Guest Post: Leigh Harkness

I discovered Leigh Harkness’s web site a few months ago while doing some research on foreign trade.  His site so intrigued me that I contacted him to see if he would be interested in doing a series of guest posts about his research and experience in his little understood area of economics. Leigh accepted my invitation.

Leigh has previously worked at the Australian Treasury and also wrote a submission to the latest enquiry into banking competition. He has some very interesting theories so I am sure his posts will stir some interesting discussions.  Without further ado here is his first post titled  “Bank credit and the current account deficit”


Some time ago, I was the economist for a small South Pacific Island country.

Until 1974, that country did not have a bank.  Even so, the country issued its own currency.   When foreign currency came in, the government would exchange that money for domestic currency and add the foreign money to the country’s foreign reserves.  When people spent money on imports, the government converted their domestic currency back to foreign currency to pay for the imports.  In that way the country always had sufficient foreign reserves to pay for its imports.

When the country established a bank, it started lending money.  That lending created additional money that did not contribute to foreign reserves.  Yet, when that money was spent on imports, it still needed to be converted into foreign currency.  Therefore, increased bank lending depleted the country’s foreign reserves.

To ensure that there were adequate foreign reserves to meet requirements, the government advised the bank to regulate its lending according to the level of foreign reserves.  If there were plenty of foreign reserves, it could lend without restraint.  But if foreign reserves were low, it had to slow down or stop lending.

That system worked well.  It limited the growth of bank credit to the growth of national savings. In the year following the introduction of these guidelines, a hurricane destroyed most of the economy’s export industries.  Yet the country did not experience any balance of payments problems.  The bank managed its lending according to the level of national savings.

I later joined the Australian Treasury.  Australia had a growing current account deficit and I investigated whether bank credit was responsible for that deficit, as it had been in that South Pacific island.  Figure 1 presents an updated graph of the evidence that I found.

There is evidence of a similar relationship between bank credit and the current account deficit for New Zealand, America and the Philippines,

Entitlements and obligations

In our monetary system, currency is a record, or account, of current entitlements.  Counterbalancing that entitlement should be accounts of current obligations.

Bonds are records of future entitlements.  Counterbalancing those future entitlements are obligations to pay in the future.  Those obligations are tied to the people that issued the bonds.  Without that obligation, the bonds would be worthless.

The obligation for currency is not tied to a particular person; it is linked to the obligations of the whole monetary system.  If currency is created without a corresponding current obligation, it affects all currency and the whole monetary system.

Currency is used as a medium of exchange to buy and sell products.  Bonds may be exchanged for currency and, occasionally, they may be accepted in exchange for products.  But whoever accepts bonds in exchange for products recognizes that they cannot be used to pay wages and suppliers. The bonds must be sold in exchange for currency before the proceeds of the products sold are available to be spent.  Bonds are not money.

If currency is issued against future obligations, it creates additional current entitlements but there are not any additional current obligations to supply the products demanded.  The additional money will cause the economy to buy more than it has produced, unless there are offsetting national savings. That is, without offsetting savings, it will cause current account deficits.

Bank lending creates current entitlements against future obligations. The deregulation of the banking system has enabled banks to increase their lending.  That has increased the amount of current entitlements issued against future obligations.  It is this growth in bank credit has led to a rise in current account deficits.

Banks’ books may appear balanced with debits equal to credits.  However, in terms of timing, the entitlements that they grant and the corresponding obligations are not synchronized.  Imports are required to satisfy the additional demand for the time between when the current entitlements were issued and when the loan was repaid.

As total bank lending has been rising, it means that new loans have been issued faster than old debt has been repaid.  Therefore, current account deficits have persisted and been equal to the growth in total bank credit, less any national savings.

National savings are not superannuation or deposits in bank accounts.  They are the nation’s income from the sale of exports that has not been spent on imports.  Essentially, they are foreign investments and the foreign reserves of the banking system.

In the days of fixed exchange rates, nations built up foreign reserves and saved.  But deregulation of the banking system caused those savings to decline.  The currency had to be floated to protect those reserves.  When a currency is floated, the whole financial system is required to balance international receipts and payments.  The monetary system no longer draws upon, nor contributes, to national savings.

Therefore, unless private international savings are greater than the growth of bank credit (as in Japan), countries with floating exchange rates will experience current account deficits equal to the growth of bank credit.

