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I think it would be worthwhile for you to read (or re-read) "United States then, Europe Now" by Thomas Sargent. https://files.nyu.edu/ts43/public/research/Sargent_Sweden_final.pdf

As Sargent points out that the ability to borrow today depends on expectations about future revenues, that good reputations can be costly to acquire, and that free-rider problems exist for subordinate governments vis-a-vis a central government.

If a country has little prospects of running real surpluses, lending will eventually stop. More to the point in your example, people trade comparative advantages and as far as country A is concerned, country B has no comparative advantage. I think your example is just the description of a Ponzi scheme in drag.

Avon: Sargent is coming at this from a public finance perspective, which is important and useful. I'm coming at this from a trade-theory perspective, which I think also adds something. I have two goods.

Purely from the production side, the banana producers have a comparative (and absolute) advantage at producing bananas. They can't produce apples at all. But we often forget that the gains from trade depend on preferences as well as technology and endowments.

My silly little model is rather like a collective Ponzi scheme. Each individual borrower is not behaving like Ponzi, but in aggregate it's a Ponzi scheme.

"But we often forget that the gains from trade depend on preferences as well as technology and endowments." Really? Who forgets that?

In your example, country A sees no comparative advantage in country B - there is nothing that anyone in country B has that country A wants. As far as anyone in country A is concerned, country B is just a giant machine that only produces useless bananas without apples as an input. Since citizens of country A see this as a useless machine - they will never supply it apples either by lending or trading. Unless you allow a Ponzi scheme from the start, there is no trade.

I think this analogy has little to do with the problems of Greece and the European Union.

So why stop there? Instead of a tax or direct lending from As to Bs enter a CB who lends to Bs who use that money to buy apples. Every payment cycle will make it appear as if there is a "shortage" of money as Bs bid up the price of dollars among themselves to service the debt- this liquidity crisis (reality a solvency crisis) will cause the CB to issue more debt- so there is a perpetual cycle of transfers from As to Bs

Avon: "Unless you allow a Ponzi scheme from the start, there is no trade."

Yes, but suppose something exogenous to my little model does get the ball rolling. Like the ECB in bacon's comment. If we add money to the model, the money will flow from the banana producers to the apple producers. Then the ECB lends it right back. But money always complicates things.

Again, re-read Sargent: free-rider problems exist for subordinate governments vis-a-vis a central government.

Your model is Country A and Country B, not subordinate governments A and B to central power C. If C has the power to forcibly redistribute from A to B, then yes, apples will appear in country B. Not insightful.

C also has the power to redistribute from B to A. With symmetric preferences, there would be no reason to expect either.

Or think way back to the days when China had goods that Europe wanted, but not vice versa. The worry about gold flows, opium wars, etc. Or that movie about blue people who produced unobtanium.

I don't see that this must be a ponzi scheme, since land can be sold.

In aggregate, the loans can be repaid if the apple farmers end up owning banana plantations, even if they never themselves eat bananas.

Majro: But if banana plantations pay rents in bananas, why would apple producers want to own a banana plantation?

So trade deficits can run on for a long time, with net assets accumulating in the surplus country and debts in the deficit country, without presuming individual irrationality. Neat result, seems right up Michael Pettis's alley.
In bringing this example to the real world, though, Pettis would make the point that it is irrelevant whether the Germans consume anything the Greeks produce, as long as someone somewhere wants to buy what the Greeks produce. Say, Chinese businessmen sell hats to the Germans and use the money to take a Greek vacation. A point you should be sympathetic to, given your recognition that money makes a coincidence of wants irrelevant.

Louis- This example is not a coincidence of wants example- its a structural demand change example.
A change (decline) in the demand for bananas leads to a recession/depression in the B producing zone, attempts to reduce this recession for B only sets up future recessions for A and works as a net transfer of assets from A to B.

louis: you are right of course. But I wanted a simple example, with only two countries, so I kept the Chinese out of it.

Nick Rowe:"But if banana plantations pay rents in bananas, why would apple producers want to own a banana plantation?"

A problem for London landlords of land in the American colonies, after the colonies issued their own currencies. Finally the British parliament passed legislation that said that colonial currencies were not legal tender. That put the burden on colonial renters to obtain British pounds, which were in short supply. One of the causes of the American Revolution.

baconbacon: Of course it is a coincidence of wants problem. The banana producers desire apples. The apple producers have no use for bananas. Trade doesn't happen in a normal sense between the two nations. It's not a problem of a change in demand (the banana producers could desire relatively more bananas than apples tomorrow, and nothing would change), it's a problem of the composition of demand (zero demand for bananas among apple producers). It's very cool that in this limited example, individual extensions of credit can cause apples to flow from A to B, with the innovation of debt denominated in apples.


