Macro 101 – Foreign debt

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.

Comments

  1. Very instructive for the non-economists.

    I always wondered why the Chinese were buying up so many American bonds, when previous articles here indicated that the long term yield was so poor after considering inflationary effects.

    So, all a ploy to keep the party going with Americans getting easy access to credit and turning the exchange rate in their favor?

    • I don’t think it is as one-sided as your use of the word “ploy” suggests, but yes that certainly is the plan.

      On the otherside though you have to realise that the US are recieving “real” goods and services and in return the Chinese are receiving an account balance.

      • The other thing that needs to be pointed-out is that when these similar transactions repeated thousand times or more, the Chinese central bank keeps creating more RMB liquidity in the Chinese economy because developed country consumers will keep buying stuff from Chinese producers and sending more monies (due to currency manipulation that keeps RMB rate artifically low against other currencies).

        This in the end may give excess-liquidity and inflation problem in China’s economy which is what happening right now. They may control the exchange rate, but they certainly would lose-out in inflation rate.

        • Hi Deo,

          I said this in the article.

          “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”

          Your statement is correct, but I did not want to confuse this post with a discussion of Chinese liquidity issues.

          They are a major issues for them, much of which they have inflicted on themselves. But that is a topic for another post.

    • Further to DE’s point about the US getting real goods and the Chinese only getting an account entry, when it comes time for the Chinese to spend the USD it has accumulated, it can only exchange these dollars for goods people want to sell at the USD price they want to sell at. You can be sure that willing sellers are gaining from the sale, otherwise they wouldn’t make it.

  2. Why dont the MMT and Austrians address each other’s theories. Does anyone know an example of where the Austrians have critiqued the MMT theory of money creation…as it seems to be contrary to what the Austrians discuss.

    What about Steve Keen…and Bill Mitchell…do they agree on this stuff?

    • When I get round to reading the copy of Debunking Economics I bought last week, I’ll let you know.

    • I don’t think the MMTers and the Austrian/Vienna guys agree on much.

      This is a great refutation MMT from someone who sounds to be biased towards an Austrian view (he refers to Ludwig von Mises).

      http://seekingalpha.com/article/242669-the-trouble-with-modern-monetary-theory

      As for Steve Keen and Bill Mitchell, I’d imagine they are good mates (but have no idea about that). I do recall – but can’t find a reference – that Steve Keen replied once on his blog that he sympathised with the Chartalists and MMTers. Keen has a circuit theory of money creation that I admit to not really getting. Keen seems to be a pragmatist – even though he may think that we are best off with a Chartalist policy of credit creation (only govt creates credit) – he doesn’t think it’s politically possible. He seems to dodge direct answers about his position on these matters – all for pragmatic ends, no doubt – who would want to be publicly proclaimed to be a monetary crank?

      As for Bill Mitchell. I think he’s wrong most of this stuff. However, he is amazingly prolific. I usually can’t finish any of his posts to his blog. I do sometimes think that he attempts to convince with a wall of words though.

      I’d really like to see Steve Keen and Bill Mitchell in a room, grilled by a professional journalist on these topics. It would sure be interesting.

    • Stav,

      Economist Ed Harrison (Credit writedowns blog) has done just this. Harrison purports to be a mixture of both Austrian and MMT and says that he does not see the two schools of thought as being mutually exclusive except mainly in the political department. I’ll try and dig up the link if you’re interested. Alternately, just go to the Credit writedowns blog home page, I think the article is still there on the small sidebar.

  3. For a moment there I thought you were accusing me of charlatanism 😉 Have to admit I had to google that!

  4. I greatly appreciate your posts.

    Thanks for fleshing out the above transaction too. About it you wrote, “It slightly lowers the ability of US banks to create credit”. Why is this? If the Chinese didn’t buy the bond, wouldn’t the fed be ensuring that there’s no shortage of reserves instead (to maintain the target interest rate)?

    Thanks.

    • Hi Brett.

      Logically yes. But it is a difficult answer many questions about politically driven economics with logic.

      There is lots to say on both side of the US China deal about what is “logical” compared to what is actually happening.

