Economic Constraints: The Balance of Payments

1. Economic Constraints: The Balance of Payments Lec 6 – Thursday, 23 September 2010J A Morrison Milton Friedman (1912-2006)

2. Economic Constraints: The Balance of Payments • Economic Constraints • The Balance of Payments • Choosing the Means to Achieve Balance • The BoP and the Current Financial Crisis

3. Economic Constraints: The Balance of Payments • Economic Constraints • The Balance of Payments • Choosing the Means to Achieve Balance • The BoP and the Current Financial Crisis

4. Up to this point, all of our explanations of foreign economic policy have centered around political variables: the structure of the international system and policymakers’ ideas, interests, and institutions. But markets also constrain and enable policymakers.

5. I. Economic Constraints Empower Interest Groups Mold Policy & Behavior Negate State Action

6. Remember that Smith & Rogowski argued that interest groups lobby policymakers to secure policies that benefit them.Interest groups’ lobbying power, however, depends to some extent on their economic status.

7. Wealth brings status and power. At a minimum, markets influence the strength of societies’ various interest groups.

8. I. Economic Constraints Empower Interest Groups Mold Policy & Behavior Negate State Action

9. Remember that market actors often enjoy exit options. If they don’t like certain policies, they can frequently work around them or even relocate to other jurisdictions.

10. Because states fret at the potential loss of these valuable actors, policymakers are somewhat beholden to market actors.Market actors can thus reward and punish certain types of behavior.

11. Remember this slide from last Thursday?

12. Example: Sovereign Debt • Sovereign has the power to repudiate debt • Lenders have several possible responses • Raise interest rates • Refuse to lend • Hide assets • Emigrate • By consistently repaying debts, sovereign ensures larger supply of capital and better terms (lower interest rate)

13. I. Economic Constraints Empower Interest Groups Mold Policy & Behavior Negate State Action

14. If market actors find policy completely noxious, they may take action—deliberate or indeliberate—that negates state policy.

15. Example: Avoiding Taxes • Hoping to increase tax revenues, a state raises its income tax • Most citizens acquiesce since the costs of circumventing the law outweigh the benefits • But the richest citizens have the most to lose and can emigrate at the lowest cost • Ultimately, the state’s revenues decrease as the richest citizens leave and no longer pay any tax

16. Economic Constraints: The Balance of Payments • Economic Constraints • The Balance of Payments • Choosing the Means to Achieve Balance • The BoP and the Current Financial Crisis

17. II. The Balance of Payments Studying the Balance of Payments The Balance of Payments Achieving Balance

18. The “balance of payments constraint” is one of the most significant constraints policymakers face when setting foreign (and domestic!) economic policy.

19. But it is also the most difficult to understand!It can be a bit abstract and complex, but we need to understand it.

20. (I’ll try to spice things up with a few pictures of my daughters along the way!) Hadley Samantha

21. Learning Objectives • Familiarity with the major components of the BoP • Understand constraints imposed by the BoP • Identify policymakers’ options for managing the BoP  We’ll revisit the BoP frequently throughout the term!

22. II. The Balance of Payments Studying the Balance of Payments The Balance of Payments Achieving Balance

23. What is the balance of payments (BoP)?

24. The balance of payments (BoP) reconciles all of a country’s financial transactions with the world.This includes trade, remittances, investment, loans, &c.As an accounting matter, the BoP must always balance, by design.

25. But that balance can be achieved in more or less painful ways…that balance can be achieved with more or fewer implications for other policy areas.

26. Balance of Payments Current Account Trade in G&S Income Receipts Unilateral Transfers Capital Account Direct Investment Securities Purchases Checking Accounts Balance of Payments Current Account = Current Receipts – Current Expenditures Capital Account = Capital Inflows – Capital Outflows Current Account + Capital Account = 0

27. Let’s look at an actual year (1997) for the US.(This is detailed in Grieco & Ikenberry, Ch 3.)

28. US Current Account in 1997 • Trade in Goods & Services: -$110,206m • Goods (Exports – Imports): $679,325m-$877,279m • Services (Exports – Imports): $258,268m-$170,520m • Income Receipts: -$5,318m • On US Assets Abroad: $241,787m • Paid to Foreigners for US Assets: -$247,105m • Net Unilateral Transfers: -$39,691m US 1997 Current Account: -$155,215m

