Gold and International Trade Settlement (Part 1)

(A New Gold Supra-Theory – Post 1.)
 
I realize that this topic sounds utterly boring. But if you think that gold has a role to play in a new international monetary and financial system (IMFS) this topic should be of the utmost importance to you. There is more than one theory about international trade. If one particular theory is correct then gold better not give up its day job just yet because it’s not going to get the trade settlement gig in a new IMFS.
A concept called “balance of trade” or “national balance of trade” is central to this discussion. This term appears to have been coined around 1615 and it started a food fight among economic thinkers that's still in full swing. There are several competing theories about the drivers of trade and the appropriate objectives of international trade.
 
Any attempt to examine this topic is complicated by the intervention of monarchs or governments and their bureaucracies down through the years. However, I think we can distil a few key themes from the debates about this subject over the centuries. The classical economists believed that free trade served human welfare and that imbalances are naturally self-correcting. The way this was done was through the prices+-specie-flow mechanism and refraining from intervention in free trade.[1]
 
(The word “specie” implies gold and/or silver to many people. This view is erroneous. Specie should be read simply as ‘money’ or ‘capital’. With money as a subset of capital provided the money is accepted in exchange for capital goods. [2])
 
Another perspective (labelled “mercantilism”) holds that the national balance of trade should be viewed as the sum total of all of the merchants cash tills in the country. The false implication this conveys is that the mercantilists sole aim was to obtain a cash surplus (or profit like a merchant) from trade. The actual aim of many of the mercantilists was to obtain a surplus of imports over exports. A money surplus represented a future goods surplus. Some of the mercantilists proposed controlling both exports and imports in order to ensure that there were enough goods available within the borders of their nation to enrich the lives of everyone who lived there.
 
On at least one issue the classical economists and the mercantilists were on the same page – viewing international trade as an indirect exchange of goods-for-goods mediated by money. Goods that contributed to human welfare and wealth (in its broadest sense). Money (bullion for “the bullionists”) stored the surplus purchasing power. The real issue between these two camps was balanced trade versus creating a deliberate imbalance in your own favour which the classical economists viewed as self-defeating.
 
In recent times the view has been propounded that a country running a trade deficit is unproductive and countries running surpluses are productive. Surplus producers are lauded and the citizens of countries with trade deficits are derided as net-consumers. The implications are that deficit = lazy and surplus = industrious. But kindly note: Countries who run trade surpluses must export capital and countries with deficits must import capital – "balance sheets must balance" as the Minskyite economist Michael Pettis is fond of saying.

For a long time I viewed this solely as a win-lose deal. Trade deficit countries are “forced to sell off the farm” to the surplus countries. But eventually I realized that there are a few problems with this lazy vs industrious and winner vs loser perspective which I’ll briefly summarize for you. The biggest problem is the existence of a theory that the capital flows occur first and lead to the trade deficits. If you subscribe to this theory you could use it to support the claim that the deficit countries like the USA are in a sense the "victims" of the surplus countries excessive saving and lack of domestic consumption.
 
Secondly citizens of a country running a trade deficit can be highly productive and industrious but obtain prices for their products which are too low to generate sufficient revenue to pay for their imports. (I suppose the rejoinder might be that these people in deficit-land were stupid in their decisions about what to produce and it serves them right. Personally I think the return of serve on that stroke might be a sizzler.)
 
Thirdly a country could have a surplus of capital absorbing investment opportunities for which there is insufficient capital available locally. If this was the case then it could make sense to adopt policies that encourage a surplus of capital imports rather than trying to "save" up enough money to finance them domestically. Figuratively speaking that “deficit” country could run an “export” surplus of in-bound foreign direct investments (FDI).
 
Now we come to an important issue that needs to be addressed by those of us who believe that a gold-based IMFS is in the pipeline. In the capital flow trade model I just outlined there is no need for so much as a single gram of gold to flow in order to settle the trade “imbalance” implied by running a current account deficit (CAD). There is NO imbalance for a flow of gold to balance.