      So I will let you read this article of mass hysteria to see if you can work out why China could be helping out the US government in regards to debt purchases.

      http://chicagobreakingbusiness.com/2010/11/fed-to-buy-600b-in-bonds-to-boost-economy.html

      However in my mind this is more about exchange rate control ( to support the currency peg ) than it is about lending.

      I wonder if others have an opinion on this, as it certainly attracts some attention from time to time.

  5. Essentially this regards the external account as an infinite and free source of funds. That works…until it doesn’t.
    The US, being the world reserve currency, a giant economy, and possessor of many aircraft carreir battlefleets, can get away with this for longer than most. Nevertheless if, for whatever reason, faith in the currency is lost, there is big trouble.

    Now the USD are already issued and ‘out there’ All anyone can really do is try to buy productive US assets. If the US blocks such purchases then the currency is sunk and ceases to be the international reserve and will not be accepted.
    Meanwhile, what you get as a result of the application of this monetary system is declining ‘real’ industrial production in the US, with greater unemployment and higher and higher indebtedness…Continuous external borrowing and sale of assets is no solution to the ills of an economy.

  6. Thank you for explaining how it is done and so lucidly. It is 4.30am here in New Zealand and I can’t sleep thinking about all of this!!!!
    Now tell me if I am wrong and please don’t label me because I am trying to understand, but theoretically then there are two currencies in a country; one for buying goods made locally and another for goods made overseas. I can remember when the Government controlled how much you could take out of the country and certainly you couldn’t buy the stuff you can now; it had to be made locally to provide jobs for New Zealanders. The government and private enterprise did borrow but it was for things such as infrastructure that added value to the country or for something that provided New Zealanders with jobs. It all stopped in the early 1980s with us being told that the Government was broke but it seems to me that the debt, or that side of the ledger in your example, has now been transferred to the private sector to provide us with stuff and to the Banks who create a housing bubble because they want want security. And we are told we are broke again. All terribly confusing.

  7. Patricia,

    From you description I think you are referring to a fixed exchange rate.

    This is where the NZ government was trying to keep the NZ dollar at a particular level versus other currencies.

    This no longer applies. NZ now has a floating exchange rate, where the demand for currency and its availability regulates its value compared to other currencies.

  8. Surely it applies because, at the time, New Zealand were trying to preserve their foreign exchange holdings. The Government was conscious of foreign debt.
    You can’t assume that you can print up as much of your currency as you please any time and exchange it for whatever currrency you want. Theoretically it is possible yes but you may quickly get to a point where you require an infinite number of your pieces of paper for one of whatever country you are trying to buy goods from.
    This particularly applies to a country such as NZ which has chronic CAD’s and a small economy.
    If we face a foreign exchange crisis a government could, in fact, institute controls on trade and travel and still have a ‘flexible’ exchange rate. The problem we have, at the moment,is that our govts with an idea as promoted by this blog, think that external debt doesn’t matter at all and that such debt is virtually ‘free money’

    • Flawse my point about no longer applying is to do with the fact that the NZ government no longer runs a fixed exchange rate policy

      > . The problem we have, at the moment,is that our govts with an idea as promoted by this blog, think that external debt doesn’t matter at all and that such debt is virtually ‘free money’

      Hmmm… I think you need to be very careful about making assertions based on how you have interpreted this post.  I said at the beginning this is discussion about the functional aspects of foreign debt I made no such assertion that this was ‘free’

      As I said at the bottom of the post , a foreign debt is the record of the net borrowing of resources from foreign entities. Like all borrowings it is extremely important what you do with them. NZ like Oz has wasted much of it’s foreign utilization on non productive stupidity. But this has little to do with foreign trade, and much to do with domestic economic mismanagement

  9. Patircia you are right to lie awake at night and worry about the dire state of our international finances. It’s a pity more people don’t.

  10. Ah! Apologies delusional…I have a particularly sensitive spot which has been rubbed red raw! As a result I interpreted your posts as promoting the particular piece of delusion.
    I reckon I got side-tracked by this paragraph.
    “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?”

    So again my apologies and I’ll try to be more careful!