November 08, 2004

John Taylor Blasts Off for the Gamma Quadrant

Take a look at the figure above. The blue line shows (gross) investment in America as a share of total GDP. The green line shows savings--household, business, and state and local government savings--as a share of GDP. The purple line subtracts the federal deficit--federal government anti-savings--from the green line. It shows national savings as a share of GDP.

The gap between the blue line and the purple line is the U.S. trade deficit. Because there is more being invested in the U.S. than Americans are saving, the difference is financed by foreigners. And to earn the dollars to finance their investments in the United States, foreigners in total have to sell us more in imports than they buy from us in exports. They take their earnings from imports, use some to finance the surplus of investment in America over American savings, and use the rest to buy exports from America.

Treasury Undersecretary John Taylor's speech last week on the current account was incoherent. But without the figure above it would simply be incomprehensible.

Taylor says:

JS-2084: The U.S. Current Account: John B. Taylor: [T]he increase of the U.S. current account deficit over more than a decade has been linked to domestic U.S. capital formation increasing more than U.S. saving. Perceived high rates of return on U.S. assets, based on strong productivity growth relative to the rest of the world, combined with an efficient and secure U.S. capital market attracts foreign investment....

Well, not really. Nominal investment has grown because of inflation. Real investment has grown because of normal growth in real incomes. But investment as a share of GDP has not grown at all. We have a large trade deficit now--and did not back in 1997, when investment as a share of GDP was as high as it is now--because (a) the federal government budget deficit is much larger now than it was then, and (b) private savings declined as a share of GDP during the bubble years of the late 1990s, and has not fully recovered.

John Taylor, however, is not allowed to say the--obvious--thing: that savings as a share of GDP has declined as a result of the big Bush budget deficits. So he boldly forges on:

Thus, sound, growth enhancing, economic policies are continuing to make the U.S. an attractive place to invest. There are parts of the world that currently have large savings rates and limited domestic opportunities....

[T]his view of the current account also tells us the kind of economic policies that will reduce the current deficit and at the same keep the United States and the world economy strong. So let me now describe three types of economic policies that the Bush Administration is pursuing and will continue to pursue which relate directly to the current account.... Let me first turn to policies aimed at increasing saving.... [A] reduction in the U.S. fiscal deficit now as the economy expands will reduce the current account deficit.... Next year the budget deficit is projected to be less than 3 percent of GDP, and continue to contract through the rest of the decade.

This statement is about to become inoperative, if it is not already so.

Taylor then turns to talking about factors that are macroeconomically insignificant, as far as their effect on the current account is concerned:

Likewise, increased private saving can play an important role.... The adoption of education savings plans and health savings plans are two steps the Administration has already taken to promote private savings.... But more can and should be done. The tax reform and social security reforms called for by President Bush--including the introduction of personal savings accounts--are an opportunity to further reduce the disincentives to save and provide long-term benefits to the U.S. economy....

A third area of policy relates to exchange rate flexibility.... [M]ore flexibility in exchange rates is desirable for major countries or economic areas that lack such flexibility to promote smooth and widespread adjustments in the international financial system, based on market mechanisms....

Given that the underlying worry is that a sharp sudden fall in the dollar will weaken the U.S. and world economies, it is not clear why anyone would think that the paragraph above is reassuring.

The beneficial impact of these positive measures may take time to materialize, but there is no reason to expect that financing and adjusting will not be adequate and smooth.... [I]t is important to put the current account in the perspective of the total amount of financial flows.... Some ask about the econometric models that are used to estimate the size of a currency adjustment that would be associated with a given current account adjustment. These models sometimes find large currency changes, but they sometimes also tend to look mechanically at the effect of an isolated exchange rate change. In reality many factors change simultaneously because the dollar and other major currencies are determined in markets....

And here John has wandered off into the Gamma Quadrant in which the Bush administration makes so much of its economic policy.

Two major factors affect demand for imports: (a) the exchange rate, and (b) the level of demand in the U.S. Two major factors affect demand for exports: (a) the exchange rate, and (b) the level of demand outside the U.S. Barring a severe recession in the United States or an exhorbitant spending boom outside the U.S., it is the exchange rate that *must* move if the U.S. current account is to be significantly reduced. "Can't increases in national savings reduce the deficit?" you ask. Yes--but as national savings rises it crowds out the foreign capital inflow by raising the dollar price of investments in the U.S. and inducing foreigners to sell their American assets, and as they sell their American assets international demand for dollar-denominated assets falls and the value of the dollar falls. The "many factors" that change simultaneously are not an alternative to looking "mechanically at the effect of an isolated exchange rate change," they are how that exchange rate change's effects on imports and exports are consistent with the adding-up constraints of the circular flow of economic activity.

