Why did the dollar rise with Trump but the pound fall with Brexit?

If you are part of the conventional liberal “elite” like me, 2016 has been marked by two colossal acts of democratic self-harm: Brexit and the election of Donald Trump. It is easy to understand why the pound sunk after Brexit. By why has the US dollar being doing so well after the election of Donald Trump as president? It is a useful lesson in macroeconomics.

The first thing to say, though, is that the way most of the media cover such market movements is unhelpful. They talk of sentiment and emotional judgements made by anthropomorphised “markets”. These may provide a satisfactory story line for a journalist, but they yield no real insight and no predictive power. They are simply projections onto past events. But very often, and this is no exception, far more satisfactory explanations are available, based on the way money flows through economies and financial markets.

Take Brexit. The obvious explanation is that markets (sticking with the anthropomorphism for now) take a dim view of Britain’s prospects amid the confusion and uncertainty thrown up by Brexit. But by itself that explanation is inadequate. The fall in Sterling was not matched by falls in stock markets (after an initial wobble) and other markets which also depend on future economic prospects. In fact there seems to be much more of a wait-and-see approach by the people and institutions who set market prices.

But wait-and-see is not so neutral. The UK runs a substantial current account deficit (5.7% of GDP according to the Economist, the highest of the 43 countries in its data table – and the second largest in money terms, at nearly $150bn in the last year). That means that the country is consuming much more than it is producing, which in turn means that the country is spending more pounds than it is getting back from exports, etc (or spending more foreign currency on imports than it is getting from exports). This deficit must be made up from the capital account – by investors buying UK assets of one sort or another (or Britons selling off foreign assets). Wait-and-see means that foreigners are more likely to defer making investments, which reduces the demand for Sterling on capital markets, causing its price to fall. This makes UK assets more attractive, UK exports more competitive and imports less attractive. All perfectly textbook.

So, what about the US? This country has a current account deficit too (2.6% of GDP which is $488bn in money terms, the largest current account balance in any direction by some margin, in the Economist table). Surely there is a lot of waiting and seeing to be done here, as Mr Trump’s policies, shall we say, lack clarity? But there are a number of differences with the UK. The first of these is that the US is an economic superpower, which dominates global financial markets, with the dollar used as the top reserve currency. It is much easier for the country to draw in investment that the aging middle-ranking country that is the UK. It has much more secure access to liquid, short-term funding. And with a huge domestic market the outlook for its businesses look less precarious than that for British ones.

But the most important difference is that, for all Mr Trump’s lack of clarity, what is known about him, and the Republicans who control Congress, points to a loosening of fiscal policy. This mainly takes the form of tax cuts. This increases the demand for dollars, because it will increase spending in the US domestic economy. Exactly how remains to be seen. On one version US corporations will repatriate foreign profits and invest in infrastructure. This is all uncertain – but Mr Trump and the Republicans in Congress certainly agree on tax cuts, especially for the wealthiest. And this happens at a time when most people are convinced that the US is running at close to capacity – so there is no question of fiscal laxity being complemented by monetary laxity, which would allow the increased demand for dollars to be met by extra supply. Indeed the Federal Reserve is in the process of tightening policy, and increased interest rates this month.

This economic dynamic is often not appreciated – that in a world of freely floating currencies and open capital markets, loose fiscal policy leads to an appreciation of the currency. But there are plenty of examples if you look for them. When Germany unified in the early 1990s, it involved a considerable relaxation of fiscal policy – which caused the Mark to appreciate, and a crisis in the European Exchange Rate Mechanism in 1992 that forced Sterling to leave, shredding the credibility of John Major’s Conservative Government. My Economics lecturer at UCL used the British government of the mid-noughties as another example – the government ran a larger budget deficit than was warranted at that point in the economic cycle, at a time when banking laxity had already led to excess demand in the economy.

The effect of fiscal policy on a floating currency is part of what is known by economists as the Mundell-Fleming model, proposed independently by economists Robert Mundell and Marcus Fleming, leading theorists of floating currencies. It is one of the reasons that floating currencies are not quite the free lunch suggested by many Anglo-Saxon commentators. It means that a floating rate tends to neutralise fiscal policy (just as a fixed rate neutralises monetary policy). As a currency appreciates, the current account reduces (or deficit gets larger), and any increase in aggregate demand is lost across the world economy. Unless monetary policy operates in the same direction (including “printing money” to monetise the budget deficit), in which case you are in effect operating a managed exchange rate policy. This often ends in inflation or default.

