The Unsustainability of Trade Deficits

I’ll be talking on this topic to the Economic Society of Australia (Queensland branch) on Thursday night at the Exhange Hotel, a well-known Brisbane cultural centre. I’m preparing a presentation and I found this graph of the US trade balance at the St Louis Fed

Bopbgs Max

The graph is in billions of dollars per quarter, unadjusted for inflation, so the pattern is exaggerated. Still it’s a good illustration of how the recent massive deficits are historically unprecedented, something which is true even when the more appropriate measure of percent of national income is used.

Australia’s experience is less dramatic, but we are, nonetheless hitting new records in terms of deficits and debts.

fn1. No animals were harmed in the preparation of this talk.

101 thoughts on “The Unsustainability of Trade Deficits

  1. >Still no information on why Trade deficits are Unsustainable for either the US or Australia. Maybe they are sustainable (well, they have been so far).

    Certainly current account deficits of, say, 2-3% of GDP are sustainable and have been sustained by Australia, and other coutnries, for extended periods.

    However this does not prove that any level of deficit is automatically sustainable.

    As I noted early in this disucssion. You can only consistently import more than you export if you borrow or if you sell assets. IN both cases, the higher the percentage of GDP you need to cover the more you need ot borrow or the more assets you need to sell.

    You can’t borrow an ever-increaing percentage of your GDP without incurring debt servicing costs which become crippling and you can only sell assets at a rate slower than the formation of new assets or you’ll eventually run out.

  2. Standard Deviant,

    Thanks for a thoughtful response.

    An easy way to visualise how the RBA could maintain a tight grip on the gold price without trading gold might be illustrated thus.

    Lets say the RBA trades in US dollars. Hence it can very accurately target any particular US dollar exchange rate that it desires so long as it does not try and mix objectives. Lets say then that its target for the US dollar exchange rate is defined as:-

    USD / AUD = K x (USD / GG)

    Where K is some constant and GG is a gram of gold.

    By using this dynamic target for the US$ exchange rate the arbitrage of third parties ensures that AUD / GG will remain very close to constant.

    I find the prospect of a significant lag unlikely given that it would leave profit on the table for those that arbitrage in currency.

    OMO does not ensure that the RBA always hits its interest rate target. In practice there is a tiny amount of jitter. And a gold price target is no different. However I see a 4% price band as being very achievable at least in a technical sence.

    I would agree that being on a gold standard and refusing to own or trade gold is a very contrived notion. However I merely use this notion to show that gold reserves are not an essential precondition for a gold standard.


    P.S. Likewise a central bank could target a commodity price index without owning any of the commodities.

  3. Razor says: “Still no information on why Trade deficits are Unsustainable for either the US or Australia. Maybe they are sustainable (well, they have been so far).”

    It seems to me the answer hinges upon the enforceability of ownership rights of incorporated assets owned in foreign countries, the ownership of transportation technology, the composition of assets owned in foreign countries in terms of commodities (natural resources and produced) relative to those demanded in the ‘home country’ and feasibility of transportation in relation to environmental pollution. I am assuming those who draft national and international laws aren’t getting themselves entangled in contradictions. Convertibility of currencies would not constitute a limiting factor.

    I am not suggesting this is how it’ll pan out – at least not in my lifetime. I am not suggesting this is how the world should look like. I am saying these would be sufficient conditions for a country to export {0} and, in the limit, import all transportable commodities (in the sense of Arrow-Debreu) sold in the same country.

    I am not sure whether I would call such a ‘global economy’ a ‘non-dictatorial one’ because it relies on a theoretical model of a ‘competitive private ownership economy with partially segmented markets and multinational firms’ and the welfare properties of the solution of this model are not quite the same as that of the Arrow-Debreu model (Gross, 1988).

    The move from a central wage fixing system toward Enterprise Agreements is a move consistent with the model of partially segmented markets and multinational firms’. But no prediction follows because this move is also consistent with a misunderstanding of the role of prices in coordinating decentralised decisions.

  4. QUTOE:But no prediction follows because this move is also consistent with a misunderstanding of the role of prices in coordinating decentralised decisions.

    RESPONSE: Can you expand on this point. It sounds interesting but I don’t really understand it.

  5. Terje,

    I continue to rely on you being interested in convergence in conversations – I don’t want to have another AVAROO media management experience.

    Which bit do you wish me to expand on?

  6. Convergence is good. Lets work on it.

    What do you regard as the role of prices in coordinating decentralised decisions? I have always seen price as a form of communication. It is a summation statement made by one party to another about costs, willingness and alternatives.

  7. “What do you regard as the role of prices in coordinating decentralised decisions? I have always seen price as a form of communication. It is a summation statement made by one party to another about costs, willingness and alternatives.”

    The role of prices in coordinating decentralised decisions is to convey the relative value (in exchange) of commodities (in the sense of Arrow-Debreu) and securities (in the sense of Radner) to all member of an economy.

    A feel for the absence of the coordinating role of open markets might be obtained if one imagines an open market (stock exchange) for shares would not exist and all trades (primary and secondary) would have to be done via over-the-counter markets. This might also help to see the limitations of Enterprise Agreements.

  8. Terje,

    Quote: “Lets say the RBA trades in US dollars.�

    Well, I did qualify my initial remarks with “or at least [trading] in some foreign currency�. I do imagine that trading in US dollars would be much more effective than trading Australian government securities (which you have suggested would be adequate, unless you were referring only to foreign government bonds), for instance. I’m not sure how using only US dollars would compare to trading gold directly, but I’ll concede that it’s probably good enough. You can’t trade Australian government securities directly for gold (not in a liquid market with prices easily observable to the RBA, anyway), as you can with US dollars. In fact, you would probably have to go back via Australian dollars, which means you’re trading in the same market the RBA would be trading in. This complicates things, and is why I think standard open market operations would not have too precise an effect on the gold price.

