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December 20, 2004

Barry Eichengreen Stitches the Short Run to the Medium Run and Sees Recession

Writing in the FT, Barry Eichengreen tries to stitch together the current short run of U.S. savings much lower than investment, a large current account deficit, and low interest rates with the medium run we all foresee of savings roughly equal to investment, a current account in rough balance, and higher interest rates. His message: DOOM (or at least recession):

Narrowing the US [trade] deficit... require[s]... increased savings and lower investment. The falling dollar will bring this about by tending to drive interest rates up.... Asian central banks... sell some of their existing holdings... upward pressure on US Treasury yields.... [A]s the dollar falls, there will be upward pressure on US import prices.... [T]he Federal Reserve will have to raise interest rates faster than currently expected. Higher interest rates will make borrowing more expensive and slow investment growth. They will have a negative impact on... house prices. US households... will have to start saving again. With investment down and saving up, the current account deficit will narrow.

Unfortunately, this happy observation is not the end of the story. A significant decline in both consumption and investment will mean a recession in the US. This conclusion is so obvious that the only question is why the markets are not forecasting it already.

The answer, presumably, is that investors do not believe that the dollar's decline will produce a significant increase in inflation. The historical data say that a 10 per cent fall in the dollar produces 3 additional percentage points of inflation, which in turn implies a 450 basis-point increase in the discount rate. Clearly, we have not seen anything like this yet.... Maybe the... traditional relationship between dollar depreciation and inflation no longer holds.... But... [this] just means that the dollar will have to fall further to generate enough inflationary pressure to force the Federal Reserve to raise interest rates. At the root of the dollar's decline is the view that the US current account deficit is unsustainable. Foreigners will therefore keep selling dollars until it narrows. This in turn means that the dollar will keep falling until US inflation heats up to the point where the Fed does indeed have to raise interest rates. The implication, that the US economy will slow or more likely succumb to recession, is unavoidable.

The question is whether there is anyone to take up the slack.... Europe is stagnant, and the European Central Bank has shown no awareness of the need for monetary stimulus. China is cooling off.... Japan's modest recovery will disappoint now that it has to raise taxes to control its own spiralling debt. Countries outside the Group of Four nations (the US, the UK, Japan and Germany) are simply too small to make a difference. The implication is that the correction of the US current account deficit that is now getting under way will mean a recession not just for the US but for the rest of the world. The optimists who are welcoming the dollar's fall should think again.

That's the thing about accounting identities like S - D - I = NX. Either you craft economic policies that make them hold at full employment, or the market takes care of making sure that they hold for you--but usually not at full employment. Stagnant or falling wages that boost corporate profits could boost savings S by boosting retained earnings. A Bush administration serious about cutting the deficit could provide financing for investment and keep interest rates from rising. Big booms abroad could raise U.S. exports and reduce investment as the Fed took steps to shrink investment to avoid inflationary overheating. Otherwise, it is indeed hard to argue with Barry just across the north wall of this office: the dollar falls; has the fall produced enough inflationary pressure to lead the Fed to raise interest rates and so reduce investment and the current account deficit? no? then repeat.

Posted by DeLong at December 20, 2004 05:35 PM


Suppose a couple of big economic players have a natural tendency to want to hold foreign assets.

One (Japan) over-saves by traditional measures, with savings so immense that interest rates at home are measured in the tenths of one percent after an extended post-bubble slowdown.

Another (China) has an emerging economy with surplus labor, 50 years behind most of the world in many ways, but catching up fast. One thing China lacks is a developed financial system. It's easier to use the world's reserve currency, a double-plus given the same currency has an effervescent consumption policy and a corporate sector happy to negotiate for vast pools of labor at 5 cents on the dollar of wages.

While neither nation would like to hold a falling reserve currency, both have strong reasons to keep acquiring those particular foreign reserves, namely, a growing export market, and for China, a comparatively reliable place to hold reserves.