This points to one of the tensions in Mr Trump’s economic policy. Fiscal laxity will lead to a widening trade deficit – exactly the opposite to what he promised on campaign. That will tend to force him into protectionist policies, which in turn could create a doom-loop of global proportions. Many believe that we have the makings of another global financial crisis, especially given developments in the Chinese economy – for example read this from Yanis Varoufakis.

But another tension could be that Mr Trump’s fiscal stimulus proves ineffective. The rich people and corporations that benefit from the tax cuts save most of their winnings; planned infrastructure spending is lost to political friction; and Congress insists on dismantling the social safety net, especially Medicare, sucking demand out of the system by hitting the less well-off. That would mean that growth is disappointing, breaching another Trump campaign promise.

But that’s in the future. For now participants in the financial markets are readying themselves for more demand for dollars, and weaker demand for pounds. They aren’t taking a view on the wisdom or otherwise of either Brexit or the new US regime.

20 thoughts on “Why did the dollar rise with Trump but the pound fall with Brexit?”

  1. …..loose fiscal policy leads to an appreciation of the currency

    You’ve made this argument before and I’m still not convinced by it. So we could get the pound back up to pre-Brexit levels by more government spending and less taxation? Sounds too good to be true -so it probably is!

    To look at it the other way around, if the currency appreciates, then imports become more attractive and exports less attractive. So we can expect the current account deficit to increase. Using the principle of sectoral balances this means that government will likely run an increased deficit too. Money spent on imports is largely untaxable so the government’s revenue will fall. That’s another way of looking at it.

    So it might appear that the government has adopted a more lax fiscal policy but what has happened has been largely outside the government’s direct control.

    But say the Government did actively decide to spend more and tax less to the extent that the economy became over stimulated. I think we’d all agree that increased inflation would be the likely result. If interest rates lagged well behind the rate of inflation there would be a direct incentive for everyone to spend more and save less. This would include overseas holders of sterling. The pound would therefore fall and imports and exports would come more into balance. If the pound fell enough there might even be an export surplus.

    So, ironically, a loose fiscal policy would (again using the idea of sectoral balances) result in a lower pound, a smaller current account deficit and lower government deficit too. Another way of looking at it would be to recognise that all that spending , brought on by the fear of inflation, would increase the government’s tax take.

    That’s why just a little bit of inflation is no bad thing. It’s a hidden tax on the money hoarders.

  2. As I’ve argued before using an identity like sectoral balances as an analytical tool is superficially attractive, but actually yields very little of value. It tells you nothing about cause and effect – as your response shows. Does currency appreciation cause a budget deficit, or is it the other way around? In each of the three cases I have cited (the US now, Britain in 2005 and Germany in 1992) I would argue the evidence that fiscal laxity was the driver is very strong (though you have argued in the British case that it is more appropriate to point the finger at the banking bubble). In the US case I am basing my assessment of this on reports from the Economist of what is actually happening in the financial markets for dollars – which make it clear that demand for dollars is rising because of expected changes to government policy.
    Of course loose fiscal policy can cause a depreciation. In the first case Mundell-Fleming only applies to real exchange rates – inflation may cause the nominal rates to fall while the real rate (the amount of foreign goods an hour’s wages will buy, for example) rises. But more to the point, holders of foreign currency might take fright – nominal inflation is a problem, and there may also be a risk of default. If that happens private sector demand has to take the strain of excess public sector demand, and we get a recession, assuming the public can’t be persuaded to save more. The currency appreciation is a short-term effect, and cannot be sustained in the medium to long term.
    Incidentally, my take on globally integrated economies is that excess demand tends not to lead to inflation – though here I am moving away from the textbooks. Prices are fixed by global processes.

  3. Matthew,

    I’m not sure why you think sectoral balances yields “very little of value”. We both agree that its is difficult to separate cause from effect, but nevertheless the relationship between the twin deficits (government and current), taking account of what the Private Domestic sector is doing is still there regardless of which way around we put it.

    But if we ask the guy in the street about it he’s unlikely to know. I’ve explained it to quite a few people and normally they pick up on the idea very quickly. It’s really not that difficult. Once they see that relationship they also see the folly of trying to reduce the govt’s deficit without doing something about the trade deficit too. I suppose that’s why the neo-libs don’t like the idea and the MSM don’t want to talk about it.

    I hadn’t heard the names Mundell and Fleming before. But their theory just doesn’t seem at all plausible. I checked out what Bill Mitchell has to say about them and he agrees with me.

