There have been a few posts on this blog recently about the fiscal position of the United States. The Unconventional Economist gave a somewhat Austrian perspective on the situation only to be jousted by Rotten Apple from what obviously is a chartalistic view of money.
I don’t think I need to add anything more to either view, but I must note that I personally am more aligned with the Apple’s MMT view of the world. However as I said previously I don’t want to use this stream of postings to vocalise my own opinions.
Today, in the context of sovereign debt I want discuss the functional aspects of the US trade with China. I think it is important to understand the money “mechanics” so you are aware of how the economic system actually functions. In my opinion I think many people ‘demonise’ sovereign debt without actually understanding what it is. That is not to say that it is always good to have sovereign debt, but if you don’t understand something you cannot make a valid determination of your own position towards it.
Given a number of comments left on this “awesome” site , I am not 100% sure everyone out there in the blogosphere actually understands exactly what sovereign debt (sometimes called “national” debt) actually is.
As I explained in my previous piece on sectoral balance the government sector’s fiscal position is simply the difference between the fiscal position of the private sector and that of the external trade sector. This may sound strange because it suggests that the private sector and the external sector are bound in some way. Well they are, they are bound by the government sector who must issue its sovereign money to match the demands of both sectors.
Since only the government can issue high powered money (money of exchange) then when it issues more than it takes back it is considered to be running a deficit, when it takes back more than it issues it is considered to be running a surplus, but the sectors are linked. House and Holes demonstrated this beautifully in his latest post, although I am not sure he realised it. I will leave it as a “Where’s Wally” for my readers to figure it out :))
So to dig a little bit deeper into how the trade sector affects the governments financial position I need to explain at a transactional level how foreign trade actually occurs from the perspective of the monetary system. So let me explain in a functional way the actual financial processes that occur when an American small business owner Jim purchases a US$2000 equivalent box of “made in China” products from Mr Chan’s Chinese plastic tatt co. in Shanghai.
Jim goes to his bank , the Bank of America, and sends a $US2000 money transfer through his bank to Mr Chan in China, lets say it is the ‘China Construction Bank’. The Bank of America sends the order to the US Federal Reserve to transfer $US2000 to Mr Chan’s banks representative at the US Reserve. As the China Construction Bank does not have a US Fed reserve account at the US Fed, the money is placed in the Peoples Bank of China account (PBoC – China’s equivalent of the Fed). At the reserve bank $2000 is removed from the ‘Bank of America’ reserve account into the reserve bank account of the ‘Peoples Bank of China’.
The Peoples Bank of China now has $2000 more US dollars than it previously held in an account at the US Federal Reserve. In China, the Peoples Bank of China issues the equivalent amount (as determined by the exchange rate ) of Renminbi from its reserve account to the reserve account of the ‘China Construction Bank’ with an order to deposit the Renminbi value in Mr Chan’s account.
The transaction is now complete.
This transaction has now changed the reserve position of a credit issuing bank in China, but so I don’t confuse this post I will ignore that effect for now. The important thing to note is that from the US government’s perspective all that a has occurred is that inside the computer that keeps account of its fiscal position a small proportion of a balance of an account called “Bank of America” has been moved to an account called “Peoples Bank of China”. Yes that is correct; cell A1 of the spreadsheet is minus 2000 while cell B1 is plus 2000. It may sound crazy but that is simply how foreign trade at a transactional level occurs.
Jim gets his products , Mr Chan gets $US2000 equivalent of yuan, and the bank of china gets 2000 added to its US reserve balance in a computer at the US Fed. So you can see from this transaction that the private sectors of both countries receive goods they determine to have value, however the governments simply push numbers around inside their computers. The amount of Renminbi Mr Chan receives and why Jim wants a box of Chinese plastic are two points of contention, but I will ignore both at this point.
The effect of this transaction is that their are slightly less US reserves available to the US banking system and slightly more Renminbi available to the Chinese. This has two effects. It slightly lowers the ability of US banks to create credit and also tips the exchange rate towards the US currency. These are both unwanted consequences for China because it needs to keep the Americans borrowing and its currency at a low exchange rate to keep its export advantage. It therefore needs to push the US currency it has taken out of circulation back into the US banking system. To do this it purchases US bonds through commercial brokerages in the US. When this occurs reserves are taken out ”Peoples Bank of China” account at the federal reserve and added back to the account of a US credit issuing bank that has the account of the person/entity that the ‘Peoples Bank of China’ purchased the bonds from.
This has the effect of moving more US dollars back into the US banking system and therefore lowering the exchange rate while effectively giving Americans access to more credit. So now the ‘Peoples Bank of China’ has exchanged its numbers in a computer at the Fed for some other numbers in another US government computer at the Treasury that says that the ”Peoples Bank of China’ owns some government bonds. At the same time it has lowered the US/China exchange rate to keep US citizens buying “made in China” boxes.
Some time in the future those bonds will mature, which means that more numbers will be added to the ‘Peoples Bank of China’ account at the fed reserve, but you may have guessed by now that this is just electrons being pushed through transistors by a press on a keyboard key. Nothing actually happens, no gold is shipped, no kittens are harmed, it is just numbers in a spreadsheet.
Yes it all sounds crazy, and it might not make sense to you given your terms of reference of what you think “money” is. But that doesn’t change the fact that this is what actually happens in modern computer driven macro financials.
The media report this process as “massive debt owed to china by the US” which technically it is, but now you understand the process you have to ask what that “massive debt” actually costs, and whether it is sustainable. Can the US Federal Reserve’s computers store bigger numbers?
The fact is that this is a mutual agreement that has served both sides of the equation well. It is only when it no longer serves one of the sides that the problems will occur, but this is much more about politics than it is about economics. China and the US are both FIAT issuing nations, from a functional perspective this can go on forever.
At a higher level a trade deficit is simply the recording of one nations utilisation of foreign resources in relatively larger amounts than foreign entities are using theirs. This issue about whether this is sustainable or not depends on the continuing mutual benefit both nations receive from the relationship, for FIAT currency issuing nations this has little to do with money.
In my next post I will try to cover the other side of national debt attributed to the private sector.