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Wealth vs the People: Why the Balance of Payments is Critical

Summary:
Money has two main functions: it is the medium of exchange and a store of wealth.  In the days before WWI it was accepted as a law of economics that a currency would be backed by gold, that there was a real asset underlying every pound or dollar.  Since WWII the world has settled into a system where the relative value of currencies is set, over the longer term, by the balance of payments.  Those countries that have strong finances and saleable goods and services have a high demand for their currencies which increase their relative value. A modern currency is a token with a value that represents the balance between production and consumption in a country.  It seems as if currencies are now a medium of exchange but not a store of wealth.  This conversion of currencies to support exchange

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Money has two main functions: it is the medium of exchange and a store of wealth.  In the days before WWI it was accepted as a law of economics that a currency would be backed by gold, that there was a real asset underlying every pound or dollar.  

Since WWII the world has settled into a system where the relative value of currencies is set, over the longer term, by the balance of payments.  Those countries that have strong finances and saleable goods and services have a high demand for their currencies which increase their relative value. A modern currency is a token with a value that represents the balance between production and consumption in a country.  It seems as if currencies are now a medium of exchange but not a store of wealth.  

This conversion of currencies to support exchange rather than wealth means that the currency is not tightly bound to the value of large assets.  The tendency of governments to print ever more cash means that the asset value of many currencies is forever falling, or, looked at the other way, assets are getting ever more expensive.  This tendency is also exacerbated by population growth which produces a shortage of land and property and hence higher prices for large assets.

Wealth vs the People: Why the Balance of Payments is Critical

The shortage of large assets compared with the amount of money in circulation means that banks have tended to lend each other money without adequate collateral.  The reason the banks jumped at collaterised debt obligations (CDO) in the noughties was that these allowed them to have collateral on their books (assets) to back their lending.  

Imaginary and fraudulent assets such as CDOs are now used less and the world of finance has returned to using the fewer, real, available assets so driving up their price.  The problem with this approach is that it leads to large differences in wealth within countries.  This fuels social unrest as people can no longer afford a home or rents.  It also means that those countries that run mercantilist economies such as Germany's EU and China can afford assets in other countries like the UK and USA even though these are priced out of the reach of the local population.

The two evils that arise from all of this are social instability and an increasing amount of foreign ownership in countries with weak balance of payments such as the UK and USA.

Economists who work for China and multinational corporations will declare that foreign ownership is wonderful.  It provides wages for local people but it gives China and Multinationals control and drives asset prices out of the reach of local people.  Of course, the UK and USA would not be exposed to foreign ownership if the balance of payments were not in perpetual deficit and would not be worried about rising tides of social unrest. (See How much of the world is owned by China?).

To recap: the value of a currency is set by the amount of goods and services that nations buy from each other.  This exchange is summarised in the "Balance of Payments".  If the Balance of Payments current account is in sustained deficit then asset prices rise for the local population and this results in foreign ownership and social unrest.

Correcting the balance of payments current account deficit is a much better way of restoring equilibrium than, say, returning to the gold standard.  A gold standard has other problems like running the risk of uncontrolled shortages of cash during downturns that can wreck an economy.  Sometimes it is good to spend what you do not have - but this must not be done all of the time. Avoiding chronic Balance of Payments current account deficits is essential.

The rule of thumb is simple: in the long run no enterprise can be run at a loss and survive.  Enterprises that run at a loss will eventually lose control of their production and customer base to other enterprises.  In the case of nations they will lose control of their wealth to foreign enterprises and nations.

It is worth asking why so many economists believe that long term trade and current account deficits are harmless, especially when those countries such as Germany and China, that balance their accounts or run at a surplus, are the new economic superpowers.  The answer is probably that they are not examining any more than the immediate consequences of the deficits like debt accumulation and failing to factor in currency movements, asset prices,  corporate control, employment patterns and all the other effects of deficits.  There is another answer to why so many economists are happy with deficits: they favour global government which nowadays will mean government by China.

Postscript:

The UK Current Account Deficit at 4% of GDP is stupendous and chronic (40 years) and largely a deficit with the EU:

Wealth vs the People: Why the Balance of Payments is Critical
UK Current Account Balance

The steadily increasing balance of payments current account deficit is reflected in the Purchase Power Parity (PPP) value of the pound (grey line below).

Wealth vs the People: Why the Balance of Payments is Critical
Purchase power of pound relative to dollar.  Actual FX rate in dark blue.
The Purchase Power Parity value of the pound is a measure of its value against a basket of goods and services. (How many pounds it takes to buy a mars bar etc. relative to the number of dollars required for the same mars bar etc. - adjusted for tariffs etc. etc.).  If the Germans, French or Chinese own your production they will sneak mars bars made in their home factories, or with ingredients from home, into your shops.  It allows them to funnel exports into your country branded as "Made in the UK" so that the balance of payments suffers and the mars bars become dearer.

How do we pay for a Current Account Deficit?  We sell domestic assets such as property and companies to overseas buyers or get into debt, both of which amplify the problems.

Investors might notice that the currency markets know what is happening three years before the ONS reports the corresponding overall balance of payments changes. The primary income balance is a better predictor because it is the part of the balance of payments current account that sets the immediate value of the currency:

Wealth vs the People: Why the Balance of Payments is Critical


The primary income balance is largely composed of dividends, profits, rents etc. These direct exchanges of currency across borders set its value.

Incidentally, can anyone spot the much touted, "devastating" fall in the pound after the EU Referendum?  The reason that the fall in the pound was much touted is that it was in the pipeline already given the primary income deficit!  The pound actually fell more in the two years before the Referendum than it did in the two years following it.  More ironically the primary income deficit was largely with the EU so the continuing fall in the pound in 2016 was due to EU membership. We were treated to processions of economics editors in 2016-17 telling us how the Referendum had made the pound fall when they knew that it had nothing to do with the Referendum.  They are on the verge of being evil.

15/2/2021

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