International Trade: Understanding the Logic of the ‘Balance-of-Payments Growth Constraint’ – and Why It Doesn’t Apply to Monetary Sovereign Governments
Modern Monetary Theory Challenges the Idea That Growth Is Limited by a negative balance of payments and that deficit spending makes it worse
What you will learn:
An understanding of the Balance-of-Payments Growth Constraint (BPGC); why the BPGC is only relevant to countries without monetary sovereignty; why countries without monetary sovereignty must obtain foreign currency from exports to pay for imports; why trade deficits don’t financially constrain monetary sovereign governments; and why productive capacity and pace rises are the real constraints on growth for monetary sovereign governments.
Technical Terms/Jargon Used in This Article
You will find definitions of all of the technical terms/jargon used in this article in my series of MMT Economic Jargon Buster articles. Paid subscribers can also download my MMT Dictionary.
Challenging the Balance-of-Payments Constraint – The MMT Perspective
Before I get into the article, I want to mention why I decided to write about this topic. I was looking (again) at the results of the questionnaire I sent out a few weeks ago and noticed that one of the topics you said you’d like to learn more about is international trade.
So, with that in mind I opened my copy of ‘Modern Monetary Theory: Bill & Warren's Excellent Adventure’ and skipped to the International Trade chapter. I read this sentence: "The balance-of-payments-growth-constraint (BPGC) concept continues to dominate the way both mainstream and heterodox economics evaluate fiscal policy choices.”
I have to admit that the BPGC was a topic I was not familiar with, but if it’s ‘dominating the way fiscal policy choices are evaluated’, then clearly this is something we should learn about. So, learn about it we will: that is my aim for this newsletter.
First, we need to understand what the Balance-of-Payments Growth Constraint is.
Defining the Balance-of-Payments Growth Constraint (BPCG)
Here’s the story: Trade deficits (i.e., importing more than is exported) are regarded as unsustainable because they lead to a build-up of net foreign currency debt – which has the potential to push a country to insolvency or at the very least make it vulnerable to external shocks.
This leads to the conclusion, that if there’s a trade deficit, the government must constrain spending – since spending will increase demand for imports, which will make the trade deficit worse, i.e. there is an even greater likelihood of the country becoming insolvent.
This is because the BPCG tells us that a country's growth is limited by its ability to finance imports through export earnings. That is, its ability to earn the foreign currency needed to pay for imports.
So, you may well ask, why does government spending increase imports? Well, because government spending will allow people to buy more things from other countries and that will result in a weakening domestic currency.
Why will it weaken the domestic currency? It will weaken the domestic currency because when you buy stuff from abroad you usually have to pay in the currency of the seller, and that means the value of your own domestic currency goes down (simple supply and demand).
For example, if your domestic currency is the UK pound and you are buying goods in US dollars, the greater demand for dollars pushes the value of the dollar up and the value of the pound down. So, now the country has a weaker domestic currency. In practice that means you need more UK pounds to buy the same amount of foreign goods and services as you did before.
Why does a weaker domestic currency matter? Well, it matters because you are now potentially importing inflation. Imports are now dearer than they used to be – and because those imports are inputs to your domestic manufacturing – that results in more expensive products, which pushes up prices.
And let’s not forget the currency traders, who, viewing your currency’s depreciation as a sign of weakness, may decide to dump it—making the situation even worse. In other words, the value of your currency could be at risk of total collapse.
What about the ‘growth constraint’ part of the BPCG?
As I mentioned earlier, BPCG tells us that a country’s growth can be constrained by a trade deficit. More specifically, it says that a country can only grow as fast as it can earn foreign currency through exports. So, the focus of policy should be on ensuring the country's exports grow fast enough to finance import needs.
However, BPCG also tells us that growth itself is a problem: because too much growth leads to people buying more imports, which increases the trade deficit – which leads to an even greater need for foreign currency – which, of course, is needed to purchase those imports.
And the only way that foreign currency can be obtained is by selling more stuff to other countries.
So, proponents of this BPCG model tell us that in order to fix the negative balance between imports and exports, the economy must slow down, i.e. government spending must be cut – to slow growth and fix the trade balance.
“The rationale behind the law is that no country can grow faster than its balance-of-payments equilibrium rate for very long, as its level of overseas debt to GDP ratio will grow to levels that will precipitate a collapse in international confidence, the downgrading of its international credit rating, and a sovereign debt and currency crisis.” McCombie (2011):
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The BPCG story has an appealing logic
The BPCG presents us with a conundrum: you need foreign currency to buy stuff (imports) – but you can only earn it if you sell stuff (exports) – but if people buy too much foreign stuff, they cause inflation (due to currency depreciation) – and that makes selling stuff harder because it’s now dearer – that makes foreign currency harder to get – making buying foreign stuff harder because you need foreign currency. Yes, that’s right: stimulating the one thing you are after (growth) seems to be the one thing stopping you from getting what you are after. It's a catch-22 for policy makers.