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Comments

  1. Congratulations …DE
    I was forced to find the Lew’s and Leighs
    After Keating told me…learn the M’s
    Do yourselves a favor..Macro readers..
    I Never looked back..

    Cheers JR

  2. Thank you Leigh! At last someone with a clue!!!!! Does anyone else in Treasury (or the RBA, Banks etc understand this or do they understand it but think CAD’s don’t matter anyway?

  3. Is this guy for real? What a load of rubbish!

    Too much bank debt is clearly a problem. But the problem is not current account deficits and it certainly isnt a direct causation. Japan has run a current account surplus since the early 1970s…and Japan probably had one of the biggest growths in credit debt ever during the mid to late 1980s. This definitely led to a huge investment bubble…but a current account deficit or surplus is irrelevant here.

    The change to a fiat monetary system was probably the best thing that ever happened. The U.S. government can always pursue domestic policies which enhance welfare by spending their own currency – but this is where they have failed.

    • BK – did you read the last line? “unless private international savings are greater than the growth of bank credit (as in Japan),…”

      Japan’s saving rate was one of the highest in the world at that stage. The rate in the 80s and the early 90s had been over 10% steadily and higher than any other developed country.

      (from http://www.mof.go.jp/jouhou/soken/kenkyu/ron164.pdf ).

  4. “If there were plenty of foreign reserves, it could lend without restraint. But if foreign reserves were low, it had to slow down or stop lending.

    That system worked well”

    In May 2007 the foreign exchange ‘reserves’ of the RBA hit nearly $82 billion.

    That didn’t work to well.

    It’s obvious this guy worked for the Treasury.

  5. NET Reserves were $32B!

    In an economy running perpetually large CAD’s how does it increase its NET Foreign Exchange Reserves?

  6. Once upon a time, the Current Account Deficit would appear on the headline of newspaper every month. Sometime after 2000, the reporting stopped, and we don’t seem to worry about it any more.

    Even though we should.

    Iceland is an example of what can happen when the banks get too carried away with borrowing foreign money. In theory, the exchange rate should work as automatic stablizers. Reality is different because the major exporting countries like Japan and China do everything they can to skew their exchange rate.

    The Australian Government’s implicit and explicit government guarantee on bank deposits only made things WORSE. However, it will take a very brave and suicidal Treasurer to suggest Australian should limit the amount they’re borrowing. It will be ‘the recession we had to have’ all over again..

    • Deus Forex Machina

      I don’t necessarily agree with this analysis. If the banks don’t fund the current account then who?

      A speech given by Ric Battelino back in June 2010 is worth looking at for those who would like to understand a little more about how the RBA sees this issue. http://www.rba.gov.au/speeches/2010/sp-dg-150610.html

      He also talks about the impact of the exchange rate regime on the build up of foreign liabilities which may also be enlightening.
      Cheers
      DFM

    • The least we can hope for, is that our government do what the Iceland government did in the aftermath of their crisis – allow the overleveraged banks to fail and then restructure them.

  7. To BK

    You question whether the current account deficit is a problem. In this blog, I have not considered the cost and benefits of current account deficits. Clearly for a small South Pacific island country, confidence in its currency depends upon how readily it can be converted into foreign exchange. Hence, foreign reserves are important.

    Regarding the cause, if we had not implemented the guidelines, I am sure that the growth in bank lending would have resulted in current account deficits and falling foreign reserves.

    On fiat money and governments printing money to finance expenditure, we did that. Sometimes if we wanted a few days credit, we would take new bank notes out of the vault and issuing them to pay wages to the public servants. They would spend that money in the shops, the shops would deposit the money in the bank and the bank would end up with surplus cash which they would return to us and debit our account. It is something that a government can pursue in a limited way to enhance economic welfare, but only for a few days.

    To JMD

    If a country has fixed exchange rates, it needs to manage its bank lending. Otherwise the banks may deplete foreign reserves and the country will be unable to pay its foreign commitments.

    But if a government uses the exchange rate to preserve its foreign reserves, then it can allow the banks to lend as much as they like (for a while).

    To Flawse

    The Philippines have turned their current account around. Since 2003, they have had large current account surpluses. To achieve that, they have managed their exchange rate and their banks.

    Leigh

  8. Leigh It was a rhetorical question!
    Of course the answer is, if you want to continue to run CAD’s, in order to maintain your Forex Reserves, you either borrow more or you sell your national assets. We do both.
    P.S. By selling national assets I don’t mean digging it out of the ground and selling it!