> But if banana plantations pay rents in bananas, why would apple producers want to own a banana plantation?

Insurance against preference change: one day, an apple grower may develop a taste for bananas. Having a stream of banana income allows the forward-thinking apple-lender the ability to purchase the apple-maker-banana-eater's produce. (Alternately: potassium deficiency kills some of the apple-eaters, needing them to import banana labour to work the orchards.)

Your narrow example involves there being absolutely nobody who produces apples who also likes bananas, hence the infinite price. That's implausible enough, but adding land means that we need to expect with certainty that this trend continues forever.

@Loius- Take the debt denominated in apples and change it to dollars, what changes? Nothing- when the debt comes due even if the Bs can pay in dollars there wont be enough apples for purchase and the price of apples will jump in dollar terms.

The game between Germany and Greece runs as follows, for years:

1. Germany sends Mercedes cars to Greece.

2. Greece provides olives and travel enjoyments, not worth a mercedes.

3. To make up the difference, Greece draws on its TARGET2 account at the ECB. In this system, Greece has obligations of over 100 percent of GNP. Germany has a corresponding credit balance.

Herbert: how much of it was financed by Target2, vs financed by private lending? Was most of it indeed financed by Target2? Or was that only recently, when private lenders withdrew, leaving only Target 2 and the IMF holding the bag?

Baconbacon - the underlying problem is that apple producers don't want bananas at any price, and banana producers want to get their hands on apples somehow. In this scenario, you can get around that by promising them apples in the future at some cost of apples today.
Alternatively, in a market with more than two participants, and with a medium of exchange, you could sell bananas to some third country for dollars, and use the dollars to buy apples. As long as Appleland wants what the third country is producing at some price, this is solvable. In this scenario, you're not trapped into Ponzi debt accumulation by Bananaland. You don't worry about bilateral comparative advantage, but global comparative advantage. Instead of wringing hands about German taste vis a vis Greek products, you think about the marketability of Greek exports on the global stage.

@ Louis- it only becomes a coincidence of wants problem when you add a third party and assume that they want bananas more than they want apples, and also that As want their goods.

I don't know Nick's intention, but his example is a demonstration of how credit expansion can APPEAR to satisfy a coincidence of wants, only to have one generation at the end holding the bag when they go to cash in.

baconbacon - agree to everything you say @2:50 pm (well, I would strike the words "more than they want apples", that they like them at all is sufficient for trade to happen at some price).
My original post was only pointing out that in the real world (but not in the bilateral world of Nick's example), whether or not the Germans like Greek olives is barely relevant.
Probably enough said in this exchange already.

louis, in our example Bs only want goods from C to exchange for As. If Cs want As more than Bs their goods (by the assumptions we have so far) will always be traded for As because Bs cannot be traded for As. Its just an artifact of the overly simplistic system.

As far as real world vs non real world- I think this post gets to a great deal about trade and monetary policy. If I were to sum up lazily my interpretation- just because money can be used to satisfy a coincidence of wants doesn't mean that all money use automatically satisfies a coincidence of wants.

I was wrong- what matters is that C has a lower preference for As in terms of Bs than B does. If C's is higher then no trade occurs.

I think the point with Germany is that the Germans have enormous and very unrealistic savings demand. They want to consume neither German nor Greek output, but need to export huge amounts of German output every year just to avoid their (German) economy going into a very painful internal devaluation with large unemployment.

So something is very wrong with the German economy that has nothing to do with the nationality of the output that they refuse to purchase. They are equal opportunity savers.

I think one option is to create Martian Exports. Firms wanting to export to mars will deposit their goods at a loading dock, where workers will set fire to the output and in exchange give the firms euros (or Martian Euros). This is much more virtuous, from the point of the view of the Germans, than having the German government run budget deficits and purchase output directly. Then German households can accumulate large claims on Mars to the point where they feel that they are being sufficiently righteous so that they are saving enough and can go out and consume a bit, too.

rsj: "They want to consume neither German nor Greek output, but need to export huge amounts of German output every year just to avoid their (German) economy going into a very painful internal devaluation with large unemployment."

Suppose there is a symmetric home bias in preferences, so both are Cobb-Douglas, but the exponents are h for the home good and 1-h for the foreign good, where h > 0.5. That is the normal assumption, because of transport costs, especially for services.

If the apple producers consume more, save less, and so export less apples and import more bananas, then Pa/Pb rises. It's a revaluation.