    Quote: “I find the prospect of a significant lag unlikely given that it would leave profit on the table for those that arbitrage in currency.�

    I’m not sure if you’re referring here only to simple cross rate arbitrage, or also to “arbitrage� based on expectation that the RBA will make the gold price return to its target value. With respect to the latter, there is only an arbitrage opportunity if it is certain that the RBA will maintain its peg, which presumably precludes a speculative attack. With respect to the former (which I think is what you meant), as I have argued above, this would probably not work very well when the central bank trades in government bonds. I would not generally take “standard open market operations� to include changes in holdings of foreign reserves.

  9. Standard,

    Even with government bonds I doubt that the RBA would have any trouble meeting its target. Although as you point out the trassmission factors are not as direct.

    I was refering to cross rate arbitrage in the example of trading in US dollars. However in a pure bond trading OMO setup then “arbitrage� based on expectation would no doubt be significant in short circuiting any lags. Not that I think such lags would be significantly large.

    In the case of OMO targeting interest rates I would guess that “arbitrage� based on expectation is also significant.

    If I loosened my original assertion and said that a central bank only needs a small proportion of OMO trades to be directly in gold (to smooth lags) then would you accept that the bulk of the OMO trades could be in government securities.

    And of course if a government was commited to a gold standard then it might deepen that commitment by denominating its bonds in physical gold weights such that a direct cross market between bonds and gold did emerge.

    In Australias case given the recent reduction in government debt I would expect that if the RBA went onto a gold standard it would want to trade in gold and currencies. I suspect that if the Australian dollar was on a gold standard there would be strong demand for the currency anyway and we would need to expand the base money supply to accomodate foreigners who want to hold a gold standard currency. What the RBA buys as it expands the money supply would not be insignificant.


  10. Ernestine,

    Can you illuminate me with the difference between an “open market” and an “over-the-counter market”.


  11. Terje,

    In an open market, goods are effectively auctioned to all comers with everyone having access to bid and offer prices.

    In an over-the-counter market, one or mroe brokers/market-makers quote buy and sell prices for goods.

  12. Terje,

    On the issue of the inflexibility and fragility of foreign exchange fixed to any standard, may I recommend Andrew Boyle, “Montagu Norman. A Biography,” Weybright and Talley, New York, 1967.

    Boyle’s argument is that a successful fixed exchange rate regime required more than competence; it required good will between the central bankers of the leading financial powers. Mutual suspicion was the inevitable consequence of central bankers who were required to promote divergent and ultimately contradictory priorities.

    Thus, [in 1927] Emile Moreau, Governor of the Bank of France, recognised that Norman, Governor of the Bank of England, had pegged the pound too high against gold:

    “By going daily into the market and purchasing with francs large amounts of foreing currencies [Moreau was able to secure a vice-like grip on the London money market]. The tenacious Frenchman had now got his hands on big sterling balances. If he sent further and converted these into gold, he could squeeze British credit, upset Norman’s wider plans and gradually deplete the Bank of England’s gold reserves. ‘This was a situation,’ as Benjamin Strong’s [Chairman of the US Federal Reserve] biographer aptly comments, ‘calling for mutual understanding andclose co-operation. But relations between Norman and Moreau were … strained …'” (pp. 226 -7)

    Boyle concludes:

    “[Strong and Moreau] so abused the inordinately great power that was temorarily theirs, converting their respective prejudices and weaknesses into principles of action and thus opening a fresh chapter of mistrust, that when Britain was confronted with financial ruin in 1931 the continued intransigence of the Bank of France helped to precipitate the collapse of the gold standard.” (p. 238)

    Thus reasonable selfishness and unreasoning prejudice were combined in a witches brew that helped embroil the world in utter financial and economic chaos.

    Today, Alan Greenspan is often called the most powerful man in the world. Yet he has only a tiny proportion of the power of central bankers who had access to the financial levers provided to them by the gold standard.

    It seems to be quite rash to set up a system that gives a small number of individuals more power than Alan Greenspan.

  13. Katz,

    I accept that when Sterling was returned to the gold standard in 1925 with a deflationary stance then this of course put pressure on debtors and created a benefit for creditors. In essence sterling debts were going up in value with a net transfer of wealth from debtors to creditors.

    I can’t see any logic in the story of Moreau. I think it likely that he is merely a scapegoat for the deflation created by Churchill.

    When Churchill decided that the target price for gold would be the same as the pre WWI target then he ensured two things.

    1. The central bank would loose collateral (ie gold reserves) in the process of draining Sterling liquidity from the markets in its efforts to hit Churchills target. This is a basic reality of open market operations. If you want your currency to appreciate you must sell collateral.

    2. The sterling zone (which included Australia and most of the commonwealth) would suffer deflation.

    All of this was a logical consequence of Churchills decision. Blaming other market participants is futile because the facts of the matter could have been predicted ahead of time and in fact where by many of Churchills critics.


  14. The point is that in 1927 the problem with the gold standard was not its existance but the choice of entry that Churchill chose in 1925. His choice played a significant part in creating the great depression. Although the advent of American protectionism and the European backlash was also crucial.

    All this could have been avoided if:-

    a) Britian did not leave the gold standard during WWI.
    b) Churchill in 1925 did not try to re-enter the gold standard at the pre-WWI price.

