Handbook of International Economics | Macro Paper Warehouse

Chapter 34 The intertemporal approach to the current account

The intertemporal approach treats the current-account balance as the outcome of forward-looking saving and investment decisions rather than as a residual determined by relative prices, and this chapter surveys the theory and the evidence for it as developed since the early 1980s. The authors trace its origins to two pressures: Lucas’s critique, which suggested that open-economy models “might yield more reliable policy conclusions if demand and supply functions were derived from the optimization problems of households and firms rather than specified to match reduced-form estimates,” and the large, divergent current-account adjustments that followed the oil shocks of 1973-74 and 1979-80, on which “[n]either the classical monetary models nor the Keynesian models in vogue at the time offered reliable guidance.” Before any theory they flag a measurement problem that “plague[s] all of the empirical literature”: reported current accounts omit net capital gains on foreign assets and are not corrected for inflationary erosion of their real value, so that for the United States in 1991 the economically meaningful deficit is “probably much closer to” minus 108.7 billion dollars than to the national-accounts figure. The theory is then built up in stages. From time-separable isoelastic preferences and the economy’s intertemporal budget constraint comes a characterisation in which the current account responds to deviations of interest income, output, government consumption and investment from their permanent levels, plus a consumption-tilting term reflecting any gap between world real interest rates and domestic impatience – each prediction stated with an explicit ceteris paribus clause. The model’s quantitative failure is displayed rather than hidden: with a world real interest rate of 8 percent, growth of 4 percent and an intertemporal elasticity of 0.4, the implied steady-state net foreign asset position is minus twenty times annual output and “the economy’s trade balance surplus each period must be 80 percent of GDP” – levels “never observed in practice.” Successive sections add comparative advantage, investment with adjustment costs, nontradables, consumer durables, terms-of-trade and transfer effects, demographic structure and fiscal policy, then uncertainty under complete markets, bonds only, partially complete markets and endogenous incompleteness. On the evidence, the authors first take on Feldstein and Horioka, reproducing the original 16-country OECD regression for 1960-74 (a saving coefficient of 0.887 with a standard error of 0.074, R-squared 0.91) and reporting a weakened but still highly significant coefficient of 0.622 for 1982-91; they also note that the average OECD time-series correlation between saving and investment rates over 1974-90 is 0.495 after linear detrending and 0.512 in first differences. Their conclusion is that these correlations “provide[] no basis at all for dismissing the basic premises of the intertemporal approach,” offering four reconciling mechanisms – current-account targeting by governments, OECD countries sitting near stochastic steady states for external debt, retained earnings raising investment through the Gertler-Rogoff channel, and demographic structure – while conceding that “no single one fully explains the behavior of all countries.” Formal structural tests are treated much more sceptically. Constructing permanent values is “perhaps the most problematic issue of all”: with a real rate of 3 percent, moving the persistence parameter from 1 to 0.97, “an amount generally too small to detect empirically,” halves permanent output, and the discount rates that would remove this sensitivity “appear implausible.” The Campbell-Shiller present-value tests reject the model’s exact restriction for most countries – Sheffrin and Woo reject for Canada, Denmark and the UK but not Belgium; Ghosh does not reject for the US but rejects for Canada, Germany, Japan and the UK; and even the weaker Granger-causality implication is passed only by the US in Ghosh’s full sample – while the actual current account is generally more volatile than the predicted one, six times more so for Canada on Otto’s estimate, which Ghosh reads as evidence of “’too much’ capital mobility, in contrast to the Feldstein-Horioka claim of too little.” Extending Britain’s sample back to 1870 improves the visual fit “dramatically” yet still fails the formal restriction. Distinguishing global from country-specific shocks helps substantially: global shocks are about half of G-7 productivity shocks, and once separated “the coefficients on the global shocks are invariably much smaller than those on the country-specific shocks, and are usually insignificant.” The chapter’s closing claim is comparative rather than triumphal: the models “provide only a starting point,” but the complete-markets alternative makes the current account “little more than an accounting convention” in a world the authors judge far from complete, while Mundell-Fleming “offers no valid benchmark for evaluating external balance” and “has no clear, much less testable, predictions about current-account dynamics.”

