The Balance of Payments

We looked before David Hume’s essay “On the Balance of Trade,” from 1742. This essay has become strangely influential, even though it doesn’t really say what people claim it says. Rather, although there is a little confusion in his argument, Hume mostly argues the opposite of what others claim he said.

January 17, 2016: David Hume, “On the Balance of Trade,” 1742

In Hume’s day, governments were strangely fixated on inflows and outflows of gold and silver. British would import tea from Chinese, and Chinese would take silver in payment. The fact that Britain’s silver outflows to China were offset by other silver inflows didn’t seem to dissipate this underlying fear. Perhaps they weren’t really aware of it: it was not so easy to measure aggregate inflows and outflows of silver, in the mid-18th century.

Let’s say there was a continuous and chronic net outflow of silver, as many people feared. The potential result would be that Britain would “run out of silver.” This could cause all sorts of problems. But, Hume argued that such a thing never happens. Money (silver and gold) are, he said, “like water,” the same value everywhere, and also, consequently, the same relative scarcity. Trade between “Britain” and “France,” or “China,” was no different than trade between London and Manchester. It wasn’t a problem.

Fron Hume’s essay derives the “price/specie flow mechanism” commonly ascribed to Hume. But, I would say that the “price/specie flow” description is actually what Hume was arguing against. The PSF theory holds that Britain’s coinage supply is more-or-less dependent on British tea-drinking habits. Silver flows out to China in payment for tea (perhaps), until there is such a dramatic shortage of silver in Britain that it leads to meaningful changes in the value of money in Britain, reflected in prices — in other words, a “monetary deflation” caused by shortage of money supply, which is another way of saying: a rise in the value of silver coinage. This fall in prices would change the “trade balance,” because the lower prices would make British exporters more competitive. Thus, there would be more exports, and silver would “flow into” Britain, basically due to foreigners’ purchasing habits for British manufactures. Thus, we can see that the PSF requires dramatic changes in the value of silver, and its relative scarcity compared to areas outside of Britain — changes dramatic enough to cause substantial monetary effects on prices (“deflation”), which in turn would have effects on trade balances and thus British silver supply.

Although he is a little vague, Hume basically disagrees with this notion. He says that there is never a shortage or surplus of money (coinage) in Britain of such degree that it could change prices by some meaningful amount by monetary factors alone. Money is the same value everywhere, “like water,” and, related to that, there is never a relative shortage or surplus of silver coinage in Britain, compared to other areas. If money is the same value and the same relative supply everywhere, then there can be no meaningful effects on prices from a rise in money value (“deflation”), no consequent effects on trade, and so forth. All the mechanisms of the PSF disappear — said Hume.

We can see that money is never of a different value between London and Manchester, that money is never “scarce” in London and “plentiful” in Manchester, and that there are no corresponding effects on prices between the two cities. The money is the same in either; of the same relative scarcity in either; and that such monetary factors, being non-existent, do not affect relative prices between London and Manchester.

In other words, the “balance of payments,” such as tea imports from China, does not matter. The money is neutral and unchanging either way. There is never any significant “surplus” or “shortage” of silver in Britain compared to France. The silver is the same value everywhere — no matter what the “balance of payments” might be.

Unfortunately, despite Hume’s efforts, economists today — yes, in the year 2016 — actually subscribe to a notion rather close to the Mercantilist notions that Hume was trying to dispel. Everywhere, in texts of monetary theory and especially international monetary theory, we hear about the supposed great importance of the Balance of Payments upon monetary affairs. British tea-drinking habits are once again in the driver’s seat.

If this sounds a little stupid, that’s because it is. But, for some reason, economists obviously have a hard time with this, so I think we will have to go through it in detail.

Here is a description of typical contemporary economic thinking about the Balance of Payments:

What is the Balance of Payments? It is a record of inflows and outflows of “money,” also known as “payments.”

Now, the first thing we have to see is that a “country” has no Balance of Payments. A “country” does not make monetary payments or receive payments. All Balance of Payments statistics on the country level are aggregates of individual economic entities.

An “economic entity” is my term to describe some entity that is able to make or receive payments, to own assets or contract liabilities. The common “economic entities” are: individuals, households, corporations, nonprofits, and various government entities. No “countries,” except in the extreme case of communist central planning perhaps.

An “economic entity” is an entity that is capable of opening a checking account; to make and receive payments; to own assets or contract liabilities. The Federal goverment has a checking account. But, there are many kinds of government entities, with their own checking accounts, able to hold assets independent of the Federal government. These include: state governments, county governments, municipal goverments, school districts, libraries, state universities, transportation “authorities,” government pension funds, and so forth. A corporation, household, or government entity can borrow money. A “country” cannot borrow money.

Let’s use a simple economic entity: a household, or basically a family. Let’s look at the household’s trade interaction with the Rest of the World.