    You say that Trump’s “fiscal laxity will lead to a widening trade deficit”. It’s always difficult to predict which way currencies will move. Anyone who’s worked out how that all works can safely give up their day job. It’s possible that looser fiscal policy will stimulate the US economy leading it to grow and become healthier. That growth will encourage others outside the US to buy US Federal bonds pushing up the dollar’s value. That’s what will lead to a widening trade deficit.

    On the other hand, a looser fiscal policy could increase US inflation. That will cause a flight from the dollar and will lead to lower deficits all round. If you really do know which way it will go, and can prove you know, then you’ll be able to command a healthy salary on one of the London trading desks.!

    PS You might want to correct your spelling of collosal in your second line. You can edit out this afterwards if you like. 🙂

    1. Sectoral analysis is a good way in for people not familiar with economics to get there heads round the consequences of particular developments, and it is still useful if you want work through potential consequences. That’s it. It gives you no guide to the myriad of possibilities it leaves open. I suspect people like you of using it to support the possibilities you find compatible with your prejudices (not that you are any more prejudiced than I am) and to disregard the others.

      Which makes it very like the Mundell-Fleming model. Mundell and Fleming are two of the giants of post war economics. They explored the logical consequences of floating exchange rates and free capital movements. The model that bears their name is a useful analytical tool, which, like all such tools, is highly idealised. Yes it was harnessed to the neo-Keynesian consensus, but it can be used against it too. To say that that discredits it is a bit like saying that the sectoral model is “fatally flawed” because it forms part of that consensus too. In fact, like the sectoral model, it gives you clues as to what to look for, rather than having a huge amount of predictive power. In using it to explain the current US situation, you need corroborating evidence, of which I believe there is plenty. Loose fiscal policy will not lead to a currency appreciation in may circumstances (such as if there is spare capacity in the economy which the stimulus unlocks – such as if it frightens the financial markets). So what? All the model suggests is that it can. And, indeed, it often does. Often is not always, or even mostly.

      What a lot off rubbish Billy Mitchell writes. You often say about how weak economics is as an analytical discipline compared to physics. Well he is a particularly egregious example of that. He simply describes anything he dislikes as “flawed” based on “evidence” that amounts to a few loose correlations. And sometimes he even gets that wrong. Take this: “Australia demonstrated in the late 1990s and beyond that record budget surpluses were associated with record depreciations in the exchange rate. More recently our exchange rate has reached levels not seen for 35 years while the budget has gone back into substantial deficit.” Isn’t that precisely what Mundell-Fleming predicts? (Not that I would necessarily claim that Australia’s case supports the model – that needs deeper analysis – something which is clearly beyond Mitchell’s imagination). I hope that debate on physics gets beyond this puerile level!

      1. I’m not sure exactly what Bill Mitchell is meaning here. My take on all this is that a country’s exchange rate is what it is and that’s just about impossible to predict.

        It is the exchange rate which largely determines the current account deficit. At any one time there is a value which we could, in the case of Australia, call A$(0) at which trade will balance. If it is above that there’ll be a trade deficit. If its below there’ll be a surplus.

        If there’s a trade deficit there’s likely to be a government deficit too. Using the idea of sectoral balances. If there’s a trade surplus the govt deficit will be lower and there may even be a surplus in that too. So that’s in accordance with what everyone is saying. I think!

        But i’ts too much of a stretch to say that a govt deficit causes or as you put it “leads to” an increase in the exchange rate. The most you can say is that there may be some association. And the cause could (I’d say probably is) be the exchange rate rather than govt fiscal policy.

        Bill Mitchell makes the comment ” Some economists have recently considered this hypothesis again for the US (Kim and Roubini, 2008) give(n) that a lot of the work was previously done on data that applied to the fixed exchange rate period.

        They found that expansionary fiscal policy actually improves the current account and depreciates the real exchange rate (indicator of competitiveness) – which they call the twin divergence hypothesis.”

        That’s what I would expect. But I do have to keep emphasising that exchange rate movements are, by their nature, unpredictable and can turn out to be the opposite of what nearly everyone, including myself, might expect.