Back home, in the USA, there is a very low savings rate, but propelled by a 24 year old deflationary cycle and a federal reserve that is at least benign if not positively inclined towards asset inflation, targeting primarily wages to keep inflation in check, a consumption-based economy keep rolling on with the assistance of low interest rates.

Short term rates were cut dramatically to deal with a crisis (9/11) and with a whiff of a deflationary spiral. The federal reserve now wants to return to a "neutral" policy, neutral meaning they're happy with long term rates low, but they want to reallign short rates to a more natural rate curve.

Lots of build-up here. What's the question? I guess the question is, how long can these mutually reinforcing cycles go on, and where do they lead?

Given that our imports are about double our exports, it doesn't seem likely we can get to balance any time soon. Also, given the utter dependency we've built, purchasing import goods for pennies on the retail sales dollar, we can't just build new factories and take a 10% hit. We take a 5X hit to shift production on a big chunk of retail goods. Don't we?

Was this the way it was in previous empires dependent on colonies? And weren't the capital flows going the opposite direction most of the time in empires?

The simple answer seems, some day, things have to revert towards balance. Crash, boom. But maybe not. If so, why not?

Posted by: Charlie at December 20, 2004 06:09 PM

"we can't just build new factories and take a 10% hit. We take a 5X hit to shift production on a big chunk of retail goods. Don't we?"

CNBC had a feature several weeks ago showing the manufacture in China of a popular doll being sold in the USA. The estimate by the CEO was that the doll which retailed for $15 would be a $60 item if it were made here. I don't know how feasible it would be to automate more steps, but the guy they interviewed didn't think the product would exist if it had to be made in the US. I think if cheap labor were not available we would choose not to make so many of these items rather than attempt to shift production here.

Posted by: snsterling at December 20, 2004 06:41 PM

"...The dollar falls; has the fall produced enough inflationary pressure to lead the Fed to raise interest rates and so reduce investment and the current account deficit? no? then repeat."

This is not encouraging, especially so since investors seem to be of a different optimistic mind. Higher long term interest rates, slowing economic growth and falling profit margins do not bode well for the labor market or for asset markets.

Posted by: anne at December 20, 2004 06:51 PM

Brad, are you ever going to fix this blog? Dump Moveable Type and go with something--anything--else.

I am convinced that we're on the road to a very deep recession. The Chinese can't hold out forever. They (and other finance ministers) are looking at some stark choices: Start shifting away from dollars now or in the very near future and deal with the ensuing recession, or hang on as long as possible knowing that the longer this goes on the more likely it is that the breaking point will be global depression.

The Chinese ain't dumb, and they'll probably figure they can cope with recession much better than depression. Especially since depression has a bad habit of fomenting civil unrest and revolution.

Posted by: Derelict at December 20, 2004 07:44 PM

For all of those economists who fall under the category of neoconomists, I have to ask, what models are you guys using to predict growth? If we are elimating taxes on everything but income, privatizing Social Security, and doing a host of other things, what will need to happen in return? I'd hate to think that people who believe in these things design models with no tradeoffs. The Bush administration either believes everything can pay for itself, or, more likely, it's being dishonest in pretending that such a thing can happen, but academic economists?

Posted by: Brian at December 20, 2004 09:03 PM

"The falling dollar will bring this about by tending to drive interest rates up.... Asian central banks... sell some of their existing holdings... upward pressure on US Treasury yields.... [A]s the dollar falls, there will be upward pressure on US import prices...."

The dollar has been falling for three or so years and interest rates haven't gone anywhere and import prices have stayed pretty much constant if not gone down.

I doubt that Asian central banks will sell their holdings. On the other hand, if they just don't add to their existing holdings, there will be downward pressure on the dollar.