Are you assuming that capital flows are banned? Because the baseline euro case would be perfect flows of capital, with possibly a home bias in investing, but not so much with the euro. In that case, Pa/Pb isn't necessarily going to rise at all, and even if it does, it need not rise enough to offset the net export position.

E.g. suppose the equilibrium rate in Germany is -10% (my actual best guess), but in the rest of the world, it is 0%. And the actual rate in Germany is 0% and in the rest of the world it is 0%. Now there is no reason for the euro to appreciate against the rest of the world -- doing so would violate covered interest parity -- so Germany just keeps exporting to the rest of the world up until the equlibrium rate in the rest of the world also falls to something negative. Germany has just achieved a global deflation because of their excess savings demands, and because actual rates don't change a whole lot due to the zero bound, there is no reason for the euro to appreciate against the rest of the world.

rsj: "Are you assuming that capital flows are banned?"

No. Just the opposite. Let the apple producers have preferences U=A^0.6 B^0.4 and the banana producers have preferences U=A^0.4 B^0.6 So each spends 60% on home production and 40% on imports. If apple producers spend more, and banana producers spend less, (capital flows match net export flows), then Pa/Pb rises in competitive equilibrium. Demand for apples rises, and demand for bananas falls. Basic trade theory (I don't do trade theory, but I think I've got it right).

Right, but that's not what's happening here -- e.g. Germany wants to be a net exporter. Rather, it needs to be a net exporter, in the sense that if Germany cannot export 10% of its GDP, then there will be large unemployment in Germany. How does that fit into your apple/banana model? German's don't want their own goods and they don't want foreign goods. They don't want goods, they want savings, whether those be claims on the future production of apples or the future production of bananas.

Said in another way, Germany savings demands intersect german investment demand at an interest rate of say, -10%. But at a rate of 0%, there is a gap of, say, 10% of German GDP. That gap needs to be filled by claims on foreign output or else Germany falls into a depression.

Of course, the gap could be provided by government deficit spending as well (the economy is clearly non-Ricardian with negative interest rates). However, there is moral outrage at deficit spending that prevents it from occurring, so the foreign sector is the only hope of fully employing the German labor force. This has *nothing* to do with a preference for home production versus foreign production. The key differential is a preference for savings versus consumption of production of any kind.

From the Economist:


"Yet one thing has not changed: most Germans still do not invest in local firms. Whereas over half of Americans own equities in some form, only 15% of Germans own shares directly, while a partly overlapping 21% own mutual funds. The omission is all the more striking since Germany’s main share index, the DAX, is at a record high and interest rates are at record lows. […]Yet Germans still prefer to put their money in safe-seeming but far less lucrative savings accounts. The most common sort, theSparbücher, earned a mere 3.1% over the past five years.
Germans tend to see share ownership as a kind of gambling.
[…]According to a 2011 poll for the Association of German Banks, Germans said they were saving “for old age” (30%), “for emergencies” (27%) and “for major purchases” (27%). Only 7% mentioned “building wealth”. Asked about the most important criterion for an investment, 60% said “security”; only 15% said “returns”.
Instead of switching to more rewarding investments, Germans have responded to low interest rates by cutting back on saving. German household saving rose steadily between 2000 and 2008, to a high of 11.5% of take-home income. But it has dropped since, reaching 10.3% last year. Postbank, a retail bank, expects these numbers to fall still further.

Public policy does not help, by treating investment in securities as dangerous or even illicit.

Also interesting is that Japan, another profligate net-exporter, has very similar social dynamics. An abhorrence of risk of any kind and a preference for keeping wealth in government guaranteed savings accounts. The population appears to be extremely risk-averse -- e.g. my company tries to hire some employees in Japan, but they don't want to work for any company that doesn't have at least 300,000 employees and can reasonably guarantee lifelong employment without any risk of being laid off. It's almost impossible to find someone to hire, even at substantially above market wages, because households really demand safety.

In that kind of an environment, you can see how there would be a large wedge between domestic savings and domestic investment, necessitating very large deficit spending and/or very large net exports just to keep people employed. But by making this out as a reduced preference for foreign goods versus domestic goods you are getting at the wrong conclusions. It wouldn't matter if foreign companies produced goods identical and indistinguishable from domestic goods as the wedge would still be there.

Here is another nice article about the German's need for savings as a route to personal salvation -- excess savings of _water_:


"People here are known to flush toilets with old bath water and to take turns bathing in the same tub without refilling it. New German toilets typically use about two gallons of water for a full flush and less than one for water-saving.

