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.

nef Report on QE

There's a new report out from my friends at nef on alternative ways of doing QE in the UK.  I provided some comments on an earlier draft.  Although, I wouldn't agree with everything they say, it provides a good picture of what QE has and hasn't achieved in the UK and how it might be used more effectively.

Bank Capital and Derivatives

I've spent a bit of time recently thinking about how to model banks empirically and have come to the conclusion that it's quite difficult.  There are a number of theoretical models around, which do a good job of illustrating the connections between capital, lending, reserves and rates.  It's a useful exercise to play around with these and they are helpful in understanding the way these things are related.  I've particularly looked at the role of bank capital, as it has been crucial in shaping bank behaviour before and after the global financial crisis.

However, it get's much harder once you start to look at actual data.  There are various problems that emerge, but one of them struck me as quite interesting because it played an important part in the crisis itself.  This is the transformation of banks' balance sheets that has accompanied the growth of credit derivatives and the associated impact on the relationship between bank capital and risk.

A consultative document released by BIS this week on the revised leverage ratio framework makes some attempt to address this issue, but there are some good insights into the problems with the old capital framework in this report, particularly Annex 1.  This latter report deals with capital adequacy treatment of trading book transactions.  It is useful to elaborate on the distinction between banking book and trading book for regulatory capital purposes, as it helps explain one of the key ways in which derivatives contributed to the crisis.

The banking book covers loans.  Banks are required to hold capital based on the outstanding amount of loans on the banking book.  For most of the period prior to the crash, the amount of capital required for a given loan principal was based on some fairly simple rules, under which loans fell into one of a small number of different categories.

The trading book covers the bank's trading activities (obviously), where the bank may be taking positions in various markets, such as currency, equities and interest rates.   Capital is required against (amongst other things) market risk - the risk that market movements will lead to a loss.  Because trading positions are generally short term, capital is typically calculated on some estimate of possible market movements within a short time frame (a few days).  The idea is that because the positions can be traded and the bank has staff actively managing the position, the risk can be substantially mitigated by unwinding positions if the market moves adversely.

From around the beginning of the last decade, there was a massive growth in the market for traded credit, facilitated by the increased use of asset securitisation and of credit derivatives.  The use of these instruments increasingly enabled banks to hop in and out of counterparty credit positions that would historically have sat on the banking book.  This meant that it became possible to treat these positions as trading positions, subject to market risk based capital measures.

A traded credit position can take many forms.  However, in general the amount of capital required against the risk of a default by the underlying credit is significantly lower than that required on the banking book.  This makes sense as, in a very meaningful way,  there is less risk on the trading book.  Assets on the banking book sit there till maturity which may be many years.  The risk of things going wrong is much greater over several years than it is over a few days.

This difference in capital treatment created significant incentives to develop the traded credit market.  There were other reasons as well, notably the ability to sell assets to investors who were restricted to holding rating paper.  But for banks, traded credit was able to generate much higher returns on capital than could be earned on the banking book.  This tended to lead to more capital being allocated to traded credit and more and more credit risk being repackaged into tradable form.  At the same time, the reduced capital requirement meant that the same amount of capital was able to support greater and greater risk positions.  This fuelled a demand for more and more assets, pushing banks to take on credit risks that might otherwise have been unacceptable.

Notwithstanding the lower level of risk on traded assets, there is obviously a big flaw if you look at it from a system-wide point of view.  From a single bank's perspective, risk is reduced if they can exit a position quickly.  But the risk is still in the system and if everyone wants to exit at once, there's nowhere to go.  The risk assessment measures used to evaluate capital requirements were based on normal market conditions and did not adequately cover the more remote risks, including the possibility of the market seizing up.

The problem is that risk is not a linear quality.  One position can be unequivocally less risky than another in one sense, but be just as risky in others.  For example, if I were to place my life savings on the favourite to win the Derby, that would be less risky than if I placed it on a 100-1 outsider.  But there's also clearly a sense in which it just as risky - I still stand to lose my life savings.

