In this post, I want to lay out the basics of international finance at the level of my Principles of Macroeconomics class. Trust me, it will be worth it. There are many points about economic policy I have wanted to make on this blog that I have been unable to make without first laying the groundwork with a discussion of international finance like this. This post focuses on international finance in the long-enough run that aggregate demand is not an issue. So any discussion of monetary policy will have to wait for another post: “Short-Run International Finance: A Primer” to come. Also, the longer-run focus of this post will show up when I talk about an increase in the national saving rate as a good thing–which I think it will be, about five years from now. But right now (2012) it would be good for people to spend more, as I assume in my posts so far about short-run fiscal policy and about monetary policy.
I use Greg Mankiw’s Brief Principles of Macroeconomics in my class; I like his treatment of international finance very much. Underneath the surface, Greg’s treatment of international finance has two key foundational pillars:
People have definite ideas (somewhat independent of the true distribution of returns on those foreign assets) about how much in the way of foreign assets they want among the assets that make up their wealth
Foreign currency is a hot potato that people want to get rid of.
Let start by discussing these two foundational pillars in turn.
Having Definite Ideas about the Amount of Foreign Assets to Hold. Having definite ideas about how much of one’s portfolio should be in foreign assets, in a way that is partly independent of the true return properties of those assets, is not fully rational. But home-bias, the tendency to be underweight in foreign assets relative to what would be optimal in the absence of prejudice based on the distribution of asset returns alone is one of the well-documented psychological biases in economics. And because of finite cognition that is scarce in relation to the difficulty regular households have in thinking about foreign assets, people’s attitudes toward foreign assets are likely to change over time in ways that are not fully rational.
If people were fully rational about foreign assets, I suspect that Greg’s treatment of international finance would not work very well. But I think it actually does work well because cognitive limitations exist. Financial decisions are some of the hardest decisions that people make, and international finance adds an extra layer of complexity. Having some players in the market who are fully rational would make a difference, but risk aversion and limitations on the quantity of wealth those rational financial actors control means that they cannot necessarily make the markets over in their own images. Also, many people think they are being fully rational when they are depending very heavily on returns in the future having similar properties to returns in the past, and depending on those returns to have few sudden jumps.
Foreign Currency as a Hot Potato. Nick Rowe, who is a Canadian, gives a good discussion of why foreign currency is more of a hot potato than domestic currency, in his post “Money is Always and Everywhere a Hot Potato”:
I sold my car for Australian dollars, which were also a hot potato. I sold them at a place, called a “bank”, which is a dealer in Australian dollars. Because, including transactions costs and search costs and everything else, I would probably have got the best deal from someone who specialises in trading Australian dollars and who holds an inventory of Australian dollars. Only banks do that.
If I had sold my car for Canadian dollars, which are also a hot potato, I would have looked for a buyer who specialises in trading Canadian dollars and who would give me the best deal. But everyone I deal with here in Canada specialises in dealing with Canadian dollars and holds inventories of Canadian dollars. Everyone does that. Not just banks, but jewelers too, and car dealers, and my local supermarket, and my broker, and everyone I know.
Right now I have $100 in my pocket. It’s a hot potato. I don’t want it. I plan to get rid of it. Only not right now, because I am typing this right now. I plan to get rid of it a little later. Where will I get rid of it? At my bank? Well, if I thought my bank would give me the best deal, and something I really wanted more than anything else right now, then yes I would get rid of it at the bank. But I don’t think that. I think I will get a better deal at the supermarket and gas station. So that’s where I’m planning to spend it, in a little while. (Unless the bank phones me with a great new offer that can’t wait.)
The gas station trades gas for Canadian dollars. The supermarket trades food for Canadian dollars. Continue through a long list of other traders. And the bank trades IOUs for Canadian dollars. A bank is just 1 out of 999 other places I could trade Canadian dollars.
Thus, for reasons that Nick describes, most people are willing to tolerate a significantly bigger pile of domestic currency than of foreign currency. And they are reasonably quick to trade even domestic currency for assets that are IOU’s from someone else such as an addition to the balance in a checking account, savings account or money market fund, or for stocks or bonds. And for most people, those assets that people regularly convert currency into are primarily domestic assets.
