Trade, The Current/Capital Account, and the Value of the Currency

By Philip Pilkington, a London-based economist and member of the Political Economy Research Group at Kingston University. Originally published at his website, Fixing the Economists.

One thing that I notice on the blogs is that I don’t think I have ever seen anyone give a clear description of the external trade account of a country. Nor have I seen anyone give a clear explanation of what determines the value of a given currency. Now, I am sure that you can find some mainstream garbage where the external account always tends toward equilibrium and so forth. But that is obviously useless nonsense and anyone who has ever looked at the trade balances of countries and the currencies of those countries knows it.

Basically the mainstream theory states that if there is a trade deficit in a country two things will happen. First of all, interest rates will rise as the money supply contracts due to money ‘flowing out of the country’. Secondly, the value of the currency will fall in value as the domestic currency saturates foreign exchange markets. A combination of these two dynamics will reestablish equilibrium on the external account. The rise in interest rates will cause investment, GDP and, hence, imports to contract. While the fall in the value of the currency will decrease imports and increase exports.

There is so much wrong with this presentation that it would take a blog post in its own right to pick all the necessary holes in it. The most obvious error is the idea that interest rates would rise when these are obviously set by the central bank. In addition to this currency depreciations will not always correct the trade balance and trade imbalances will not always lead to currency depreciations. I could go on. I won’t.

Anyway, here I more so want to lay out a clear explanation of the external account and, in doing so, describe what determines the value of the currency in a floating exchange rate system like we have today. In fact, I do not need to do much of the heavy lifting here because G.L.S. Shackle has one of the clearest explanations of the external account that I have come across in his book Economics for Pleasure.

Since the book is hard to come by I’ve provided the chapter on the payments system here. I hope it will encourage people to seek it out because it is one of the best overviews of economic theory I have ever read. Shackle was a very gifted writer. Anyway have a quick read of the chapter, it is only a few pages, and then you should have a fair comprehension of the accounting involved.

I assume that you’ve now read the chapter. Good. Let’s turn to what determines the value of the currency in a modern system. The claims that foreigners make within the country that has a trade deficit can, as Shackle says, be either in the form of currency or securities. These are recorded in the capital account of the country running the trade deficit.

Let us break this down slightly. The trade balance is a flow. When the trade balance is in deficit more goods flow into the country than out of the country. A corresponding amount of claims flow out of the country into the hands of foreigners. Now, if the foreigners don’t want to hold these claims they may sell them and then convert the money they receive into money from their own country. This will drive down the price of the currency of the country with a trade deficit and drive up the price of the country with the trade surplus.

But we should be clear: this need not happen. There is every chance that the foreigners will hold the claims on the country running the trade deficit. If they do this there will be no effect on the value of the currency. Why might they do this? Any number of reasons really. Maybe they think that the country is a good investment. Or maybe the government of the surplus country wants to hold foreign reserves.

“But,” the reader might say, “these claims eventually have to be paid back and so the effect will eventually be felt on the currency.” Again, that is not altogether clear. For example, let’s say that all the claims are held in the form of stocks. Now let up say that these stocks were worth a total of $1bn. Basically what has happened is that foreigners have traded goods for these stocks. But what if these stocks half in value? Well then, the whole amount of the claim need not be ‘paid off’.

The key point to take away from this is that in order to understand trade dynamics in the modern world we must appreciate the financial dimension. Mainstream economists are altogether incapable of doing this and it completely blinds them to the real world. For them finance is just a veil. But for Post-Keynesians finance is very, very real. Most of the trade imbalances in the world today can only be understood by taking both finance and politics seriously. If you want to see how the mainstream prove unable to do this and why the Post-Keynesians give the only realistic view, check out this recent paper by Tom Palley.