An overwhelming proportion of bank losses in the financial crisis were realised in traded credit positions (or positions originally on the trading book and transferred when the markets seized up).  Of course, this is only one of a number of factors behind the financial crisis and it would be a mistake to look for a single cause.  However, the explosive growth of the traded credit market, facilitated by the development of credit derivatives and asset securitisation, was an important element in what happened.

The Short Rate, the Long Rate and the Exchange Rate

Reading about the market reaction to Bernanke's comments on a possible end to monetary stimulus, I was interested to note the appreciation of the dollar being generally attributed to associated expectations of a rise in dollar short rates.

Whilst this may indeed be the case in this instance, it's a good opportunity to highlight that there are two quite distinct reasons why we might expect an announcement on asset purchases to have this effect on the exchange rate.  It would be quite reasonable to expect an exchange rate impact, even if expectations of short term interest rates remained anchored.   The mechanics behind this are closely related to the way I have looked at Modelling QE.

For this type of analysis, it can be useful to think in terms of expected single period rates of return.  To simplify, we can think in terms of two asset classes: deposits, carrying a short rate of interest and bonds with a long rate.  For our single period, the return on deposits is known, but the return on bonds is not, because the latter depends on how the bond price changes in the period.  We therefore need to use an expected return, based on what the bond price is expected to be at the end of the period.

In the simplest models, the actual return on deposits and the expected return on bonds will be equal.  The assumption is that if they were not equal, investors would keep trying to switch their portfolios until the change in demand drove the expected returns into line.

This assumes that the two assets are perfect substitutes, but in reality there are plenty of reasons for believing they are not.  More sophisticated models will recognise that the two rates will typically be different.  The difference might be attributed to a liquidity premium or a term preference.  For convenience, I am going to call the excess of the expected single period return on bonds over the short rate the term preference (noting that this value could be positive or negative).

The important point here is that  the size of the term preference is a function of demand and supply.  For whatever reasons (often institutionally), there will be some investors that want exposure to long term rates and some that want exposure to short term rates. At the same time the relative supply of short term and long term assets may vary (through QE for example).  This is going to change the value of the term preference.

We can extend this analysis to the long term.  The expected long term return on bonds will be the compound of all the expected single period returns (that is, all the future returns expected now).  The expected long term return must equal the actual return (if a Treasury yields 2% to maturity and I expect it to yield 3% to maturity, I'm clearly mistaken).  In which case, the actual yield on bonds is equal to a compound of:

1. all the expected short term rates from now until the bond maturity; and

2. all the expected values of the term preference from now until the bond maturity.

where, in each case, expected means expected now.

So, when the bond yield changes, it may represent a change in expectations of future short rates, or it may represent a change in expectations of the term preference, or maybe a combination of both.  However, whilst it's possible that a change in asset purchases might not result in any changes to the actual short rate, it is highly unlikely that it will not lead to any changes in the term preference, as that would imply that investors were indifferent between long and short rate exposure.

Therefore, where the bond yield changes in response to an announcement on asset purchases, we know for sure that the expected value of the term preference has changed, but we don't necessarily know what it implies about the expected course of future short rates.

This has all been about changes in the domestic term structure.  How does this relate to the exchange rate?  The important point here is that what matters to the exchange rate is not just the short rate on deposits, but also the expected single period rate of return on bonds.  If investors with long-term rate preference invested exclusively in the domestic market, then this might not matter.  However, this does not appear to be the case; cross-border holdings of long-dated securities are substantial.  The demand and supply for these assets (which has immediate impact on the exchange rate) depends on the single period expected return on long assets, not on the short rate.

In conclusion, an announcement on asset purchases may do two things: it will definitely have an effect on the term preference; but it may also have an effect on expectations of short term interest rates.  These two effects are quite distinct, but both will have an impact on the exchange rate.

Sterling Commodity Prices

This graph shows the real cost of commodities in sterling terms, monthly and as a moving average, based on the IMF price index for all commodities.

The fact that this measure remains so high, around 2.5 times its level for the period up to around 2005, goes some way to explaining continued inflationary pressure in the UK in the face of weak wage growth.






Based on:
US$ commodity price index: PALLFNF, source IMF
US$ / £ exchange rate: XUMAGBD, source Bank of England
RPI, source ONS