[1] I changed the text from "prices+costs" to this - ‘prices+-specie-flow mechanism’ - to reflect the fact it’s influenced by more factors than prices and costs alone and to give this mechanism my version of its formal title which is the "price-specie-flow mechanism".

[2] Hat tip to 'DP'. The way I expressed it originally implied that money and capital are two different things.

19 comments:

Beer Holiday said...

This is interesting. Do your three methods of settlement above have historical examples? Even in the current $IMFS, does China's FDI in Africa count as an example.

DP said...

Hi costata,

Looking forward to the remaining brief installments of your post! ;D

I have to confess I'm a little confused about your definitions of a couple terms. Perhaps I need another coffee, or could they benefit from a little tightening up?

The word “specie” implies gold and/or silver to many people. This view is erroneous.

Agreed!

Specie should be read simply as ‘money’ or ‘capital’.

Are you saying "specie" = "money" = "capital"?

Might it have been more accurate to simply say "Specie should be read simply as 'base money'"? (i.e.: money that is not just a ledger entry credit in a bank's book, which under ye olde gold standard did mean gold/silver coin, but now means a fancy-schmancy piece of paper or a ledger entry credit in a central bank's book.)

The other term I am currently unclear of your definition for (and this is probably really only due to my misunderstanding above), was 'capital'. The uncertainty arises because, per the above, you appear to be saying specie/money/capital are the same thing(?), yet:

Countries who run trade surpluses must export capital

Which appears to suggest net-exporters are giving up 'capital' (in this case, clearly you mean trade goods/services)… which they do in exchange for specie/money/…err… capital? But, if they (net-exporters) are on balance giving up 'capital', then they are not getting 'capital' in return for their 'capital'? So does that mean specie/money are not 'capital' after all?

Please send meds!

Cheers,

DP :-)

costata said...

Intelligent comments deserve intelligent replies. I will respond tomorrow. Cheers

costata said...

Hi BH,

"Do your three methods of settlement above have historical examples?"

Yes, in so far as each of these three was occurring but there was only one "method" described for settlement in the material I have been reading - a flow of money.

"Even in the current $IMFS, does China's FDI in Africa count as an example."

I think it could count as an example of "capital flows occur first". One of the problems you encounter in trying to prove or disprove this theory is that trade is already in motion.

If you look at the trade flows at any point in time they are two-way. So it's hard to tell which flow is the "chicken" and which flow is the "egg". I think the classical economists had the advantage of seeing trade occurring for the first time between, say, a new colony and a developed country with a money-based economy.

costata said...

Hi DP,

"Might it have been more accurate to simply say "Specie should be read simply as 'base money'?"

Perhaps but this distinction doesn't appear in the literature I have been reading.

"..they are not getting 'capital' in return for their 'capital'? So does that mean specie/money are not 'capital' after all?"

From my reading the classical economists thought in terms of "goods-for-goods". Money was merely mediating the exchange. So the concept of an exchange of capital would have been meaningless to them. Kind of like saying "we exchanged a dollar for a dollar" as opposed to saying "I exchanged a dollar for your orange and you exchanged that dollar for an apple from someone else".

But all money of any type is capital in this perspective. A flow of "specie" cash as an investment or a flow of specie as a loan is still a flow.

Thanks for responding. Some valuable pointers here to what needs clarification.

Cheers

Jeanne d'Arc said...

@Costata,

Welcome to the Screwtape fold! And a wonderful first post - thank you so much. I have a comment, which may not be particularly relevant, but I'll mention it anyway.

The elephant in the world economics room at the moment is always the trade imbalance between the US (or 'the West', if you prefer) and China (or BRICs, if you prefer). The figures speak for themselves: China has accumulated a huge surplus of dollars through exports, and the US has an import problem of some import.