Conserving water is an expression of personal virtue and social responsibility. But as scholars, utility managers, and municipal officials point out, there is a dark side to the impulse. Sewage stagnates in too-large canals and noxious gas is corroding cement. Basements in Berlin are flooding because of the rising water table.

As good as saving water might feel, they explain, a shower skipped in Marburg won't add to rainfall in the Maghreb.


But when the children leave half-full glasses standing around, Dilek Güngör dumps the contents into her watering can. Same goes for the bowl of water left over after she washes lettuce. If the watering can is full, there is also the old coffeepot in the kitchen.

Ms. Güngör, a writer in Berlin, is aware that saving water in the hydrologically rich capital isn't necessarily a good thing.

Nevertheless: "I feel sorry for the water," she said."

rsj: stop. Re-read my last two comments. They are not about Germans saving a lot. I know Germans save a lot. They are about the consequences on the terms of trade of a reduction in German saving if there is a home bias in preferences. You got the sign wrong in your 5.44

I don't understand all this nonsense. Nick, the problem you set is Country B has nothing that Country A wants. Ever. No trade will happen. No lending will happen. Period. Everyone here asking, "What about land?", "What about a medium of exchange?", these are all non-sequiturs. I could equally ask, "what about Country B's space program and their extra-dimensional wormhole that transforms bananas into banks notes. What then?" This is NOT how you get anywhere. State a model, then work out the consequences.

Nick, the problem as stated is vacuous. There is no content. Country B might as well not exist as far as Country A is concerned.

If anyone here wants to learn about problems in Europe, start with something sensible, like Sargent's "United States then, Europe now".

Avon: there's only one good in Sargent's model. So he can't see the terms of trade effects.

Think of my model as two limiting cases. We see what happens with no home bias (terms of trade are independent of transfers, so it's like a one-good model), then we see what happens in the limit as Germany has a bigger and bigger home bias.

No, Nick, you stated a limit case, not a limiting sequence. You state that there is nothing in Country B that Country A wants. So there is no trade and there is no lending. Sorry but that is simply a fact, it vacuous. To get A to trade, lend or interact with B you need something else. The limit that the something else, whatever it is, goes to zero gives the model problem you stated - but that is the terminal state of an infinite number of something "elses". For your discussion to have content you need to tell us what the something else is.

OK, let's say that country A has a bigger home bias than country B. Suppose that the interest rate in A is 2% and the interest rate in B is 0%. That means that A's currency is depreciating at a rate of 2% per year against B, _even_ _though_ A has a bigger home bias. B is running trade surpluses against A, and A's budget line is shrinking inward even as B's budget line is moving outward, and as that happens, the relative prices p_a/p_b are adjusting in both currencies to reflect that appreciation.

Preferences for goods tells you the relative price of the two goods in your currency in one instant snapshot. They do not tell you about the direction of trade flows, e.g. whether you are importing more than exporting, or whether those prices are rising or falling over time in response to the increase or decrease in your budget line.

Greater savings demands --> greater trade surplus + currency appreciation, irrespective of home bias in preferences.

IIRC, all of the above is orthodoxy, even if you don't buy the overshooting thesis, right? Therefore focusing on home bias isn't very enlightening for understanding trade flows.

And, I'm only saying this because this line of argument comes up a lot in the popular media -- e.g. the U.S. is running a trade deficit against China because the Chinese don't want to buy anything that we have to sell, etc. You are making a similar argument about Germans not wanting to buy anything that Greeks want to sell. To me, this is just a very populist and un-economic argument. Trade flows are driven by openness of capital flows and relative interest rates, not because one party doesn't have anything the other party wants to buy. That's always been a canard, IMO.

I will stop commenting on this thread now :)

rsj: "Greater savings demands --> greater trade surplus + currency appreciation, irrespective of home bias in preferences.

IIRC, all of the above is orthodoxy,..."

No. That is the opposite of orthodoxy. Trade theory 1000 and macro 1000 and the empirical evidence say the exact opposite. Canada mid-1990's fiscal policy tightened turning a deficit into a surplus, so national saving increased and the real exchange rate depreciated and net exports increased. The Loonie fell to US$0.60.

And you get that result because of home bias. If apple producers and banana producers have the exact same (homothetic) preferences for apples and bananas, the relative price of apples and bananas would be unaffected if the apple producers spend less and the banana producers spend more. Because the demand for apples relative to bananas would be unaffected if the apple producers demand less fruit and the banana producers demand more fruit.

