September 17, 2003

If Something Is Unsustainable, It Will Stop

If Something Is Unsustainable, Then It Will Stop

Up through 1997 the measured United States current account deficit was a relatively-small one percent of GDP. Since then the measured deficit has grown remarkably--to 2.7% of GDP in 1999, to 3.5% of GDP in 2001, to an estimated 4.7% of GDP this year, and with the U.S. economy currently forecast to grow significantly faster than most of its trading partners to 5.1% of GDP in 2004. How long will non-U.S. residents continue to embrace the large flows of capital to the United States needed to finance this deficit? And what will happen when they stop doing so?

Clearly the United States's current account deficit is unsustainable. And, as the late Herb Stein used to say, if something is unsustainable then someday it will stop. I used to think that the United States current account deficit would stop when the rest of the world "balanced up"--when Japan recovered from its more than a decade-long stagnation, and when western Europe restructured its economy, boosted aggregate demand, and reduced its unemployment rate to some reasonable level. But as the years have passed "balancing up"--rapid growth in the rest of the world boosting demand for American exports--has become less and less likely.

The other way the current account deficit could come to an end is if the inflow of capital into America comes to an end. As the late Rudi Dornbusch used to say, unsustainable capital inflows always last much longer than fundamentals-watching economists believe possible. The investors funding the capital inflow and the country receiving the money always think up reasons why this time the inflow is not unsustainable but is the result of permanently transformed fundamentals. That mass delusion, Rudi argued, keeps the inflow going long after it should come to an end. But when it does come to an end, the speed with which the capital flow turns around is much faster than anyone--even fundamentals-watching economists--believes possible.

Whenever the capital inflow to the United States comes to an end, it is clear what happens to the value of the dollar: it declines by between 25% and 50%, depending on how rapidly Americans switch spending from imports to domestically-produced goods and how much of an expected dollar bounce-back is needed to induce investors to hold U.S. assets while the switching of spending takes place. In Mexico in 1995, in East Asia in 1997-1998, and in Argentina in 2002 the collapse of currency values caused enormous distress: as currency values fell, the local-currency value of debts owed to foreigners and linked in value to the dollar rose, and the danger of effective national bankruptcy grew. Deep recessions, high real interest rates, and financial chaos were all on the menu--although the skills of Robert Rubin, Michel Camdessus, Stanley Fischer, and many others including Mexico's and East Asia's politicians and central bankers kept the Mexican and East Asian crises much less destructive than they might have been.

But should the value of the dollar collapse suddenly, the United States will follow a different course. Like Mexico, East Asia, and Argentina America's international debts are largely denominated in U.S. dollars. But unlike Mexico, East Asia, and Argentina, the dollar is America's currency. A decline in the real value of the dollar does not increase but instead reduces the real value of America's gross international debts. A fall in the value of the dollar reduces Americans' standard of living by 4% or so, but it does not cause the kind of liquidity and solvency crises that we have seen so often in the past decade. (At least, it does not do so if New York's major financial institutions have well-hedged derivative books: if their derivative books are not well-hedged, all bets may be off.) The ending of the inflow of capital to the United States should not set off the worries about solvency and the derangement of finance that generated recessions in Mexico and East Asia and deep depression in Argentina.

The currency crises in Mexico, East Asia, and Argentina primarily impoverished workers who lost their jobs and those who found their hard-currency debts owed to the industrial core suddenly a much greater burden, and secondarily rich country investors who found themselves renegotiating terms with insolvent creditors. A rapid decline in the dollar is likely to have a very different pattern of impact: to primarily impoverish workers whose products are exported to America and investors in dollar-denominated assets who see their portfolio values melting away, and only secondarily affect Americans who heavily consume imported goods or who work distributing imports to consumers.

But why, then, does the capital inflow continue? Investors outside the United States can see the magnitude of the trade deficit, calculate the likely decline in the dollar to eliminate it, recognize that the interest rate and equity return differentials from investing in the United States are insufficient to compensate for the risk that next month is the month that the capital inflow into the United States starts to fall. To this fundamentals-watching economist, the fact that so much of the risk of loss from a decline in the dollar falls on those investing in America means that the capital inflow has already gone on much longer than I would have believed possible. What stories are investors far from America telling one another to justify continuing to add to their exposure to dollar depreciation? And when will they stop believing these stories?

Posted by DeLong at September 17, 2003 10:59 AM | TrackBack

Comments

yykes!

Posted by: john c. halasz on September 16, 2003 08:45 PM

um, Brad? Why won't you pay attention to me? I have an excellent post about how rich women should stay at home and poor women should work.

Posted by: Hackenkaus on September 16, 2003 09:14 PM

I suspect that if you started this graph in about 1980, you could label it - "If Something Is Unsustainable, It Will Stop - And Start Again"

Posted by: Tom Maguire on September 16, 2003 09:28 PM

Brad - why is there such a HUGE gap between America's net foreign asset position (measured at historic cost) and the ACTUAL net factor payments account, which shows America to be paying out as much as it is taking in, and shows NO deterioration since 1985. On this basis, the 5%of GDP current account deficit is permanently sustainable. Am I missing something?

Posted by: Peter vM on September 17, 2003 12:03 AM

Scary numbers. Not only that, but I seem to have slept through 1904. Who won the election?

Posted by: phil p on September 17, 2003 05:48 AM

Scary numbers. Not only that but I seem to have slept through 2004. Who won the election?

Posted by: Phil P on September 17, 2003 05:49 AM

Stiglitz has a comment column on the US trade deficit, the US budget deficit, and the relationship between the two, at http://www.guardian.co.uk/comment/story/0,3604,1043494,00.html

Posted by: Tom Slee on September 17, 2003 05:52 AM

The poster above started talking about America's net foreign asset position. It makes me think we are only looking at potentially half of the equation. If we've invested a ton of money in these developing countries, couldn't this import to export difference be thought of as our return on investment?

Interesting.

Posted by: Chad Peterson on September 17, 2003 06:44 AM

roach on monday...

http://www.morganstanley.com/GEFdata/digests/20030915-mon.html

"As I see it, the model of a sustained US-centric global growth dynamic rests critically on a very stylized depiction of the world economy. It implicitly presumes that ever-mounting current account deficits in the worldís growth engine do not trigger a depreciation in the value of the US dollar. This is basically the functional equivalent of a one-currency model in an increasingly borderless world. As such, it also presumes that the rest of the world has an insatiable appetite for dollar-denominated assets. There are also obvious geopolitical implications of this stylized depiction of the world as well: Americaís gaping and ever-rising current account deficit is basically being judged as a small price to pay for US geopolitical hegemony. In other words, as long as America takes care of the worldís security, its imbalances can be freely financed.

"I just donít buy it. Despite upward revisions to our global forecast, the world economy is still a very sluggish place. And such a sluggish global climate, beset by ongoing labor market distress, remains very much a zero-sum game as politicians now take the upper hand in driving the battle over market share. Thatís why the Japanese have been intervening massively to stem the appreciation of the yen. Thatís why European leaders are now sending signals that they believe it is unfair for the euro to bear a disproportionate share of any downward adjustment in the dollar. Thatís also why the US Congress has now singled out China as a scapegoat for Americaís jobless recovery. And thatís why negotiations over world trade liberalization all but collapsed at the just-completed WTO meetings in Cancun. A still sluggish world is listing increasingly toward trade frictions and the pitfalls of competitive currency devaluation. In my view, that underscores the mounting tensions that another bout of US-centric global growth would most assuredly produce. For that reason, alone, I believe that the global economy is now nearing the end of an extraordinary seven and a half year period of unbalanced growth.

"If Iím right, that means that the key to global recovery lies less in the world trade cycle and more in the prospects for domestic demand in the non-US segments of the world economy. On that count, thereís still good reason to worry...

"All in all, the world appears to remain as US-centric as ever. And thatís just the problem. Unlike earlier periods, another such burst of unbalanced global growth would occur in the context of a massive US current-account deficit. Thereís another New Paradigm being put forth to rationalize why such an outcome may be possible, but itís starting to smack of dťjŗ vu. As was the case during the Nasdaq-led mania of the late 1990s, this has all the trappings of a flow-driven argument being used to justify powerful momentum swings in world financial markets. Like the last time -- only a scant three and a half years ago -- I fear this bout of denial could also end in tears."

Posted by: dirk on September 17, 2003 06:59 AM

"If Something Is Unsustainable, It Will Stop"

... or spiral out of control (at least until the world as we now it comes to an end)? Say the budget deficit reaches 5-6% in the next couple of years, US interests (bond) rates would then shoot up no matter for the Fed's "official rate" be. That would make the budget deficit potencially slip out of control, especially if the grown-ups don't take the white house back next year. Now this budget deficits will have to be financed by someone. And I can hardly how the over-indepted US consumer would pick up the tab... Meaning a twin budget explosion. Scary, very scary.

Posted by: Jean-Philippe Stijns on September 17, 2003 07:30 AM

Not so fast - A budget deficit of 9% of GDP or higher does not necessarily lead to high rates - look at Canada and Italy in 1992. The US today has a VERY low debt/GDP ratio by international standards and in comparison to its own history. The US needs to run BIG deficits for a LONG time before a fiscal crisis kicks in. Look at Canada in 1995. It too 15 years of fiscal craziness to get it there, and interest rates FELL throughout. Ditto for Italy.

Posted by: Peter vM on September 17, 2003 07:43 AM

Note that the graph is of the trade deficit, not of the federal budget deficit.

Posted by: Walt Pohl on September 17, 2003 08:23 AM

Dr deLong and other experts: I am struck by your title "If something is unsustainable, it will stop", which I think you use to imply some correction to the 5% plus loss to GDP from the trade imbalance. Could not that statement also be used as a pry bar to move consideration into a new way of looking at the USA economy.

In particular, I wonder about the "units", the denominator used to calculate those numbers. Lets say, for experiment, that the trade imblance is actually within a sustainable 1/2% or so, and it is the miscalcualtion of the denominator, the units used which leads to an erroneous 5% plus. So, using this "perverse" approach, what has to change to bring it back to 1/2%. Well, I have to increase the denominator by such an amount that 5.1% becomes 1/2% - or increase "Effective GDP" by 5.1/.5, or by 10.2. Could a case be made that the effective GDP is not 10.794 trillion but is in fact about 50 trillion. What is interesting is this just about neatly coincides with the GDP of all the countries that, whether they like it or not, a US naval battle fleet could tie up in port and US soldiers enjoy libery in the town - or where US battle fleets are now imposing order. Or where US buiness and trade dominate or are the most important factor in setting prices and setting economic flows.

If one thinks about this, about what is the true "unit" to use when considering the USA economy, all sorts of interesting considerations emerge - the actual "true" size of the USA deficit, the stock market evalaution in relationship to a Tobin Q consideration and so on.

We actually have precedence for considering the USA economy in this light in both how the Dutch stock market and the UK stock markets surged past a Tobin Q of 1 just after or at the height of their trade or actual empires and, more importantly, stayed in excess of 2 to reflect their true geographic reach and true size of the GDP to sue for calculating their Q. I suspect the FTSE and the Dutch stock market do trade around a Tobin Q of 1, it is the denominator of only a singular specific national unit that is wrong.