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About Lambert Strether

Readers, I have had a correspondent characterize my views as realistic cynical. Let me briefly explain them. I believe in universal programs that provide concrete material benefits, especially to the working class. Medicare for All is the prime example, but tuition-free college and a Post Office Bank also fall under this heading. So do a Jobs Guarantee and a Debt Jubilee. Clearly, neither liberal Democrats nor conservative Republicans can deliver on such programs, because the two are different flavors of neoliberalism (“Because markets”). I don’t much care about the “ism” that delivers the benefits, although whichever one does have to put common humanity first, as opposed to markets. Could be a second FDR saving capitalism, democratic socialism leashing and collaring it, or communism razing it. I don’t much care, as long as the benefits are delivered. To me, the key issue — and this is why Medicare for All is always first with me — is the tens of thousands of excess “deaths from despair,” as described by the Case-Deaton study, and other recent studies. That enormous body count makes Medicare for All, at the very least, a moral and strategic imperative. And that level of suffering and organic damage makes the concerns of identity politics — even the worthy fight to help the refugees Bush, Obama, and Clinton’s wars created — bright shiny objects by comparison. Hence my frustration with the news flow — currently in my view the swirling intersection of two, separate Shock Doctrine campaigns, one by the Administration, and the other by out-of-power liberals and their allies in the State and in the press — a news flow that constantly forces me to focus on matters that I regard as of secondary importance to the excess deaths. What kind of political economy is it that halts or even reverses the increases in life expectancy that civilized societies have achieved? I am also very hopeful that the continuing destruction of both party establishments will open the space for voices supporting programs similar to those I have listed; let’s call such voices “the left.” Volatility creates opportunity, especially if the Democrat establishment, which puts markets first and opposes all such programs, isn’t allowed to get back into the saddle. Eyes on the prize! I love the tactical level, and secretly love even the horse race, since I’ve been blogging about it daily for fourteen years, but everything I write has this perspective at the back of it.


  1. Keynesian

    Quote:”The key point to take away from this is that in order to understand trade dynamics in the modern world we must appreciate the financial dimension.
    Shouldn’t the sentence read, “…we must appreciate the political dimension”?

  2. Michael Hudson

    Here’s the problem, Lambert. Only about a THIRD of trade involves actual PAYMENT. The rest if trade among corporations and either not paid for or financed by loans. This is what my balance of payments monograph and Trade, Development and Foreign Debt are all about. The statistics are designed to fit into GNP AS IF they involved payment, not on a payments-flow basis.
    The US balance of payments was in close balance for the private sector throughout the 1960s and into the 1970s. THE ENTIRE DEFICIT came from overseas military spending. And the central bank LOWERED interest rates as part of guns and butter.
    So Shackle’s neoclassical picture gets everything wrong, by beginning with “the market,” not military spending. (Foreign aid did not involve ANY international payment!) And not trade by multinational corporations at fictitious prices and just-pretend payments.
    So the key you want to trace is “Errors and Omissions.” THAT is the financial sector.:)-

  3. diptherio

    Standard economic practice is to select one simple dynamic of the process under study and then claim that that dynamic is the only relevant one. Ceteris paribus….

    The problem is that the world is a complex place and economic processes inevitably have many interacting and intertwingled dynamics in play. But your typical economist looks at this and says, “that’s too messy, let’s make a simple model,” and then thinks that their model will tell them something about the actual world, which is anything but simple.

    T’would be funny if it weren’t used as justification for so much f-ed up sh*t…

  4. financial matters

    I think Palley makes some key points in the mentioned paper, such as concerning the IMF and World Bank ‘Those reforms included abandoning state-led development policies that used strategic protection.’, and ‘prevents governments from implementing needed social and environmental regulation and policies that are the hallmark of development that generates shared prosperity.’

    and an important conclusion: ‘Furthermore, the entire model is vulnerable to stagnation that first infects the North and then spreads to the South. The reason is the model undermines the Northern consumer on whom it depends to provide demand.’


    I think Godley’s sectoral balance is useful here as well. Stephanie Kelton has analyzed this with an emphasis on the Eurozone. These issues are intimately involved with the use of public funds and employment.

    “”Wynne Godley 1992: “”The power to issue its own money, to make drafts on its own central bank, is the main thing which defines national independence. If a country gives up or loses this power, it acquires the status of a local authority or colony.””

    Using Godley sectoral balance (govt deficit = private surplus + current account deficit) Greece has very little fiscal space. It must keep it’s deficit to 3% of GDP and it along with 14 other Eurozone countries are running a current account deficit. This makes it virtually impossible to turn its private sector balance positive. Governments with their own currency can afford to employ labor so unemployment is always a policy failure. The only real constraints are full employment of resources and inflation Countries with floating exchange rates have more policy space


    In the US, Japan, Australia etc there is more fiscal space but there are self imposed constraints by deficit hawks and deficit doves. Deficit owls use more of a Godley sectoral approach..””

  5. Chauncey Gardiner

    Thank you for this post. Shackle is challenging reading for me, but keeping in mind Michael Hudson’s comment about U.S. military spending and transfer payments above, I will do so because I want to understand what is happening WRT the Argentine peso, the Russian ruble, and the perceived fears regarding China’s purchases of U.S. Treasury debt.