If both countries have a foreign bias (apple producers like bananas more than apples and banana producers like apples more than bananas) you get the opposite affect on the terms of trade. Pa/Pb rises if the apple producers demand less fruit and the banana producers demand more fruit.

Yes, current and capital account surpluses/deficits are driven by relative saving and investment. But the effect of those surpluses/deficits on the real exchange rate depends on home bias.

I think this here is just a collection of national stereotpyes, which are not supported by the facts.

Germany accounts for 9.5% of Greek imports, or less than 5 b(illion)USD. For Germany, with an export volume of 1493 b, exports to Greece are just a rounding error.

The problems of Greece have nothing to do with Germany but with their chronic mismanagement.

Germany does not have "high saving rates" in contrast to the endless repetition of this myth. In contrast we have to raise the saving of the lower 70%, to cover for theire retirement, with pension payouts only at 43%.

The median personal wealth is actually lower than in Greece http://en.wikipedia.org/wiki/List_of_countries_by_wealth_per_adult
despite the GDP per capita higher by

Please take a look at the OECD annex table 58, and keep in mind that Germany has for several reasons only a home ownership of a little over 40%. Subtract mortgages from total liabilities for consumer debt , not covered by home assets, and you find that Germany and Japan had/have higher numbers than the others.

When we had to finance reunification (accumulated 100% of West German GDP, drained out over the years) we did this by taxing people to the hilt, and not with debt. The Eastern Germans went on a spending binge, which ended for many in bankruptcy (http://de.statista.com/statistik/daten/studie/150565/umfrage/privatinsolvenzen-in-deutschland-seit-2000/ compare the 150 000 cases to birth numbers of about 650 000 per year)

For japanese savers to not invest in stock, steadily falling since 1990, please see the Nikkei 225 made perfect sense.
For a majority of germans, with no house and very little savings, going into stock with the main index DAX dropping from 8000 to 2700 after the year 2000 was als not calculable

All this has nothing to do with "home bias" or "transfer problems"

Greeks problem is that they fudged the books, lived way beyond their means (15% current account deficit and government deficit in the boom years 2007 / 2008), did not invest that in any productive assets, but just driving the price of their homes up, higher in Germany, public salaries, pensions.

And now they still expect that the Rest of Europe, of which Germany is just 27%, should somehow pay their debt, and continue to subsidizes their overconsumption.

Their main (export) income is tourism, but there they have cheaper competition with Turkey and Egypt, which are at similar travel distances from Germany.

Greek olives may taste a little better, but I get Spanish olives for half the price.

For some countries, like Slovaky, Portugal, the output of German foundries actually accounts for 20% or more of their exports.
(for Romania French Renault ?).

But who would be so mad to invest in Greece? With lunatic socialist governments and unions, not even one train connection to the central european manufacturing belt.

And public pensions still higher than in Germany http://www.faz.net/aktuell/wirtschaft/eurokrise/griechenland/griechenland-zahlt-hoehere-renten-als-deutschland-13501028.html

To bring this in line with government income, they have to cut this by 20%, and that is political suicide, unless Greece is just days away from a second bankruptcy, Grexit, and another 20% or more drop of GDP


covered interest parity is about relative rates, not absolute rates (and the total IS-LM-BOP has to be relative to the natural rate).

In 1990, rates in Canada were much higher than in the U.S. -- a good proxy for "the world" as far as canada was concerned -- and Canada had a negative current account balance. The differential fell and Canada in 1995 had a relatively *loose* monetary policy and the current account swung to a positive position, etc.


"Herbert: how much of it was financed by Target2, vs financed by private lending? Was most of it indeed financed by Target2? Or was that only recently, when private lenders withdrew, leaving only Target 2 and the IMF holding the bag?"

Sorry for the delay. Initially, Greece's spending was privately financed. In 2009, private investors withdrew, and the ECB stepped in, the crucial point of its policy being that it accepts junk bonds as "collateral". Currently, Germany's TARGET2 balances amount to 500 billion euros.

Herbert: thanks. And if private lenders expected that to happen, you could get an equilibrium with private loans even if private lenders knew it would be impossible for Greece to repay, like in my little model.

This is basically exactly the phenomenon I was trying to show in my macro model from a while ago. (http://realfreeradical.com/2014/07/16/a-model-of-endogenous-money/) You are so close to seeing things my way, it's remarkable. One of these days I'm going to get you too look past the silly notion that money is valuable solely because of liquidity preference and then I think a lot of things will come together. In the meantime here is my alternative to IS/LM.


Mike: But mine is a pure Trade Theory Model, with no money?

I will have a look at your rgmv model.

Yes, I was trying to make a similar point about money, not apples.

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