I bet if one had stock market data from Rome around 200 AD, you would find a Tobin Q way in excess of 2 or 3, and a reported deficit that was staggering - yet not at all a problem when one considered the true extent of Rome military and economic reach.

Is not the USA now more powerful and more influential than all three of these past dominate empires and trade networks?

I suspect there will be motivation and even need to try and get a better feel, a better definition of what the denominator actualy is over and beyond national units.

The logic of this consideration is completely irrefutable in the age of USA military reach, trade reach, the age of WTO and GAT, the age of global internet. It does not harm the arguement by thinking that this might is being misused, the reach and scope is still there.

Just because it seems nearly impossible to arrive at definition of what the actual "effective" USA GDP unit is and what its actual size is does not mean that this type of consideration does not have to be considered by economist.

Hegemonist economic analysis will likely dominate consideration if any sort of accuracy or relevancy is sought in terms of economists being prescient or able to provide any useful analysis and useful public policy.

I offer that the majority of economists are ignoring, almost willfully, the reality of what the world's true economic unit denominators are now and therefore can provide little help in suggetsing correct and useful Fed Reserve policy, US deficit policy, public funding policy, taxation, and being useful in predicting possible financial markets and dynamics.

By denying the obvious, most economist are left to becoming shrill idealogues, basically babbling cant from yesteryear which is ineffective; they are forced to become politicians as their economic predictions and "calls" seem to almost always fail. In fact many economists seem to sense this as some have almost completely left the economic field no longer producing fine work as they have done in the past, and these "failed" economists become solely propagandist and idealogues as discussions in that realm cannot be countered by the real numbers and resulting actualities or facts. These economists are leaving science for art. Sort of a complete wheel, returning to where the study was before Ricardo, Locke, Say, Keynes etc made it into a science.

This reminds me how when Marxist "economists", seeing the failure of the "science of "Marxist economics", ended being mere party hacks and party bosses.

Posted by: Mac Robertson on September 17, 2003 08:35 AM

Please, all of you, stop your scaremongering. The U.S. is too rich and powerful to face an economic disaster like Argentina.

Bush/Cheney '04

Posted by: freeperboy on September 17, 2003 10:27 AM

Peter vM-

It's a longstanding puzzle why the returns on US assets abroad are so much, and so consistently, higher than returns on foreign assets here.

One approach to this puzzle involves asking why US debts are denominated in our own currency. As long as international transactions are sttled predominatly in dollars, the demand for highly liquid dollar-denominated assets should rise roughly in line with world trade. So foreign holders of US assets have a distinctly different set of preferences in terms of liquidity versus return than US foreign investors do.

If the US were to have a balanced current account, or even worse, a surplus, for an extended period of time, the dislocations would be much worse -- in fact this is essentially the problem the Marshall Plan was required to solve.

This is all stuff I learned in school by the way...

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Posted by: Laura in DC on September 17, 2003 10:59 AM

Or to put it a little more clearly-

An analysis like Brad's is based on the assumption that holders of dollar assets are generic "investors" who ar trying to maximize their risk-adjusted return. But this is not the case.

As Krugman notes, the most important purchasers of dollar-denominated assets are foreign central banks. They are need dollars as reserves -- expected rturns -- within broad limits -- just don't matter.

Another point is, you can't look at the US position in isolation. Japan certainly, and maybe China, I don't know, have for their own reasons commitments to large trade surpluses. Since this commitment is absed to a large extent on domestic considerations, their central banks will ensure that there are buyers for dollar assets as long as a US deficit is the condition for those surpluses.

Posted by: jw mason on September 17, 2003 11:10 AM

I haven't a clue about what Mac R said, but shouldn't he have used "100 trillion" instead of "50 trillion" as the, uh, proper denominator?

And if $50 trillion "neatly coincides" with, uh, whatever it is that it neatly coincides with, $100 trillion probably doesn't.

Posted by: Anno-nymous on September 17, 2003 11:14 AM

I have the story non-american investors are telling themselves. Actually several stories, some of which are plausible:

1) "Well, it may be true we are expecting a drop of 25 - 50 % in the dollar sometime in the next 5 years or so. That's still better than my own currency will perform over that period." (China)

2) "Interest rates in America are sufficiently high to pay for this risk, compared to my home rates" (Japan)

3) "Alan Greenspan will save us all." (Most everyone)

4) "This newfangled Euro thing is unreliable. Who knows what will happen when some Italian is put in charge of the collective currency." (Europeans)

5) "If America collapses, we are all so scr*w*d. If (insert country) collapses, America is safe. Therefore, it is safer to invest in America, where I am only exposed to America's risk, rather than (insert country), where I am exposed to America's risk AND (insert country)'s risk. And gold just doesn't have the ROI I want."
(Everyone)

Posted by: rvman on September 17, 2003 11:15 AM

Or to put it a little more clearly-

An analysis like Brad's is based on the assumption that holders of dollar assets are generic "investors" who ar trying to maximize their risk-adjusted return. But this is not the case.

As Krugman notes, the most important purchasers of dollar-denominated assets are foreign central banks. They need dollars as reserves, and expected returns -- within broad limits -- just don't matter.

Another point is, you can't look at the US position in isolation. Japan certainly, and maybe China, I don't know, have for their own reasons commitments to large trade surpluses. Since this commitment is absed to a large extent on domestic considerations, their central banks will ensure that there are buyers for dollar assets as long as a US deficit is the condition for those surpluses.

Posted by: jw mason on September 17, 2003 11:16 AM

Scaremonging perhaps, or lack of ideas. I mean, the dollar depreciated during the last couple of years from .80ish USD per EUR to 1.20. Now it is what, like 1.12? So, why is a future possible depreciation of 25-50% so much more important than a recent historic of 30%?

Brad?

Posted by: Mats on September 17, 2003 11:20 AM

Against the euro, not against other currencies. You're right: so far the consequences of dollar devaluation have been that those who were long dollars and short euros have taken a huge bath, and there has been some reduction in U.S. living standards as euro zone-made goods have become more expensive.

Perhaps the rest of the landing will be as soft. And perhaps not.

Posted by: Brad DeLong on September 17, 2003 11:31 AM

Suppose the value of the dollar were to decline by 30 to 50%. Well, that was what happened after the September 1985 "Plaza Accord." Ministers of Finance agreed to allow-encourage a decline in the value of the dollar. Foreign assets were a terrific buy for Americans for the next 2 years as the dollar lost value.

What I have to think about is whether the debt collapse in Latin America of 1987 was a result of the decline in value of the dollar. Also, there was the stock market break of October 1987. Remember the Fed raised interest rates forcing 10% on long term treasuries in 1987. Then came the stock market break and the Fed changed course at once and began to provide liquidity.

Would a 30 to 50% drop in dollar value lead to 10% treasury rates? Would the stock market be shaken? Would Latin American falter?

I am not happy with the sorts of imbalances we have generated with our absurd fiscal policy!

Posted by: anne on September 17, 2003 11:36 AM

Peter vM,

One thing that should be kept in mind when comparing deficits at other times and in other places - with regard to sustainability and all that - is the medium term demographic future. Our official deficit figures ignore retirement obligations. With our demographic hump retiring soon, sustainability of fiscal deficits is very much reduced. I'm not absolutely certain about the demographics faced by Canada or Italy, but I have the impression that retirement problems around the globe are only now coming home to roost (Edward Hugh, where are you?). If so, then similar deficit to GDP ratios now and 10 years ago would have very different implications.

In addition, you need to look at real interest rates. Looking at nominal rates can confound an inflation premium (which was falling in the period of which you spoke - thus falling nominal rates) with other factors determining interest rates, such as deficits.

Posted by: K Harris on September 17, 2003 11:50 AM

anne, you *had* a 30% drop against the euro, now 10yr T-notes is at 4.20% < 10%! I do think there is scaremonging going on here.

First the national border, it's a scare-classic. But economically speaking, a national border means nothing for traded goods (under non-protectionism), and nothing for non-tradables (which exist on a much smaller sub-national geographic scale), its only a question of wage-levels actually.

Then the traded goods, specifically the imports, another scare-classic. You can't make a car by yourself, but you could transport your own garbage to the city dump. So carmaking must be a more critical activity than garbage-collection, right? No, Of course not (!), a garbage collector strike is as we all know much worse than an auto worker strike.

The point is that living-standards depend more crucially on non-tradeables than on import goods. Brad thinks that from the falling USD vs EUR "there has been some reduction in U.S. living standards as euro zone-made goods have become more expensive." But you could equally well say that US goods have become more competitive, thus supporting labour market demand, holding back unemployment.

And this is exactly what borders are about: wage levels. Which yields the better overall living standard: stronger currency, better wages, higher unemployment, or weaker currency, lower wages, lower unemployment?

Posted by: Mats on September 17, 2003 12:05 PM

Though the dollar declined against the Euro, and the Canadian, and Australian dollars these past 2 years, the dollar was stable against the Asian currencies and most other currencies. There was no general dollar value decline. The decline against the Euro was merely a reversal of the same rapid rise in the dollar before 2001.

There has really been no dollar value adjustment.

Posted by: anne on September 17, 2003 12:11 PM

There is a problem here. We are an aging country and a country that saves far too little to meets the needs of the aging. Even if the is endless credit from abroad, so we can run endless deficits, we are not going to be earning enough from investments to lvie happily after.

Foreign investors are buying American assets and will control the income from those assets, rather than Americans. We are saving too little, way way too little. The problem is aging and being income short. This is worth worrying about.

Posted by: anne on September 17, 2003 12:16 PM

anne, you tell me that $/eur is fine as is the us/canada and the us/australia. Yet you tell me that us$ is too strong, but I hear from others that Yen is too strong and the Chinese Yuan is too strong.

Now pls, agaist which currencies is the us$ too strong?

Posted by: Mats on September 17, 2003 12:19 PM

This time IS different. I do not worry about the Federal or Balance of Payments deficits as such, rather I worry a lot about the lack of saving that will make it increasingly difficult to meet the needs of older households. Older households there will be! We are going to be income short in future years, for we have not saved enough. This coming year we are likely to have a combined private and public saving rate of zero! Where does the income come from for an older household? We should be saving and investing all over the world. We are not.

Posted by: anne on September 17, 2003 12:21 PM

Sorry, goofed again, they say that Chinese Yuan is too weak allright, but what other currency is it that is too weak against the USD?

Posted by: Mats on September 17, 2003 12:21 PM

anne - "We are an aging country", that's a fundamental problem, financial savings help somewhat, but in the end you need people there to provide you the non-tradeables. The US has a long tradition of welcoming immigrants, so you should be much safer than us in Europe.

Not that it is an excuse for the dissavings you run and plan to continue with!

Posted by: Mats on September 17, 2003 12:29 PM

Nationalistic scaremonging, I knew it: "Foreign investors are buying American assets and will control the income from those assets, rather than Americans"

Now, either the asset is mine - good! Or the asset is someone elses - bad! See?
;)

Posted by: Mats on September 17, 2003 12:36 PM

Chart of dld age dependency ratios for Italy Germany Japan France UK and US:

http://www.frbsf.org/images/pdfcharts/el98-20c.pdf

For some reason there seems to be a correlation with which side of WWII the country was on (France is somewhere in the middle). I think it is very likely that the US will be forced to run surpluses with Europe and Japan before long, as they will have a much worse demographic situation than the US.

