Picking up again on discussion of financial and trade flows, and how they are/are not linked. I want to lay out my own intuitions more clearly. Not saying they're right or you should accept them, just to clarify where I'm coming from. For what it's worth, here's my mental model:
(1) The US-China trade balance is determined in the short-medium run by relative income growth in the two countries. In the medium-long run relative prices may play a role, but probably more thru producer entry/exit than thru expenditure switching.
(2) Chinese capital controls limit cross-border financial flows, generating more net inward flows than there would be in absence of controls. (This is probably most important Chinese policy wrt cross-border flows — liberalization would more likely weaken RMB than strengthen it.)
(3) Chinese central bank passively accumulates/ decumulates whatever level of reserves are implied by combination of 1 and 2.
(4) Exchange rate is either chosen by China or determined in speculative markets; there is no meaningful link from trade balance to exchange rate, and at best weak link from exchange rate to trade balance. Exrate interventions are not an independent factor in reserve changes.
(5) The interest rate on US Treasury debt is determined by some combination of Fed policy and self-confirming (i.e. conventional) market expectations. Chinese reserve purchases play zero role.
(6) US deficit spending is not constrained, required, or influenced by foreign reserve accumulation. When foreign reserve accumulation varies from volume of new Treasury issues, accommodated by net sales between foreign cbs and private sector.
(7) If mismatch between Treasury issue and reserve accumulation creates pressure anywhere, it will be on private assets that are close substitutes for Treasuries. E.g. it's plausible that insufficient federal borrowing in 1990s-2000s helped create mortgage securitization market.
(8) Returning to exrates - the fact that import price elasticities are low, and most trade is price in dollars, means that exchange rates affect trade mainly via exporters’ profit margins. An appreciation *can* undermine exports...
... but this is a slow process of failure/exit by exporters, and depends on capacity to operate with diminished margins. E.g. symmetrical exrate moves in 1980s affected Japan less than US, bc bank-based financial system plus less shareholder made it easier to sustain losses.
So from where I’m sitting, there are *three* major sources of flexibility in the system, all of which undermine any claim that shift in one flow must lead to equivalent shift in some other flow.
First is existence of passive, accommodating positions that act as buffers. CB reserves can function this way, also bank loans & deposits, also positions taken by fx specialists, plus today potentially swap lines.
Second is speculative price dynamics that make asset demand endogenous to current price. If asset held largely in hope of capital gains and if there are anchored expectations of normal price x, then any price move away from x implies capital gains for anyone who takes other side.
In markets where these kinds of speculative dynamics operate - and I think they operate widely - then even large changes in flows don’t have to lead to significant price adjustments. (Conversely, shifting expectations can lead to large price changes without any shift in flows.)
Third is the fact that trade adjustment happens mainly thru entry/exit rather than expenditure switching in product markets. This means in effect that balance sheets of exporting firms act as shock absorbers.
All this is based on articles by people who are actual experts, and on concrete stuff we can observe in the world. I wish I had time to write it up properly with links to supporting arguments/evidence. Sadly I don't, so this thread of unspported claims will have to do.
Couple last points:
- I should have added private fx reserves and access to foreign loans as another buffer. The entire reason units have liquid assets, lines of credit etc is to *not* have to adjust expenditure to changes in income. This applies to cross-border positions too.
- I should have added private fx reserves and access to foreign loans as another buffer. The entire reason units have liquid assets, lines of credit etc is to *not* have to adjust expenditure to changes in income. This applies to cross-border positions too.
- Obviously I am thinking here of two large countries, like US and China. Case of smaller poorer countries is different - changes in financial flows & exrates will have bigger, more dirct effect on domestic activity...
... but still have to think critically about channels by which this happens. Need to resist shortcut of using accounting relationships as if they were causal links, or carrying over models developed for gold standard-like system into world of credit money.