Posted by: Andrew Boucher at December 20, 2004 10:25 PM

CNBC had a feature several weeks ago showing the manufacture in China of a popular doll being sold in the USA. The estimate by the CEO was that the doll which retailed for $15 would be a $60 item if it were made here. I don't know how feasible it would be to automate more steps, but the guy they interviewed didn't think the product would exist if it had to be made in the US. I think if cheap labor were not available we would choose not to make so many of these items rather than attempt to shift production here.

Posted by: snsterling at December 20, 2004 06:41 PM
Do you really believe that? Because if so, it means that the 500 billion dollars of imports we have are not responsible for low paid workers losing 10 million jobs, but 40 million jobs.
Some people I know would be delighted to work building factories to make these dolls, and some others would be delighted to work in these factories making these dolls.
Of course, if you just spent 5 years and 100,000 dollars becoming a lawyer you might not be happy at the idea of your high school diploma janitor making so much money building that factory or working in it that you had to sweep the floor yourself...

Posted by: wkwillis at December 20, 2004 10:47 PM

I'm not an economist so I guess my questions sound lame, and I seldom get much response here. Nevertheless, my questions are absolutely sincere and I persist in asking them. They also reflect a lot of thought, all of which may be entirely wrong. If so, please educate me.

Hasn't the U.S. been playing this game for a long time, since, I think, roughly the 1980s?

Over that time, I have never been able to understand why other countries would let us get away with these big trade imbalances. What, exactly, do they get in return?

Is it basically oil they get in return for their dollars? If so, doesn't that mean we've been effectively powering our whole economy on cheap (almost free) Mideast oil for about 25 years?

Isn't that why we're in Iraq - as a desperate attempt to keep that ball rolling by dominating the region through purely military means?

Isn't that attempt almost certain to fail?

Doesn't that mean that your forecasts for this country are actually very optimistic, once the toys->dollars->oil->toys cycle is finally broken?

Isn't the big question really WHEN, rather than IF?

Posted by: Ralph at December 21, 2004 12:55 AM


The short answer to your question is that the US has the advantage of controlling the world's main reserve currency. That means, in effect, that the US can pay for its imports with "checks" (dollars) that will never be "cashed" by the recipients - ie, they will ultimately be held by foreign central banks, or by foreign private individuals and companies who value them as a store of wealth.

Given the extent to which we are now abusing that privilege, I think you're absolutely right to say that the question is not IF, but WHEN. And it looks as though Barry Eichengreen and Brad DeLong agree with you.

Posted by: Dave L at December 21, 2004 03:30 AM


You might know people who would work in such a factory at prevailing US wages, but probably they don't wish to work at current Chinese wages. The demand we have now for these products is based on the low cost of labor. So if we imagined that the US lost access to cheap labor due to the advancement of developing nations then the consumer has a choice to make and the most likely choice would be to buy far fewer of the things which were previously imported.

As you point out, to continue full consumption of these things if we could not make large productivity improvements would require approximately 40 million US workers. Since the consumer would never choose to trade off 1/3 of the workforce to make what now comprises only 5% of consumption it is difficult to know how many toy/apparel/consumer electronics jobs would appear. To some degree it would be a boost for low wage low skill workers at the expense of skilled like you say, but it will also hurt the low wage worker because they are consumers too and they will have the hardest time adjusting to higher prices for Walmart type items.

Anyway I only know what I saw on TV.... for most items the cost difference is probably not that big and if there was a big need then we could probably automate much of it.

Posted by: snsterling at December 21, 2004 05:37 AM

Check out the CPI numbers on TED


Inflation is clear. High energy prices are always linked to economic downturn in the US. By not dealing with the conservation issues, the US is painting itself into another energy corner. During OPEC2, the US was at refining capacity. Oil prices were sky high and Volker had very high interest rates to keep the US from borrowing and running high trade deficits. By 1982, the CAFE fuel standards of Carter and Ford kicked in to drop gasoline consumption to 80% of capacity. Gasoline consumption in the US has recently returned to its 1980 high and we are seeing high prices again.