And here are some numbers for Canada:

http://instruct.uwo.ca/kinesiology/310a/pdf/demographics.PDF

Posted by: snsterling on September 17, 2003 12:36 PM

Nationalistic scaremonging, I knew it: "Foreign investors are buying American assets and will control the income from those assets, rather than Americans"

Now, either the asset is mine - good! Or the asset is someone elses - bad! See?
;)

Posted by: Mats on September 17, 2003 12:41 PM

mats - Jeremy Siegal at the Wharton School thinks the way out of the low saving problem is immigration and expanding foreign trade. Still, the way out means older households are going to have less income to draw on than most of us realize. Jeremy Siegal, bull of bulls, simply says the saving deficit can not be made up before the baby boomers retire.

I have NO opinion on a proper value of the dollar. As long as Japan and China and Singapore and Hong Kong wish to have steady currencies against the dollar, there will be fair stability. I am not worried about dollar value and have no immediate ideas for currency speculation. There are more interesting commodities just now.

Posted by: anne on September 17, 2003 12:44 PM

Isn't part of the import/export picture industries importing to themselves? Doesn't part of the rise in imports come from American corporations manufacturing overseas? Don't steel tariffs in the US make foreign steel parts manufacturers more competitive? How much money stays overseas, and how much is invested in the US? How much are the value of US assets expanding in comparison to the trade deficit? When Japan had a huge trade surplus and a roaring economy, there was a huge housing bubble in Hawaii. How much of the exchange is in currency and how much in assets? Is this issue really much more complicated than the simple picture?

Would one way to change the equation be for foreign workers to get more of the profits so they could afford to buy American products? Does it make sense to invest in American assets that are increasing in value instead of foreign assets that are not?

Is this why Arab investors are considering disinvesting in the US?

Arab investors likely to continue pull out from US markets

Billions of dollars are likely to be withdrawn from US markets, explained top financial experts attending the recent Islamic intra-investment conference in Almaty, Kazakhstan, ending September 3, 2003. Losses suffered by Arab investments abroad due to the global economic slowdown are already estimated at over $400 billion.

The fifty-seven Islamic countries represented at the event, also members of the Organization of Islamic Conferences (OIC), expressed uneasiness about investing in the United States. Arab depositors describe the once attractive market to be increasingly unwelcoming since the September 11, 2001 attacks. The change of heart is primarily linked to calls in the US to freeze assets of Arab or Islamic investors suspected of terror funding.

Arab funds abroad are estimated to be as high as $4.2 trillion. The conference also highlighted that OIC states have failed to loosen the Western hold over foreign trade of the region. As late as 2001, OIC merchandise exports totaled $520.2 billion, only 8.6 percent of the total world merchandize exports that year, reported Arab News.
(menareport.com)

Posted by: bakho on September 17, 2003 12:44 PM

"This is exactly what borders are about: wage levels. Which yields the better overall living standard: stronger currency, better wages, higher unemployment, or weaker currency, lower wages, lower unemployment?"

Interesting question.... I prefer to ask directly how domestic fiscal policy can be used to increase employment. Japan used fiscal policy to develop infrastructure and keep employment reasonably high. We used tax cuts. Europe has chosen to insulate workers, and has allowed low levels of employment for years. Which is the best course?

I wish we had used fiscal policy to develop infrastructure, and offered more inducements to save, while avoiding tax cuts for the wealthiest.

Posted by: anne on September 17, 2003 12:56 PM

bakho - it's complicated, you're right. But most of the compexities come from protectionism and scaremonging. anne - we were discussing a blogpost on the supposedly overvalued USD, and you were too: "Suppose the value of the dollar were to decline by 30 to 50%." and again "There was no general dollar value decline".

Suddenly you go: "I have NO opinion on a proper value of the dollar.", heading for the admin? Secy of WMD perhaps ;)

Posted by: Mats on September 17, 2003 01:04 PM

No. The value of the dollar is being set by world currency traders including central banks! I have NO worry about a change in dollar value. If a faction of foreign investors choose to sell dollars, no problem. Go ahead. The issue is we need to be saving more in America. We need to worry about the structural deficit caused by the tax cuts for the rich. I have no worry about the doolar at all. I do save and invest and can easily buy foreign assets when the opportunity comes. There is no dollar valuation problem now.

Let those who wish to sell American dollars buy Yen or Euros or or or. Why worry?

Posted by: anne on September 17, 2003 01:18 PM

snsterling: "Europe ... will have a much worse demographic situation than the US."
anne: "Europe has chosen to insulate workers, and has allowed low levels of employment for years." Describes it pretty well, its too hard to get a job, hence it is too hard for immigrants to get here, hence the demograhy falters. I like it here in Europe now, but I think it will be way too expensive to retire here, unless you have your savings in CPI-linked govvies, or are happy to be healthy enough to take care of yourself.

Posted by: Mats on September 17, 2003 01:20 PM

By the by - America gets a huge huge huge benefit for its spending on health care. - Good grief!

Mats post - Good Grief!

http://blogofpandora.blogspot.com/

Love you anyway....

Anne

Posted by: anne on September 17, 2003 01:23 PM

I wrote a similar article a while back. I said in part, "If you are waiting for a financial-market disaster to come crashing down on the evil Americans and their evil Republican administration, I would not hold your breath. If the dollar bubble bursts, it will reduce our wealth a bit (because of the rise in the cost of foreign goods), but the improvement in our trade competitiveness will help to increase output and employment."

See http://www.techcentralstation.com/061903C.html

Posted by: Arnold Kling on September 17, 2003 01:43 PM

anne - "The value of the dollar is being set by world currency traders including central banks! I have NO worry about a change in dollar value. If a faction of foreign investors choose to sell dollars, no problem. Go ahead." - well said!
"the issue is we need to be saving more in America. We need to worry about the structural deficit caused by the tax cuts for the rich." - yes, you do!

"By the by - America gets a huge huge huge benefit for its spending on health care. - Good grief!" yes you do, of course you do, this is why I ever was on the subject on non-tradeables vs imports. But you get less per dollar spent than we get here in Europe, much less!

And if your excellent rethorics eventually put you in the admin, if you love me, try to make them keep Sweden away from the countries-to-attack-list...

Posted by: Mats on September 17, 2003 01:46 PM

How can the dollar decline by 25-50% and only set standards of living off by 4%?

Wouldn't the corresponding increase in the price of oil alone be a severe enough shock to cause major disruption?

Posted by: Apressler on September 17, 2003 02:28 PM

I. A Hard or Soft Landing For the US Economy in the Future?

If the experience of the 1980s is anything to go by, then a soft landing seems much more likely than the hard one, full of dislocations for the wider US economy, that Paul Krugman predicts --- just as he predicted, wrongly, back in the first edition of his book, The Age of Diminished Expectations, that a hard landing was more likely then. In particular,

1) The sharp appreciation of the dollar between 1980 and 1985 --- the real effective exchange rate against other major currencies, trade-weighted --- was on the order of 45 Ė 50%. In that period, the prices of imported goods and services fell by 6.0%, but the prices of US exports in foreign currencies climbed a skyrocketing 80% on an average. The outcome? The volume of US exports barely rose in that period, specifically by a paltry 2.0%; in contrast, the volume of imports jumped by 51% (figures taken from Paul Samuelson and William Nordhaus, Economics, 17th ed: McGraw Hill, 2001, pp. 642-642). The upshot? The US trade deficit --- more or less in balance in 1980 --- rose to 3.% of GDP by 1984 and stayed that way for another three years. It looked like something unsustainable, exactly as Paul Krugman and Brad DeLong predict will happen again (despite their differences as to whether the outcome will be severely dislocating for the US economy in Krugmanís case, and much more benign in the soft-landing scenario set out by DeLong).

2) Then --- starting in 1985, thanks to a negotiated deal with other governments --- the dollar depreciated sharply against other currencies, both in nominal and real exchange rate terms. Specifically, the real exchange rate of the dollar fell by about 50% over the next five years despite private investment inflows that continued to jar against the efforts of the US Treasury and other finance ministries abroad to intervene in foreign exchange markets to drive the dollar lower. (Against 26 other national currencies, the dollar, itís only fair to add, hardly fell at all in real terms, on a trade-weighted basis; but it did fall sharply in nominal terms against both the Japanese Yen and the German Mark, the other two major currencies . . . enough at any rate to do the trick.) The result this time for the US current account? Almost a doubling of exports in the next six years of both US goods and services. By 1991, consequently, the current account was more or less in balance again. (Besides Samuelson and Nordhaus, there are good charts in James Gwartney et al, Economics: 10th edition, Thomson, 2003, p. 434; and N. Gregory Mankiw, Macroeconomics: 5th edition, 2003, p. 126.)

II. Did the Sharp Depreciation of the Dollar After 1985 Cause New Inflation?

No, not really . . . contrary to the worries expressed here by some about the inflationary impact of a declining dollar in the future again. Inflation itself hardly rose between 1985 and 1995, compared to the previous decade and even the previous years between 1981 and 1984 when the dollar rocketed in value. It even fell noticeably in 1986, 1987, and 1988; and though it climbed somewhat the next three years, inflation reached the 4.0% level again that the US had experienced in 1983, a time when the dollar was skyrocketing in value. Nor was that all. By the early 1990s, the rate of inflation had even noticeably moderated compared to the entire 1980s, yet the dollarís exchange rate continued to remain noticeably low compared to the early 1980s. (See the BEA table on the price deflators for the US economy as evidence: http://www.bea.gov/bea/dn/nipaweb/TableViewFixed.asp#Mid


III. What About Crowding Out? Did It Occur in the Period of Sharply Rising Reagan and Bush-Sr. Federal Deficits, 1981 Ė 1993?

A great deal of macroeconomic theory predicts that rising government deficits will have a harmful effect on economic growth, either crowding out private investment or US exports (or both). The transmission mechanism in both cases will be a rise in interest rates, caused by the way government deficits are financed. In particular, the Treasury will have to sell new securities that compete with private agents seeking investment funds in loanable funds markets, whether business firms or households that want to buy houses and other durables: selling these Treasury securities will raise interest rates and crowd out some of the private investment, or at times, if the deficits are large enough, all such investment. Simultaneously, itís argued, the higher interest rates in the US will attract more capital inflows from abroad. The impact? Though these inflows will tend to increase the supply of loanable flows and hence moderate the crowding out effects on US domestic investment, they will also cause an appreciation of the dollarís exchange rate and hence crowd out US exports. The result will be a current account deficit each year the government --- in the US, the federal government and the states --- spend more than they take in through tax revenue.

What does the experience of the 1980s reveal?