There is substantial reason to fear that adjustment will not be adequate and smooth. The surprising recent strength of the dollar has been produced by (a) the willingness of someone (mostly Asian central banks) to buy and hold the flow of new dollar-denominated assets held abroad generated by our trade deficit, and (b) the unwillingness of private hedge funds, investment banks, and other investors to place large leveraged bets that the dollar decline has started for real. If the private market--which knows that with high probability the dollar is going down someday--decides that that someday has come and that the dollar is going down NOW, then all the Asian central banks in the world cannot stop it. You need both (a) and (b) to keep the dollar up. Just one of them won't do. "Adequate and smooth" adjustment requires that (c) Asian central bank purchases of dollars tail off gradually AND (d) private investors' recognition that it is time to bail out of dollar-denominated assets be a slow and gradual process, rather than a sudden crystalization of market expectations in a new configuration.

The example of 1985-1987 shows us that a soft landing from an overvalued dollar is a possibility. It does not show us that there is no reason to fear.

Posted by DeLong at November 8, 2004 06:20 PM | TrackBack
Comments

There is, I posit, the possibility that (b) is the case because speculative capital in the aggregate has already been burned by the unexpected effects of (a). However, I wouldn't rule out the possibility that currency and bond traders now are positioning themselves opportunistically lest they miss the eventual move in those markets.

Posted by: wcw at November 8, 2004 07:32 PM

That was an excellent primer on the current situation.

I have to wonder, though, are Bush administration economic advisors so powerless that they are not getting the chance to say this, or are they simply being ignored? Perhaps they know something that we don't, but I don't know what that would be.

Posted by: Brian at November 8, 2004 08:17 PM

Brian, i think the assumption we can make from o'neill's and clarke's books and diullio's experience is that, to cite the cliche, their mind is made up, don't bother them with the facts.

certainly the evidence in front of us is that the bush administration has zero interest in what makes the best policy as opposed to what makes the best politics, and certainly the evidence in front of us is that people who previously had good reputations sell their souls when they go to work for the backbone administration.

obviously, there are other possibilities (they are idiots, for instance), but these are much less likely than that the denial of bush supporters is matched by the denial of bush insiders.

me? i believe that, in the end, reality will catch up, but of course, as keynes notes, in the long run, we're all dead....

Posted by: howard at November 8, 2004 08:25 PM

The dire problem of the US economy. How to solve it?

An interesting solution comes from Brookings and the Council on Foreign Relations. They argue that the overall framework is wrong. The international community seldom agrees with the US on what threats should be addressed, never mind how to deal with them. They think a US led alliance of democracies is the way forward.

"Efforts to improve the UNís capacity to respond to global security threats are laudable. But we are never going to see a UN army. And remaking the Security Council, training peacekeepers and increasing funding will only marginally improve the UNís ability to act. The real problem is that reform proposals such as these do not go to the heart of what ails the organisation - its founding principles are obsolete."

The new alliance's "reach would also extend to economic matters - its potential members are responsible for the bulk of world economic activity and would constitute a powerful voting bloc within the World Trade Organisation." http://news.ft.com/cms/s/b7441b2a-2e24-11d9-a86b-00000e2511c8.html

Scrap globalisation? We are still left with the question of who will fund the increasing appetite of the US.

Posted by: IJ at November 9, 2004 02:20 AM

"The example of 1985-1987 shows us that a soft landing from an overvalued dollar is a possibility. It does not show us that there is no reason to fear."

There is considerable reason to fear a decline in the value of the dollar that is accompanied by a rise in interest rates. Before the 1987 break in the stock market, the Fed was in a tightening sequence that brought long term rates above 9%.

Posted by: anne at November 9, 2004 03:09 AM

I worry about the combination of a falling dollar and high (nominal) interest rates that would occur if the Bush administration decides to monetize the debt (print money) and the damage this would do to Ginnie May and Fannie May. Would there be a bailout like during the S&L crisis in the 80s? Are the possibilities of fraud and corruption there? Could we see another trillion dollar rip-off? Or is that too audacious to contemplate? I admit that I haven't thought this through. Maybe someone else has.

Posted by: Luke Lea at November 9, 2004 04:12 AM

In 1985-87 we had a massive jump in the spread between US and foreign interest rtes that -- caused by US rates rising sharply and foreign rates remaining flat -- that was not accompanied by a strong currency. Something similiar seems to be starting now. The internaional interest rate spread is flat in the face of a falling dollar. I suspect before ths is over we will see both the interest rate spread widening, the dollar falling and a major stock market drop.


Yes, in 1985-87 we did not have a big economic impact, so in that sense we had a soft landing.
But we did have a major stock market crash that caused the Fed to abort a tightening move that was still in its early stages -- the fed had only tightened 3 time before the mkt crash.

Posted by: spencer at November 9, 2004 05:18 AM

Forgive me if I'm being naive here, but doesn't that chart show that the savings ratio is set to improve by year end 2004?

Posted by: ChrisDA at November 9, 2004 06:01 AM

In the absence of imminent change in the world's economic framework, other nations must be terrified at the dollar's decline. It is suggested in this article that politics influenced the following outburst.

"[The] president of the European Central Bank, yesterday launched a surprise attempt to curb the ascent of the euro, calling recent rises against the dollar "brutal".

"His comments, which marked a significant toughening in his stance since last week, followed the euro's rise after the re-election of President George W. Bush focused attention on the mounting US budget and current account deficits.