We will not see a repeat of conservation driving us out of this. OPEC can trade in Euros instead of dollars now making it difficult for the US to inflate away high oil prices. Mr Bush thinks it is a big joke. "If you don't like the US trade deficit, buy more American made products."

With high oil prices, there will be increased demand for conservation technology. However, with the US not making many moves in the direction of conservation, the lead will go to Europe and other countries. The recent refusal of the US to follow Montreal protocol and phase out methy bromide will insure that replacement technology will move to Europe. The recent strictures against stem cell research insures that the technology will migrate to Britain and Asia.

Why are the Republicans and Bush pursuing this course? The best explanation I have read is Stirling Newberry's Rent Wars.


Posted by: bakho at December 21, 2004 06:04 AM

Well, from what I've read and what I recall when we had a major devaluation of the dollar in the past we had a recession. When we fought a war on credit we had a recession. When energy prices got this high we had a recession. Someone will have to explain to me why anybody who's not a hack would still be saying that we aren't going to have a recession.

Posted by: Tim H. at December 21, 2004 06:17 AM


Rural Exodus for Work Fractures Chinese Family

SHUANGHU, China - Yang Shan is in fourth grade and spends a few hours every day practicing her Chinese characters. Her script is neat and precise, and one day, instead of drills, she wrote letters to her parents and put them in the mail.

"How is your health?" she asked.

Shan, who is 10, then added a more pointed question: "What is happening with our family?"

Her parents had left in March. Their absence was not new in Shan's short life. Her father, Yang Heqing, has left four times for work. He is now in Beijing on a construction site. Her mother, Ran Heping, has left three times. She is in a different city as a factory worker.

Over the years, Shan's parents have returned to this remote village to bring money and reunite the family. They leave when the money runs out, as it did in March. Her father had medical debts and needed cash to see another doctor. Shan's school fees were due, and her grandparents also needed help.

"I think they are suffering in order to make my life better," Shan said of her parents. She added a familiar Chinese expression: "They are eating bitterness."

For the Yang family and millions of others in the Chinese countryside, the only way to survive as a family is to not live as one. Migrant workers like Shan's parents are the mules driving the country's stunning economic growth. And the money they send home has become essential for jobless rural China.

Yet even that money is no longer enough. Migrant wages have stagnated, education and health costs are rising, and the rural social safety net has collapsed - a crushing combination that is a major reason the income divide is widening so rapidly in China at the expense of the rural poor.

Migration also has meant that urban and rural children in China are growing up in starkly different worlds. In cities, upwardly mobile couples call their precious only child xiao taiyang, or "little sun," as in center of the universe. Children are indulged with clothes, toys and snacks: childhood obesity is a new urban ill.

In the countryside, the new vernacular phrase is liu shou, or "left behind" child. Millions of children like Shan are growing up without one or both parents. Villages often seem to be missing a generation. Grandparents work the fields and care for the children.

"We are a triangle, three people in three different places," said Mr. Yang, 36, the father. "The pain of missing one another is very difficult. All parents are the same in this world. All parents care about their children."

But Shan's parents, strapped with debt and obligation, are among the untold millions of people in rural China caught in a brutal cycle. Studies show that medical costs are the leading reason that people fall into poverty in China. Many city residents still have some health benefits, but peasants now fall under a pay-for-service system. Sickness can mean bankruptcy.

Mr. Yang went to Beijing in part to earn enough money for medical treatment. He was warned four years ago that he needed treatment for prostate problems, but he could not afford it. Now, his health has worsened on his construction job. He has missed days and is jeopardizing the pay he needs to see a doctor.

His wife, Ms. Ran, 33, wants to visit her daughter in February for the Lunar New Year, when migrant workers traditionally go home. But she said her factory in the city of Baoding will fine her $72 - roughly six weeks' pay - if she does not work straight through to July. Shan's school fees are due soon, and the family needs more money.

Shan has never left this village in mountainous central China, a few hours' drive from the Three Gorges along the Yangtze River. She is still a child, but she understands the pressures on her family and how her own future depends on getting an education. She grew worried when the school began asking for next semester's tuition.