1) Consider the crowding out of private investment, which is supposed to occur because of higher interest rates. The problem is, there is no clear correlation between the growth yearly of national debt (as a result of federal deficits) and long-term interest rates. Specifically, as shown in the chart at this site, the 10 year Treasury bond rate actually fell noticeably in real terms from its height in 1984 throughout the era of rapidly rising federal deficits in the era of the Reagan and Bush Sr. presidencies: these deficit culminated in 1992, if I remember correctly, at around 6.0% of GDP ---- yet as the chart shows, the ten year bond rate fell by about half during that period. To repeat, real long-term interest rates in the US did not rise in the period despite rapidly increasing federal deficits. Instead, they fell steadily throughout the period.

2) What about net national investment during this period?

Despite the falling rate of long-term interest rates in the 1980s and early 1990s, net domestic investment never reached comparable levels ---as a percentage of GDP --- that were recorded in the recovery phase of the business cycles between 1950 and 1977. A good chart by Benjamin Friedman brings this out (http://www.worldbank.org/wbi/publicfinance/publicresources/friedman.pdf, p. 17; also the table on p. 16).

Does that then validate the crowding out theory of investment? Yes and no. The problem here is in the interpretation of the correlation between rising federal deficits and the trend-line in net investment during the 1980s and early 1990s.

In particular, all sorts of what statisticians call ďdisturbing conditionsĒ make it hard to draw clear conclusions about theoretical propositions . . . especially in economics and political science, the latter my discipline, and for that matter all the social sciences. There are also problems of complex dependencies in regression equations between the independent variables, and for that matter, frequently too, between the dependent and independent variables as the former shifts value in response to changes in the latter. (In neo-classical Solow growth theory, for instance, rises in per capita income --- the dependent variable ---- as capital accumulation and the growth of the labor force as the independent variables themselves rise will, in turn, feed back and affect both the savings rate of the economy and the growth of population and hence the labor force.) Then, too, there are problems of omitted variables that can always be invoked, not to mention disturbing special circumstances. (Itís for this reason, youíll note, that the most influential work in epistemology --- that of Willard Van Oman Quine and Donald Davidson --- rejected the positivist claim that scientific theories could be tested a proposition at a time; and for that matter, that rejection includes Karl Popperís version about falsifying propositions, not proving them. The arguments by both go back to the 1950s. Quine himself later elaborated on this, and the resulting argument is called the Duhem-Quine thesis, Duhem himself (a French physicist of the late 19th and early 20th century) having set out a similar argument earlier that Quine apparently wasnít aware of at the time. According to the thesis, no single hypothesis can be tested in isolation; other auxiliary hypotheses will always be required, and the failure of the former to withstand testing ---- statistical or experimental (anyway, empirical) ---- can always be blamed on the latter auxiliaries. For an interesting, easily read appraisal of the thesis as it applies to economics, see http://www.bu.edu/wcp/Papers/Econ/EconBoyl.htm).

As far as the failure of net investment in the 1980s to reach earlier percentage levels of GDP, the following counter-claims can be made by both supply-side economists and the neo-Ricardians. (The latter argue, of course, that government deficits financed by borrowing from the public will be totally offset by forward-looking economic agents; specifically, they recognize that future taxes will have to be raised by the government to pay the interest and principle on the sale of new Treasury securities, and so --- anticipating this --- they automatically increase their savings by an equivalent amount of the new government debt. As a result, nothing happens to the economy: interest rates donít rise because of crowding out; national income itself doesnít grow; and thereís no new inflow of capital from abroad to raise the price of the dollar and hence crowd out US exports.)

--- For one thing, if net investment never climbed to as high a percentage of GDP as supply-side economists hoped, it failed here only when compared to the robust levels of investment in earlier periods of economic recovery after a recession. It did rise sharply after a major dislocating period in the US economy --- double-digit inflation for nearly three years, very tight monetary policy to fight this, and the biggest (if short-lived) recession since the Great Depression years; and so both supply-siders and neo-Ricardians of the Robert Barro sort can claim that these are misleading comparisons: in particular, the first oil price rise of 1974-75 marks a pivotal turning point in the growth rates of GDP and productivity in all industrial countries, with both rates falling brusquely everywhere (though less so in the US than in Germany and Japan). The result? Comparisons of GDP and productivity growth rates --- makes comparisons with the earlier decades difficult.

As a further complicating factor here to drive home the point, the average of total net investment in the US economy --- as the table on p. 16 in Friedmanís article notes --- was actually higher as a percentage of GDP in the era of rapidly rising federal deficits of the 1980s (6.1%) than it was in the period 1991-1998 (5.2%) , when the deficits started coming down sharply, eventually turning to surplus. (Concretely put, the federal deficit reached $298 billion in 1992, after which it started falling until it declined to $53 billion in 1997 . . . after which it then turned to a surplus for the next three years. See the BEA table, http://www.bea.gov/bea/dn/nipaweb/TableViewFixed.asp#Mid.) No less important, the total deficits of both state and federal governments in the US came down even faster in the 1990s, turning into a surplus in 1996. And yet, as the table and chart in Friedman shows, net private investment in the US was lower in this era as an average percentage of GDP than it was in the 1980s.

--- For another thing, net investment might be misleading as the main indice. Why? Because the US economy was particularly dislocated by the big radical leap in oil prices between the start of 1974 and 1980, what with the ways in which we (and the Canadians) had developed economies over several generations that relied on unusually cheap energy sources compared to Japan and the West European countries throughout most of their developmental history in the 19th and 20th centuries. As a result, American firms and households had to spend more on replacement capital for existing energy sources ---- such things as environmentally sounder stackers in coal-burning utilities, most gas-efficient automobiles to replace gas-guzzlers, insulation for conserving energy in plants, office buildings, and houses, and so on. Over time, all this replacement capital added up to a lot of new gross investment, none (or little) of which would be reflected in the trends of net national domestic investment. (See the BEA table on gross savings and investment in the US economy in the 1980s and 1990s, http://www.bea.gov/bea/dn/nipaweb/TableViewFixed.asp#Mid As it shows, gross private saving rose about 45% between 1982 and 1989.)

--- For a third thing, as a further disturbing condition, that makes it hard to test a theoretical proposition statistically, if net national investment fell by comparison with earlier periods, then it would have to be because of other influences besides long-term interest rates within loanable funds markets. (These influences are numerous, and figure in lots of macroeconomic theorizing about what drives business investment, including psychological factors like optimism or pessimism, as well as international developments, confidence in political leadership, and the like.) As a fourth consideration, another chart in Friedman.)

3) What about crowding out of US exports as a result of rising federal deficits in the 1980s?

This is easier to handle. Consider the table and charts in Benjamin Friedman again. Though he thinks there was crowding out of net private investment as a result of the Reagan and Bush Sr. deficits (a trend reversed by government surpluses in the late 1990s), he also can find no correlation whatever between either the size of government deficits --- or surpluses --- and the trend in US current account in the balance of payments. The current account, more concretely, turned sharply into deficit in the first four years of the Reagan federal deficits; then the size of the current account deficit dwindled after 1986 as the dollar fell in price until it disappeared in 1991 and 1992, even though these were years of record federal deficits. Worse for the theory of crowding out of exports, the US current account almost doubled in the late 1990s era of rapidly rising federal surpluses. (See Friedman, figure 4, p. 20.)

Essentially, then, whatever causes the current account to be positive or negative --- never mind the size of any surplus or deficit --- there is no correlation whatever with the size or direction of US federal expenditures and revenues (or total state and federal expenditures and revenues). Apparently, the inflow or outflow of foreign investment on capital account --- which seems to determine what happens to the trade in goods and services in current account --- bears no clear relationship to the ebb and flow of federal deficits or surpluses. Much more likely --- this is only a guess ---- foreign private agents and central banks will increase or decrease their investment flows --- and hence determine the exchange rate of the dollar in currency markets ---- according to other things, above all their confidence in the direction, dynamism, and stability of the US economy. Then, too, those countries like China or Japan whose governments actively pursue export-led growth --- to the point that they continually intervene in currency markets to buy dollars with their own currencies, buying up to $300 million daily the last year or so --- show that they have the means to keep such export-led growth going, at least into the growing US economy. In turn, of course, their Finance Ministries and Central Banks donít bury the resulting dollar accumulation under Chinese and Japanese mattresses: they invest them here, which further contributes to an undervalued rate of the yen and yuan in dollar terms. And of course, as a third shaping influence on the direction and size of the US current account, the US economyís relatively vigorous growth compared to the EU and Japan the last two years ---- disappointing as it might be for Americans and especially those who have seen unemployment grow to over 6.0% since the recession officially ended two years ago --- will naturally lead to a much larger inflow of imports from abroad even as Japanese and EU demand for US exports has fallen or stayed stagnant.


IV. What Conclusions Can Be Inferred from the Experience of the 1980s?

1) Those who worry that the current US federal deficits will lead to some sort of semi-catastrophic hard landing of the American economy in trade and investment flows with the outside world ---- something, by the way, Paul Krugman thought the likelier outcome in the first edition of his book, The Age of Diminished Expectations ---- can find little or no justification in the outcome of the 1980s and early 1990s Reagan and Bush-Sr. deficits. That doesnít mean a hard landing is precluded. It does mean the only experience weíve had with prolonged structural federal deficits didnít end in the semi-catastrophe that the Jeremiahs of the 1980s and early 1990s predicted.

2) As for a prolonged rush out of the dollar by investors for whatever reason in the future, all that can be said is that itís unlikely to occur --- at any rate, to the extent that the experience of the 1980s and early 1990s is a guide. In particular, though the dollar fell by about 50% in value between 1986 and 1990, the rate of inflation did not increase, it decreased. Simultaneously, even as the dollar fell (with convergent efforts by the US Treasury and its equivalents in the EU and Japan to keep it falling), foreign investment inflows into the US continued at high rates even though net foreign investment inflows, of course, tapered off as the lower dollar brought about lower current account deficits. Long-term interest rates, moreover, werenít affected by the lower net investment inflow, it seems . . . any more than they rose as a result of the rapidly swelling Reagan and Bush-Sr. federal deficits. They didnít rise; they fell throughout the period of the 1980s and early 1990s.

3) As for the threat of a precipitous pull-out of Chinese or Japanese investments in this country --- presumably, this means central bank investments (though in the Chinese case, the Communist Party and the government can no doubt order private investors to do whatever they demand) --- that threat canít be excluded, but seems far-fetched. In the process of abruptly selling off their investments in US financial assets, they would see a rapid rise of the yen and the yuan no less abruptly occur, and hence find their dependence on export-led growth badly undercut . . . with no remotely equivalent market for their dependence on export sales as the major stimulus to their GDP growth to replace the US economy. They, official and private investors, keep most of their dollars earned on current account in the US economy out of self-interested behavior, finding it presumably a good economic bargain. And though they will from time to time adjust their portfolios and maybe sell off some dollars for, say, euros to invest in the EU ---- which is what presumably happened the last 18 months when the euro rose against the dollar until about June of this year --- there are limits to the attraction of euro financial assets compared to American . . . which is precisely why, since the start of June, the dollar has regained about 6% of its value against the euro. (To put it differently, the euro is still about 6% lower than it was at the time it was launched as a currency at the start of 1999.)

