Friday, 5 July 2013

Trade Imbalances: Micro to Macro


In a recent discussion on a blog post, someone made a comment that no Government would be able to allow its nation to run trade surpluses forever, because the people of such a nation would one day get tired of producing more for others than they do for themselves.  This draws on the MMT idea of seeing exports as a real cost to residents and imports as a real benefit.  Taking this view, it is perhaps natural to ask why a nation would want to run a trade surplus forever.  On the face of it, such a policy would mean that nation must lose out in the long run.

I don't want to go into the context in which the comment was made, but it raised an interesting point about the dynamic role of deficits.  I thought this was worth exploring a bit, particularly looking at the relationship between individual saving and that of the nation as a whole.

To do at this, I used a very simple model based on overlapping generations.  I started by looking at a domestic economy with a single household.  I assumed that the household lived for 30 periods and spent a constant amount each period.  However, the household only worked and earned for the first 24 periods, during which it earned a constant income.  It therefore had 24 periods of saving and 6 periods of running down savings.  The amount spent in each period was just enough to totally eliminate its assets by the end of its life.  Since this household makes up the entire economy, its income and expenditure make up the trade balance and its wealth is the net foreign assets.

The pattern is shown below:



Clearly for the single household, we get a pattern of trade surplus followed by trade deficit (almost by assumption really).  Assets build up during the household's productive years and are then eroded.

The next step is to extend this to subsequent generations.  I did this by assuming that, in each period, a new household starts out on the same life-cycle as the first.  This carries on indefinitely.  The aggregate surplus and net assets this produces are shown below:



Now, we no longer get any deficit.  The surplus builds up as more households join the economy, then falls back as the original ones start to become inactive.  Eventually it reaches a balanced budget, where the saving of younger households matches the run-down of assets by the older ones.

The next step is to introduce some growth.  I did this by assuming each new generation had a slightly higher income than the previous, growing at a constant rate.



In this scenario, we see that, although the surplus falls once we are up to a full complement of households, it does not fall to zero.  We have a growing economy and households that want to save income until later in life.  This requires a growing stock of assets, which can only be achieved through a running a small surplus.

So far, I have ignored any return on the assets, so the final element I looked at was the inclusion of interest on the balance of assets.  In particular, I assumed an interest rate greater than the growth rate.  Household income is now higher, due to the interest income, so their expenditure is also higher.  This scenario is illustrated below, with an additional series illustrating the current account balance, to distinguish it from the trade balance.


In this final case, we get a trade deficit.  We still have growing assets, but this is fed by a current account surplus due to the interest income.  It should also be clear that the trade deficit depends on the interest rate exceeding the growth rate.  The level of current account deficit is dictated by the need for asset accumulation; subtracting the interest income then dictates what the trade deficit needs to be.

So in this instance, after the initial accumulation, we have a permanent trade deficit.  However, it is worth noting that one person's trade deficit is another's surplus.  So in a two economy world, this would imply that the other country is running a permanent trade surplus.  Maybe their people would not like it, but unfortunately it would be the inevitable consequence of being a debtor nation.

My model economy consists only of households that save.  If I were to add in firms, governments and other net borrowers, then the nation's net financial assets would reduce, or it might become an overall debtor nation.  But the analysis would be essentially the same.

In the real world, surpluses and deficits do come and go, although it is clear that they can persist for some time.  Hopefully, this analysis shows that this is not such an unexpected result and how trade imbalances of appropriate size could in theory last forever.

6 comments:

  1. This is great stuff; your didactic analysis really helps me get my head around the imbalances issue that have been articulated but seldom understood (by the majority). In terms of modern political economy, can we imagine for a moment Germany, or for that matter China, not running a trade surplus? You have illustrated this in your model. As long as policy makers and mandarins are content in suppressing the growth in income for the household sector then the pursuit of mercantilism is not only logical for those nation states but sustainable. The spoils of greater assumption accrue to those at the top tier of the household income sector. The gains from trade work for all in theory but for few in practice. No amount of so-called structural adjustments mandate by the troika at the micro level in the euro periphery will bring an end to the macro imbalances in the Eurozone.

    ReplyDelete
  2. Thank you.

    I wasn't necessarily trying to demonstrate any particular point; I just wanted to share what for me is a useful way of thinking about the issue. That said, I think you are right that the full implications of the dynamics of trade imbalances are greatly misunderstood.

    ReplyDelete
  3. Hmmmm, at graph three, shouldn't the steady state trade surplus increase in parallel with the increase with net foreign assets? Graph 3 is considering income growth (no distinction made between inflationary or real growth) which should not result in a constant surplus/deficit trade value.

    Conceptually, I think of a foreign worker who ALWAYS produces for an importing nation as being a domestic worker of the importing nation living in the exporting foreign country. Yes, the worker is a foreign citizen but his working life is dependent upon the importing nation.

    I find it interesting to examine the currency dynamics supporting this situation if the two trading nations have a different currency. The offshore worker needs lots of currency assistance. Possibly a subject for future postings.



    ReplyDelete
  4. You're right Roger and the surplus does increase at the same rate as the balance - it's just not very easy to see in the chart.

    I think there are a number of extensions of this that might be worth looking at, so I'll probably do something else on it at some point.

    ReplyDelete
  5. Roger,

    The balance of payments and the system of national accounts classify people and institutions according to their residency status (with definitions of who is a resident). And this makes sense because the resident is likely to have lots of transactions in the place of his/its residence such as consumption.

    Also think of a tourist guide who mostly entertains foreigners from many countries. His earning is an export. Which country does he belong to?

    Of course brass plate companies make it interesting!

    ReplyDelete
  6. Not only a MMT idea...

    http://www.mecpoc.org/2013/02/do-exports-lower-a-nation%E2%80%99s-standard-of-living/

    ReplyDelete