Here it is in bullet points:
A country needs foreign currency to buy imports.
It can only get that foreign currency by selling exports.
If people buy too many foreign imports, that can cause inflation or downward pressure on the domestic currency. Obtaining too much foreign currency weakens the domestic currency: making imports dearer – which imports inflation.
That inflation makes it harder to sell exports because they are now more expensive.
And that in turn makes it harder to earn the foreign currency needed to pay for imports.
If the country doesn’t issue its own currency, or its currency is pegged, it has no choice but to earn or borrow foreign currency to pay for imports.
In that case, the government cannot increase domestic demand (e.g. through public spending) without risking an increase in imports and a worsening trade balance.
So, to avoid running out of foreign currency, governments must limit growth by cutting spending or slowing the economy, even if there are domestic resources sitting idle.
I’m sure that this circular logic felt very satisfying to Post-Keynesian economist Anthony Thirlwall (Nicholas Kaldor helped lay the foundations), who first formalised this idea. I can understand its appeal. However, in the rest of this article, I explore why the Balance-of-Payments Growth Constraint does not hold up for modern monetary sovereign countries.
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MMT Addresses the Balance-of-Payments Growth Constraint in the Context of Governments With Currency Sovereignty
“The current account balance need not ... be seen by itself as a reliable indicator of vulnerabilities … The fact that Australia has managed to sustain investors’ confidence is evident in the maintenance of the current account deficit at an average of around 41/2 per cent of GDP over two decades combined with a real exchange rate showing no discernible trend over the same period.” Belkar et al. (2007)
The above story (i.e., BPCG) makes more sense for governments with fixed exchange rates and no ability to freely issue their own currency (i.e. if they are on the gold standard, where the issuance of new money must be backed by gold).
A fixed exchange rate implies a need to find foreign currency reserves which can be used to buy and sell the local currency in order to keep it at a target level.
The danger, with a fixed exchange rate, is that you can run out of foreign reserves and that can lead to currency collapse. (If your currency is on the gold standard, the issue is that you can run out of gold.) In that case, you may well want to discourage people from buying too many foreign goods — leading to a negative balance of trade.
And indeed, if exports were your only way to access foreign currency and therefore you believed that growth was the driver of greater consumption of foreign goods, you would want to discourage deficit spending.
Having said all of that, the logic fails when applied to modern, currency-issuing governments that have floating exchange rates. Countries like the UK, US, Australia, Japan, Canada, China, New Zealand, and more.
MMT Economists Don’t Agree That the Balance-of-Payments Growth Constraint Model Applies to Currency Sovereign Countries
"Warren [Mosler] met with Tony Thirlwall at Cambridge while participating in an MMT research project and after a brief conversation Tony agreed that the underlying context of this literature is that of a fixed exchange rate policy, which means it is inapplicable with today’s floating exchange rate policies. Ironically, John McCombie was party to the conversation at the time and agreed as well. The problem is that economists continue to use their ‘out of paradigm’ publications to analyse current events and promote policy.” 'Modern Monetary Theory: Bill and Warren's Excellent Adventure' by Warren Mosler and Bill Mitchell
The first problem with trying to apply the BPCG to monetary sovereign countries, is that the facts don’t support its conclusions. Balances of trade deficits have historically been the default for countries like the UK, Australia, the US, and others — and the consequences predicted by BPCG have never arrived.
For example, as MMT economist Bill Mitchell points out, Australia has run large trade deficits for much of the last 40 years. Yet the country hasn’t suffered from hyperinflation or a collapsing currency. In fact, it’s been considered one of the world’s most stable economies. Investors around the world hold Australian dollars and buy Australian assets: it is considered a safe haven.
Monetary sovereign countries float their currency
With a floating exchange rate, the currency’s value is set by the market. It moves up and down automatically based on trade and financial flows (and of course, currency speculation). So, a country that is not trying to manage a fixed currency has no need to continually find foreign currency to peg it to any particular value. Such countries never need to worry about running out of currency reserves.
Currency depreciation can still happen (think, Liz Truss crashing the value of the UK Pound in 2022); however, it is not necessarily harmful. And yes, currency depreciation makes imports dearer, but it also makes exports cheaper. Those cheaper exports will, in time, help change the balance of payments back to a more balanced level — as exports increase due to the competitive price advantage.
That’s not to say that imported inflation is not or will not be a problem — however, MMT economists would point out that ‘supply side’ inflation can be managed by addressing supply constraints. For example, by investing in domestic renewable energy to reduce reliance on expensive foreign oil and gas.
Notwithstanding that, countries have been running deficits for decades and none of these disasters have happened.
