Daily Archives: January 29, 2012

MMP #34 Functional Finance and Exchange Rate Regimes: The Twin Deficits Debate

By L. Randall Wray

In theprevious weeks, we examined the functional finance approach of Abba Lerner. Itis clear that Lerner was analysing the case of a country with a sovereigncurrency (or what many call “fiat” currency). Only the sovereign government canchoose to spend more whenever unemployment exists; and only the sovereigngovernment can increase bank reserves and lower (short term) interest rates tothe target level. It is important to note that Lerner was writing as theBretton Woods system was being created—a system of fixed exchange rates basedon the dollar. Thus it would appear that he meant for his functional financeapproach to apply to the case of a sovereign currency regardless of exchangerate regime chosen.

Still itmust be remembered that all countries in Lerner’s time adopted strict capitalcontrols. In terms of the “trilemma” they had a fixed exchange rate anddomestic policy independence, but did not allow free capital flows. We haveseen that domestic policy space is greatest in the case of a floating currency,but that adopting capital controls in combination with a managed or fixedexchange rate can still preserve substantial domestic policy space. That isprobably what Lerner had in mind. Most countries with fixed exchange rates andfree capital mobility would not be able to pursue Lerner’s two principles offunctional finance because their foreign currency reserves would be threatened(only a handful of nations have amassed so many reserves that their position isunassailable). Managed or fixed exchange rates, with some degree of constrainton capital flows, can provide the required domestic policy space to pursue afull employment goal.

Weconclude: the two principles of functional finance apply most directly to asovereign nation operating with a floating currency. If the currency is pegged,then the policy space is more constrained and the nation might have to adoptcapital controls to protect its international reserves in order to maintainconfidence in its peg.

The US Twin Deficits Debate. Deficit hawks in the US frequentlyraise three objections to persistent national government budget deficits: a)they pose a solvency risk that could force to government default on its debt;b) they pose an inflation, or even a hyperinflation, risk; and c) they impose aburden on our grandkids, who will have to pay interest in perpetuity to the Chinesewho are accumulating US Treasuries as well as power over the fate of theDollar. This often leads to the claim that the US Dollar is in danger of losingits status as international reserve currency.

We haveseen that national budget deficits and debts do not matter so far as nationalsolvency goes. The sovereign issuer of the currency cannot be forced into aninvoluntary default. We also have dealt with possible inflation effects of deficitspending (more on that later). To summarize that argument as briefly aspossible, additional deficit spending beyond the point of full employment willalmost certainly be inflationary, and inflation barriers can be reached evenbefore full employment. However, the risk of hyperinflation for a sovereigncountry like the US is low.

Later wewill address the connection among budget deficits, trade deficits and foreignaccumulation of treasuries, the interest burden supposedly imposed on ourgrandkids, and the possibility that foreign holders might decide to abandon theDollar.

Let us setout the framework thoroughly examined in previous blogs. At the aggregatelevel, the government’s deficit equals the nongovernment sector’s surplus. Wecan break the nongovernment sector into a domestic component and a foreigncomponent. As the US macrosectoral balance identity shows, the governmentsector deficit equals the sum of the domestic private sector surplus plus thecurrent account deficit (which is the foreign sector’s surplus). We will put tothe side discussion about the behaviors that got the US to the currentreality—which is a large federal budget deficit that is equal to a (large)private sector surplus (spending less than income) plus a rather large currentaccount deficit (mostly resulting from a US trade balance in which importsexceed exports).

There is apositive relation between budget deficits and the current account deficit thatgoes behind the identity. All else equal, a government budget deficit raisesaggregate demand so that US imports exceed US exports (American consumers areable to buy more imports because the US fiscal stance generates householdincome used to buy foreign output that exceeds foreign purchases of US output.)There are other possible avenues that can generate a relation between agovernment deficit and a current account deficit (some point to effects oninterest rates and exchange rates), but they are at best of secondaryimportance if not wrong.

To sum up:a US government deficit can prop up demand for output, some of which isproduced outside the US—so that US imports rise more than exports, especiallywhen a budget deficit stimulates the American economy to grow faster than theeconomies of our trading partners.