    Using this piece of history to judge the gold standard is a little like saying that “inflation targeting” would be awful if the central bank put interest rates up to 30% tommorow just on a whim.

  15. “Using this piece of history to judge the gold standard is a little like saying that “inflation targetingâ€? would be awful if the central bank put interest rates up to 30% tommorow just on a whim.”

    Not correct Terje. These circumstances are different in kind and are therefore not analogous.

    The decision of a Central Bank unilaterally to raise domestic interest rates has a direct effect only domestically. (I recognise that raising interest rates, especially to the ridiculous extent that you use as an example (30%) would have the effect of attracting capital inflows.) But this would happen at the cost of locking the wheels of the domestic financial and credit systems. Greenspan, for example, could do this tomorrow. But by the next meeting of the Fed Board he’d be gone. And in the meantime, private currency speculators and hedgers would remake the market in US$ in the light of this bombshell news. Spot dollar and dollar future markets would whipsaw around as a consensus is forged about the (bleak) future of the US dollar.

    Moreau’s manoeuvres and manipulation of the exchange in 1927, on the other hand, involved direct intervention into the supply of sterling and potentially gold in British credit markets. A Central Banker could, and did, exploit the commitment of the Central Banker of another country to keep the value of sterling steady against gold. This kind of manipulation is possible regardless of at what level the currency ispegged against gold.

    Moreau’s manipulation was possible *because* Norman was commited to keeping the value of sterling steady against gold.

    In other words, the Central Banks were the risk-takers in this transaction, rather than allowing distibution of risk by means of floating exchange rates and a liquid fx market.

  16. Katz,
    All I think he was saying was that to judge the gold standard by one stupid action would be like to judge inflation targetting by a different stupid action and not trying to look too deeply into it from there.

  17. Andrew is spot on.

    The errant thinking so often evident in modern monetary policy discussions is the notion that our currency has two unrelated values. One is the domestic value (measured in baked beans) and the other is the international value (measured by foreign currencies).

    The fact that we can devalue our currency on international markets and see no domestic consumer price movement is taken as proof of the concept. However this ignores the institutional nature of consumer prices, wages, office leases etc. Such an inflation immediately sets of a chain of events within the domestic economy even if it does not get reflected in consumer goods for months or years. It is however reflected in domestic spot markets. The domestic price of gold will change as rapidly as the exchange rate with US dollars or Pesos. The stock market will also respond rapidly.

    A monetary policy decision to target a 30% interest rate would be highly deflationary. Anybody holding Australian currency could anticipate a significant capital gain (barring a change of policy). This would cause others to pile in buying the aussie dollar. To suggest that the effect would be domestic only is simply wrong. People piled in buying YEN all through the 1990s precisely because errant monetary policy had put the YEN in a deflationary cycle.

    You recount that in 1927 Britian was losing gold reserves. Blaming this on the French (or else giving the French credit for causing this) is not credible. This was something that was simply going to happen regardless the minute that Churchill choose the gold price fix that he did. It was inevitable.

    The British hate the French so the story is not surprising. It is also consistent with the host of stories that get told about monetary errors. For instance when Nixon stuffed up US monetary policy in the 1970s they blamed the Arabs for causing US inflation. In Ghana where inflation is in double digits today it is common for people to blame foreigners for putting up the price of imports. In the 1970s in Australia lots of people routinely blamed the unions for causing inflation, while lots of other people routinely blamed retailers.

    What gets missed is that the players in a wage price spiral (upward or downward, inflation or deflation) are reacting to forces bigger than themselves. They may be easy targets for blame but they are not the source. Likewise blaming the French may have let the British wash their hands of guilt or responsibility for their situation but it does not change the fact that it was Churchills fault.

    You suggest that if Greenspan put interest rates at 30% he would be gone tomorrow. Perhaps. Paul Keating survived the recession we had to have even if only for the short term. A flawed gold standard such as Churchills effort also unleashed strong political forces. In fact consequences and pain was such that within less than a decade the political forces were busy dismantling the gold standard and large slabs of the neoclassical system. And not long after than the world was engaged in the bost bloody war in all history. Had it not been for a certain toughness of character during the military hardship Churchill may be remembered somewhat less favourable.

  18. AR, I understood what Terje was arguing.

    I disagree with your premise about Moreau’s act being “stupid”.

    Moreau’s actions in 1927 were not “stupid”. They were very much in France’s national interest. Poincare, the French PM and the bulk of the French political nation applauded his actions.

    Under the hypothetical jointly constructed by terje and myself, on the other hand, Greenspan’s action in raising interest rates on a whim to 30% would be seen by all sane people as “stupid”.

    Thus, to restate the concept enunciated in my post above, the Gold Standard (or for that matter any fixed exchange rate system) encourages “cheating” of the kind exemplified by Moreau in 1927. Moreau wasn’t being “stupid” he was being tough and smart.

    Interestingly, the French threatened to do the same thing to US gold reserves in 1968 as they threatened against the British in 1927 when the French National Bank started to worry about rapidly growing deposits of US$ fuelled by US consumer expenditure and the financial demands of the Vietnam War. Again, the French were being smart and tough.

    And it worked.

    This crisis set the stage for the end of the Bretton Woods system some years later.

    So we can thank the French to some extent for our free floating exchange rate environment.

  19. “You suggest that if Greenspan put interest rates at 30% he would be gone tomorrow. Perhaps. Paul Keating survived the recession we had to have even if only for the short term.”

    The comparison between Alan Greensspan and Paul Keating is not useful.

    Alan Greenspan holds his chairmanship of the Federal Reserve Board at the pleasure of the President of the US and subject to the confidence of the members of the Board.

