5. Money and the External Constraint

The focus of this chapter is twofold. First, we return to the theory of endogenous money, providing further details on how banks create money in the form of loans to businesses and households. Secondly, we open our economy to foreign trade and introduce another workhorse of heterodox economics, the “balance of payments constraint”. We explain what the balance of payments is: far from being a boring accounting document in which foreign trade and financial transactions are recorded, it is a key to many important questions. In particular, it tells us how countries that want to grow faster in order to catch up with more developed nations often find themselves stuck in unsustainable foreign debt and financial crises. This is because when a country grows faster, it ends up importing more goods from abroad. These must be paid for in international currencies (e.g. in dollars), that can be obtained through exports or through borrowing from foreign banks. Debt in foreign currency is risky because the country may fail to increase its exports and therefore to repay its foreign debt. The final part of the chapter discusses the Modern Money Theory thesis that the balance of payments constraint is overestimated.