Whenforeign nations run trade surpluses (and the US runs a trade deficit), they areable to accumulate Dollar denominated assets. A foreign firm that receivesDollars usually exchanges them for domestic currency at its central bank. Forthis reason, a large proportion of the Dollar claims on the US end up atforeign central banks. Since international payments are made through banks,rather than by actually delivering US federal reserve paper notes, the Dollarsaccumulated in foreign central banks are in the form of reserves held at theFed—nothing but electronic entries on the Fed’s balance sheet. These reservesheld by foreigners (mostly, central banks) do not earn interest.

 Since the central banks would prefer to earninterest, they convert them to US Treasuries—which are really just anotherelectronic entry on the Fed’s balance sheet, albeit one that periodically getscredited with interest. This conversion from reserves to Treasuries is akin toshifting funds from your checking account to a certificate of deposit (CD) atyour bank, with the interest paid through a simple keystroke that increases thesize of your deposit. Likewise, Treasuries are CDs that get credited interestthrough Fed keystrokes.

In sum, aUS current account deficit will be reflected in foreign accumulation of USTreasuries, held mostly by foreign central banks. You can see the evidencehere, in Figures 2 and 3:  

While thisis usually presented as foreign “lending” to “finance” the US budget deficit,one could just as well see the US current account deficit as the source offoreign current account surpluses that can be accumulated as treasuries. In asense, it is the proclivity of the US to simultaneously run trade andgovernment budget deficits that provides the wherewithal to “finance” foreignaccumulation of US Treasuries. Obviously there must be a willingness on allsides for this to occur—we could say that it takes (at least) two to tango—andmost public discussion ignores the fact that the Chinese desire to run a tradesurplus with the US is linked to its desire to accumulate Dollar assets. At thesame time, the US budget deficit helps to generate domestic income that allowsour private sector to consume—some of which fuels imports, providing the incomeforeigners use to accumulate Dollar saving, even as it generates Treasuriesaccumulated by foreigners.

In otherwords, the decisions cannot be independent. It makes no sense to talk ofChinese “lending” to the US without also taking account of Chinese desires tonet export. Indeed all of the following are linked (possibly in complex ways):the willingness of Chinese to produce for export, the willingness of China toaccumulate US Dollar-denominated assets, the shortfall of Chinese domesticdemand that allows China to run a trade surplus, the willingness of Americansto buy foreign products, the (relatively) high level of US aggregate demandthat results in a trade deficit, and the factors that result in a US governmentbudget deficit. And of course it is even more complicated than this because wemust bring in other nations as well as global demand taken as a whole.

While it isoften claimed that the Chinese might suddenly decide they do not want UStreasuries any longer, at least one but more likely many of these otherrelationships would also need to change. For example it is feared that Chinamight decide it would rather accumulate Euros. However, there is no equivalentto the US Treasury in Euroland. China could accumulate the Euro-denominateddebt of individual governments—say, Greece!—but these have different riskratings and the sheer volume issued by any individual nation is likely toosmall to satisfy China’s desire to accumulate foreign currency reserves.Further, Euroland taken as a whole (and this is especially true of itsstrongest member, Germany) attempts to constrain domestic demand to avoid tradedeficits—meaning it is hard for the rest of the world to accumulate Euro claimsbecause Euroland does not generally run trade deficits. If the US is a primarymarket for China’s excess output but Euro assets are preferred over Dollarassets, then exchange rate adjustment between the (relatively plentiful) Dollarand (relatively scarce) Euro could destroy China’s market for its exports.

This shouldnot be interpreted as an argument that the current situation will go onforever, although it could persist much longer than most commentators presume.But changes are complex and there are strong incentives against the sort ofsimple, abrupt, and dramatic shifts often posited as likely scenarios. Thecomplexity as well as the linkages among balance sheets ensure that transitionswill be moderate and slow—there will be no sudden dumping of US Treasuries—thatwould destroy the value of the financial wealth held by the Chinese, as well asthe export market they currently rely upon.