    The Federal Reserve Board is composed of members appointed for terms of 14 years. Board members are in theory above politics. But they are political appointees nominated by the President and ratified by the Senate. The political cycle being what it is, it is highly likely that a range of views will be represented on the Federal Reserve Board.

    According to Bob Woodward, “Maestro. Greenspan’s Fed and the American Boom”, Paul Volcker, Greenspan’s predecessor, lost the confidence of his own Board.

    In 1986 the Reagan administration wanted a cut in official interest rates. Volcker disagreed. A Reagan appointee, Manuel H. Johnson Jr., informed Volcker that he demanded a vote on the question.

    Volcker lost the vote.

    “‘Good-bye,” [Volcker] announced to the Board after the vote was taken. “You’re going to havve to do it on your own.” He got up and walked out, slamming the door. Hard.” (p. 18.)

    Of course Volcker could have stayed on. But pride and ego, and no doubt a sizeable family trust account, argued against it.

    Paul Keating, and any other popularly elected prime minister, on the other hand, lead for the duration of their elected term. When that term comes to an end, or the PM prematurely ends it to go to the people on what s/he believes to be the propitious time, s/he appeals to the people on a wide range of issues.

    If the people vote against a PM (i.e., the PM fails to construct a working majority in Parliament), s/he necessarily is stripped of authority.

    Thus, the Chairman of the Fed and a popularly elected PM hold authority on two entirely different bases. Therefore there are few useful grounds for comparison of the means by which they may have that authority removed.

  20. Ernestine

    A belated and very brief respone to your detailed reply to me, for which I’m grateful.

    Friedman’s legacy is mixed as far as useful advice is concerned. The emphasis on the money supply and monetary targetting was unhelpful, and has long been repudiated by orthodox macroeconomics. On the other hand, his contribution coincided with a revolution in thinking about expectations, central bank credibility and so on, which seems to have contributed to the current era of price stability. And of course Hahn was right that no one ever ‘ground out’ a natural rate of unemployment from a Walrasian system, but I think the concept at least drew attention to the limits of demand management as a cure for unemployment, and the inflationary risks associated with exclusive reliance on it.

    I don’t know if I dare cross swords with you on the topic of GE, but for what it’s worth, my feeling about Walras’ contribution was that he solved a particular formal problem in the theory of value, and that’s about all. He found a way to reconcile cost- and utility-based explantions of price, by showing that you can tell a coherent story in which everything depends on everything else. But I don’t see that this formal solution took us far beyond Adam Smith in terms of our understanding of the day-to-day workings of markets. I defy you to read, say, a typical Industrial Organisations textbook, and not conclude that Smith would find it more interesting than Arrow and Debreu. Though it’s obvious that the participants are having plenty of fun, I just don’t see that the GE research project has yielded much by way of testable hypotheses or policy implications.

  21. * Thus, the Chairman of the Fed and a popularly elected PM hold authority on two entirely different bases. Therefore there are few useful grounds for comparison of the means by which they may have that authority removed.

    I agree. However there are few other comparable precidents for the example we are discussion.

    In any case it does not change my position that the loss of gold reserves (and national pride) suffered by Britian in 1927 was as a direct result of Churchills 1925 decision to overvalue Sterling relative to gold.

  22. James,

    Thank you for giving your assessment of the usefulness and influence of Friedman’s advice in the area of monetary policy. I am aware of ‘schools of thought’ and associated debates between and among members of ‘schools of thought’ and I accept your opinion on Friedman’s influence on the thinking of schools of thought. Using the broad brush we are using, I would agree with your summary of Walras’ work. So we seem to differ in the information we share on the Arrow-Debreu model and all subsequent theoretical models since the 1950s.

    You ask me to read a typical Industrial Organisation textbook and to reach a conclusion on whether or not Adam Smith (1776) would find it [the Industrial Organisation textbook] more interesting than Arrow-Debreu. Furthermore, depending on my conclusion, you would defy me or not. If I would be silly enough to engage in such an exercise, I would be putting words into Adam Smith’s mouth – more than 200 years after his death! What would be the purpose? Debreu’s (1959) book states right at the beginning that the area of Industrial Organisation is not treated. Typical Industrial Organisation books, (eg Tirole, 1988), state right at the beginning that its content [applications of game theory to analyse the interaction of a ‘small’ number of decision makers, each one them being self-interested and aware that the outcome of its decision depends on the decisions of the others] is not suitable for welfare questions [for ‘the economy as a whole’ – as distinct from ‘the economy as a hole’; ie where the individual decision makers aren’t considered at all] and it refers to general equilibrium theory for the latter. The methodology of general equilibrium theory is the same as that of game theory (and the theory of the core and dynamic agent models). There is no ‘competition of schools of thought’ involved; no crusaders and persuaders. This methodology was not available in 1776 – how on earth would anybody know what Adam Smith, who wrote in 1776, would think of it?

    You talk about the “current era of price stabilityâ€?. I don’t understand. It does not seem to match observables. A huge industry (finance) thrives on price instability. Between Friedman’s time of influence and now there were ‘stock exchange crashes’ (1987) in the ‘western world’. There was another series of such discontinuities in share prices and relative currency prices that affected South East Asia in the 1990s, and Argentina, among others, defaulted between Friedman and now. Again, I am using a broad brush to pick out the ‘big’ items from the ‘real world of how markets work’ that seem to contradict your statement.

    Given the above mentioned information asymmetry and the different methodologies, it seems to me a bit too much to expect to get agreement on the usefulness of the GE (and GT) research programs. As for your impression that participants in the GE research program are having plenty of fun – maybe you are right; I don’t know. On a lighter note (it is Saturday after all) would you give me a pass for my answer to ‘Smith in relation to IO’?

