March 18, 2002

Trade Deficit

The U.S. trade deficit has not shrunk as rapidly since the recession began as most analysts were expecting. Imports have fallen by about fifteen percent, but exports have fallen too.

Last March 13, Alan Greenspan said:

During the past six years, about 40 percent of the total increase in our capital stock in effect has been financed, on net, by saving from abroad. This situation is reflected in our ongoing current account deficit, which, by definition, is a measure of our net investment in domestic plant and equipment financed with foreign funds, both debt and equity. But this deficit is also a measure of the increase in the level of net claims, primarily debt claims, that foreigners have on our assets. As the stock of such claims grows, an ever-larger flow of interest payments must be provided to the foreign suppliers of this capital. Countries that have gone down this path invariably have run into trouble, and so would we. Eventually, the current account deficit will have to be restrained. The nation's economic potential will be brighter if that comes about through an increase in domestic saving rather than a reduction in domestic investment.

If we were still on a gold standard, the United States would (eventually) have no choice but to trigger a domestic recession in order to deal with the trade deficit. But John Maynard Keynes and Harry Dexter White got rid of the gold standard. In large part the reason they got rid of the gold standard was to make deficits the problems of surplus as well as of deficit countries. As Bob Rubin and Larry Summers used to say: don't balance down, balance up. Europe and Japan need to loosen policy and accelerate their growth to boost their imports (from America).

Meanwhile--as long as the U.S. foreign debt is made up of foreign equity investments and foreign dollar-denominated securities--a large-scale dollar depreciation is not primarily our problem,* it's primarily their problem. It lowers American's terms of trade, yes, but the fall in the value of the dollar boosts the competitiveness of export industries. More important, it writes down the value of the external debt, and it does so smoothly and automatically. Thus the "surplus" countries have a much greater stake and incentive to balance up than America does to balance down (and alan Greenspan has gotten quite attached to a sub-six percent unemployment rate).

Since 1980, those countries that have gotten into big trouble from current account deficits have done so because their trade deficits have cumulated into large foreign currency-denominated debts that have meant that home currency depreciation does not write down the value of the debt. Thus whenever the currency depreciates, the home currency value of foreign debt becomes crushingly large. America is going to be able to avoid that (at least, America is going to be able to avoid that if the Federal Reserve and SEC do their job and keep both eyes on the derivative books of major (and minor) financial institutions).

*Maury Obstfeld and Ken Rogoff think that when the depreciation comes America is going to have to move 4% of its labor force from investment-goods industries to export industries within the space of a year or so, that that degree of expenditure-switching is going to produce some kind of recession, and that if monetary and fiscal policy do not hit the sweet spot when the depreciation comes that the recession could get very bad. But the absence of large-scale foreign currency-denominated debt means that the U.S. economy still has room to maneuver to avoid a serious crack-up.

Of course, were you to tell me that New York financial institutions' derivative books had a net notional principal that was long the dollar to the tune of $3 trillion, my mind would change. My mind would more than change: I would be reduced to a gibbering, nervous, fearful, insane wreck cowering beneath my desk...

Posted by DeLong at March 18, 2002 04:12 PM | TrackBack

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