DSGE macro-models criticism, a round up. Part 7. Claudio Borio on the current account.
Looking at neoclassical macro-models through the lens of economic statistics. Today: the current account. See at the end for part 1-6.
Claudio Borio, chief economist of the Bank of International Settlements, gave a speech on how the concept of the current account is used in neoclassical macro models and is not happy. Without any reservation in can be included in this series (even includes some ‘Lucas bashing’ as it states that the ‘Lucas Paradox’ (Robert Lucas, before 2008 the most influential neoclassical macro economists, coined this idea to explay why capital often flows from poor to rich countries) is based upon a poor understanding of the concept of the current account). According to Borio:
As these models are often non-monetary in nature, a ‘sudden stop’ (i.e. foreign and domestic banks which suddenly stop financing
imports of a country companies like supermarkets or car dealers which want to import) can’t be modelled as a change in the behaviour of banks (which is what actually takes place) but has to be modelled either as a sudden change in the propensity to import of the importing country or a sudden change in the propensity to export of the exporting country. Banks and financial flows are outside the scope of the models.
Economists conflate the micro and macro concept of saving. On the micro level, when you save money your stock of money (or, when you invest it in other financial assets, your stock of financial assets) increases. On the macro level, this micro behaviour however does not lead to an increase in the amount of money and the only real saving takes place when the money is invested in new real assets (houses, new medicines, etcetera).
Even then, this money has to be channelled towards these investments, while investments can also be financed by money creation. This means that we also have to make a distinction between macro ‘saving’ and macro ‘financing’ – which often does not happen – we do not need savings to invest.
Gross flows of money matter (I extend the Borio argument a little, here). International financing takes place in different ways: bank credits, trade credits (which, in international trade, are often pre-financed by banks), intergovernmental loans and, in the Eurozone, the Target2 system. As different people and organizations call the shots about these flows and as there are flows between these organizations, too, just looking at net lending and borrowing might hide important problems – the 2008 crisis being a case in point. Even importers in a country which is a net exporter can run into difficulties when the banks are panicking (e.g. tomato exports from Dutch horticulturists to German supermarkets).
The whole thing is of course entirely consistent with post-Keynesian macro or, for that matter, pre-DSGE macro and stock-flow consistent modelling. Borio however does not mention the relation between the output gap and the current account.
The origin of the problem – the “original sin”, if you would like – is the conflation of two quite different concepts: saving and financing. Saving is a national accounts concept and denotes income (output) not consumed. Financing is a cash flow concept and denotes access to purchasing power in an accepted settlement medium (money), including through borrowing. In a causal sense, all expenditures, and hence also investment, require financing, not saving. Financing, in turn, is about gross, not net, financial flows. And it is required for both financial and real transactions, which may or may not add to output. Look at it another way. Saving alleviates an economy’s real resource constraint: abstaining from consumption makes room for investment to take place without putting pressure on resources. Cash flows alleviate the economy’s financing constraint: without cash flows, no spending can take place. Why are the two concepts conflated? Probably, this reflects the use of models that do not explicitly trace the financing (monetary) flows – what I would call real economies disguised as monetary ones. This includes many DSGE models as well as the benchmark consumption-smoothing model of the current account – the workhorse model of international finance these days. In the simplest form, with a representative agent and a single asset (“bonds”), the relevant distinctions disappear (eg Obstfeld and Rogoff (1995)): there is no need to model financing flows explicitly and gross flows collapse into net flows.
First, there need be no relationship between the current account position and the financing flows underpinning expenditures, and hence investment and output. A country may be in surplus, but have all its investment financed from abroad; or be in deficit but have it all financed at home. For instance, in a simple model in which banks are the only source of funding, it will depend on where they are located. In other words, the location of those who spend and produce determines current account positions while the location of those who provide the funding determines financing flows.
Second, the nature of the credit risks is unrelated to the current account position: it depends exclusively on financing patterns. For instance, if the banks are located in the deficit countries, they will be the creditors and bear the credit risk in the first place. Thus, the irresistible image that surplus countries are “creditors” and are exposed to risk on deficit countries is misleading. True, balance of payments identities must hold: a surplus country is accumulating, on net, claims on others. And in a two-countryworld this would necessarily be on the deficit country. But answering the question whether any credit risk is involved and how it is distributed requires an understanding of financing patterns, by both location and instrument, and how they crystallise in outstanding stocks.
Earlier posts in this series, which consists of concise posts looking at DSGE models using the lens of statistical concepts, were about money, market fundamentalism, unemployment, capital, the intertemporal budget constraint for the government and consumption