The Recycling of Dollars (and Other Currencies). Let’s start by looking at things from the perspective of Americans thinking of buying something from abroad or otherwise sending dollars abroad, say as a charitable gift. Since U.S. dollars are a foreign currency in most of the world (leaving aside places such as Ecuador, which do use U.S. dollars), people there will want to get rid of those dollars. They are likely to go to a bank and exchange those dollars for euros, yen or whatever the local currency is. But the bank doesn’t really want those U.S. dollars either, so it wants to get rid of them as well. One way or another, the price system will ensure that those dollars get back to the United States where they are wanted, instead of staying where they are not wanted except as a way to get euros, yen or whatever the local currency is. The key part of the price system that accomplishes this are exchange rates between different currencies. But the brilliance of Greg’s approach is that one can wait until the very end to figure out what happens to exchange rates. To begin with, all one needs to know is that the exchange rates will do whatever it takes to get U.S. dollars back to the United States (or other places such as Ecuador that use U.S. dollars as the local currency).
The other thing to realize is that exchange rates primarily affect the level of exports and imports–and given a little time, usually quite a bit: more than a 1% change in the quantity of exports or imports for a 1% change in the exchange rate. As a result:
A lower value of the dollar as expressed in foreign currency makes American goods cheaper to foreigners, increasing exports, and makes foreign goods look more expensive to Americans, reducing imports. (Thus, net exports, which equals the value of exports minus the value of imports, definitely increases.)
Why? Let me look at things from the perspective of American, and think of transactions as having dollars on one side or the other of a transaction (with whatever currency exchange necessary to think of things that way rolled into the transaction). From that point of view, exports are an exchange of foreigners’ dollars for some of our goods and services. More exports are a way to get dollars that are in foreigners’ hands back to the United States. And imports can be seen as an exchange of dollars in our hands for foreign-produced goods and services. So fewer imports means less outward flow of dollars. Therefore, a lower value of the dollar shifts the flow of dollars back toward the United States.
A higher value of the dollar as expressed in foreign currency makes American goods more expensive to foreigners, reducing exports, and makes foreign goods look cheaper to Americans, increasing imports. (Thus, net exports, which equals the value of exports minus the value of imports, definitely decreases.)
Since imports send dollars outward, while exports bring them back, a higher value of the dollar shifts the flow of dollars away from the United States.
The bottom line is that, in response to any initial flow of dollars, exchange rates will adjust to modify the levels of exports and imports in a way that will recycle those dollars back to where they came from. The total amount of recycling of dollars is equal to the value of net exports. And the same principle works for any other currency. The flow of U.S. dollars helps us think about the U.S. dollar zone (the U.S. plus Ecuador and few other places), the flow of euros helps us think about the Eurozone, and the flow of yen helps us think about Japan.
The Effects of Exchange Rates on Asset Holding. The reason to emphasize the effect of exchange rates (in this case the dollar in relation to other currencies) on net exports rather than on asset flows is that, as long as I want to start and end in the same currency, the level of exchange rates does not affect my rates of return. For example, suppose that there are 100 yen to the dollar, and the interest rate is 1% per year in Japan. I change a dollar into 100 yen, get 101 yen a year later, then turn those 101 yen into $1.01. The interest rate is still 1%. It is only predictable changes in exchange rates that should affect rates of return. (And the fact that something is a foreign asset, which I am assuming you care about, is pretty much the same regardless of the level of the exchange rate.) What Greg does is to effectively assume that the only predictable exchange rate movements are those associated with the two currency areas at issue having different rates of inflation. That means that there are no predictable movements in real (that is, inflation-adjusted) exchange rates, so that if we think about real interest rates, we don’t need to worry about the effects of exchange rates on rates of return in our home currency. (I should say that advanced international finance models worry a lot about the effects of predictable exchange rate movements on the desire to hold various assets.)
There is one part of the effect of predictable exchange rate movements that we should definitely worry about here. If people can ever predict a sudden movement in exchange rates, they will want to get ahead of that movement by getting into the currency that is going up relative to the other, and out of the one that is going down. That tends to make the sudden movement happen early–that is, as soon as people are confident there will be a sudden movement.