  23. Terje,

    Quote: “If I loosened my original assertion and said that a central bank only needs a small proportion of OMO trades to be directly in gold (to smooth lags) then would you accept that the bulk of the OMO trades could be in government securities.�

    Trading in government securities could certainly reduce, up to a point, the gross amount of gold trading needed to be done. Over a long enough time horizon it could probably reduce the required net trade of gold to zero. So I would not really disagree with your statement. However, I wouldn’t really know what proportion of trading would still have to be done in gold to maintain a peg within a given band, and it would depend on many variable factors (including market expectations) anyway. So I can’t categorically agree with your statement either.

  24. Standard Deviant.

    In any case there is no law against central banks buying and selling gold. My original point was merely that it is not overly necessary for the purposes of maintaining a gold standard.


  25. Terje,

    Re: Gold standard.

    I’ve been following more or less consistently your posts on the gold standard. Perhaps it is helpful to distinguish between the gold standard, as an international monetary system, and historical records on the empirical details of its implementation and practice. Sometimes historical detail can make it quite difficult to see the underlying logic of the system.

    There is a book by Krugman and Obstfield on international economics, which is quite detailed on ‘the mechanism’; that is the rules of the game, which make up the international monetary system, known as the gold standard. For example, one rule was that national ‘monetary authorities’ had to settle net balance of payments positions in gold. The gold points (see earlier post) are of interest to arbitrageurs (approximately risk free arbitrage). The book by Krugman and Obstfield should be in all University libraries. There are various editions. Amazon may offer it.

    It seems to me your usage of the term gold standard is not consistent with its originl meaning.

    My message is not to be understood as me being in any way in support of the gold standard. It is simply meant to clarify the term ‘gold standard’.

  26. I have read enough Krugman articles on the topic to be inclined towards “no thankyou”. I find his analysis of the gold standard (and most things) to always be overly selective and biased.

    There have been various versions of a gold standard. The only rule that I think defines a gold standard is a monetary rule that ensures a near fixed price of gold. That is not to say that the underlying mechanisms are not interesting or relevant.

    A gold standard is not without faults. And elsewhere I have argued with gold bugs about the faults surrounding the historical institutions and rules associated with the gold standard. I am happy to acknowledge the weaknesses of various systems. However like democracy a gold standard is generally better than all the alternatives that have been tried.

    Which monetary system do you think is superior to a gold standard? And by what measure do you find the results superior?

    P.S. I am still inclined towards tracking down the earlier book that you recommended (when time in the vicinity of a library permits).

  27. Terje,

    When you say “monetary system” in your last post, do you mean:

    1. The bases upon which central banks and currency issuing authorities vouchsafe the value of the currency they issue


    2. The bases upon which the changing relative purchasing power of different currencies is controlled/negotiated


    3. Something else


    4. Some aspects of the above


    5. All of the above.

    Was there a period when foreign exchange transactions worked satisfactorily?

    If so, what forces militiated against the persistence of this system?

    Can you explain how the defenders of this system failed to protect it from the actions of those who had no desire to protect it?

  28. Ernestine,

    Of course not. However in my experience having read several Krugman articles, having followed several Krugman debates and having skimmed his website previously I find that he often asks me to believe that 2+2 is only sometimes four. He tends to start his analysis of issues with a set of a-priori assumptions that I simply don’t share.

    If you wish to quote Krugman then I will happily play the ball. However I am not likely to put his book at the top of my list of things to read. I know he is a pin up boy for the Keynesians but I don’t share their enthusiasm.


  29. QUOTE KATZ: When you say “monetary systemâ€? in your last post, do you mean…

    RESPONSE: I was being open ended. I was asking Ernestine to name an alternative to the gold standard and to define why he found it superior. It may be that he finds all monetary systems (as he chooses to define monetary systems) to be equally flawed. He has stated previously that he has a hunch as to which might be better but to date he has been pretty tight lipped about which alternative he prefers. I am just interested in which he prefers and the reasons why.

    Can Katz tell me which system he prefers and why?

    My definition of monetary system would be any set of rules that defines the managment objectives and processes used by a central bank (or some such government body) to regulate the distribution of additional national currency and/or the reduction of national currency in circulation.

    In other words a monetary system is any system of rules that encodes the circumstances and means for changes to M0.

  30. Terje, I have no objection to your “M0” definition of currency. Domestic currency issuing authorities all over the world issue currency according to financial and prudential criteria. In some places this is corrupt and/or imprudent. I guess I ould point to Zimbabwe as an example. Such corruption or imprudence is almost always a sign of deeper-seated crisis. I’m aware of no country that links its M0 to gold or any other stoe of value. (I may be wrong and would be happy to be corrected). In other words, domestically, as ar as I know, all currencies are fiat currencies.

    Thus, in terms of domestic currency creation, there seems to be nothing to prefer. The world has voted with its feet.

    More interesting and more important are the mechanisms that determine the relative value of all of these fiat currencies.

    As I write there are thousands of fx dealers hedging and speculating in trillions of dollars negotiating the exchange rates of all of these currencies. This is a zero sum game. For every winner in a transaction there is a loser. Governments and Central banks are also involved in this game. I recall that a year ago the RBA announced an annual $200m profit from open market transactions. Good luck to them, but they may have lost too. However, the value of the $A is negotiated with or without the intervention of the RBA or any other Australian government body.