4) Though nobody can say now what will happen with much certainty to the size of the US federal deficit --- the Congressional Budget Officeís March projections of an unusually optimistic sort have been turned topsy-turvy by the growing burdens of financing defense, including the Iraqi war (as the CBO updated estimates of August showed) --- the experience of the 1980s and early 1990s suggests that a soft-landing of the sort DeLong believes in ---- not Krugman and some others --- is much likelier.

-- Michael Gordon
http://www.thebuggyprofessor.org

Posted by: michael gordon on September 17, 2003 02:50 PM

I. A Hard or Soft Landing For the US Economy in the Future?

If the experience of the 1980s is anything to go by, then a soft landing seems much more likely than the hard one, full of dislocations for the wider US economy, that Paul Krugman predicts --- just as he predicted, wrongly, back in the first edition of his book, The Age of Diminished Expectations, that a hard landing was more likely then. In particular,

1) The sharp appreciation of the dollar between 1980 and 1985 --- the real effective exchange rate against other major currencies, trade-weighted --- was on the order of 45 Ė 50%. In that period, the prices of imported goods and services fell by 6.0%, but the prices of US exports in foreign currencies climbed a skyrocketing 80% on an average. The outcome? The volume of US exports barely rose in that period, specifically by a paltry 2.0%; in contrast, the volume of imports jumped by 51% (figures taken from Paul Samuelson and William Nordhaus, Economics, 17th ed: McGraw Hill, 2001, pp. 642-642). The upshot? The US trade deficit --- more or less in balance in 1980 --- rose to 3.% of GDP by 1984 and stayed that way for another three years. It looked like something unsustainable, exactly as Paul Krugman and Brad DeLong predict will happen again (despite their differences as to whether the outcome will be severely dislocating for the US economy in Krugmanís case, and much more benign in the soft-landing scenario set out by DeLong).

2) Then --- starting in 1985, thanks to a negotiated deal with other governments --- the dollar depreciated sharply against other currencies, both in nominal and real exchange rate terms. Specifically, the real exchange rate of the dollar fell by about 50% over the next five years despite private investment inflows that continued to jar against the efforts of the US Treasury and other finance ministries abroad to intervene in foreign exchange markets to drive the dollar lower. (Against 26 other national currencies, the dollar, itís only fair to add, hardly fell at all in real terms, on a trade-weighted basis; but it did fall sharply in nominal terms against both the Japanese Yen and the German Mark, the other two major currencies . . . enough at any rate to do the trick.) The result this time for the US current account? Almost a doubling of exports in the next six years of both US goods and services. By 1991, consequently, the current account was more or less in balance again. (Besides Samuelson and Nordhaus, there are good charts in James Gwartney et al, Economics: 10th edition, Thomson, 2003, p. 434; and N. Gregory Mankiw, Macroeconomics: 5th edition, 2003, p. 126.)

II. Did the Sharp Depreciation of the Dollar After 1985 Cause New Inflation?

No, not really . . . contrary to the worries expressed here by some about the inflationary impact of a declining dollar in the future again. Inflation itself hardly rose between 1985 and 1995, compared to the previous decade and even the previous years between 1981 and 1984 when the dollar rocketed in value. It even fell noticeably in 1986, 1987, and 1988; and though it climbed somewhat the next three years, inflation reached the 4.0% level again that the US had experienced in 1983, a time when the dollar was skyrocketing in value. Nor was that all. By the early 1990s, the rate of inflation had even noticeably moderated compared to the entire 1980s, yet the dollarís exchange rate continued to remain noticeably low compared to the early 1980s. (See the BEA table on the price deflators for the US economy as evidence: http://www.bea.gov/bea/dn/nipaweb/TableViewFixed.asp#Mid


III. What About Crowding Out? Did It Occur in the Period of Sharply Rising Reagan and Bush-Sr. Federal Deficits, 1981 Ė 1993?

A great deal of macroeconomic theory predicts that rising government deficits will have a harmful effect on economic growth, either crowding out private investment or US exports (or both). The transmission mechanism in both cases will be a rise in interest rates, caused by the way government deficits are financed. In particular, the Treasury will have to sell new securities that compete with private agents seeking investment funds in loanable funds markets, whether business firms or households that want to buy houses and other durables: selling these Treasury securities will raise interest rates and crowd out some of the private investment, or at times, if the deficits are large enough, all such investment. Simultaneously, itís argued, the higher interest rates in the US will attract more capital inflows from abroad. The impact? Though these inflows will tend to increase the supply of loanable flows and hence moderate the crowding out effects on US domestic investment, they will also cause an appreciation of the dollarís exchange rate and hence crowd out US exports. The result will be a current account deficit each year the government --- in the US, the federal government and the states --- spend more than they take in through tax revenue.

What does the experience of the 1980s reveal?

1) Consider the crowding out of private investment, which is supposed to occur because of higher interest rates. The problem is, there is no clear correlation between the growth yearly of national debt (as a result of federal deficits) and long-term interest rates. Specifically, as shown in the chart at this site, the 10 year Treasury bond rate actually fell noticeably in real terms from its height in 1984 throughout the era of rapidly rising federal deficits in the era of the Reagan and Bush Sr. presidencies: these deficit culminated in 1992, if I remember correctly, at around 6.0% of GDP ---- yet as the chart shows, the ten year bond rate fell by about half during that period. To repeat, real long-term interest rates in the US did not rise in the period despite rapidly increasing federal deficits. Instead, they fell steadily throughout the period.

2) What about net national investment during this period?

Despite the falling rate of long-term interest rates in the 1980s and early 1990s, net domestic investment never reached comparable levels ---as a percentage of GDP --- that were recorded in the recovery phase of the business cycles between 1950 and 1977. A good chart by Benjamin Friedman brings this out (http://www.worldbank.org/wbi/publicfinance/publicresources/friedman.pdf, p. 17; also the table on p. 16).

Does that then validate the crowding out theory of investment? Yes and no. The problem here is in the interpretation of the correlation between rising federal deficits and the trend-line in net investment during the 1980s and early 1990s.

In particular, all sorts of what statisticians call ďdisturbing conditionsĒ make it hard to draw clear conclusions about theoretical propositions . . . especially in economics and political science, the latter my discipline, and for that matter all the social sciences. There are also problems of complex dependencies in regression equations between the independent variables, and for that matter, frequently too, between the dependent and independent variables as the former shifts value in response to changes in the latter. (In neo-classical Solow growth theory, for instance, rises in per capita income --- the dependent variable ---- as capital accumulation and the growth of the labor force as the independent variables themselves rise will, in turn, feed back and affect both the savings rate of the economy and the growth of population and hence the labor force.) Then, too, there are problems of omitted variables that can always be invoked, not to mention disturbing special circumstances. (Itís for this reason, youíll note, that the most influential work in epistemology --- that of Willard Van Oman Quine and Donald Davidson --- rejected the positivist claim that scientific theories could be tested a proposition at a time; and for that matter, that rejection includes Karl Popperís version about falsifying propositions, not proving them. The arguments by both go back to the 1950s. Quine himself later elaborated on this, and the resulting argument is called the Duhem-Quine thesis, Duhem himself (a French physicist of the late 19th and early 20th century) having set out a similar argument earlier that Quine apparently wasnít aware of at the time. According to the thesis, no single hypothesis can be tested in isolation; other auxiliary hypotheses will always be required, and the failure of the former to withstand testing ---- statistical or experimental (anyway, empirical) ---- can always be blamed on the latter auxiliaries. For an interesting, easily read appraisal of the thesis as it applies to economics, see http://www.bu.edu/wcp/Papers/Econ/EconBoyl.htm).

As far as the failure of net investment in the 1980s to reach earlier percentage levels of GDP, the following counter-claims can be made by both supply-side economists and the neo-Ricardians. (The latter argue, of course, that government deficits financed by borrowing from the public will be totally offset by forward-looking economic agents; specifically, they recognize that future taxes will have to be raised by the government to pay the interest and principle on the sale of new Treasury securities, and so --- anticipating this --- they automatically increase their savings by an equivalent amount of the new government debt. As a result, nothing happens to the economy: interest rates donít rise because of crowding out; national income itself doesnít grow; and thereís no new inflow of capital from abroad to raise the price of the dollar and hence crowd out US exports.)

--- For one thing, if net investment never climbed to as high a percentage of GDP as supply-side economists hoped, it failed here only when compared to the robust levels of investment in earlier periods of economic recovery after a recession. It did rise sharply after a major dislocating period in the US economy --- double-digit inflation for nearly three years, very tight monetary policy to fight this, and the biggest (if short-lived) recession since the Great Depression years; and so both supply-siders and neo-Ricardians of the Robert Barro sort can claim that these are misleading comparisons: in particular, the first oil price rise of 1974-75 marks a pivotal turning point in the growth rates of GDP and productivity in all industrial countries, with both rates falling brusquely everywhere (though less so in the US than in Germany and Japan). The result? Comparisons of GDP and productivity growth rates --- makes comparisons with the earlier decades difficult.

As a further complicating factor here to drive home the point, the average of total net investment in the US economy --- as the table on p. 16 in Friedmanís article notes --- was actually higher as a percentage of GDP in the era of rapidly rising federal deficits of the 1980s (6.1%) than it was in the period 1991-1998 (5.2%) , when the deficits started coming down sharply, eventually turning to surplus. (Concretely put, the federal deficit reached $298 billion in 1992, after which it started falling until it declined to $53 billion in 1997 . . . after which it then turned to a surplus for the next three years. See the BEA table, http://www.bea.gov/bea/dn/nipaweb/TableViewFixed.asp#Mid.) No less important, the total deficits of both state and federal governments in the US came down even faster in the 1990s, turning into a surplus in 1996. And yet, as the table and chart in Friedman shows, net private investment in the US was lower in this era as an average percentage of GDP than it was in the 1980s.

--- For another thing, net investment might be misleading as the main indice. Why? Because the US economy was particularly dislocated by the big radical leap in oil prices between the start of 1974 and 1980, what with the ways in which we (and the Canadians) had developed economies over several generations that relied on unusually cheap energy sources compared to Japan and the West European countries throughout most of their developmental history in the 19th and 20th centuries. As a result, American firms and households had to spend more on replacement capital for existing energy sources ---- such things as environmentally sounder stackers in coal-burning utilities, most gas-efficient automobiles to replace gas-guzzlers, insulation for conserving energy in plants, office buildings, and houses, and so on. Over time, all this replacement capital added up to a lot of new gross investment, none (or little) of which would be reflected in the trends of net national domestic investment. (See the BEA table on gross savings and investment in the US economy in the 1980s and 1990s, http://www.bea.gov/bea/dn/nipaweb/TableViewFixed.asp#Mid As it shows, gross private saving rose about 45% between 1982 and 1989.)

--- For a third thing, as a further disturbing condition, that makes it hard to test a theoretical proposition statistically, if net national investment fell by comparison with earlier periods, then it would have to be because of other influences besides long-term interest rates within loanable funds markets. (These influences are numerous, and figure in lots of macroeconomic theorizing about what drives business investment, including psychological factors like optimism or pessimism, as well as international developments, confidence in political leadership, and the like.) As a fourth consideration, another chart in Friedman.)

3) What about crowding out of US exports as a result of rising federal deficits in the 1980s?