Where it gets interesting is the degree to which this trade (in)balance can be attributed to oil. Or more specifically, energy. Opinions diverge, but some analysts place the responsibility of oil/energy for the trade deficit at anything between 20 and 80%. Not just energy imports, of course - but also costs of production, shipping versus domestic production costs, and a whole host of other energy-related factors. It's a sharp challenge to those who cite labour costs as the big factor. A plummeting oil price could invigorate the US economy like no time since the post-Depression years.

[I am aware that China has big energy needs too - but with a massive dollar surplus, I submit that they are less pressing]

So, with the advent of fracking, tar oil extraction, and a range of other domestic 'dirty' energy extraction methods, one could construct an argument that says the balance of payments deficit could be reduced or - optimistically - eliminated for the West. And that a resultant shock to the Far East could see its economies crumble. In fact, I've been to a number of presentations in the oil sector recently that argues exactly that. Dirty oil is the great hope for the deficit and the debt. [And, yes, I know such people are talking up their book too...]

Anathema to the environmentalist, of course. But - I wonder - also to the goldbug, perhaps?

S Roche said...

Interesting series Costata, I look forward to where you are going with this. We have practical examples of Mercantilism in China and Germany, (and Japan leading the way), that we can observe and draw conclusions in real time.

Jd'A,

I think the impact on the USD as reserve currency must be a factor in the whole US oil self sufficiency scenario. What you see might therefore be very relevant to Costata's series.

DP said...

Perhaps but this distinction doesn't appear in the literature I have been reading.

Along with a lot of other things! ;D

From my reading the classical economists thought

OK, but that was then and this is now. I could go back and read some papers if I want to see what they thought, but I'm more interested in what you think, today! :-)

But all money of any type is capital in this perspective.

OK.

So, does this mean capital is limited to just money? Or is money just a subset of capital?

Would my confusion be resolved by defining what "all money of any type" means, exactly? (Rendering your sentence more obviously a statement of fact.)

I have to say, this currently feels like it contradicts "Countries who run trade surpluses must export capital"? It feels like something here is 180° out, but again I am ahead of my first decent coffee today so that would probably be me. I should probably just save up my comments until late morning, when I can delete them instead of making myself look stupid like this!

Happy to help! %<];o)8 (Well, someone has to provide the entertainment!!)

costata said...

Hi JdA and S Roche,

I'll respond to your comment and DP's latest tomorrow. I need some more instruction from Warren on issues like getting alerts about new comments. I'm still on a learning curve with blogger.

Cheers

Beer Holiday said...

Thank you for the reply Costata. It's put me more on track along with the comments above.

@DP You look like a genius compared to me :-)

costata said...

JdA,

I don't think that cheap oil/energy would solve the problems confronting the USA. The numbers don't stack up for a grow-your-way-out scenario if the growth rate is expected to just deal with the debts in the system alone. Once you start to factor in other issues the hole gets deeper and deeper.

If the USA defaults on its debts via a currency devaluation and the government reduces the tax and regulatory burdens on business I think their economy would take off. Cheap oil could be a huge help in their recovery.

But the overarching issue is the need for a global system reset. So I don't think cheap oil would be a negative for gold. In fact I think gold will help to deliver cheap oil/energy.

costata said...

BH,

Happy to chat with you and looking forward to more of it in the future.

Cheers

costata said...

S Roche,

Australia appears to be one of the few countries that isn't taking a mercantilist approach to trade. So it's a good 'laboratory' for testing the theories about trade. After I respond to DP I'm going to get back to part 2 of the post.

I appreciate any and all feedback.

costata said...

Hi DP,

You're mighty feisty for a pre-morning coffee carbon-based-unit. I was going to repeat your comments and quotes but it got too messy to be easily read. So I'll reference your key points and see if I can clarify/respond.

1. Specie/base money etc

The composition of the money supply isn't the focus of the material I'm working with. When the classical economists discussed their theories on trade the assumption was that it was sound money

Elsewhere they advocated a gold exchange standard but paper was always part of the mix regardless of what the goldbugs assert.