    These hedgers and speculators pay greater or less attention to the conditions of the country issuing currency. Knowledge is often rewarded. Ignorance is often punished. But not always. Whatever, the $A is assigned a value based on the perceived self-interest of all these speculators and hedgers, and not according to the determination of our government andd central bank to spend the nation’s tax revenues to defend a certain value.

    This system distributes power, it uses greed and fear to maintain relative stability. It does not demand active intervention by national politicians who are driven by a set of non-financial imperatives.

    It isn’t perfect, but it is predictable. And it imposes discipline on national currency and credit-creation agencies.

    This is the system I prefer.

  31. Katz,

    You seem to be saying that the absents of a gold standard is a system. This seems somewhat naive.

    M0 is the amount of national currency in circulation. It includes coins and notes but not bank deposits etc.

    M0 is currently regulated in Australia with the objective of meeting short term interest rate targets and longer term CPI targets.

    For historical data on M0 the following is useful:-

    It shows for instance that in September 2000 there was A$25.6 billion worth of our aussie fiat currency in circulation. However 5 years later in September 2005 this figure had been increased to A$34.0 billion.

    In other words in five years the amount of currency in existance was 33% higher (ie 6% more per annum). Or to put it another way the reserve bank had during this period printed A$8.4 billion in new currency and spent it.

    Hopefully you know all this.

    You seem to be saying that the correct policy dictating how they grow or shrink M0 is to just print as much new currency as they please as long as its consistent with not being like Zimbabwe and consisten with ensuring that the currency does not maintain any form of parity with gold.

    In essence what you advocate is a non-system. You think that there should be no significant restraint on the printing presses other than at the absolute extremity.

    Now why do you think such an approach would be superior in it’s outcome?


  32. Terje, I didn’t know the figures, but they don’t surprise me.

    Presumably, the folks who map out strategies for dealing the $A in fx markets are much more aware of these figures than I am. And the enormous weight of money they handle are exhanged with tose underying realities in mind.

    And look at what has happened to the value of the $A in the same time frame.

    The $A has appreciated significantly in value against most major currencies.

    In other words, this weight of money is happy with the numbers you quote.

    Now consider what might happen if these same dealers learned that Australian public institutions were commited to protecting the value of the $A against any other store of value, including gold. Very quickly the latterday Geore Soroses of this world would devise strategies to take advantage of this determination and take those public institutions, and Australian taxpayers, down.

    Now I’d be interested in your answers to the questions I posed further up.

  33. Terje,

    Paul Krugman is, IMHO, not a member of the set of ‘crusaders and persuaders’ who produce rhetoric suitable for ‘quoting’.

    Paul Krugman’s academic background is in analytical economics. It is the antithesis of rhetoric.

    You mentioned on a previous post that your background is in engineering (electrical?). Would it make sense to engineers to try to work out something by means of quoting rhetoric?

    Please do give me a list, if it exists, of all electrical egineers who are in the ‘quoting of rhetoric business’ for I surely would like to avoid them. The same applies for civil engineers (and I, like many others, apply it also to Economics).

    For all I know some people may have a picture of Krugman on the wall next to a picture of Picasso and a picture of Einstein. Who cares.

  34. Katz Says: November 25th, 2005 at 12:28 pm : “Of course traffic signals are reasonable, given the unreasonable nature of our species. The red lights you mention could exist and work without any rules being enunciated. Reasonable people could arrive at appropriate behaviour in regard to the operation of these signals without ever being informed of any rules. This is how people learned their native language for millennia before the invention of formal laws of grammar.”

    I read your qualification re policy. But policy is not the issue.

    I accept that local conventions can emerge and native language may be an example. I take this as given for the purpose of the following. However, I am not convinced that your analogy with the development of languages answers my point that traffic lights provide an efficient way of communicating traffic rules to road users. I am sceptical because:

    Even if people would be ‘reasonable’ enough to think through a coherent set of rules, there are multiple possible coherent sets of rules (eg drive on the left hand or on the right hand side, etc, etc). Suppose the degree of ‘reasonableness’ (computational abilities) is such that each person works out all possible coherent sets of rules. It still would not solve the problem because each person would not know which of the possibly many alternative coherent sets of rules would be used by any one of the other members in society (‘equilibrium selection problem’) and each person would not know whether each of the other members of society has worked out all possible coherent sets of rules (absence of common knowledge). Enter your analogy with learning a language. O.k. suppose this is an example of the emergence of conventions (unwritten rules). But it is not convincing for the traffic light rule. While it may be the case that historically the introduction of traffic rules evolved with the increasing number of people and vehicles of one sort or another, there is another problem, namely not all conceivable coherent sets of traffic rules are equally ‘efficient’. One of the possible sets of coherent rules is ‘opportunities to move approximately in the direction you want to go at whatever speed is possible, given the opportunities that are taken up by all other traffic participants to move approximately in the direction they want to go’ – something close to this seems to have been (or still is) operating in New Delhi. It works, true, but it is inefficient in terms of traffic volume. India has many developed languages and, I understand, European languages have borrowed from one or several Indian languages. The population of the proverbial New Delhi has solved an equilibrium selection problem for traffic rules but has not selected any one of a number of relatively more efficient coherent sets of rules. (I am saying ‘proverbial New Delhi’ because my information on the traffic conditions in this city might be very much out of date.)

    I would say that traffic signals are a reasonable solution to a social equilibrium selection problem in a society where its members want to have a road traffic communication system that is efficient with respect to a set of criteria. (I won’t go through an analogous argument in a dynamic context – takes too much time and space).

    What do you mean by ‘reasonable’?

  35. Katz,

    It is true that the value of the aussie dollar has not be adversely effected as M0 has grown over the last 5 years (at least not as adverserly as in earlier periods). No doubt the demand for aussie dollars has grown at a similar rate to this increase in supply.

