periphery to burst, thus giving rise to the so-called sovereign debt crisis – which of course is a pure banking and trade imbalance crisis.