Beforeconcluding, let us do a thought experiment to drive home a key point. Thegreatest fear that many have over foreign ownership of US Treasuries is theburden on America’s grandkids—who, it is believed, will have to pay interest toforeigners. Unlike domestically-held Treasuries, this is said to be a transferfrom some American taxpayer to a foreign bondholder (when bonds are held byAmericans, the transfer is from an American taxpayer to an American bondholder,believed to be less problematic). So, it is argued, government debt really doesburden future generations because a portion is held by foreigners. Now, inreality, interest is paid by keystrokes—but our grandkids might decide to raisetaxes on themselves to match interest paid to Chinese bondholders and therebyimpose the burden feared by deficit hawks. So let us continue with ourhypothetical case.

What if theUS managed to eliminate its trade deficit so that it ran a perpetually balancedcurrent account? In that case, the US budget deficit would exactly equal the USprivate sector surplus. Since foreigners would not be accumulating Dollars intheir trade with the US, they could not accumulate US Treasuries (yes, theycould trade foreign currencies for the Dollar but this would cause the Dollarto appreciate in a manner that would make balanced trade difficult tomaintain). In that case, no matter how large the budget deficit, the US wouldnot “need” to “borrow” from the Chinese to finance it.

This makesit clear that foreign “finance” of our budget deficit is contingent on ourcurrent account balance—foreigners need to export to us so that they can “lend”to our government. And if our current account is in balance then no matter howbig our government budget deficit, we will not “need” foreign savings to“finance” it—because our domestic private sector surplus will be exactly equalto our government deficit. Indeed, one could quite reasonably say that it isthe budget deficit that “finances” domestic private sector saving.

Yet, thedeficit hawks believe the federal budget deficit would be more “sustainable” ifforeigners did not accumulate Treasuries that supposedly burden futuregenerations of Americans. But how could the US eliminate the current accountdeficit that allows foreigners to accumulate Treasuries? The IMF-approvedmethod of balancing trade is to impose austerity. If the US were to grow muchslower than all our trading partners, US imports would fall and exports wouldrise. In fact, the “great recession” that began in the US in 2007 did reducethe trade deficit—although only moderately and probably temporarily. In orderto eliminate the trade deficit and to ensure that the US runs balanced trade,it might need a much deeper, and permanent, recession. By reducing American livingstandards relative to those enjoyed by the rest of the world, the nation mightbe able to eliminate its current account deficit and thereby ensure thatforeigners do not accumulate Treasuries said to burden future generations ofAmericans.

Now, canthe deficit hawks please explain why Americans should desire permanently lowerliving standards on their promise that this will somehow reduce the burden onthe nation’s grandkids? It seems rather obvious that grandkids would prefer ahigher growth path both now and in the future, so that America can leave themwith a stronger economy and higher living standards. If that means that thirtyyears from now the Fed will need to stroke a few keys to add interest toChinese deposits, so be it. And if the Chinese some day decide to use dollarsto buy imports, America’s grandkids will be better situated to produce thestuff the Chinese want to buy.

Inconclusion, while there are links between the “twin deficits”, they are not thelinks usually imagined. US trade and budget deficits are linked, but they donot put the US in an unsustainable position vis a vis the Chinese. If theChinese and other net exporters (such as Japan) decide they prefer fewer dollarassets, this will be linked to a desire to sell fewer products to America. Thisis a particularly likely scenario for the Chinese, who are rapidly developingtheir economy and creating a nation of consumers. But the transition will notbe abrupt. The US current account deficit with China will shrink, just as itssales of US government bonds to Chinese (to offer an interest-paying substituteto reserves at the Fed) decline. This will not result in a crisis. The USgovernment does not, indeed cannot, borrow Dollars from the Chinese to financedeficit spending. Rather, US current account deficits provide the Dollars usedby the Chinese to buy the safest Dollar asset in the world—US Treasuries.

To beclear: the US Dollar probably will not remain the world’s reserve currency.From the US perspective, that might be a disappointment. In the long view ofhistory, it is inconsequential. There is little doubt that China will becomethe world’s biggest economy. Its currency is a likely candidate forinternational currency reserve, but that is not a foregone conclusion—norsomething to be feared.