    Soros could never shake Australia from a gold standard just as he would never have shaken the Chinese from their dollar standand (which they ended themselves just recently). You underestimate the power of central banks.

    However you have avoided the question which was what type of “monetary system” do you think is superior to the gold standard.

    Let me try and answer your questions which I missed:-

    Q1. Was there a period when foreign exchange transactions worked satisfactorily?

    A1. No. However some periods were more satisfactory than others. The 1950s and the 1960s were more satisfactory than the 1970,1980s and 1990s.

    Q2. If so, what forces militiated against the persistence of this system?

    A2. Fashion and politics.

    Q3. Can you explain how the defenders of this system failed to protect it from the actions of those who had no desire to protect it?

    A3. Brenton Woods was structurally flawed because it depended on a single nation to hold good to the cause (ie the USA). This was why Keynes had argued for an independent reserve currency (the Bancor). The IMF was intended to evolve into the custodian of such a reserve currency but it never happened.

    The breakdown of the pre WWI gold standard was heavily dictated by the decisions of the UK. Lots of Commonwealth Countries like Australia were never really on a gold standard but were in fact on a Sterling standard. When the Pound Sterling was taken off gold it effected a much bigger economic space than just Britian.

    Leaving the gold standard to fund a war was an example of inflation financing. It happened during the US civil war also. Whilst such a decision might seem necessary in desparate times it rarely proved effective.

    Other choices could have been made. And given hindsight at the consequences I think that many of the proponents who caused the system to come to an end might have chosen differently.

    The system was further weekend by the creation of central banks in places like the USA (1913) and Australia (1912). A notion called socialism was becoming popular and it called for new ideas and institutions.


  36. Ernestine,

    QUOTE: Paul Krugman is, IMHO, not a member of the set of ‘crusaders and persuaders’ who produce rhetoric suitable for ‘quoting’.

    RESPONSE: Then we disagree.

    Krugman is a New York times columnist. He routinely has vocal opinions about government policy and he is well and truely engaged in public debate. He is quite busy in the persuasion business.


  37. EG,

    Note how you conflate “reasonable” and “efficient”.

    The core or my argument is that a means of communicating information about the behaviour of traffic, or anything else for that matter, can be “reasonable” without being “efficient”.

    If traffic lights were installed and working to some discernible pattern, persons would, inefficiently but reasonably, come to a consensus about what they may signify and moderate their behaviour according to the consequences of this consensus.

    The most efficient means of communicating this meaning might be to have snipers posted at every light. Any infraction would result in a fatality for the wrongdoer. But is this “reasonable”?

    During my residence in the Southern States of the US, I noticed the effects of an analogous system. Afro-American motorists drove with infinite care. They were fastidious in their observance of “Stop” signs, to such an extent that I could be certain of the race of the driver of a car at the distance of a city block. There was no written traffic rule that dictated this behaviour, only fear of the consequences of any collision with a white driver, even though the Afro-American may have been in the right, from the point of view of the letter of the traffic law. This was “reasonable” but not “efficient” behaviour on the part of the Afro-American.

    For example, it is no more “reasonable” for cars to travel on the left or on the right. Luxembourg could declare a law to that effect tomorrow.

    However, given the size and location of Luxembourg locked between France and Germany, such a law would be very inefficient for reasons that I don’t need to elaborate.

    On the other hand, it wasn’t “reasonable” for cars in Sweden to be left-hand drive and yet drive on the left, as they did until the late 1960s. Nor was it “efficient”, given the increased number of catastrophic accidents that this state of affairs allowed.

    And again, it was “reasonable” for the Japanese to adopt driving on the left, which had the effect of protecting the nascent local car industry from American competition. However, forcing Japanese car owners to pay a premium for inferior local product (how times have changed!) could not be called “efficient”.

  38. Terje,

    Thanks for your reply. If you consider Krugman’s articles in the NY Times contain rhetoric, then I’ll take this as your perception, with which I might or might not agree.

    My point relates to his acadeic writing, including the textbook, which I had mentioned.


  39. Terje,

    Thanks for your responses to my questions. Allow me time to digest them.

    Meanwhile an answer to your question:

    “However you have avoided the question which was what type of “monetary systemâ€? do you think is superior to the gold standard.”

    My short approximation at an answer: from the perspective of domestic currency creation: prudent opportunism that takes aims to take intelligent advantage of the lags and enthusiasms of the floating exchange rate regime.

  40. Katz,

    So do you agree or disagree with the short term targeting of interest rates? Do you think a government authority should essentially regulate the price of credit risk in this manner?

    The problem with a system called “prudent opportunism” is that we can’t say much about it as a system. It is not open to objective analysis. It is like arguing in fiscal policy that the correct tax rate for Australia would be the one that is optimal. Its hard to disagree with that statement but it does not cast much light on the topic.

    If we were to assume that Australia had been on a system of “prudent opportunism” since 1984 then I would wonder in what way you think the result has been better than a gold standard. If these are the apples that we are to compare then I think that the historical record would show that a gold standard would be better for Australia. If we have been on a system of “prudent opportunism” since 1971 then the gold standard definitely wins in my book.

    I will be the first to admit that a gold standard is flawed. However before dismissing it you have to propose an alternate system that is less flawed. That is why I advocate a gold standard.

    If you really want to just leave it to the market place then you would need to advocate that the government repeal the Notes Act of 1910, cease printing currency and really leave the currency business to private interests. However even then our tax laws have a powerful pull on the choice of our national “unit of account”, so you would probably not be able to truely leave it to the market unless you re-wrote all our tax laws and made the “unit of account” and “means of settlement” completely optional for tax purposes. That would be no minor undertaking.