        1. I don’t accept that exchange rate movements (especially real exchange rate movements) drop from the sky as acts of God, to which the rest of the economy must conform – which seems to be what you are suggesting. To me it is another macroeconomic variable, like GDP, inflation, budget deficit, etc., and no more or less predictable than any of these – though I would make a distinction here between the real rate and the nominal rate that is actually traded. And as for the Trump bump, the Economist did predict it pretty much as soon as the election result came in, using a chain of logic that boils down to Mundell-Fleming – though monetary policy context was important too..
          I am puzzled why you struggle to accept that there can be a causal chain from a government decision to loosen fiscal policy to an exchange rate appreciation. This follows pretty smoothly from your favoured sectoral analysis. The government decision increases the budget deficit; the private sector balance takes time to react (this is the critical assumption) so the current account balance must take the strain; the mechanism by which it must do so is the real exchange rate. This is a short term effect and not inevitable. And in the US, which is far from the small open economy on which the model is based, you would expect to see variations. But in the case of the Trump bump direct causal evidence is available; we don’t need to speculate.
          And as for Kim and Roubini, I haven’t read their analysis, so wouldn’t I like to comment. I would just say two things. The US is not a small open economy, so there are more factors that would throw any correlation out – for example if the fiscal expansion occurred in a recession, which it often does. The second thing is that this kind of macroeconomic study is nearly useless evidentially – it is a very small dataset and the contextual factors are impossible to control for properly. Comparative case studies of individual episodes may appear to be more subjective, but they have much greater analytical power.

          1. Matthew,

            I didn’t say it was an “act of God”. The exchange rate is determined by the actions of multiple buyers and sellers. It is sometimes said that when there are more buyers than sellers the price goes up. But, that can’t be right when you think about it . There are always equal numbers. For every buyer there has to be a seller.

            The reason the exchange rate is harder to predict than the other examples you give (like inflation , GDP) etc is that traders are trying to profit from future movements. If there was a way for you and I to know what the value of the pound was in six month’s time, we’d both be able to make lots of money. But if everyone else had the same access to that magic formula, not everyone could make a profit. For everyone who makes a profit there has to be others who lose out. It can’t just come from nowhere.

            So there can’t really be that magic formula. The only time the speculators can make money reliably is when Govt is intervening in the market and they don’t have deep enough pockets to hold their desired position.

            That’s primarily the reason why currencies should be allowed to float freely.

          2. Hmm. Well by “act of god” I meant what economists call “exogenous” – not an integral part of the system you are modelling. You are, of course, right about making money on the foreign exchange markets. But fundamentally these markets are no different from those for coffee and aluminium – the price is a function of supply and demand. If the Brazilian coffee crop is hit by frost, the price goes up. If Vietnam ramps up production of its coffee, the price goes down. But you’d be a fool to try and make money on coffee speculation. Speculation itself may affect the price, if people hoard or short for prolonged periods – but the effects are short-term. These days the most usual complaint about forex markets is that they are illiquid – i.e. there is too little speculation, which makes them bumpy. Of course predicting the exchange rate in six months time is a mugs game – but I would say that is just the same for inflation and GDP. That does not mean you cannot explain the variation of exchange rates, GDP and inflation in the past by reference to government decisions and macroeconomic models. And for some flavours, such as the quarterly real exchange rate, this is easier than others – like the daily spot rate.

            It is sometimes wise to float the exchange rate; it sometimes isn’t. Sweden does, Denmark doesn’t. Both are well-run economies. I would say that running an economy with a fixed exchange rate is harder – or else those speculators will have you for breakfast – but far from impossible.

          3. “I am puzzled why you struggle to accept that there can be a causal chain from a government decision to loosen fiscal policy to an exchange rate appreciation. This follows pretty smoothly from your favoured sectoral analysis. The government decision increases the budget deficit; the private sector balance takes time to react (this is the critical assumption) so the current account balance must take the strain; the mechanism by which it must do so is the real exchange rate.”

            Of course this is possible but it’s just speculation. I’ve just been listening to Jack Dee on the radio. The panel had to supply amusing endings to popular song lyrics. They came up with:

            You that I would untrue
            You know I would be a liar
            If I was to say to you..

            .. that our budget deficit reduction plan was on track!

            So it has entered the popular consciousness that Governments can’t simply choose to do things they’d like to do. It would be the same if if they tried to increase their budget deficit. They’d spend more and tax less which would stimulate the economy. That could have the effect of increasing everyone’s nervousness about inflation which would result in less saving and the a smaller budget deficit.

      2. I have now discovered that Bill Mitchell is a professor of economics as Newcastle NSW. God help us. Not a very big or important institution I suppose.

        1. You did take Bill to task for a couple of sentences he wrote in his critique of Mundell and Fleming. That was fair enough. What you said made sense and it’s possible he did get that part wrong. Whether the rest of it is wrong too is a matter yet to be decided.