"Analysts expressed surprise at the tone of Mr Trichet's remarks, which they expected would not stop the dollar's fall for long. They noted that the ECB president had not received public backing from other central bankers. They were also sceptical about the chances of financial intervention. "The market feels Trichet and the ECB can hardly start intervening just yet when they signed off on the last four G7 statements talking about the primacy of the market," said Simon Derrick, head of currency strategy at Bank of New York. http://news.ft.com/cms/s/9e574bb4-31f3-11d9-97c0-00000e2511c8.html

Posted by: IJ at November 9, 2004 06:08 AM

It looks like there is a fundamental disagreement between world economic policymakers about who's currency is worth less - nobody right now wants to have the strong currency. Europe worries about unemployment and damage to its manufacturing; same for China and the other Asian nations. Japan doesn't want a rising yen to choke off its recovery. So Europe and Asia want a strong dollar.

That would be fine if the US was willing to continue paying for a strong-dollar policy. But we're not - at least, not if it would prevent Bush and Congress from doling out the red-state pork and the tax breaks to their contributors. And while a strong dollar policy provides benefits (cheap energy and imports), it also has real costs for the US, mostly in manufacturing jobs but also in the drain of investment returns paid to foreigners and debt-service payments needed to finance all the borrowing.

But if US policies reflect an indifference to the level of the dollar, can Europe and Asia prop it up all on their own? In effect, the US has shifted the burden for a strong dollar onto Europe and Asia; if they want to keep the dollar propped up, they can do so. China and Japan have felt it worth the costs until recently, and perhaps they still do. Europe's complaints also suggest that they are concerned enough about a rise of the euro to consider propping up the dollar.

But the dollar won't collapse: as it drops a little, it becomes easier for Europe and Asia to hold it up - and they want to hold it up. After a small decline, financing America's debt could once again become the offer they can't refuse.

It is, I am sure, aggravating to European and Asian policymakers that Bush is playing "chicken" with the international economy. Bush has implicitly decided that there are costs in an international system based on a strong dollar, and maybe the US can bluff or browbeat Europe and Asia into paying a larger share of those costs.

It is very much like the "starve-the-beast" fiscal games played by the GOP against Democrats: run up a huge deficit on weapons and tax cuts and then force the Democrats to do the dirty work of raising taxes cutting spending. Now, they've figured out how to do it on a global scale.

Posted by: Silent E at November 9, 2004 06:46 AM

ChrisDA - Yes, but not so much as the level of investment.

If I save $10, but $12 gets invested, someone else has to put in the $2. Translation: trade deficit increase.

The surprise of the graph, if any, should be the green line. If I'm reading the slopes correctly--always possible I'm not, but the denominator is common so it's not a difference of scale--either State and Local budgets are better balanced, or a significant portion of Private savings are going into offshore assets. Anecdotally, the first is not the way to bet.

Posted by: Ken Houghton at November 9, 2004 07:08 AM

>>
[Taylor] ... but they sometimes also tend to look mechanically at the effect of an isolated exchange rate change
>>

So it seems that just as for the values voters, for whom Charles Darwin never happened, for John Taylor's New Economics, Alfred Marshall never happened. "other things being equal" is now an inadmissible way of thinking.

Posted by: P O'Neill at November 9, 2004 07:26 AM

Damn, I wish you'd been my economics professor in college. The guy I had was a resident of the Gamma Quadrant.

Posted by: Susan at November 9, 2004 08:57 AM

The graph shows net US savings in 1995. But in 1995 the US was running a deficit.

methinks there's either something wrong with the graph or the theory you're using it to explain.

Posted by: Giles at November 9, 2004 09:11 AM

>>
The graph shows net US savings in 1995. But in 1995 the US was running a deficit
>>

You are looking at the private plus sub-federal line. National savings did not exceed investment in 1995.

Posted by: P O'Neill at November 9, 2004 09:48 AM

All of your comments are helpful in getting me up to speed on these issues. Can somebody translate this part for me with an example, or break it down a little more? Thanks very much:

".....as national savings rises it crowds out the foreign capital inflow by raising the dollar price of investments in the U.S. and inducing foreigners to sell their American assets, and as they sell their American assets international demand for dollar-denominated assets falls and the value of the dollar falls. The "many factors" that change simultaneously are not an alternative to looking "mechanically at the effect of an isolated exchange rate change," they are how that exchange rate change's effects on imports and exports are consistent with the adding-up constraints of the circular flow of economic activity."

Posted by: Franklin Delano Sinatra at November 9, 2004 10:50 AM

I'll take a stab at the first part, although I'm woefully underqualified.

You have a certain number of dollars chasing a certain number of domestic investments. If national savings rise, this increases the number of dollars chasing the investments. This increase in demand will increase the price of investments, thus "crowding out" some of the foreign investors who will seek better investment values elsewhere. When they do that, they are exchanging dollars for other currencies, thus reducing the value of the dollar.

He lost me with the rest of it.

Posted by: fling93 at November 10, 2004 05:00 PM

The trouble with jogging is that the ice falls out of your glass. Martin Mull (1943 - )

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