This is easier to handle. Consider the table and charts in Benjamin Friedman again. Though he thinks there was crowding out of net private investment as a result of the Reagan and Bush Sr. deficits (a trend reversed by government surpluses in the late 1990s), he also can find no correlation whatever between either the size of government deficits --- or surpluses --- and the trend in US current account in the balance of payments. The current account, more concretely, turned sharply into deficit in the first four years of the Reagan federal deficits; then the size of the current account deficit dwindled after 1986 as the dollar fell in price until it disappeared in 1991 and 1992, even though these were years of record federal deficits. Worse for the theory of crowding out of exports, the US current account almost doubled in the late 1990s era of rapidly rising federal surpluses. (See Friedman, figure 4, p. 20.)

Essentially, then, whatever causes the current account to be positive or negative --- never mind the size of any surplus or deficit --- there is no correlation whatever with the size or direction of US federal expenditures and revenues (or total state and federal expenditures and revenues). Apparently, the inflow or outflow of foreign investment on capital account --- which seems to determine what happens to the trade in goods and services in current account --- bears no clear relationship to the ebb and flow of federal deficits or surpluses. Much more likely --- this is only a guess ---- foreign private agents and central banks will increase or decrease their investment flows --- and hence determine the exchange rate of the dollar in currency markets ---- according to other things, above all their confidence in the direction, dynamism, and stability of the US economy. Then, too, those countries like China or Japan whose governments actively pursue export-led growth --- to the point that they continually intervene in currency markets to buy dollars with their own currencies, buying up to $300 million daily the last year or so --- show that they have the means to keep such export-led growth going, at least into the growing US economy. In turn, of course, their Finance Ministries and Central Banks donít bury the resulting dollar accumulation under Chinese and Japanese mattresses: they invest them here, which further contributes to an undervalued rate of the yen and yuan in dollar terms. And of course, as a third shaping influence on the direction and size of the US current account, the US economyís relatively vigorous growth compared to the EU and Japan the last two years ---- disappointing as it might be for Americans and especially those who have seen unemployment grow to over 6.0% since the recession officially ended two years ago --- will naturally lead to a much larger inflow of imports from abroad even as Japanese and EU demand for US exports has fallen or stayed stagnant.


IV. What Conclusions Can Be Inferred from the Experience of the 1980s?

1) Those who worry that the current US federal deficits will lead to some sort of semi-catastrophic hard landing of the American economy in trade and investment flows with the outside world ---- something, by the way, Paul Krugman thought the likelier outcome in the first edition of his book, The Age of Diminished Expectations ---- can find little or no justification in the outcome of the 1980s and early 1990s Reagan and Bush-Sr. deficits. That doesnít mean a hard landing is precluded. It does mean the only experience weíve had with prolonged structural federal deficits didnít end in the semi-catastrophe that the Jeremiahs of the 1980s and early 1990s predicted.

2) As for a prolonged rush out of the dollar by investors for whatever reason in the future, all that can be said is that itís unlikely to occur --- at any rate, to the extent that the experience of the 1980s and early 1990s is a guide. In particular, though the dollar fell by about 50% in value between 1986 and 1990, the rate of inflation did not increase, it decreased. Simultaneously, even as the dollar fell (with convergent efforts by the US Treasury and its equivalents in the EU and Japan to keep it falling), foreign investment inflows into the US continued at high rates even though net foreign investment inflows, of course, tapered off as the lower dollar brought about lower current account deficits. Long-term interest rates, moreover, werenít affected by the lower net investment inflow, it seems . . . any more than they rose as a result of the rapidly swelling Reagan and Bush-Sr. federal deficits. They didnít rise; they fell throughout the period of the 1980s and early 1990s.

3) As for the threat of a precipitous pull-out of Chinese or Japanese investments in this country --- presumably, this means central bank investments (though in the Chinese case, the Communist Party and the government can no doubt order private investors to do whatever they demand) --- that threat canít be excluded, but seems far-fetched. In the process of abruptly selling off their investments in US financial assets, they would see a rapid rise of the yen and the yuan no less abruptly occur, and hence find their dependence on export-led growth badly undercut . . . with no remotely equivalent market for their dependence on export sales as the major stimulus to their GDP growth to replace the US economy. They, official and private investors, keep most of their dollars earned on current account in the US economy out of self-interested behavior, finding it presumably a good economic bargain. And though they will from time to time adjust their portfolios and maybe sell off some dollars for, say, euros to invest in the EU ---- which is what presumably happened the last 18 months when the euro rose against the dollar until about June of this year --- there are limits to the attraction of euro financial assets compared to American . . . which is precisely why, since the start of June, the dollar has regained about 6% of its value against the euro. (To put it differently, the euro is still about 6% lower than it was at the time it was launched as a currency at the start of 1999.)

4) Though nobody can say now what will happen with much certainty to the size of the US federal deficit --- the Congressional Budget Officeís March projections of an unusually optimistic sort have been turned topsy-turvy by the growing burdens of financing defense, including the Iraqi war (as the CBO updated estimates of August showed) --- the experience of the 1980s and early 1990s suggests that a soft-landing of the sort DeLong believes in ---- not Krugman and some others --- is much likelier.

-- Michael Gordon
http://www.thebuggyprofessor.org

Posted by: michael gordon on September 17, 2003 02:54 PM

I can remember an adage in the early 1980's excusing the current account deficits as appropriate if the economy were investing in new capital formation. Maybe good finance but irrelevant for then as investment fall but not as much as national savings. During the ICT boom, this old adage might have been appropriate as investment rose relative to an unchanging savings rate. But alas since 2001, investment is very low and savings is zero. But do we here the Bush43 economists admitting this or are they dragging out the excuses from 20 years ago?

Posted by: Hal McClure on September 17, 2003 02:56 PM

yes, if oil is no longer priced in u.s.$, which would seem to be the reasonable thing for oil exporters to then do. but if so, what becomes of the u.s.$ as a reserve currency, since other oil importing nations would no longer need $ to finance oil imports? what are the implications of this and how large an effect would it have?

Posted by: john c. halasz on September 17, 2003 03:04 PM

Isn't there a problem of cause and effect. Cause: trade deficit, effect foreigners investing in U.S. or
Cause: foreigners investing in U.S. , effect trade deficit.
The trend may be unsustainable, but what is causing the trend?

Posted by: Daniel on September 17, 2003 03:22 PM

BDL:

(At least, it does not do so if New York's major financial institutions have well-hedged derivative books: if their derivative books are not well-hedged, all bets may be off.)

This worries me a lot. Proprietary trading revenues have increased dramatically at institutions such as JP Morgan, Citibank and Goldman Sachs and a good deal of their earnings now comes from trading. The steep yield curve (courtesy of the Fed) has been very beneficial for these institutions and many other companies have swapped long-term interest rates for short-term interest rates is also very good for "carry trades". But what happens when the yield curve starts to shift ? The derivatives exposure of JPMorganChase is ENORMOUS (it's tens of trillions in nominal terms), and I think it will be a casualty when the interest environment starts to change.

Posted by: Nescio on September 17, 2003 03:34 PM

According to my intuition, if real external liabilities grow faster (trade deficit) THAN our ability to repay them (here real GDP) => big problemo, i.e. snow-ball effect. So, the question is, how fast do we really think the US will be growing in the (not-so-)foreseable future? Definitely faster than 6%, any doubters out there?

Posted by: Jean-Philippe Stijns on September 17, 2003 03:40 PM

Oops, the comment by John Halasz at 3:04 PM reminded me that my earlier analysis forgot to deal with the fears expressed by him nd others about the price of oil should the dollar fall sharply in the future.

Again, instead of fecklessly speculating in an intellectual vacuum as to what might happen to the oil price, we can at least find solid empirical ground in the 1980s . . . especially in the period after 1985, when the dollar declined rapidly and lost 50% of its value in nominal exchange rate terms. See http://www.wtrg.com/oil_graphs/crudeoilprice4797c.gif

1. Specifically, as a chart shows which tracks the price of oil per barrel in 1996 dollars since 1947 (down until 1998), you will find that the price of oil dropped noticebly even as the dollar itself fell sharply in value. It did rise rapidly in 1991, but as a result of the Gulf War,nothing else.

2. There's opposite evidence for the era of the high dollar after 1996. The dollar was now rising rapidly against other currencies in both nominal and real exchange rate terms --- especially against the DM and then the euro (oppositely against the smaller Asian currencies) --- and yet a price of oil per barrel almost tripled in price after 1999, at the height of the dollar's value. More specifically, the price about tripled by the start of 2001, then fell slightly, then rose, then fell, and has risen against to nearly $40 a barrel in the last month or so. (The chart doesn't show this, stopping at the end of 1997.)

3. So there's no correlation whatever between a fall in the exchange rate of the dollar --- in real or nominal terms (and presumably too on a trade-weighted basis) --- and a rising price of oil. Exactly the contrary, both in the 1980s and late 1990s.

4. One other point, missed by the worried Casandras here. Not only is there no correlation of the sort just analyzed, but the energy sector of the US economy --- thanks to much greater efficiency than in the 1970s and early 1980s --- has declined by about half: from roughly 7.0% of GDP to around 3.0 - 3.5% (depending on the vigor of economic growth). The upshot? Should a big rise in oil prices materialize--- even to the $60 level or so as in the late 1970s (in 1996 dollars) --- it would not have the same impact nearly on the US economy that the big jump in prices did in that decade.

4. For that matter, maybe unknown to the contributors here who have expressed worry, the price already has jumped from about $12 a barrel at the end of 1998 to around $40 a barrel, and the ripple effects on the US economy have hardly even been visible.

Posted by: michael gordon on September 17, 2003 03:42 PM

BDL:

(At least, it does not do so if New York's major financial institutions have well-hedged derivative books: if their derivative books are not well-hedged, all bets may be off.)

This worries me a lot. Proprietary trading revenues have increased dramatically at institutions such as JP Morgan, Citibank and Goldman Sachs and a good deal of their earnings now comes from trading. The steep yield curve (courtesy of the Fed) has been very beneficial for these institutions and many other companies have swapped long-term interest rates for short-term interest rates is also very good for "carry trades". But what happens when the yield curve starts to shift ? The derivatives exposure of JPMorganChase is ENORMOUS (it's tens of trillions in nominal terms), and I think it will be a casualty when the interest environment starts to change.

Posted by: Nescio on September 17, 2003 03:42 PM

According to my intuition, if real external liabilities grow faster (trade deficit) THAN our ability to repay them (here real GDP) => big problemo, i.e. snow-ball effect. So, the question is, how fast do we really think the US will be growing in the (not-so-)foreseable future? Definitely faster than 6%, any doubters out there?

Posted by: Jean-Philippe Stijns on September 17, 2003 03:45 PM

BDL:

(At least, it does not do so if New York's major financial institutions have well-hedged derivative books: if their derivative books are not well-hedged, all bets may be off.)

This worries me a lot. Proprietary trading revenues have increased dramatically at institutions such as JP Morgan, Citibank and Goldman Sachs and a good deal of their earnings now comes from trading. The steep yield curve (courtesy of the Fed) has been very beneficial for these institutions and many other companies have swapped long-term interest rates for short-term interest rates is also very good for "carry trades". But what happens when the yield curve starts to shift ? The derivatives exposure of JPMorganChase is ENORMOUS (it's tens of trillions in nominal terms), and I think it will be a casualty when the interest environment starts to change.