2. Capital

In the first part of the post I set out the free trade and the mercantilist positions to establish a foundation for the trade = goods-for-goods versus the trade = goods-for-money conflict later part in the post.

On the subject of capital Von Mises family will no doubt be thrilled to learn that I agree with him. There's no logical basis for separating money-as-capital and capital-goods-as-capital unless money can no longer buy capital goods. With that caveat - it's all capital.

3. OK, but that was then and this is now.

It's instructive to see how relevant their theories are to the problems we confront today. They had two advantages in formulating their theories that we lack today. Trade is global today and very active. So it's very difficult to avoid the chicken and egg problem.

Their first advantage is that over a period of a couple of hundred years they witnessed new trading relationships actively being constructed e.g. new colonies, new trading partners becoming accessible for the first time.

The second advantage they had is that mercantilism had been dominant and it was failing during that period and progressively being dismantled. Mercantilism is once again dominant today.

4. but I'm more interested in what you think, today!

Has the above gone some way toward satisfying you. Bear in mind there is a second part of this post in the pipeline.

5. I have to say, this currently feels like it contradicts "Countries who run trade surpluses must export capital"? It feels like something here is 180° out...

It's not clear to me why this troubles you so much. Put two currencies into the picture. Surplus country can't spend FX into their domestic market. It's not legal tender in their domestic market.

In part 2 I need to delve a little deeper into the classical view of how to conduct and settle trade. How their presentation of the "brake and spur" mechanism functioned.

DP said...

:-) Feisty?

I just want to see the tightest, leanest, cleanest exposition on New Gold Supra-Theory possible. Once you've finished. So the world can properly understand it and instantly see the merit it has.

When the classical economists discussed their theories on trade the assumption was that it was sound money

This may prove an important premise in your series, so we'll just have to wait and see where you go with it.

paper was always part of the mix regardless of what the goldbugs assert

Absolutely. Money is by its very nature credit, the issue is only one of "how long will the creditor wait?". Even in the classical gold standard, the gold was really only used to clear at trade completion (i.e.: the creditors generally didn't wait very long at all).

With that caveat - it's all capital.

Very good! ;D

It is clear that the later installments in the series will build on the classical foundations you are laying here. So I will STFU, sit back with that coffee I will make in a moment, and hopefully enjoy watching where this journey takes us all.

Sincerely!

DP :-)

DP said...

Sorry, realised I didn't address a key point in your comment:

Surplus country can't spend FX into their domestic market. It's not legal tender in their domestic market.

No, but does the CB have to buy a bond from the trade partner's economy, sending the FX back (to be re-spent by the bond issuer)?

Isn't this a choice to be made by the surplus country's CB?

Do they have to re-export the financial capital they imported, or have they merely chosen to?

You were, I daresay, probably already going to address this in the next installment of the post, if I would just STFU and stop delaying you from posting it! :-)

I'll get me coffee…

costata said...

Hi DP,

This one is dead easy:

No, but does the CB have to buy a bond from the trade partner's economy, sending the FX back (to be re-spent by the bond issuer)?

A resounding 'No' on this. The reserves could have been reinvested in the US economy instead of being handed over to the Congress and USG to spend. The first major deal that the Chinese proposed was, if memory serves me, trying to buy Conoco and the USG killed the deal. A search should confirm which oily it was. (A life lesson for China's government IMVHO.)

I will touch on those issues in the final post (part 3). I'm trying to make the posts as brief as possible so if there isn't sufficient detail for your taste I'll take it up in conversation in the comments.

The next post explores how this price-specie-flow mechanism operates.

Cheers

DP said...

Yes, Dubai Ports world rebuff also springs to mind.

They could also just choose to keep the FX as backing for their own currency, much like the bonds have.

I look forward to the remaining two installments…

Cheers! :-)

costata said...

JdA,

I have to apologize for not thanking you earlier for the warm welcome and kind remarks about my post. I was focusing on the content and forgot my manners.

Cheers