A Money View of Global Imbalances

Who’s afraid of finance?

Today’s Financial Times article: “Bernanke says foreign investors fuelled crisis” (Feb 19, 2011).

The latest evidence is that Bernanke is moving in a money view direction, but he is not there yet. He is not yet moving from his “global savings glut” interpretation of the origins of the crisis, but he is adding a global portfolio dollar demand dimension to it. In a money view, we reason from the opposite direction.

What does it mean, “imbalance”?

People use the word to refer to a situation in which countries run large and persistent surpluses (or deficits) on current account. Surpluses mean that earnings from exports and foreign investments are greater than expenditures on imports and foreign debt service. Deficits mean just the opposite.

But why “imbalance”? In the world as a whole, surpluses exactly equal deficits, as a simple matter of accounting. Indeed, surpluses must be financing deficits, else we would not see the surpluses and deficits in the first place. Surplus countries must be accumulating net claims on the rest of the world, and the rest of the world must be accumulating net claims on deficit countries.

“Imbalance” suggests that there is something wrong, something distorted or perhaps unsustainable, about the current pattern of international claim accumulation. Behind the scenes, there seems to be some counterfactual state of affairs, a “balanced” state, against which current patterns are compared and found wanting. What is that state, and is it even possible?

One seductive counterfactual is a world in which everyone runs a surplus, not really a possible world (as all economists know) but seductive nonetheless, and so highly influential in policy debate.

The nearest to this counterfactual would be a world of outside international money, such as a gold standard world. The non-gold-producing countries would all run current account surpluses which they use to accumulate gold balances, and the gold-producing countries would run current account deficits financed by drawing down their gold endowments, dug out of the ground and sent abroad.

In an fiat money world, the nearest we get to the seductive counterfactual is a world in which the international reserve currency country runs a deficit, financed by issuing currency that is accumulated by the rest of the world running surpluses. The exorbitant privilege of mineral endowment is replaced by the exorbitant privilege of the printing press.

Note that neither of these counterfactuals needs to involve any actual international capital flows at all. Under the gold standard world, the surplus countries are not accumulating claims on the rest of the world; they are just accumulating a pile of gold. The same goes for the fiat money world, but the pile is paper. Indeed, if we were to reclassify the gold as a commodity, then surpluses and deficits would both vanish—everyone would be in perfect “balance”. The same is true if we were to reclassify fiat money as a commodity.

The point I am trying to make is that, behind this language of balance and imbalance lies an image of an ideal world in which there are no capital flows at all. No one is accumulating claims on anyone else. Everyone is perfectly free of future encumbrance. “Neither a borrower nor a lender be,” says Polonius to his son. “When you run in debt, you give to another power over your liberty,” says Benjamin Franklin.

But this seductive ideal is not the world we live in, nor can our world be made to conform with it. Within the borders of every country, borrowing and lending is the very stuff of business, and indeed of individual life cycles. Even without net international capital flows, portfolio diversification would imply substantial offsetting gross flows as wealth-holders swap domestic claims for foreign claims.

Even more, the world we live in is an inside money world, a credit money world that is intimately bound up with the borrowing and lending world. Even without net international capital flows, wealth-holder portfolio demand would have the rest of the world holding dollar-denominated money claims, and the U.S. holding offsetting non-money claims on the rest of the world.

The point is that, basically, the U.S. is a bank. Long ago this point was made in a famous article “The Dollar and World Liquidity: a minority view” (1966) by Emile Depres, Charles Kindleberger, and Walter Salant. Apparently it is still a minority view, but no less illuminating for that.

From this starting point, so-called global imbalances look somewhat different. We expect the rest of the world to be accumulating dollar balances, but those dollar balances are not a pile of paper, rather the U.S. liability counterpart of an offsetting foreign asset position. So-called “imbalances” are a case where the increase in dollar balances exceeds the increase in foreign assets held, and so shows up as net capital flows into the U.S., most recently into the U.S. housing market.

The “imbalance” is really just discontent with how this system has been working. Fair enough. Some would prefer to see the capital flows directed elsewhere. Others would prefer to see the demand for dollar balances directed elsewhere. My modest point (to Bernanke, but also the rest of the G20) is that these are logically two separate issues, and we can engage them better if we keep them separate.

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