29. US Capital Account in 1997 • Direct Investment: -$28,394m • Outward FDI (Sent Abroad): -$121,843m • Inward FDI (Received): $93,449m • Portfolio Investment: $255,574m • Foreign Stocks Purchased by US: -$87,981m • US Stocks Purchased by Foreigners: $343,555m • Checking Accounts: $12,778m • Established by US abroad: -$267,842m • Established by Foreigners in US: $280,620m US 1997 Capital Account: $239,958m

30. Balance of Payments Current Account -$155,215m Trade in G&S -$110,206m Income Receipts -$5,318m Unilateral Transfers -$39,691m Capital Account $239,958m Securities Purchases $255,574m Direct Investment -$28,394m Checking Accounts $12,778m US BoP in 1997

31. Calculating the BoP In Theory Current Account + Capital Account BoP = 0 In Practice -$155,215m + $239,958m 1997 BoP = $84,743m  So, what about the extra $84.7 billion?

32. Well, much of this is explained by statistical discrepancies. Governments recognize that they can’t get fully accurate reporting on all of these transactions.In 1997, the US statistical discrepancy was estimated at $99.7 billion.

33. But that still leaves $14.8 billion!!! I thought the balance of payments always balances!

34. It does--but often not without some help!

35. (And people thought I was cute…)

36. II. The Balance of Payments Studying the Balance of Payments The Balance of Payments Achieving Balance

37. Milton Friedman describes the various mechanisms available to states to redress imbalances of payments. (p 202)

38. Relieving Pressure on the Balance of Payments • Adjustment of Reserves • Adjustment of Internal Prices & Incomes • Exchange Rate (ER) Adjustment • Exchange Controls

39. (1) Adjustment of Reserves • The first option is to “adjust reserves” using “official transactions” • Reserves: non-domestic financial assets (foreign currency, bonds, &c.) held & used by govts to support their currency • Official Transactions: govt purchase/sale of foreign reserves so as to alleviate pressure on the balance of payments

40. Example: US in 1997 • Foreign central bank purchases of US currency & US treasury bills & bonds: $15.8bn • US holding of foreign currency & government debt: -$1bn  US & Foreign official transactions account for the missing $14.8 billion

41. Oh, that must be nice: you can clear your imbalances just by adjusting your reserves! That does sound nice. But is there any limit to the amount of “adjusting” you can do?

42. Asymmetric Options • Selling Reserves • A central bank cannot sell more reserves than it has initially • Amassing Reserves • There is, theoretically, no upper limit to the quantity of reserves a central bank can acquire • A central bank can purchase limitless foreign currency by continually printing and selling its own currency in exchange • To prevent inflation, it might employ sterilization: selling govt bonds and “soaking up” excess currency  This is precisely what China has been doing.

43. Returning to the US BoP in 1997, we’re all set:The official transactions and “statistical discrepancy” resolve the US autonomous surplus of $84.7 billion.

44. But Friedman listed three other mechanisms that can be used to maintain balance. These mechanisms, however, work dynamically—so we don’t always see their effects on the balance sheet.

45. (2) Adjustment of Internal Prices & Incomes • Central bank influences domestic rate of interest (RoI) • Double effect of RoI adjustments • Influences domestic price level  current account • Influences int’l capital flows  capital account

46. BoP Adjustment via Interest Rate Changes

47. (3) ER Adjustments • Mechanism 2 maintained the external value of currency (the ER) at the expense of adjusting the internal value (the domestic price level) • Mechanism 3 does the opposite: maintain the domestic price level but allow the ER to adjust

48. BoP Adjustment under Flexible ER Regime

49. (4) Exchange Controls • State directly manages the current and/or capital account • Current Account Intervention: management of trade & commerce • Subsidies, tariffs, restrictions, &c. • Capital Account Intervention: restrictions on capital convertibility • Limits on currency exchange, dual exchange rates, Tobin tax, &c.

50. Balance of Payments Current Account Trade in G&S Income Receipts Unilateral Transfers Capital Account Direct Investment Securities Purchases Checking Accounts Managing the Balance of Payments Trade Management Capital Controls