The Specie Flow Mechanism

One of the reasons most people’s view of the effects of a tariff are wrong is that they are implicitly imagining a world where everyone uses the same money. In that context it makes sense to believe that the reason the Chinese can export to us more than we export to them is that they pay their workers less, have fewer environmental restrictions, or in some other way have lower costs. But in the real world Chinese wages are in yuan, American wages are in dollars; until you have an exchange rate between dollars and yuan it makes no more sense to say that their costs are lower than yours than to say that my height is more than your age.

Understanding why they can or cannot sell things to us for less than it costs us to make them requires you to understand how the exchange rate, which converts yuan costs into dollar costs, is determined. Once you understand that you discover that most of the reasons people offer for who can export what to whom are the result of logical errors as are at least some of the effects people expect tariffs to produce. I explained all of that in a post I put up more than two years ago; you may want to read (or reread) it before going on.

My purpose this time is to show how the logic of trade described in the earlier post for a world where different countries use different currencies works in a world where all countries, or at least many countries that trade with each other, use the same currency. That is not the world we live in, although many people think about trade as if it were, but it is a world of the past, the world of the gold standard.

Under a gold standard,¹ a country’s currency consists of gold coins or bank notes redeemable in gold coins. To convert a price in francs into a price in marks all you need is the ratio between the amount of gold in one coin and the amount in the other. In that world it makes sense to compare costs in different countries; they are defined in the same units, ultimately ounces of gold. If all costs, measured in gold, are lower in Germany than in France, then Germany can sell everything to France, France can sell nothing to Germany. France has a trade deficit — imports larger than exports — and Germany a trade surplus.

The French are buying German goods with gold coins, so gold is flowing out of France and into Germany. The less gold there is in France the higher its price, not its price in gold, by definition one, but its price in goods, how much bread or wine exchanges for an ounce of gold. The more gold there is in Germany the lower its price. The price of gold in goods is the inverse of the price of goods in gold, the more loaves of bread it takes to exchange for an ounce of gold the less gold it takes to buy a loaf of bread. Prices measured in gold are going down in France, up in Germany.

When prices go down in France and up in Germany German goods become less attractive to people in France, French goods more attractive to people in Germany; the French trade deficit and the German trade surplus get smaller. The process continues as long as there is any imbalance of trade, stops when trade precisely balances, when Germans are buying as many ounces of gold worth of French exports as French are buying of German experts. The logic is the same as in the modern world with floating exchange rates.

Just as in the previous post I am simplifying my explanation by assuming a world of two countries and no capital movements, no Germans using their gold to buy French stocks or bonds or land instead of French goods. What happens if we drop those assumptions?

Introducing more countries does not change either the logic or the conclusion. If France is importing more from other countries than it is exporting to them gold is flowing out so prices are falling; lower prices in France makes imported goods less attractive to French consumers, French goods more attractive to foreign consumers, so the French trade deficit gets smaller. The process stops only when the total value of exports equals that of imports.

Introducing capital flows, however, does change the conclusion, because it introduces another way in which gold can flow in or out. If a German buys a French security, or French land, or shares in a French company, gold flows out of Germany into France. Germans are buying something from Frenchmen but what they buy stays in France so doesn’t appear in the French import or German export statistics. If France imports a hundred thousand ounces more than it exports but Germans invest a hundred thousand more in France than French invest in Germany — I am back in a two country world — then there is no net flow of gold from one country to the other so no reason for prices to change in either.² The equilibrium price levels are no longer those at which exports and imports are equal but those at which, in each country, the trade deficit, the difference between exports and imports, is equal to the net inflow of capital.

It is now possible to have a trade deficit in equilibrium. One reason that might happen could be that France has a growing economy, more attractive investment opportunities than Germany. Another is that Germans save more, have more money to invest. A third reason, possibly the one most relevant to the US at present, is because the French (American) government is running a large budget deficit, spending more than it collects, and financing it with German (Chinese) money.

There are at least two differences between the systems. The exchange rate is a price, the price of dollars in yuan, so it can shift almost instantaneously to reflect changes in supply and demand on the dollar/yuan market. The equivalent under the gold standard, the ratio of the price level in gold in one country to that in another, changes gradually as gold flows out of one and into the other.

The other difference is that a change in the exchange rate is relevant only to trade between countries since trade within a country is conducted in that country’s currency. A change in the price level within a country can have large effects on its internal economy. Most obviously, an unanticipated increase in the price level hurts creditors and benefits debtors since the money lent out was worth more than the money paid back will be and, more generally, hurts any one with net nominal assets, assets defined in money, helps anyone with net negative nominal assets.

Suppose France has a trade deficit and the government does not want prices to fall; perhaps it has net negative nominal assets, debts denominated in francs, hence in gold. One solution is to run a budget deficit and finance it with German gold, borrow money from German lenders. Suppose it has a trade surplus and the government does not want prices to rise. One solution is to run a budget surplus, accumulate gold in it vaults or use it to buy German capital assets. Similarly, in the modern world, a government that wants to keep the exchange rate from changing in response to a change in exports or imports can hold the value of its currency down by printing more of it and using it to buy foreign currency or securities, thus increasing the supply of its currency on the foreign exchange market and holding down its price. It can push up the price of its currency by selling foreign securities it accumulated in the past. The result is a “dirty float,” a system of fixed exchange rates in a world of multiple currencies. Eventually the government runs out of foreign securities and has to revalue its currency, accept an increase in the amount of other currencies it exchanges for.

I have described all this as done by “the government.” Monetary policy was (and is) sometimes implemented by the central bank, whose relation to the government was different in different countries, but the distinction is not important for the logic of how it worked.

As I hope you can now see, the basic logic of trade is the same in a world with one currency as in a world with many, with changes in relative prices playing the same role in the former as changes in exchange rates. In both the equilibrium result is that a country’s trade deficit equals its capital inflow.

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1. I am describing a pure gold standard. Things short of that sometimes get the label.

2. Obviously there are other reasons prices might change such as economic growth, but I am only looking at trade.