"I love school," she said.

Posted by: anne at December 21, 2004 08:07 AM


A Desperate Village

The students in Shan's fourth grade class rose in unison as the teacher, Du Nengwei, tapped his pointer against his desk to start the lesson.

'Hello, teacher!' the children shouted dutifully in early December as Mr. Du, his eyes magnified through thick glasses, signaled for everyone to sit down. The children began shouting out memorization drills, and the sounds of rote drilling rose out of other classrooms, as noisy as squawking birds.

The village school, the focus of so much hope, is little changed from a century ago. The dirty, whitewashed building is made of mud brick and concrete. Shan's classroom has no heat or electricity. Light comes from two small windows.

Mr. Du said 8 of his 14 students had at least one parent who is a migrant worker. He knows that parents leave in order to pay tuition, about $50 a year for families that often live on less than $300 a year. School, even this school, is their only chance, he said.

'Some say they want to be a driver, a scientist or a teacher,' Mr. Du said. 'But nobody wants to go on being a farmer.' Of Shan, he said, 'she studies very hard and does well.'

She usually ranks second or third in the class. At home, she studies as much as three hours a day. She said she wanted to advance to middle school, then high school, even college.

'The more schooling I have, the more knowledge I have,' she said.

Her home is a mud-walled communal house built more than a century ago during the Qing Dynasty. Her grandparents sleep in one section, her aunt and younger cousin in another. Shan sleeps alone in two unheated rooms converted from a small barn. Her room is above the pen with the family's three pigs. Her parent's empty room is over the open pit that is the communal toilet.

'I'm not scared,' she said. She has painted her colorless wooden shutter with the Chinese characters for 'wealth' and 'prosperity.'

Her grandfather, Yang Xianglin, 72, said his three sons each contributed $150 a year to support the family. Two of the three are migrant workers; the third just returned home from a migrant job. But the money is not enough, so the grandfather must borrow from other relatives.

Shan knows she is poor, but does not seem to feel poverty's sharp sting. Asked if she has any toys, she brightened and showed off two tiny plastic figurines and a single silk flower. Her parents cannot afford more, though her mother stitched her a pink sweater.

'She misses them always,' her grandfather said. 'She keeps asking, when will her parents come home?'

Nearly every family in Shuanghu has had someone leave. Local wages are as low as $1 a day; a migrant can make $5 or more. A few fortunate families have built concrete homes with migrant money.

'We have more freedom now than when we had a communal life,' said Lei Jinchen, 53, a neighbor whose two sons work at the same factory as Shan's mother. 'We can now go out and find work. But we only have enough to feed ourselves. That's it.'

Central government leaders often boast of new programs to benefit China's poorest villages. One national program called for farmers to hand over land for reforestation in exchange for annual payments. In 2002, Shan's grandfather surrendered two-thirds of an acre for promised payments of $65 a year. As yet, he and other farmers have received nothing.

Shuanghu was also designated for special antipoverty assistance, and about 50 families - including the Yangs - were named poverty households eligible to divide a $2,500 annual fund, or about $50 per family. But again, the Yangs and others have gotten nothing.

'Not many benefits get down to us,' Mr. Lei said. 'Local governments skim most of the money off.'

So what remains is migrant work for the young and farming for the old. The mountainous landscape is impressive, but only narrow strips of land can be used for farming. In early December, Shan left for school one morning, and her grandparents walked up a rocky hillside toward their small plot.

The frost had lifted, and the grandmother, Hu Yangui, 65, squatted in the dirt and pulled turnips. She takes medicine for stomach ailments and arthritis, and the work tires her. She would let the turnips dry in the sun until afternoon, then feed them to the pigs beneath Shan's bedroom.