Posted by: Nescio on September 17, 2003 03:49 PM

The net exports deficit looks set to exceed the trend rate of growth of nominal GDP. If that condition is hit and sustained, then the foreign debt to GDP ratio will rise toward infinity even if US returns on foreign assets continue to exceed foreign returns on US assets. (After all the already-accumulated net external debt stock means that America is already running a deficit on its factor payments accounts, despite the supposedly low returns paid on US assets.) So just as a matter of arithmetic, the US net exports deficit is already at an usustainable level -- or damn close.

The arithmetic aside, I find it strange that some (not BDL) would argue here that low returns on foreign investments in the US mean that the trade deficit is more likely sustainable. If the net exports deficit clears the nominal GDP growth rate, then those low returns will only SLIGHTLY delay the date on which the net external debt stock goes non-linear. And in the meantime, the low returns imply a weaker not stronger foreign appetite for dollar-denominated assets at today's exchange rate.

I agree with BDL. There is much story telling going round, not all of which is even coherent. Of course, this does not mean that the US is screwed. Maybe the dollar just falls a lot, the trade deficit gradually narrows and life goes on after a brief dip in detrended real consumption.

Posted by: Gerard MacDonell on September 17, 2003 05:38 PM

I live, work, and my Thai wife has a business in Thailand. I've been here for 22 years. I was studying the crash of 97 very closly. Your statement The currency crises in Mexico, East Asia, and Argentina primarily impoverished workers who lost their jobs and those who found their hard-currency debts owed to the industrial core suddenly a much greater burden,---------------------Hides the reality of what heppened here. Take what heppened in America in 1987 and compound it five-ten fold. 56 Finance companies went bankrupt, tens of thaousnds of houses were reposesed, factorys were closed, houndreds of thaosands of people lost their jobs, ect. Thailand and the people of Thailand were really hurting. You do them a grave injustice by the casual way you just brush them off. For your information, The Economical "CRASH" started in 1996 The Recession started in 2000. There is a big difference between the two. America's economical Crash started in 2000, The recession will start in around the year 2004/5. Since you got it wrong about Thailand, I HAVE to assume that you got it wrong about the rest of Asia, and Mexico. Do you remember the American CRASH of 1987? Did you study the crash while it happened. Had you done your homework befor the crash inorder to know what to look for in a crash? I DID!!! What single factor caused the CRASH, as apposed to just having a laymans recession? Answer: The inability or the supposed inability to service the "DEBT"!!!!! May I be so bold as to suguest that you re-think/learn what you know about an economical crash and a recession.

Posted by: Jim Coomes on September 17, 2003 05:52 PM

Very brief reply to Jim Coomes.

Much as I or anyone can regret what happened to the per capita income of average people in Thailand or the rest of SE Asia and some of North Asia, there is a huge difference between what they experienced and the causes of their currency and financial crash, and what the US is undergoing as foreign inflows of capital drive up the price of the dollar, or because of currency interventions by Japan and China and other Asian countries to keep their currencies undervalued.

1) In particular, Thailand and all the other Asian countries were obliged to pay back their loans of portfolio investment in dollars, not their own currencies. By contrast, the US runs up debt to foreigners --- based on mutually gainful economic transactions (foreign countries get export-surpluses with the US, which is what they want, plus a good outlet for investing their surplus dollars in the US eonomy; the US gets capital inflows to close the gap between our savings and investment rates) --- in dollars, our own currency, something we can never run out of.

2) The US continues to flourish better as a country with ongoing current account deficits than do countries like Japan, Germany, most of the rest of Asian countries, and most of the EU, all of which seek export-led growth and hanker after current account surpluses. Job growth in the US economy, though surprisingly lagging since 2001 --- owing to insufficient aggregate demand compared to the new potential output of the US economy (its long-term growth rate) --- is much better here than in those other countries or regions, and has been for decades. Similarly, GDP growth is much more vigorous here than in the EU or Japan, both badly stagnating --- Japan for a decade, the EU for two years (with a lower average GDP advance and growth in productivity than the US too throughout the 1990s).

Only neo-mercantilists can explain why countries with huge domestic markets --- the EU as a region, Japan, China, even South Korea --- continue to believe in the allures and magic of export-led growth, rather than domestic-generated growth.

3) As for productivity levels, the Bureau of Labor in 2002 found that US workers were by far the most productive in the world: each producing about $72,000 in output, compared to the next competitor, tiny Belgium (around 65%) Japanese workers produced about 60% of the US level.

4) Almost all the doomsday scenarios represented in these forums rely, in short, on either excessive fears or, possibly --- as in Krugman's case, where he was blatantly wrong about the future of the US economy in the 1990s in his book about it (published around 1990 or so in its first edition) --- wishful thinking. As with any economic trend, there are costs and benefits, each of which has to be measured carefully. The possible decline of the dollar, even a sharp one as in the late 1980s and early 1990s, is no different. Far from leading to catastrophe as Krugman and others predicted, itself a result, it was alleged, of growing fiscal profligacy (mounting national debt as a percentage of GDP), the US economy enjoyed in that decade of the 1990s its longest boom in history, a revival of its labor productivity to levels thought to be impossible by the declinists and doomsters, and the lowest levels of unemployment in 3 decades.

Why should we think that the doomsters will then be right this time?

-- Michael Gordon
http://www.thebuggyprofessor.org

Posted by: michael gordon on September 17, 2003 09:17 PM

3) That depends a bit on an inflated U.S. dollar, no?

Posted by: Andrew Boucher on September 17, 2003 10:00 PM

Hey its not so bad. After all people lived through the great depression in the 1930s and lived to tell about it.

Posted by: bakho on September 17, 2003 10:12 PM

Saw the Thai crash first hand. It was more than just a pure case of $s in short supply. That initiated the crisis, but a series of systemic shocks followed. One prime factor was the IMF tring to bring in much needed reforms at an AWFUL time. When the economy needed kid gloves reform was not the way to go. Have enormous sympathy for the views for Sachs and Stilitz (er not so vehement, perhaps) after seeign what transpired.

As a point of interest Thailand started recovering only when the current Premier Thaksin started aprogram of agressive fiscal stimulation and monetary policy was very relaxed.

While not everything that Mr. Thaksin says makes good sense, he got this one right.

Couple of points - if foreigners "dumped" US$ holdings instead of taking losses - and the Fed was obliged to step in to buy US sovereign obligations (given that Bush/Cheney et al are busy supplying us with new ones all the time), what would happen to money supply? At present Asias central banks hold close to US$ 1.7/1.8 trillion of US paper. Would such gyrations cause huge changes in either rates or inflation? Enough to cause a dislocation in the Us economy?

That said, its only if the central banks become panic sellers that this would transpire - an orderly devaluation would be far less damaging and riskier.

Lastly, since the early 1990s ASEAN was not mercantilist - it ran huge CA deficits - which is where the forex vulnerability came from. Funny, if the cycle was to end with Asian currencies returning to values close to their 96 values - enough to make one belive in re-incarnation.

Peeyoosh

Posted by: peeyoosh chadda on September 17, 2003 11:28 PM

re 'the US saving too little'.....not true when you look at household net worth figures across the G7. The US & Japan are at the top of the table. Even after adjusting the difference in social security & govt-funded health care, the US has a higher net worth/income ratio than other countries. It is Europe and Canada that save too little and are facing
poverty in retirement.

Posted by: Peter vM on September 18, 2003 01:29 AM

Peter vdM:
"re 'the US saving too little'.....not true when you look at household net worth figures across the G7. The US & Japan are at the top of the table. Even after adjusting the difference in social security & govt-funded health care, the US has a higher net worth/income ratio than other countries. It is Europe and Canada that save too little and are facing poverty in retirement."

I think that this is not completely true. Canada saves a lot more, has run current-account surpluses for many years and its demographics are not as bad as Europe's or Japan's, because of immigration. The US is absolutely saving too little and in my opinion you are just trying to make the US situation look good. The net savings ratio in the US is at around 1%, whereas it is above and sometimes far above 6% in other OECD economies. The US is also facing a retirement problem, just listen to what Paul Krugman and other economists have said about the Social Security Trust Funds.

Posted by: Nescio on September 18, 2003 03:59 AM

Coming back to what John C. Halasz asked.
Could someone explain the the consequences of the oil trade being invoiced in Euro? For America? For the world? How likely is it? What factors would make it more likely? Am I asking too many questions?

Posted by: Vivek on September 18, 2003 06:42 AM

The USA imports about a 50% of their oil consumption, and they have a reasonable level of trade with euroland, so that should not have much of an effect directly. As for indirect effects, I don't think to have a sufficient grasp of relevant data.

DSW

Posted by: Antoni Jaume on September 18, 2003 06:52 AM

The current account deficit - another scare du jour ? Australia has been waiting for the shoe to drop for 20 years and counting.
See
http://www.abc.net.au/lateline/content/2003/s934453.htm

Posted by: PEmberton on September 18, 2003 07:49 AM

There is no question about the lack of saving-debt burden in America being a long term drain on our domestic wealth. We have a serious long term problem that will affect middle class households severely. But, though the saving-debt problem ought to be addressed now severe effects are not going to emerge for some time to come.

Mats - you always argue well!

Posted by: anne on September 18, 2003 08:17 AM

Buggy Wuggy

You are inventing a new subject other than economics.... Like the Administration.

Posted by: jd on September 18, 2003 08:19 AM

Buggy Wuggy

Always has the answer. Blame all on Paul Krugman and all is wonderful. Buggy Wuggy for sure buggy wuggy.

Posted by: Ari on September 18, 2003 11:06 AM

1. Briefly reply to Andrew Boucher.

Andrew's comment on Sept 17th, 10:00 PM, refers apparently to one of the buggy-prof observations that the US bureau of labor in 2002 found that each US worker produced on an average of $71,600 $71,600 in output, compared to the next competitor, tiny Belgium --- where labor productivity was $64,100 on an average. Japanese workers produced about 70% of the US level, at $51,700.

The question Andrew raises is whether these figures aren't inflated by a high dollar. The answer: no. All such comparisons across countries --- by the Bureau of Labor, the BEA, the IMF, the OECD, the UN, and the statistical bureaus of foreign governments --- translate GDP and per capita income into purchasing power parity terms. So they're not affected by exchange rates, which do rise and fall . . . some times sharply so.

2) A similar study, just produced by the UN, found more or less the same results. See the summary at MSNBC< http://stacks.msnbc.com/news/959839.asp?0sl=-11, They are also duplicated, and have been for years, in the Annual Competitiveness Reports put out by the EU Commission. Last year, 2002, it found that the level of productivity in the EU was, on an average, 69% of the US's.

