The Balance of Payments Constraint

Last week I introduced the idea of a hierarchy of money.  Each level is a claim on the level above:

  • Securities are a promise to pay deposits at a time in the future.
  • Deposits are a promise to pay central bank reserves on demand.

Central Bank Reserves are the ultimate means of payment in any national system.  But once we consider the global economy, the top level of the hierarchy has to be the means of payment for foreign trade.  In the days of the gold standard, this top level was gold.  In the modern economy it’s the US dollar.  Specifically, it’s the “Eurodollar”:  the vast majority of international trade is conducted in dollars, regardless of which countries are involved, and the domestic banks of trading companies will access dollars via London financial markets, not via the US (the process is fascinating but would take way too long to explain in this blog).

And because most, if not all, countries are dependent on imports to some extent – oil being an essential input in any economy, and many countries being dependent on food imports – the exchange rate becomes the ultimate limit on any country’s ability to expand its economy.  I pointed out a couple of weeks ago that any Government could boost domestic demand through a deficit funded with new money, and indeed that such deficits need to be routine in a functioning economy.  The main constraint on the extent to which this can be done is that it will inevitably lead to an increase in imports.  This leads to an increased demand for the Eurodollar, which will raise the exchange rate, raising the the price of imports and thereby causing inflation.

What I have described here is known as the balance of payments constraint.  It’s also known as Thirlwall’s Law, although Thirlwall was actually building on the work of Nicholas Kaldor who first identified this phenomenon.  Creating new money will lead to inflation through the process described above, and this is probably far more significant than the ‘more-money-chasing-the-same-amount-of-goods’ explanation presented in textbooks.

Just to give you more insight in how it works, if a government wanted to boost demand by having a deficit and to avoid the inflationary pressures of an increasing demand for exports, it would have to ensure that exporting industries expand as much, if not more, as industries selling domestically.  But this is challenging, as those selling domestically are responding to an increased demand stimulated by Government expenditure – there is no such increased demand for exporting industries.  In addition, as almost any business needs some level of oil (even if it’s just petrol to drive to work), any increase in the economy will increase demand for oil, increasing imports if you are an oil importer.

You cannot fully understand the dynamics of the monetary system unless you also understand the foreign exchange system.  In fact, the presentation of the monetary system on this blog is incomplete because I have not covered monetary policy or foreign exchange (I was going to make monetary policy my next topic, but I just feel the blog is dragging on too much and will have to be less comprehensive).

When Perry Mehrling presents the idea of a hierarchy of money, he shows how this enables flexibility and discipline.  In times of expansion, the lower levels of the hierarchy expand through credit – both deposits and securities.  (Remember, securities are financial assets that are packaged together so that they can be sold on – the whole point of securities is to be saleable, or “liquid”.)  But ultimately, final payment must be made – securities have to be converted into deposits, and bank payments have to be settled using central bank reserves.  The higher levels of the hierarchy impose discipline, and the need for foreign exchange imposes a level of discipline that transcends any national government.  (The USA is a special case, as its domestic currency is also used as the currency for international trade, but how this works and its impact on the US economy are way beyond the scope of this blog at this stage.)  Mehrling doesn’t mention the balance of payments constraint explicitly (in any of his work that I have read), but the theory is entirely consistent with his work:  foreign exchange at the top of the hierarchy is imposing the ultimate source of discipline – the constraint – on the system as a whole.

In summary, there are 4 things to take from this concept of a hierarchy of money covered over the last 2 weeks:

  1. When thinking about the monetary effects at the national level of any economic action – be it Government policy, action in the financial markets, or anything else – you need to think the process through to the point of final payment – the transfer of CBR reserves from one bank to another.
  2. But don’t think that CBR is “money” as we know it.  Just because the Central Bank can create new CBR, we still need to understand how that will become the money that you and I will spend – how will it enter the economy, what will it be first spent on, and who will have access to this new credit.
  3. Never, ever, ever use “printing money” as a short-hand expression for the creation of money.  It entirely obscures the complexity that underlies these processes.
  4. The ability to purchase foreign exchange (Eurodollars), the means of final payment in international trade, places an ultimate limit on the value of any domestic currency.  And hence foreign exchange sits at the top of the hierarchy of money.  Economists often imagine a closed economy for the interests of simplicity, but if you want to understand how the economy and its monetary system works you have to understand foreign exchange.  Otherwise it’s like trying to predict European weather by ignoring weather systems across the rest of the world for the sake of simplicity!

This is all I’m going to say about money for now.  I want to build on this understanding by exploring the impact of financial markets in intermediating savings and wealth into investment and productivity.  But first we need to cover a bit of mainstream theory about saving and investment, looking at how we use money as a measure for what we have produced in our economies.

I may also take a couple of weeks off the blog – I write a rough draft of the blog several weeks in advance, and then refine each week’s draft as it comes up for posting, often extending and adding extra posts to my original draft.  I need to write a rough draft of the next few weeks of the blog before I can start posting, and that may take a couple of weeks or more.

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