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This is a very interesting conversation. The more I think about it, more I think Nathan is right. The claim of direct link between current account and (distinct set of) financial flows is widepread and wrong, even if there are indirect links mediated by exrates or other variable. https://twitter.com/NathanTankus/status/1283904531798069248">https://twitter.com/NathanTan...
The claim you see very often is that for a change in the current account to take place, there has to be a distinct offsetting transaction on financial account - someone else has to make a separate investment decision to finance current account move toward deficit.
The claim is that there is an accounting-enforced link between two distinct balances. E.g. that the choice of Chinese units to increase their holdings of US assets must increase US current account deficit. Not just is one factor tending that way, but necessarily results in it.
This is definitely the impression you get from a lot of international finance textbooks, where the current account must balance with a financial account that cosists of portfolio flows and FDI, which are in turn aggregates of investment decisions made by wealth owners.
Nathan& #39;s point is bank positions are also component of financial account, and these are not actively chosen but are passive counterpart of transactions by other units. When a deposit is transferred between units from different countries, that shows up in financial account of BoP.
When I make a payment to someone in another country - whether for a good or an asset - the payment itself shows up as an offsetting entry in the financial account. There is no need for anyone else to do anything to maintain payments balance.
Suppose I’m in Canada and buy a good from the US. "Buy" means I transfer a deposit at either US or Canadian bank to seller. In 1st case, Canada’s foreign assets decline, in 2nd, Canada’s foreign liabilities increase. Either way, no further financial account transaction is needed.
So transaction itself creates offsetting BoP entry. As far as accounting goes, nothing more needs to happen. No one else& #39;s decision to make a decision to buy a Canadian asset or sell an American one.
Now, my purchase of US asset/good has created a long position in Canadian dollars, or short position in US dollars, somewhere in financial system. (In this perspective, that’s a better way of putting it than loss of foreign exchange.) That position may cause change in behavior.
Maybe added to Canadian banks& #39; dollar liabilities. This may make them banks less willing to lend, pushing up interest rate. Or perhaps a US entity ends up with Canadian dollar deposit they don’t want, and their effort to find a buyer pushes down the value of the Canadian dollar.
These adjustments may lead to changes in cross-border flows that offset initial change. E.g., if Canadian banks end up with more dollar liabilities and this reduces their willingness to lend, that will slow income growth in Canada, which will mean less imports.
But the *possibility* of these kinds of offsetting behavioral changes is very different from the idea of a direct, one-for-one link between current account and foreign investment. You can& #39;t make any causal claims based on accounting identity between current and financial account.
Because of course many other factors influence exchange rate, interest rate, credit conditions, growth, and these can change without any corresponding changes in either current-account or foreign-investment flows.
The textbook model that suggests there is some unique point in interest rate-exchange rate space that balances independent trade and financial flows is deeply misleading, imo, and Nathan& #39;s post is helpful in seeing why.
There& #39;s a deep analogy here with the Keynesian liquidity-preference story about interest rate. Pre-Keynesians saw it as equating two distinct flows of saving and investment. Keynes showed that I always creates its own S, no need for interest rate adjustment to maintain equality.
The interest rate rather is determined as *stock* equailibrium, based on investors desire for more liquid assets. Similarly people are imagining exrate in terms of cross-border flows, but really it& #39;s a stock equilibrium based on portfolio preferences, not cross-border payments.
