Monday, 2 January 2017

The Net Internation Investment Position and the Trade Balance



In commenting on tariffs and the trade balance, Paul Krugman states that, in the "simple story", tariffs result in an exchange rate appreciation which leaves the trade balance unchanged. 

A critical point here (which Krugman goes on to explore) is the idea that neither tariffs nor any associated exchange rate appreciation has any impact on capital account flows (or for that matter on the net flow of investment income).  However, the simple story also contains an implicit assumption that the level of output is unchanged.  If instead tariffs are accompanied by an increase in domestic activity, demand for imports may be unchanged and there may be no change in the exchange rate.  It all depends on what else we think might be going on.

What interested me more here though was Krugman's assertion that trade deficits must eventually be replaced by surpluses (and thanks to Matias Vernengo for drawing my attention to this comment).  The idea he is appealing to is that a country cannot have a negative net international investment position (NIIP) that grows indefinitely.

In fact this comes down to an r versus g question.  g here is the rate of growth of the economy.  r is the average rate of return on the NIIP.  If r is less than g, then even with balanced trade, the NIIP will be declining as a percentage of GDP.  No trade surplus is ever needed to correct a negative NIIP.

The thing about r here is that it is an average return and the NIIP is the difference between two larger numbers.  For example the US NIIP of around negative $8 trillion is the difference between assets of $25 trillion and liabilities of $33 trillion.  This means that the average return can vary greatly and can look nothing like a normal asset return.  For example, in the US case, if the return on assets is sufficiently greater than the return on assets liabilities, the average return on the NIIP can easily be negative.

This means that, in cases where the NIIP is small relative to the gross positions, we cannot generally say anything meaningful about r and it is quite possible that a country can run a trade deficit for ever without any need for eventual surpluses.  This is not, of course, the same as saying that a country can run any level of trade deficit for ever.

8 comments:

  1. good one

    the old USA as hedge fund effect

    it's the relative size and the returns on the two gross pieces that is the key

    a curious case of innumeracy on the part of the K-man, but not the first time

    where theory clouds arithmetic

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    1. Thank you.

      I think the problem here is that the possible variation in r makes it difficult to make predictive statements and more mainstream economists are less comfortable with that.

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    2. PK in particular is handicapped by the fact that his academic work is on trade, which tends to crowd out the common sense he displays in other areas.

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  2. "... if the return on assets is sufficiently greater than the return on assets,..."

    A typo here?

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  3. This comment has been removed by a blog administrator.

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  4. Good post.

    Of course another issue for the US (and a few others) is that depreciation automatically improves the NIIP since foreign liabilities are mostly denominated in domestic currency. In effect this ensures that r moves to whatever level required by "sustainability."

    There's also the fact that international financial positions are endogenous to trade in all kinds of ways.

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    1. Thank you.

      "Of course another issue for the US (and a few others) is that depreciation automatically improves the NIIP since foreign liabilities are mostly denominated in domestic currency."

      I think this must be the case, but oddly I can't find this effect when I look at the data for the UK. I haven't looked for the US.

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