The grandfather grabbed a large bale of corn stalks to use as bedding for the pigs and loaded it onto his back. His arthritis sometimes keeps him from sleeping, but he said the corn was not heavy. In a lower field, a child's voice echoed against the hillsides. It was Shan's cousin, Yang Qinlin, 4. Her own father works several hours away, and she goes months without seeing him.

She was singing a melancholy poem about missing home that is memorized by schoolchildren across China:

Looking up, I find the moon bright;

Bowing down, in homesickness I'm drowned.

Posted by: anne at December 21, 2004 08:18 AM

I think the Bush Administration has a plan for dealing with the labor issues involved with bringing some manufacturing back to these shores. They call it "immigration reform" or a "guest worker program." But essentially, we'll be importing workers, pay them sub-minimum wages, and ship them back before they qualify for naturalization.

As I see it playing out over time, these workers will be able to stay in country only as long as they are under contract. Corporations which need masses of cheap labor--consumer manufacturing, agriculture, construction--will own these contracts (and presumably, be able to buy and sell them). The workers will be housed in special barracks close to the site of employment, and might well be obligated to purchase food, clothing, and so forth from their employers. Those that leave the site would be subject to manhunts and forceable return to their employers, who could mete out punishment outside the jurisdiction of local officials.

Nonetheless, we will be assured that the guest workers are very fond of the employer, who loves them almost as a father would, and that the workers would not wish to trade their status for that of citizens (to be known as "free" men). And there will be lots of singing and dancing.

Posted by: jlw at December 21, 2004 08:32 AM


Other than being, technically, unlawful, your posting of full or extensive excerpts of N.Y. Times articles causes a problem on this site in its present state of technical crisis. To get through your two posts, I had to page down more than 200 times. (I get, at most, one line per screen thanks to some MT bug.)

I think a choice graf or two and a link more than suffice until the bugs are at long last ironed out.

That is all.

Posted by: jlw at December 21, 2004 08:39 AM


Pay no mind, the posts are superb.

Posted by: Randall at December 21, 2004 08:54 AM

"CNBC had a feature several weeks ago showing the manufacture in China of a popular doll being sold in the USA. The estimate by the CEO was that the doll which retailed for $15 would be a $60 item if it were made here."

This sounds a lot -- people in China say that the average markup for US distributors is around 300-400%, while Walmart's markup is around 600%. That is, for a shirt that sells for $12 in Walmart, the Chinese factory gets $2. So take the average markup of 300%, a doll retails for $15 is manufactured in China for $5. Does the CEO say that it will cost US manufacturers $50 to produce? If so, that is a factor of 10 in cost differences, which a 20% depreciation in Chinese yuan will do little to alter. In fact, if the cost difference is that big, no dolls will be produced in the US, regardless of the amount of currency depreciation.

Posted by: pat at December 21, 2004 01:26 PM


I love your posts. I particularly appreciate these two as they provide a good background reading in this discussion about trade and globalization. It is important to remind people that foreign workers are not our enemies. It also makes me wonder about the future of China. While everyone seems to think that China is set in this road of development and prosperity, these posts suggest that there is at least a possibility that the vast and fast increasing income inequality may lead to political instability which could disrupt China's development drastically.

Posted by: pat at December 21, 2004 01:42 PM

So, Bush raised an illegal immigrant into legal immigrant plan this year that was striking for its indentured servant aspects. Now today's jlw poster next to Anne's downloads of the Chinese migrant worker post seems to show we'll try to recreate the Chinese system on American soil. That will help for import substitution. How will that help our Americans that are unemployed or underemployed?

I don't think thoroughly copying newspaper or magazine articles and posting them here is correctly observing copyright. I think it is a nuisance scrolling past these long postings. I would rather read what the readers of this site have to say rather than run across what I can read at nytimes.com, the most commonly copied site here. Can we skip the copying?

Posted by: christofay at December 21, 2004 01:56 PM


I'm with jlw and christofay.

Please provide at most a link and a summary paragraph.

Posted by: liberal at December 22, 2004 04:36 AM