But there is another part of predictable exchange rates that it might be OK for us to ignore for now: small predictable movements. Because unpredictable movements in exchange rates tend to be so large, it is hard for people to be confident about the small predictable movements in exchange rates that might be there. Given the uncertainties, it is easy for people to ignore those small predictable movements even if they should pay attention to them. In any case, as a starting point for a Principles of Macroeconomics level analysis, Greg and I will treat asset transactions as unaffected by exchange rates.
The Principle of Comparative Advantage from the Perspective of International Finance. Suppose that in the future, some other country became better at making everything. Let’s call it Superbia, since they are superb at making everything, and call its currency the superbo. Would we run a trade deficit with Superbia? In order to save the effects of international transactions involving financial assets until later, let’s imagine that Superbia doesn’t allow any international financial transactions except in currency. Also, assume there are no international gifts. And let’s keep things simple by thinking of Superbia as the only other country in the world.
At first, we might imagine that we would be buying just about everything from Superbia, and they would be buying very little from us. But if initially that did happen, the people in Superbia would soon get big piles of dollars that they would be trying to get rid of. They would start getting very reluctant to let go of their superbos (the currency of Superbia) for dollars that they already had way too many of. So the value of dollars relative to superbos would go down, and the value of superbos relative to dollars would go up. That would make all of the wonderfully made Superbian goods look quite expensive. The exchange rate would keep adjusting until the dollars were well recycled.
Knowing that the dollars will get recycled, what can we say about imports and exports? With no international financial transactions and no gifts, basically the only way dollars get from one country to another are in exchange for goods. For dollars to be recycled, the Superbians must be buying things from America as well as Americans buying things from Superbia. Indeed, the value of imports and exports must be equal, which is what we mean when we say that “net exports” are zero. Of the everything that the Superbians make better with the same resources or just as well with fewer resources, Americans will end up buying those things where the Superbian advantage is greatest. But where the Superbian advantage is less, the high price of the superbo in dollars will make the Superbian version look more expensive than the American version of the good, so it will be exported from America to Superbia.
International Asset Purchases and Sales Drive Net Exports. Now let’s add in asset purchases and sales. Suppose, for example, that my readers in the United States (but not elsewhere) really took to heart the arguments I give for international diversification in my post “Why My Retirement Savings Accounts are Currently 100% in the Stock Market.” So American purchases of foreign stock increase. Initially, this puts a lot of dollars in the hands of foreigners. Those dollars are a hot potato. And no one outside the United States has been convinced by my arguments to change the amount of U.S. assets they have. So they don’t want to get rid of those dollars by buying and holding U.S. assets for any substantial period. Those unwanted dollars then kick around in the rest of the world until the price of dollars in terms of other currencies goes down. That makes American goods cheaper to the rest of the world, increasing our exports, and makes foreign goods more expensive to the rest of the world, reducing our imports, as discussed above, and eventually the dollars make their way back home.
Notice that the shift in Americans’ portfolio choices toward holding foreign assets ends up raising net exports from America. And we can figure out how much, without knowing the details of how much the dollar goes down! The increase in net exports must be exactly equal to the value of the foreign asset purchases American’s made. If they shifted $100 billion into foreign assets, it will result in $100 billion worth of extra exports as compared to imports from America.
An Easy Policy to Restore America’s Industrial Heartland (Including Key Swing States). It is not likely that many people will actually be persuaded by my portfolio advice, so let’s think of a policy that really would increase the amount of foreign assets that Americans buy and so increase our exports and reduce our imports. David Laibson and his coauthors have found that in retirement accounts, people often stay with the default contribution level and allocation to different assets, even if they are allowed to change the contribution level and allocations of contributions to different assets by going through a little paperwork. There are at least two reasons for this. One is that people are sometimes a little lazy–or to be more charitable, perhaps scared of financial decisions. That makes them want to do nothing. The other reason people often stick with the default settings for their retirement accounts is that they think (unfortunately wrongly for the most part right now), that their company, or maybe the government has carefully thought through how much they should be putting aside and what they should be financially investing it in.