The household receives payments. This is most likely payment for employment. Since the employer is “foreign” to the household, part of the Rest of the World, this can be categorized as “foreign trade” of services for payment. There are other kinds of payments that can be received, such as gifts (which we can ignore for now), investment income (dividends and interest income), and so forth.

The household then spends most of its money, to purchase goods and services.

Now, it should be apparent that the household’s trade with individual entities is not particularly representative of anything. The household has an enormous “trade surplus” with the employer. The household has enormous “exports” of employment labor to the employer, but no “imports” at all. Conversely, the household has an enormous “trade deficit” with the supermarket, but no “exports” at all. This is not particularly meaningful, which is why we will aggregate all such external entities into an abstraction “the Rest of the World.” However, like a “country,” the ROW itself is not an entity, but rather a statistical aggregation. It is worthwhile to consider what is really happening in terms of interactions of entities, which is the only kind of interaction there really is in an economy.

Thus, the household has a “trade balance,” money coming in from its “export” of employment services, and also money going out from “imports” of goods and services from the Rest of the World. Also, the household might have some investment income, dividends and interest payments. In aggregate, these are the Current Accounts of the household.

Now, the household might have some savings. It does not spend all of its income. There is some money left over.

What then? This “savings” can take two basic forms. One: the household can accumulate actual money, in this case paper banknotes (or you can imagine gold and silver coins if you wish). Two: the household trades its “money” for some kind of asset.

The most basic kind of asset is a bank deposit account. If the household does not accumulate actual paper banknotes, then the increase in “money” will, in the first instance, take the form of an increase in the household’s bank deposit account, such as a checking account. This deposit account amounts to an overnight loan to the bank. It is a form of debt, not base money. As a form of debt, it is not intrinsically much different than many other forms of debt, such as a bank term deposit or a government bond.

At some point, the family may wish to trade one asset for another. It trades its checking account balance for a holding in an S&P500 index fund.

Thus, on the asset side of the household’s balance sheet, we see an increase in assets; namely, an increase in a checking account balance.

Now, look at what has happened here. The family has “exported” its employment services and also “imported” a great many goods and services. However, the “exports” were a little bigger than the “imports,” leading to the increase in the checking account balance. Thus, the family has a “trade surplus” and also, since we have no investment income for now, a “current account surplus.” This is balanced by an increase in asssets in the financial account.

Thus, the Balance of Payments has balanced itself perfectly, with the “current account surplus” offset by the financial account. And if the family had accumulated actual dollar bills instead? That is also an increase in assets, obviously.

It should be obvious that the Balance of Payments must balance, all by themselves. This is a tautology of trade. Trade is giving and receiving. This creates the Balance. You could even take the case where someone buys something, and doesn’t pay for it. What then? In that case, the seller has, on the asset side of its balance sheet, an accounts receivable. (Gifts are obviously an exception. Since there are no Payments, they are not part of the Balance of Payments.)

It is worthwhile to relabel the savings and investment element as “trade in assets.” We see that the family exports its employment labor, and imports goods, services, and assets, which include equity, debt, and also money, literally banknotes. You can also have other kinds of assets, such as real property or other physical things. Equity and debt are legal contracts. Money (banknotes), or also gold and silver, are in essence goods, along with real property and other forms of physical assets.

So, we can see that the family interacts with the ROW, trading goods, services, and assets. These trades must balance, by definition, or they would not be trades. Of course, there can be inflows and outflows also due to gifts, or various forms of interaction that are not trades, such as taxes.

What does this have to do with the money — dollar base money, consisiting of dollar bills and deposits at the Federal Reserve? Nothing.

Now, let’s say the household borrows money to buy a house. The family “imports” the house. It runs a gigantic “current account deficit.” This is offset by a huge new liability: the home mortgage, on the financial accounts balance. The family “exports” an asset. Thus, the trade was the house on one hand, and the asset (the mortgage loan) on the other. This liability on the family’s balance sheet becomes an asset held by the Rest of the World. The family also now has an interest expense on its “current accounts.”

Now, we can see that here the Balance of Payments must balance. If the family was unable to get a loan for the house, then it would have been unable to buy the house. The “import” and the financing of the import are part of the same transaction. You can’t have one without the other, unless someone gives you the house as a gift (in which case it is not “trade”.)

Today, we see some hand-wringing as people say “how can we finance the U.S. current account deficit?” It’s simple: if you couldn’t finance it, there wouldn’t be a current account deficit. The Balance of Payments is always in balance. But, there might obviously be some consequences of being unable to obtain financing. In the case of the family, it would not be able to buy the house. In the case of the government, if it was not able to sell its bond issuance, then it would not have the money to spend on what it would like to spend money on.

We can see that all of the economic entities — households, but also corporations, governments and so forth — are doing similar things. They have money coming in and money going out, accumulation or disaccumulation of assets and liabilities. All Balance of Payments statistics that are not of individual entities are basically statistical aggregates of several entities.