    In the case of Argentina, I want to understand why a sharp depreciation in the Argentine peso has occurred, particularly in the wake of Argentina’s decision not to repay in full some of that nation’s sovereign bonds that had been purchased by U.S. vulture funds, and why the magnitude of the Argentine peso depreciation against the US dollar has been so large.

    In the case of the Russian ruble, the currency decline of that currency against the $USD seems counterintuitive given high energy prices.

    In the case of China’s holdings of U.S. Treasury debt, I want to understand why this is presented as a risk to the U.S., and if that perceived risk is real or is merely another tool used by the proponents of austerity and those who sow the seeds of public fear in an effort to build support for their policy initiatives.

    Control of financial and currency markets seems to be pivotal.

    1. financial matters

      The answer to the third is that it is a tool used by the proponents of austerity and those who sow the seeds of public fear in an effort to build support for their policy initiatives.

      Argentina and Russia have valid claims.

      Financial and currency markets are superfluous.

      Labor is the key to economic development.

      1. Chauncey Gardiner

        FM, disagree that the financial markets are now superfluous. They are used for price determinations of currencies, bonds, and derivatives. However, financial markets now mostly measure political control IMO, not economic health, distress or value.

        I appreciated your comment above about the lack of fiscal space accorded sovereign European governments under the current regime.

        1. financial matters

          Yes, sorry, a bit overstated there. More to make the point as you mentioned that they can be heavily manipulated and often don’t reflect the underlying fundamentals including labor.

    1. human

      ROTFLMAO It is simply not allowed to happen, and, judging by the number of replies to your comment, it is not a topic for polite discussion. It’s a good thing it is not Punch a Hippie Day.

  6. Enrique Fleischmann

    As long as a national currency , in our case the USD ( and to lower extent a few half dozens currencies) is THE mean of exchange , denominator and store of value , the system cannot be balanced ( by definition) : If we add to this anomaly the massive intervention in financial markets ( QE in its various versions) we get a totally distorted, system.

  7. Washunate

    “But we should be clear: this need not happen. There is every chance that the foreigners will hold the claims on the country running the trade deficit. ”

    Until they don’t? I don’t really follow the real world point. Dollars held abroad represent claims on the future productive output of the US economy. Foreigners will hold those claims until such time as the ‘future’ becomes the present for each particular saver who has chosen dollar-denominated assets as their savings. Then the US will have to reverse the flow – export labor and import currency – to continue funding the national security state and corporate welfare.

    1. Moneta

      Norway is a perfect example. An oil producing country with a huge sovereign fund. They are RICH, no? But wait a minute… they have traded wealth that could have stayed underground for posterity for securities as a good percentage of this fund is invested in US treasuries and other securities which will most probably get devalued…. now it makes sense for the US to “stealthily” reduce the value of those bonds by devaluing its currency, essentially stiffing Norway for its work.

      1. Moneta

        Historically, there are at least 3 countries that have been experts at playing this game: US, UK, France. Somehow, they always manage to write-off and restructure and the world just keeps on kneeling down for them.

  8. Moneta

    It will be interesting to see how much value those sovereign funds will retain over time. Every country’s dream is to import without having to export or pay. For some countries, that dream can come true… but it needs the military to be sustained.

    The trillion dollar question now is by how much can the US cut its military to keep importing what it can pay with dollars that get devalued over time.

    It’s all about the good life… the serfs and those enjoying the free lunch.

  9. The Dork of Cork

    The strange trade dynamics within the Eurozone can be explained by usury , pure and simple
    Interest and rents flows to the UK France and Holland in the main (and also internally in national and other financial capitals)
    These countries and national capitals extract tokens / real purchasing power from their hinterland forcing their hinterland to export, court tourists or whatever in order to gain scarce currency.
    The real costs for people is gigantic as most of the capital / energy is used to fight for scarce money rather then core human scale consumption creating the illusion of scarcity.
    We can see the physical outcome of this via the giagntic trade deficits of the UK and France and also I am sure Holland if you can manage to subtact port hub operations feeding the absurd euro entreport.

    This vast empire of usury causes the complete change of the physical world overtime.
    For example we can best see the trajectory of this change from local , to national and international trade if we look a specfic regions.
    In Aragon Spain for example the village system of supply to local population centers and limited cross border trade declined over time.
    In the first half of the 20th century we can see “national” projects destroying the fabric of exchange (think of hydro works and the like destroying farmland)
    Most especially after 1959 and the end of the period of Autarky the network of local exchange died a total death.
    The rest of Spanish history is of course a bankers inside joke.

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