So imagine that the government establishes a regulation that employers all need to have a retirement saving account and have a relatively high default contribution level. The employers are not required to match it. And employees can get out of making any contributions just by doing a little paperwork. But many, many employees won’t change the default contribution. So this simple regulation could dramatically raise the household saving rate in America. Assuming the government keeps its budget deficits on the same path as it otherwise would, that would also raise the national saving rate. A higher national saving rate would make loanable funds more plentiful at any real interest rate, making a surplus of loanable funds at a high real interest rate and so drive down the real interest rate. With real interest rates low in the United States, Americans would start thinking of buying more foreign assets that earn higher interest rates, and foreigners would be less likely to buy low-interest-rate American assets. (How much people want foreign assets is only somewhat independent of rates of return, not totally independent. A big enough interest rate differential will lead people in both countries to shift.) With Americans buying more foreign assets and foreigners buying fewer American assets, the flow of dollars has shifted outwards. Something has to happen to recycle those dollars. That something is a change in the exchange rate that increases net exports. And it has to increase net exports by the same amount as the change in the flow of dollars for asset purchases.
Indeed, following the tradition of calling the flow of dollars for intentional asset purchases net capital outflow, we can say that net exports would have to equal net capital outflow. More precisely, the net flow of dollars for anything other than buying goods and services has to be exactly balanced by a countervailing net flow of dollars that is about buying goods and services. And except for short periods of time, the net flow of dollars for purposes other than buying goods and services has to be intentional; it won’t take long before unintentional movements get undone by recycling.
Now suppose that the government wants to increase net exports even more than was accomplished by mandating that all employers provide retirement savings accounts and setting a high default contribution level for retirement savings accounts. The government could simply add the regulation that the default asset allocation would be, say, 40% in foreign assets. That would dramatically increase the buying of foreign assets relative to what would be likely to happen otherwise (at least in the United States with current attitudes toward foreign assets). That would further increase net financial capital outflow from the United States, and lead to exchange rate adjustments that would further raise net exports to recycle those dollars back to the United States.
China’s “Currency Manipulation.” China has been accused of “currency manipulation,” meaning doing something unusual to affect its exchange rate. But in Greg Mankiw’s approach, we don’t need to think much about the exchange rate at all. We can just track the flow of dollars. The bottom line is that China is buying a lot of American assets, which accounts for a big chunk of their trade surplus and a big chunk of our trade deficit. But let me tell the story starting at a little different place. Let’s start with Americans buying a lot of Chinese goods that come over on container ships. Normally, the dollars we sent to China would get recycled by the Chinese buying a lot of foreign goods. Then one way or another, exchange rates would adjust so that Americans were exporting enough more and importing enough less to counteract the initial increase in buying of Chinese goods. But in China’s case, the government intercepts those dollars before they make it back to the United States. The Chinese government gives the Chinese exporters the Chinese currency for those dollars. Then the Chinese government takes those dollars and buys foreign assets with them–including a large amount of U.S. Treasury bills. That gets the dollars back to the United States without the Chinese buying very many American goods, or buying very many goods from other countries who then buy American goods.
At the end of the day, we get a lot of Chinese goods that come over in container ships, and they get a large pile of IOU’s such as U.S. Treasury bills. There is something odd about this. An argument can be made that this hurts the Chinese much more than it hurts us Americans, and probably even helps us, but the effects are actually quite complex because they affect different groups within each country differently. In China, the political elites are often closely connected to exporters, and may even have a strong financial interest in exporters, so they may want to help their exporters even if it hurts China overall. And the part of the U.S. trade deficit caused by large Chinese purchases of American assets hurts many American businesses (both exporters and those who compete with imports) even while it helps American consumers.
For now, though, I want to emphasize the economics without getting too much into policy evaluation. I want to emphasize that if the Chinese buy a lot of foreign assets, they will run a trade surplus, and we can say that in a quantitative way without even knowing the details of what will happen to the exchange rates. For example, if the Chinese buy an extra $1 trillion worth of foreign assets, it will result in an extra cumulative trade surplus of $1 trillion. Sometimes people say that something like that can’t go on forever. But if the Chinese government had an unlimited willingness to accumulate foreign assets, there is nothing to stop it from going on a long, long time. At some point, the pile of foreign assets will get so big, that I doubt the Chinese would actually succeed in trying to collect on all of those assets. But if they are willing to risk not getting their money back, they can keep on accumulating.