For example, we could have an aggregate of the Balance of Payments for Households Including Blue-eyed Men Named Phil. Obviously, this statistical aggregate will have some kind of aggregate “export” to the Rest of the World, and some kind of “import”. It will have aggregate assets and liabilities, and aggregate “financial accounts.” There will also be trade between HIBMNPs, which cancel out in the aggregate. Thus, if one HIBEMNP sells a used car to another HIBEMNP, with payment in cash (banknotes), this will net out in the statistical aggregate. The aggregate balance sheet is unchanged: it still shows an asset of a car and an asset of cash (banknotes). There was no trade with the Rest of the World. The aggregate only measures interaction with ROW.

What does this have to do with the money? Nothing.

You can make any sort of statistical aggregate, for any sort of arbitrary reason, and calculate the Balance of Payments for that aggregate. One arbitrary categorization we could choose is entities recognized as resident in the same state — the state of Florida, perhaps. Now, in addition to individual or household entities, we have corporate entities, government entities, and other sorts of entities like churches or other nonprofits perhaps. You can aggregate all of the activities of this arbitrary “resident in Florida” category just as you can aggregate the activities of Households Including Blue-eyed Men Named Phil.

Now, let’s look at this Florida aggregate. For one thing, Florida does not make its own money. All of the base money owned by the Florida aggregate had to be obtained in trade with the Rest of the World, which includes the rest of the United States, including the mints and the Federal Reserve, which holds the “bank reserve” (Fed deposit account) element of dollar base money.

The way that the Florida aggregate obtained this dollar base money (“dollars”) is in trade. There was some “export” of goods and services, or perhaps an asset, and dollars were received in trade.

Remember always that “Florida” is a statistical aggregate of all the individual entities that (arbitrarily, perhaps) make up the “Florida” aggregate. Thus, we are looking at the aggregate of individuals managing their own affairs, of the household, corporation, goverment etc.

So, let’s get back to the individual level. There is a certain amount of “base money” (basically banknotes, and for Florida banks perhaps deposits at the Fed) that all of the individual entities in the Florida aggregate want to hold. If an individual person has more banknotes than they wish, they can deposit them in a bank. This is a trade of banknotes (money) for a debt instrument, a bank account. From there, the individual may acquire a different debt instrument, like a mutual fund that owns mortgage-backed securities.

We can see that, although any entity might wish that they had “more money,” they nevertheless have exactly as much money as they want, given their circumstances. If a person wanted to hold more “money” (literally banknotes), then they might “trade” employment services for it, or sell an asset, or get a loan. And if a person has more money (banknotes) than they wish, it is very easy to trade them for something else.

Thus, we can see that “Britain’s” demand for Chinese tea was really the aggregate of individual British entities’ demand for tea. We can also see that any individual British entity that did not want to part with its silver coin for some tea, would obviously not have to. We can see that, in its trade with ROW, British can acquire as much silver as they want, within their capabilities, just as entities in Florida can accumulate as many dollar banknotes as they want. But, they don’t want to acquire banknotes. They would rather have an asset, or some goods and services, like tea.

Obviously, if all the individual entities have as much “money” (dollar banknotes, or silver perhaps) as they want, then there can never be a “shortage” on an aggregate level. Any entity that felt that it needed to keep hold of its silver, and not trade it for tea, could do so at will. On the aggregate level, nobody would buy Chinese tea, an no silver would flow to China.

Let’s say that British entities wanted to accumulate silver. They would, individually, “export” something and receive silver in payment. Rather than spending this silver on something else, they would keep it, thus accumulating a larger amount.

If all British did this, then “Britain” in aggregate would have exports to the ROW, get silver in payment, and not spend the silver on other things. The amount of silver in Britain would increase. (This is basically what the Chinese were doing.)

We can also see that, much as Hume described, dollar banknotes (“money”) are “like water, the same everywhere,” and there is never a shortage or surplus of banknotes in Florida. Banknotes have the same value as banknotes in the ROW. Prices do not go up and down in compensation. There is no “price/banknote flow mechanism.” The Balance of Payments is always in balance, as a tautology of trade, and needs no government supervision, or “adjustment” by some central bank.

Since all of the world used silver and gold as money in the days of Hume, certainly in international trade, we can see that, in essence, it was all one currency. True, there were different coinages. But, foreign coins from any issuer were often accepted in payment, particularly in Continental Europe although somewhat less so in island Britain. Also, you could, at minimal expense, go to the mint with foreign silver coins, or raw silver bullion, and have some new domestic coins made.

Thus, the condition of the world in the mid-18th century, when Hume was writing, was a little like Florida and the rest of the United States. Everyone used the same money — gold and silver. As Hume said, the situation between “Britain” and “France” was really no different than between Florida and North Carolina, or Miami and Tampa Bay. Money was the same everywhere, in equal supply, and there is no “price/banknote flow mechanism.”

We will look at the later condition of paper currencies linked to gold (the Classical Gold Standard system of 1850-1914), and also today’s floating fiat system. But, you will see the basic conclusion is the same. Money doesn’t have anything to do with the Balance of Payments.