The Balance of Payments

It’s time for something a bit different here on Alpha Sources. In November I published my first in-depth essay on one of the most profound ideas and theories in economics, to my mind at least; the life cycle hypothesis. Now I am back with an essay about the balance of payments, and more specifically the fascinating, and often controversial, interaction between open economies. The BOP isn’t a theory or even an idea; it’s an accounting framework. But as I hope to show in my essay, its interpretation and significance remains the source of immense economic debate and controversy. If I have done it right, I should leave the reader with a better understanding of the economics of the BOP and the theories that economists have developed to explain global capital flows. But I go one step further. I also argue that the current discourse on current imbalances and international capital flows is too caught up in normative economics about what one or more countries should do to “balance the books.” This is an unhelpful to look at global capital flows in my view, and I hope that I offer somewhat of an alternative here. Specifically, I try to re-vive the idea that global capital flows can, assuming free capital mobility, be explained to a large extent by population ageing, and via the path dependency of countries that have suffered BOP stress.

I have re-printed the introduction below. I hope you’ll enjoy it.

Click here for the PDF of the full piece.

The flow of goods and capital across borders and between nations has featured in human storytelling and economic relations since the beginning of time. The biblical protagonists traveled and traded with each other, and often fought over the dominion of resources. The protagonists in modern historical tales of trade and war since the turn of the millennium continue the habit in similar ways. You would be hard-pressed to find a better historical account of that than in Ronald Findlay and Kevin H. O’Rourke’s Power and Plenty. The book is as much about the wars that divided empires and nations as it is about the exchange of goods and capital that bound them together, though it is reasonable to say that these two perspectives are joined at the hip. Economics plays a specific role in the study of global trade and empire-building. The exchange of goods, capital, and services across borders gives rise to transactions as the ownership of resources shifts. Over time, these processes lead to the accumulation of wealth and debt on the part of nations and economic actors—assets and liabilities, in the jargon of modern finance. It is the economist’s job to trace, identify, and record the nature and value of these transactions. The economic historian faces obvious challenges when it comes to dissecting the scope and value of trade and capital flows that occurred centuries ago. That said, Findlay and O’Rourke’s (2007) work illustrates how far historians have come in giving an accurate account of the flow of goods and capital over time. The details, though ultimately unverifiable, are impressive and convincing. For contemporary economists, and those studying recent history in the 20th century, the balance of payments (BoP) is the framework through which the flow of goods, capital, and services across countries is recorded and analyzed. Effectively, the BoP is a simple double entry accounting system which ought to lend itself to relatively uncontroversial analysis and conclusions. As this essay will show, however, tracking the flow of international capital in modern economies is a hugely contested exercise, generating deep divides among economists regarding the accuracy, importance, and implications of the data recorded in the BoP. Therefore, it is probably the most controversial piece of accounting ever created.