Many MMTers regard a trade deficit as a good thing
Warren Mosler and Bill Mitchell point out that from a consumption perspective, imports actually represent a real benefit to a country’s people. When a country runs net imports, it is effectively enjoying a higher material living standard by consuming more goods and services than it produces for export. Exports, on the other hand, represent a real cost — they are goods and services that the nation produces which are sent to people in other countries. Goods and services that can no longer be consumed at home.
Beyond supply-side measures like investing in domestic industries to ease bottlenecks, Modern Monetary Theory highlights that fiscal policy itself is a powerful tool to manage inflation. By adjusting government spending and taxation, the government can influence overall demand in the economy to keep price inflation in check — without necessarily having to cut spending drastically or slow growth. This contrasts sharply with the Balance-of-Payments Growth Constraint view, which assumes governments must limit spending to avoid external financial crises.
MMT points out that what truly limits a country’s growth (apart from political considerations) is not a shortage of foreign currency but the availability of real resources: labour, materials, technology, and productive capacity. A country issuing its own currency is not financially constrained like those on a fixed exchange rate or currency peg. It can always spend in its own currency to mobilise idle domestic resources.
MMT: a bullet point summary of why BPCG doesn’t apply to currency sovereign countries
A currency-sovereign country still needs foreign currency to buy imports.
However, a floating exchange rate allows the domestic currency to adjust in value against foreign currencies.
If import demand puts pressure on the exchange rate, that might cause depreciation and imported inflation, but that does not mean that the government is going to run out of domestic currency or foreign currency. It does not need foreign currency reserves to support a particular currency exchange value.
Historically. most instances of inflation are supply-side (shortages due to geopolitical disruptions: pandemics, war and so on), therefore, most inflation can be managed by addressing supply-side constraints using fiscal policies, rather than by cutting spending (or raising interest rates) or slowing the economy.
Because of this, the balance-of-payments growth constraint story does not apply: there is no need for currency-sovereign countries with floating exchange rates to slow growth in order to manage foreign currency shortages.
A country that issues its own currency and has a floating exchange rate, can always buy anything that is for sale in its own currency. This means it is not financially constrained in the way that fixed or pegged currency countries are. Domestic exporters do not need to ‘earn’ foreign currency before the government can spend for domestic growth.
If people buy more imports, that can affect the exchange rate — but there is never a risk that the government will run out of money.
A weaker exchange rate may make imports more expensive, but inflation can be managed through targeted policies, not by cutting spending.
So the government doesn’t need to slow growth or reduce spending just because the trade balance shifts — the real limit is price inflation, not the balance of payments.
A country needs real resources to grow. Growth is not constrained by the need for exporters to earn foreign currency.
And finally, I should note that both Warren Mosler and Bill Mitchell point out that imports represent a real benefit, allowing a country to consume more than it produces; whereas exports represent a real cost. By this they mean that goods being made for others to consume - means they are not available for consumption in the domestic market
Conclusion: The Balance-of-Payments Growth Constraint Should No Longer Be Used to Analyse Current Events or as the Basis for Developing Policies
The Balance-of-Payments Growth Constraint story may be a useful model for developing policy in countries that lack monetary sovereignty and/or operate under fixed exchange rate regimes — but it is not applicable to monetary sovereign countries.
For currency-issuing governments with floating exchange rates, as I’ve shown in this article, the story breaks down.
MMT reveals that the real constraint on growth for monetary sovereign countries is not a shortage of foreign currency, but a shortage of real resources and the resulting inflation (as defined by Warren Mosler below) — and the capacity to mobilise those resources effectively.
Warren Mosler, in his paper A Framework for the Analysis of Price and Inflation, outlines the idea that prices are set by the government, as the monopoly issuer of currency and payer of last resort, and that inflation results from excessive nominal demand — from both the public and private sectors — relative to real productive capacity.
Related resources
Modern Monetary Theory: Bill & Warren's Excellent Adventure – Warren Mosler and Bill Mitchell.
A Framework for the Analysis of Price and Inflation - Warren Mosler.
That’s all for now.
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In New Zealand we produce enough food to feed about 40 million people. Our population is about 5.5m. We have seen foodbanks unable to keep up with demand for free food parcels as people struggle to afford increased food prices on top of rising rents and electricity.
One of our largest export categories is dairy, which is primarily controlled by one company, Fonterra, which is a farmer-owned co-op. Because the export price of butter is very high at the moment, the local retail price of butter has risen by 67% in the past year, to around $20 per kg. Although I am a keen baker and can afford the prices, I have been reducing my purchasing because it seems a ridiculous price for a basic staple.
How can MMT help to ensure that people living in countries with high export prices also can afford to feed their families?
Also, where is there a "country without monetary sovereignty"? I do not know of any.
The decision of nation-X to employ a foreign currency is exercise of X-sovereignty, of the completely stupid type. It can be reversed overnight by policy to switch to a domestic tax credit. Where did the "absence of sovereignty" disappear to? Nowhere, it was all psychological.