          Bill Mitchell writes a lot. His posts are too long in my opinion. He’d be better splitting them up over two or three days. It’s hardly surprising, therefore, that he writes a few things that we might disagree with. I disagreed with one of the answers in his quiz as I referenced previously. So if we disagree with something we should say so and explain ourselves.

          But that doesn’t mean we should be totally dismissive as you are with your “God help us” comment. There’s plenty of intelligent criticism of the mainstream from people like Yanis Varoufakis, Steve Keen, Randall Wray, Stephanie Kelton, and others.

          Stephanie Kelton is my favourite of this school of thought. I listened to this lecture a few years ago and thought “Of course. That’s it. I’m sure she’s quite right”. That’s when everything started to make a lot more sense.


          1. That’s fair, Peter. I was very disappointed in the quality of Bill’s post. Apart from being too long, and the howler, it was very polemical – which means I automatically distrusted it. He dismissed things as “flawed” for reasons that he did not make very clear – “of limited practical value” is probably what he meant. I understand that Newcastle NSW (which I have visited a couple of times…) is an outpost of a branch of alternative economics referred to as neo-chartalism. Given the way academic economics works I can understand how frustration can build up – though it isn’t really an excuse for poor writing by a professor. I find heterodox economists much more interesting when they try to build alternative ideas, rather than just rubbishing the conventional wisdom – which every crank does. I was pretty unimpressed with my first readings of Steve Keen, for example – but much more interested in a post I picked up yesterday on non-equilibrium models, where he is clearly on to something.

            Your video link is 1hr22mins – but I will give it a try! Thanks.

        2. Well I did have a spare hour and I have watched it. I thought she started off very strongly, and collapsed into nonsense at the end, but left me with an interesting thought that I will need to ponder on: that the private sector should ordinarily be in surplus. The three problems that I can see are first that she avoided talking about production restraints on the economy as a whole, which in practice limit the amount of currency that should be issued without leading to financial bubbles or inflation. She had me spitting with fury when she suggested that the only reason the US economy was not hitting the trend line of pre-crash growth was lack of demand and that bad policy had led to a massive opportunity cost. That trend line is not a rule of nature but dependent on the underlying economy, and there are plenty of reasons to think that it has flattened. This is very lazy – or just a politically motivated wind-up. The second problem is that governments do not in fact have absolute freedom to denominate their debt in their own currency – especially if there is a current account deficit. In essence that’s why the Italians and the Portuguese opted for the Euro, because they were on the point of having to borrow in DM to keep going. The third problem (in common with most macroeconomics) is that it is a theory of flows which plays no attention to accumulated balances – and yet these play a critical role in financial markets – indeed I think that was Hyman Minsky’s most important insight. Deserves a blog in its own right – which would be a better place to have a conversation.

          1. OK we’ll pick up the discussion when you’ve written your blog. I don’t think she ignores production constraints for example.

            I hope we don’t lose sight of this one. “governments do not in fact have absolute freedom to denominate their debt in their own currency ”

            If anyone wants to run a trade surplus with the US they have to accept US$ as payment. They can swap them for US Treasury securities, if they want, which also are denominated in US$. That debt has to be in US$. There’s really no negotiation about that. Sure, that can be swapped for pound denominated debts or euro denominated debts – but all that means is that a third party has to hold US$ denominated debts.

            Now, I know you’ll be thinking that the USA is a special case. But is it? The same has to apply to the UK too. If anyone wants to run a trade surplus with the UK they, or a third party, has to want to hold UK pound based securities. We’d make the same argument about any country too. Of course it’s possible that the big exporters, like Germany, would not want to run a trade surplus with some countries. But that’s Germany’s decision not the particular country in question.

            If no one wants to run a trade surplus with Argentina and there aren’t enough willing holders of Argentinian debt, then trade will have to balance. If residents of Argentina want to save in Argentinian pesos the government will have a debt in pesos. If they don’t – it wont.

          2. I’m too harsh with “nonsense” of course, she went quickfire through a number assumptions that I think are questionable, and I blew my top with that trendline gap – though some mainstream economists say the same thing. She promised to talk about the threat of inflation, but never got to that bit. I guess it is not uncommon for people to dwell on the strong bits of their propositions, and skate through the more questionable ones. It’s all interesting enough for me to blog about, probably in two weeks. My next economics blog is already in draft – and deals with the poor state of academic macroeconomics.