  41. Katz,

    Thanks for your reply.

    No, I do not conflate ‘reasonable’ and ‘efficient’.

    My initial post read: “I should think it is very reasonable to have road traffic light rules. These rules communicate information efficiently among road traffic participants and resolves conflicting interests without requiring individually negotiated settlements at every intersection.”

    We agree on policy (roughly speaking: traffic lights should not be removed) but we don’t agree on the reason for agreeing on the policy.

    You argue that traffic light signals are a reasonable solution to the problem of people being unreasonable (“Of course traffic signals are reasonable, given the unreasonable nature of our species. The red lights you mention could exist and work without any rules being enunciated. Reasonable people could arrive at appropriate behaviour in regard to the operation of these signals without ever being informed of any rules. This is how people learned their native language for millennia before the invention of formal laws of grammar.”).

    In my reply I give reasons for rejecting the hypothesis that it is the unreasonable nature of humans which is the cause of the agreement on policy regarding traffic lights. I found myself having to reject your statement that the same outcome that can be achieved with traffic light rules could be achieved but for the unreasonableness of humans. On the contrary, I reached the conclusion that “traffic signals are a reasonable solution to a social equilibrium selection problem in a society where its members want to have a road traffic communication system that is efficient with respect to a set of criteria.”

    You may know a higher-order intelligence than that which I have assumed people to have. If this were the case then my conclusion might have to change. However, your reply does not contain such information. Your reply gives examples of situations which you judge to be ‘reasonable’ and ‘efficient’. Irrespective of how much I would respect your personal points of views, it would not change my conclusion.

  42. Terje, inflation financing (as you describe it) is in fact a splendid way to loot someone else’s economy (in the short run) or to mobilise its resources in your own interest (in the longer run), provided only that the area is sufficiently advanced already that you don’t have to create the cash economy in the first place. The French did the former to countries it “evacuated” during the revloutionary wars, as did the Nazis to Vichy France, and the Dutch did the latter in setting up their culture or cultivation system in the East indies, though they in fact used a depreciation of a copper coinage which limited how far inflation could go.

  43. If you control the finances of a foreign nation then there are lots of ways to loot the wealth. That is bad enough but all to often national governments have used such policies to loot the wealth of their own citizens at home.

  44. EG we agree that traffic signals represent a more efficient means of traffic control than a traffic signal-free regime.

    I now acknowledge that the language/traffic signal parallel is by no means perfect.

    Both are systems of communication of information. Language is much richer than red/amber/green. But that isn’t the most important difference.

    Language is a positive sum game. The acquisition of new language skills by one individual or collectivity does not restrict the access of others to those new resources. On the contrary, it encourages enrichment.

    Traffic systems are different. From the point of view of traffic controllers who can impose various algorithms on traffic flow to optimise traffic movement in the entire system, they aim for the most efficient traffic solution, given certain parameters. However, from the point of view of the many drivers, traffic flow looks like a zero sum game at best. Either the lane of traffic is “winning” or it’s “losing”.

    Thus, your comment:

    ‘I reached the conclusion that “traffic signals are a reasonable solution to a social equilibrium selection problem in a society where its members want to have a road traffic communication system that is efficient with respect to a set of criteria.’

    presupposes a large number of drivers accepting as true the proposition that those traffic controllers have established “a road traffic communication system that is efficient with respect to a set of criteria”. Now this is what these drivers might “want” but how do they know they have got it?

    These drivers may accept that the traffic system is reasonable. But they have no way of knowing it is efficient.

    Thus, this acceptance by a multitude of drivers is not based on knowledge. It is based on trust, or to use an old-fashioned word, on faith.

    Drivers use a set of rough and ready rules of thumb to decide whether this faith is well founded. So long as they don’t experience intolerable delays or danger they are prepared to play along with these rules.

    But there comes a time when all drivers are provoked to abandon their faith. Last evening we had storms in Melbourne. Unusually, I was driving my car at the time. The traffic lights at several intersections were not operating. There was a wide range of rule-breaking behaviour that signified that many drivers had lost faith that the normal rules of traffic flow would be restored.

    Unreasonable behaviour suddenly became reasonable as many individual drivers sought the most efficient solution for themselves.

  45. In Italy stopping at a red traffic lights is only required if the driver or pedestrial who has the green light looks assertive. If you are riding a scooter then a red traffic light means “swerve as required”. The rules for round-abouts also seem to be different.

  46. Terje,

    Re: Traffic in Italy.

    Are you talking about a small country town or are you talking about ROMA, MILANO, PALERMO, FIRENZE, eh?? Or maybe VENEZIA where GONDOLA traffic is the attraction?

    What is your sample size? 1?, 2?, ? What was the sampling method used? When did the sampling take place? 1950s? 1960s? last year?

  47. The sampling took place in Rome in 1997. I think that in the time we were there we probably observed several hundred traffic light controlled intersections although to be honest our record keeping was non existent.

    I don’t trust their taxi drivers either.

    I must admit that my study has not been peer reviewed but we won’t let that get in the way.

  48. Katz,

    Thank you for your detailed reply. It is, if I may say, a magnificent example of an attempt to substitute your premise for not wishing to abolish traffic lights, namely the unreasonable nature of humans, for my premise for not wishing to abolish traffic lights, namely the reasonable nature of humans. The word ‘impose’ in your paragraph 5 does not follow from what I had written. All your subsequent paragraphs suffer from this.

    Unrelated to the traffic light signal example, I agree that languages are a good example of ‘commons’.

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