3) There are some discrepancies across countries in the ways in which nominal GDP each year is deflated to arrive at real GDP. The US Bureau of Economic Analysis began using a chain-weighted GDP deflator in 1996, in response to the criticisms of the Boskin Committee that it had been overstating US inflation for decades . . . somewhere on the order between, the committee estimates, of 0.6% - 1.8% (if I recall correctly) In an era of rapidly changing relative prices year to year, a chain-weight deflator tracks the changes each year. Technically, the BEA calls these "real GDP in chained dollars", and constructs a "chain-type price index for GDP." (For more illumination, go to the BEA site, click on methodologies: http://www.bea.gov/bea/mp_national.htm)

The relevance to cross-country comparisons?

Only some EU countries have switched to chain-weights themselves in deflating nominal GDP to arrive at real GDP each year. France has; not Germany. As a result, German real GDP is probably understated --- according to a recent study put out by a German economist by about 0.4% a year the last six years or so. That doesn't, he noted, account for more than about a fifth the gap in the German GDP growth performance the last decade compared to the US, but it is something worth considering.

4a. Note that the figures in 1 refer to GDP (output)/worker. On that basis too, the EU's Annual Competitiveness Report for 2002, p. 22, http://faculty.insead.fr/fatas/econ/Articles/Chasing%20the%20Leader.htm, shows that the EU average is 78% of the US average output.

There are, it's worth noting, two alternative ways to calculate labor productivity --- which, of course, is what we're referring to here (as opposed to capital productivity and total factor productivity . . . the latter, a residual in growth accounting models, usually interpreted to be equivalent to technological progress, broadly understood: new knowledge, whether embodied in better machines or software or in organizing and managing firms and agencies.)

The alternative measures of labor productivity are GDP/hours-worked and GDP/population --- the latter the same as per capita income, always translated into purchasing power parity terms for cross-country comparisons.

4b. When it comes to GDP/hours-worked, three West European countries turn out to have higher levels of labor productivity according to the recent UN study mentioned earlier --- France and Belgium, plus Norway (not an EU member). The average level of EU productivity on that basis rises to around 80% of the US level. The problem here? It's recognized by the EU Commission itself in its Annual Competitiveness Reports: the participation ratio of the population -- the percentage of the adult population (18-65) in the work force --- has declined in the EU since 1975, the big turning point in post-WWII economic dynamism in the industrial world, while the US ratio has jumped noticeably higher.

Specifically, in 1975, around 62% of both the EU and US adult population held jobs. Then, of course, women flocked into the labor force, and on top of that, there have been big influxes in the EU and the US of immigrants. The outcome? In the US, the participation ratio rose from 62% to around 75% at the start of 2001 (now down to 73% as a result of rising unemployment since then). By contrast, it fell to around 59% in the EU by the early 1990s, and though it rose eventually back to near 62% by 2000, the sharply rising unemployment in the EU since then has brought it back to around 59%.

Nor is that all. In contrast to the US, more and more unemployment in the EU --- which afflicts especially young people looking for a career, and immigrants --- is long-term. In the US, it's overwhelmingly short-term. Most jobs created in the EU the last 15 years or so, moreover, have been temporary or part-time.

4c. The overall problem then for making sense of the levels of labor productivity between the US and the EU using GDP/hours-worked? Only if the high levels of EU unemployment --- roughly 10-11% of the work force --- are voluntary, then looking at hours-worked as the denominator in the productivity equation overlooks the consequences caused largely, it appears, not by a preference per se for leisure over work in the EU compared to the US --- that no doubt exists to an extent --- but by rigid labor markets, high social security taxes, regulations restricting lay-offs by firms in recessions (and hence an unwillingness by them to hire new labor in the upswing of the business cycle), and so on.

Add in part-time and temporary jobs --- some of which are, of course, preferred by West Europeans to full-time work (as is the case for some Americans too) --- and the EU countries have upped labor productivity calculated on a basis of hours-worked at the expense of the young, the immigrants, and others with weak bargaining power in EU labor markets. For what it's worth, though, a recent study put out by Robert Gordon of Northwestern, taking into account a greater preference for leisure in the EU workforce, found that it brought the EU level of overall labor productivity up to around 92% of the US level. See The Economist's take on this recent study, http://faculty.insead.fr/fatas/econ/Articles/Chasing%20the%20Leader.htm

(Hours worked, by the way, are estimated by business firms in this country in Bureau of Labor surveys. Their accuracy has been questioned, but a study put out by Alan Krueger of Princeton in 2001 found that the estimated hours were more or less accurate. See http://www.irs.princeton.edu/krueger/produc3.htm

5. In the end, quite likely --- given all these problems --- the best measure of overall labor productivity is per capita income, translated into purchasing power parity terms. On that basis, as the EU's Annual COmpetitiveness Report for 2002 showed, it's about 67% of US per capita income. See p. 20, http://europa.eu.int/comm/enterprise/enterprise_policy/competitiveness/doc/competitiveness_report_2002/cr_2002.pdf

6. Capital productivity --- how efficient investments in machines, plant, software, etc --- happens to be is hard to measure across countries, in no small part because of different depreciation measures for replacement capital. Taking all the complexities into account, the McKinsey Global Institute --- relying on a committee of well-known economists as consultants --- found in the mid-1990s that the German and Japanese levels were about a third lower in productivity.

7. It's worth noting, as a final comment, that the US per capita income lead is hardly new. It goes back to the 1880s, when it surpassed the then leader country, Great Britain. By the late 1980s, Germany and Japan --- the two front-running "follower countries" (to use a term taken from convergence theory and catch-up growth) --- had cut the lead in per capita income that the US enjoyed to around 85-90%. Since then, far faster US growth in the 1990s --- plus a decade of stagnation in Japan, and a decade in which Germany ended up the worst grower in the EU --- have brought Japanese per capita income down to 72% and in Germany, roughly the EU average, to 69% in 2002. (Again, see p 20 of the EU Annual Competitiveness Report for 2002, http://europa.eu.int/comm/enterprise/enterprise_policy/competitiveness/doc/competitiveness_report_2002/cr_2002.pdf

For what it's worth, I've dealt with these matters at length in several buggy professor articles posted at this site: http://www.thebuggyprofessor.org

For instance, http://www.thebuggyprofessor.org/archives/00000105.php

Posted by: michael gordon on September 18, 2003 03:45 PM

I forgot to give the link to the German study mentioned above in 3), which uses a chain-weighted deflator to raise German GDP annual growth. It's a good study by Manfred Scheuer, which was sent to me by an economist in Belgium this last weekend.

See http://www.bis.org/publ/cgfs19bbk1.pdf

-- Michael Gordon
http://www.thebuggyprofessor.org

Posted by: michael gordon on September 18, 2003 04:10 PM

Well, I guess I was trying to be clear before and scholarly rather than the hump trader I am and I was actually rather vague.

The problem with all your analysis is you are using the wrong unit.

The eocnomic unit of specific "nation-states" allows for ready data arrays and throwing back and forth of supporting facts to reach a conclussion, but it fails in one very robust and obvious and simple fact. The unit that determines the US inflation, true deficit, size of effective GDP and so on is not the US GDP, but is a unit considerably larger that contains not only the United States but all areas where the USA has dominence or at least strong suassion.

Most of you, and deLong and Krugman types and Paul K himself, seem dismiss this view as something abstract and not applicable for it makes it almost impossible to come to any mathematical answers for the true unit that should be used is at best subjectively defined.

But just because it is very very hard to identify does not argue against that the true unit is the size scope and breadth of the USA economic empire. There, said it, the dirty word: empire.
That empire is, my best guess 30 to 60 trillion is size.

That unit makes all these worry about trade deficit and crashes really alot to do about nothing. For being an empire we have the luxory of restricting the numerator to only the specific USA GDP unit variables but use a global denopmionator. Thats the perk of having a pretty large navy and the ability to enter Iraq with out without other's help.

Until you start to consider it in this light you are only being blind folks feeling various parts of the elephant.

It also means that the truly crucial factor is the change in the boundries of that empire. Therefore how we far in Iraq suddenly has direct and real impact on US financial assets and economic policy.

Posted by: Mac Robertson on September 19, 2003 02:14 PM

To Michael Gordon. I must say, I went over the top, wrongly, in my posting above. (emotionaly)-------Setting a base line: The US crashed economicaly in 1974, 1987, 2000, and will probably crash again around 2013. Greenspan says: after 2010, Delong says: maybe a small recession around 2008/9. Actualy he said maybe 5/6 years from now. He even has history behind him. The crash of 1920, followed by the crash of 29. Now, Knowing that the next crash is going to come between 2009 and 2013 we have ample time to prepare ourselves! What is the best way to prepare ourselves so that the crash will have minimal impact on us and America? Very symple, GET OUT OF DEBT! Now here is the down side to the US government getting out of Debt, It would slow down or Halt the world economical recovery. Remember that the USA is the economical engin of growth for the world, at this time. Also it would put more people out of work, mostly government workers, IF, the government cuts the right spending, and not the wrong spending. Governments by their very nature grow and never srink, except from external force. With good leader ship, the government could re-direct privet capital investment to needed areas that would both creat jobs and fill social needs that tend to take too long to show a profit above 7%. Example; tree "farms" with crops grown between the roles of trees, the recycleing industry, you can think up others that are needed but show only a small profit. This would actualy take the place of Keynes's ideal of, governments borrowing money durning the bad times. His theory also said, governments should pay it back in the good times. "Pay It Back". Wait a secound, if we pay back the DEBT then there won't be an economical crash, there might be a lack of demand lead recession. "Economical crashes happen because of 'the inability or supposed inability to survice the DEBT'" England, Great Britan, is a good example of how the lack of government debt can soften the crash. America is the leader/teacher of the world. What America has been teaching the world for the last 40 or more years is to borrow money!!!! Weather you borrow the money in your own curency or another, is still DEBT! Borrowing in a foreigen curency only compounds the problem. There are two ways to go when a country crashes, the easy way to go is to devalue/debase the curency ie. INFLATION. the other way is undercut the competition with cheeper products, thus selling more, ie deflation. Deflation, being the harder way to go tends to be the better long term way to go. Look at what a mechanic, carpenter, ect. earned and could buy 30 years ago, include medical and insurance and taxes, compare it to what he can earn and buy now. Far Less. Real inflation lowers the standard of living of people who do not or can not get the latest technology high paying job. There is a down side to a no, low DEBT society, slower growth and maybe less technological inovation. (good leadership could reduce this probability.) ------The doom sayers really do have a valid point AND are very much needed IN TODAYS SOCIETY. Notice the lack of media coverage of the Doom sayers during the Bubble years of the 90's. Read the "The Great Recogning" by Davison and Mogg. They even predicted back in the 70's the big increase in teroricst activities. The better ones get the years wrong and some of the senario, but they are justified in The "Potential". America has the very high probable potential of a US Tresuries crisis in the forseeable future. Just look at what Japan did to America back in 1991. America tried to re-value the Yen, stoped at 70 Yen to the Dollar from 130yen. Then the roumer came out of Japan that they would sell US Treasuries. The Yen went up to 140 Yen to the Dollar. All this on a roumer of dumping the bonds. So, where is America's economical security at it's weakest point? The US DEBT!!! Everything keeps comming back to DEBT. Get rid of ,pay off, the DEBT and 90 percent of your economical problems go away.

Posted by: Jim Coomes on September 20, 2003 07:32 PM
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