CIP deviations, the dollar, and frictions in international capital markets

This is a survey chapter, written for Volume V of the Handbook of International Economics, rather than a paper presenting new results; its claims are drawn from the literature it reviews and its own descriptive statistics. (The full text used here is the freely available NBER working-paper version of May 2021.) The organising fact is the dollar’s outsized role in global finance: the United States is about 15 percent of world trade and 25 percent of global GDP, but the dollar accounts for roughly 50 percent of cross-border loans and international debt securities, 90 percent of FX transactions, 60 percent of official reserve holdings and 50 percent of trade invoicing. Because “the global market for dollar funding is highly fragmented” and many participants who need dollars cannot reach dollar-rich lenders directly, large global banks have to intermediate – and since the Global Financial Crisis their balance sheet constraints have tightened, partly through regulatory reform. The most visible symptom is the failure of covered interest rate parity, measured by the cross-currency basis: the difference between the cash-market dollar rate and the synthetic dollar rate implied by borrowing in foreign currency and swapping into dollars. The chapter documents a sharp pre- and post-crisis dichotomy – CIP “held remarkably well prior to the GFC,” with only fleeting deviations of 30 seconds to 40 minutes – and shows the post-crisis deviations survive replacing Libor with OIS or with government-collateralised repo rates, so they are not simply a credit spread. Three stylised facts follow. The basis is generally negative, with the Australian and New Zealand dollars the G10 exceptions; it correlates 90 percent in the cross-section with the level of nominal interest rates since 2008, which means the hedged CIP arbitrage runs opposite to the unhedged carry trade; and it has a strong factor structure, with the first principal component of quarterly changes in the five-year G10 bases explaining 51 percent of variation over 2008Q1-2020Q3 and correlating 96 percent with the average basis, so the basis widens in bad times alongside a strong broad dollar, high VIX, wide BBB-Treasury spreads and negative intermediary capital shocks. The explanatory framework is a supply-and-demand diagram for swapped dollars. Pre-crisis supply was perfectly elastic at a zero basis; post-crisis the leverage ratio requirement, which “mandate[s] banks to maintain capital against all assets, regardless of their risk characteristics,” makes even a riskless matched-book trade costly, tilting the supply curve upward so that demand shifts now move the equilibrium basis. On the demand side the chapter identifies three client types willing to pay the basis as an intermediation fee: non-top-tier non-US banks with local-currency insured deposits but dollar assets, non-US institutional investors with local-currency liabilities and dollar portfolios, and multi-currency corporate issuers exploiting currency-segmented bond markets. Central bank swap lines are the crisis backstop, priced at a fixed spread over OIS that fell from 100 basis points in the Global Financial Crisis to 50 in November 2011 and 25 in March 2020, with peak outstanding of about $580 billion in 2008-09, $110 billion in the European debt crisis and $450 billion during COVID. The chapter then separates government bond CIP deviations, which need not be arbitrage at all, since they can reflect sovereign default risk, capital controls and market segmentation, or cross-country differences in convenience yields. A final section surveys two views of what CIP deviations mean for exchange rates – one treating them as a signal of intermediaries’ risk-bearing capacity, the other as a determinant working through bond convenience yields – and the chapter closes with open questions about whether post-crisis regulation is calibrated correctly, about the growing role of non-banks, and about the macroeconomic consequences.

Sovereign Debt

This is a survey chapter, not an empirical paper: it takes one benchmark limited-commitment model of a small open economy and uses it as a common spine for the whole sovereign-debt literature, showing which branch of the literature each modification of the benchmark generates. The starting claim is that what distinguishes sovereign from private debt is not insolvency but enforcement – a firm is “at least technically, always subject to a legal authority,” a sovereign is not – so the sovereign’s option to walk away is modelled as a participation constraint that must hold at every history, and that constraint doubles as an endogenous borrowing limit. Before building the model the chapter assembles six empirical regularities it then holds the theory against: default recurs throughout history and in waves, and “graduation” to non-default status is extremely rare; default is more common in bad times but far from exclusively so (in Tomz and Wright’s sample of 175 countries output is on average 1.6 percentage points below trend at the start of a default, yet more than a third of their 169 episodes began with income at or above trend); creditor losses in restructurings are large and very heterogeneous (roughly 30 percent in Uruguay to over 60 percent for some Argentine and Russian bond series, averaging roughly 30-40 percent across the wider samples); renegotiation is slow, taking eight years on average across ninety episodes, with the median country leaving restructuring carrying a debt-to-GDP ratio 5 percent higher than at default; emerging-market spreads rise with maturity, co-move strongly with global factors, and the yield curve inverts while new issuance shortens during crises; and fast-growing economies are net exporters of capital, a pattern driven by government rather than private net foreign assets. Run through the benchmark, the model delivers a tight set of predictions: limited commitment impedes risk sharing and does so worst when debt is high; the efficient response is to back-load consumption, which means saving, so a patient sovereign eventually reaches full risk sharing while an impatient one never does; a large debt stock depresses and destabilises investment because capital makes walking away more attractive; and the participation constraint binds in high-endowment states, which the chapter is careful to say does not mean the model predicts “default happens in high-endowment states” – what it means is that borrowing is limited in bad times. Extensions then generate equilibrium default (add a shock to the outside option that lenders cannot see), costly delay in renegotiation (drop state-contingent assets, add hold-out incentives), self-fulfilling rollover crises (Proposition 1’s crisis zone, following Cole and Kehoe’s timing), and the quantitative Eaton-Gersovitz models of Aguiar-Gopinath and Arellano. The chapter’s own verdict on that quantitative literature is candid: it works, but “often relying on ad hoc assumptions that restrict equilibrium objects such as financial contracts and the output costs of default,” and it lacks both microfoundations and a coherent theory of equilibrium selection.