            We’ll pick up on the whether countries can dictate the currency with which they pay for their imports. I would say that depends on how badly the buyer needs to buy and the seller needs to sell. Saudi insists we pay for oil in USD. We could stop importing oil, and that would lead to trade balance, but not in any way that would be good for the economy at large – it would involve a meltdown.

          3. One point of disagreement that I would have with Stephanie Kelton is her advocacy of a “Job Guarantee” to replace unemployment benefit. I wouldn’t say it was nonsense. It is an interesting idea but I’d say it would be a very difficult idea to sell politically.

            The right would object to the cost. The left would, and do, see it as a form of dressed – up “workfare” -which it could well be if it were administrated harshly.

            Also it’s straying into political territory. Economics should be about describing what is rather than prescribing what should be. I think the concept initially came from Bill Mitchell too.

            So I’d go along with most of their ideas. But not all. Another criticism is what they call Modern Monetary Theory is not all that modern. It’s really just a form of post-Keynesianism with the ideas of the JG and sectoral balances tacked on. They are unique, though, it pointing out that when unit money was tied to an amount of metal, or pegged to a currency which was, different economic considerations do apply but that the mainstream carry on just the same as before.

            I’d say the idea of sectoral balances is very important and much overlooked by the mainstream. It’s not that difficult and if we understand them we can understand why the EZ is in such a bad way and why austerity and deficit reduction schemes don’t work at all well.

            They are right to argue that it is immoral to deliberately run an economic system which requires a number of workers to be unemployed to provide a pool of reserve labour. Also they are right to say that when workers remain unemployed for lengthy periods they become less employable and less able, in the modern economy, to fulfill that ‘role’ of a pool of reserve labour.

    1. It’s my science/maths background coming to the fore, pure trained economists probably have fewer scruples. An identity is useless of itself. To turn it into a useful equation means you need to make assumptions about one of the terms – substitute an equation into it. It is that substituted equation that contains the power. Actual Jan Hatzius puts this quite nicely: “…every dollar of government deficits has to be offset with private sector surpluses purely from an accounting standpoint, because one sector’s income is another sector’s spending, so it all has to add up to zero. That’s the starting point. It’s a truism, basically. Where it goes from being a truism and an accounting identity to an economic relationship is once you recognize that cyclical impulses to the economy depend on desired changes in these sector’s financial balances.” The key to his analysis is not the identity, but his assumptions about private sector behaviour. Talking about the identity is just distracting attention from this assumption and seeking false authority. That people do so often just shows how shallow lots people’s grasp of the identities at the heart of economics are.

  4. My background in Physics and Mathematics, and as we would understand an identity, we’d say they differ from equations in that they are true for all values. So for example :

    (x + y) ^2 = x^2 + 2xy + y^2

    Is an identity because it’s true for all values of x and y.

    But if we said z= x + y

    That would still be an equation. Even though it had an infinite number of solutions, it wouldn’t be true for all values of x and y and therefore wouldn’t be an identity in the mathematical sense.

    But I do understand that economists , even ones I agree with, tend not to view it like that.

    So for example, as I would argue, the equation :

    Govt Deficit = Private Sector Surplus + Current Account Deficit

    does contain useful information. If you know two terms you can calculate the third. Even if you only know one, you can calculate the sum/difference of the other two. So from the Government’s perspective it is a false assumption to think that the Government’s deficit can be reduced by increasing taxation and/or reducing spending.

    But this is the assumption that’s nearly always made. It never works as George Osborne discovered the hard way. In fact it can well go the other way!

    The neolibs do understand that the Govt’s deficit can be reduced, as the above equation would suggest, by reducing the tendency of the Private Domestic sector to want to run a surplus. ie encourage them to borrow more!

    If they understand that, why don’t they understand that reducing the CAD by devaluation, or nudging the currency down, will work too?

    1. Yes – I’m overdoing my case against the use of identities. In an off-guard moment I might even admit to using them myself. My comments are only justified when everybody has internalised the identity concerned so much that they are second nature – as double-entry bookkeeping has become to me. It still annoys me when people misuse them. The worst was monetarism in the 1980s – this theory was (mainly) based on a particular understanding of the velocity of circulation. Its advocates never liked to mention this, but instead wheeled out the identity linking prices, real income, money supply and velocity as if that by itself said anything useful at all. That Hatzius article is rather good example of how economics identities should be used when explaining things. It is part of the explanation, but insufficient of itself.

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