You may be familiar with Paul Krugman's New York Times column. Many on the right have been disappointed that Krugman-the-academic hasn't morphed into Krugman-the-neocon, and have portrayed him as a once-great economist, now fallen from grace.
I don't normally read his column, but I have read his textbook and various papers. The test of genius, in my view, is not the ability to achieve great insights, but the ability to explain these insights in a way that makes them seem almost trivial. Krugman has this gift.
Now Mark Thoma gives the full text of Krugman's preliminary paper presented yesterday at Princeton.
I've been following theories about the U.S. trade deficit and it's future impact on the dollar for a couple of years now. You read one day that the dollar will collapse into hyperinflation, only to learn the next day that the trade defict is an illusion created by "dark matter". It's enough to leave a mortal like me off-balance. Did I really study economics so I could be more confused than before? With this paper Krugman comes to the rescue. He summarizes all of the recent theories and, even if he can't provide a definative answer, at least stops your head spinning.
The paper is lengthy, so I don't expect many will read it through. If you do, just skip the math - it's not necessary to understand the concepts. Here is the conclusion for the impatient:
Concerns about a dollar crisis can be divided into two questions: Will there be a plunge in the dollar? Will this plunge have nasty macroeconomic consequences?
The answer to the first question depends on whether there is investor myopia, a failure to take into account the requirement that the dollar eventually fall enough to stabilize U.S. external debt at a feasible level. Although it’s always dangerous to second guess markets, the data do seem to suggest such myopia: it’s hard to reconcile the willingness of investors to hold dollar assets with a very small premium in real interest rates with the apparent necessity for fairly rapid dollar decline to contain growing foreign debt. The various rationales and rationalizations for the U.S. current account deficit that have been advanced in recent years don’t seem to help us avoid the conclusion that investors aren’t taking the need for future dollar decline into account.
So it seems likely that there will be a Wile E. Coyote moment when investors realize that the dollar’s value doesn’t make sense, and that value plunges.
The case for believing that a dollar plunge will do great harm is much less secure. In the medium run, the economy can trade off lower domestic demand, mainly the result of a fall in real housing prices, for higher next exports, the result of dollar depreciation. Any economic contraction in the short run will be the result of differences in adjustment speeds, with the fall in domestic demand outpacing the rise in net exports.
The United States in 2006 isn’t Argentina in 2001: although there is a very good case that the dollar will decline sharply, nothing in the data points to an Argentine-style economic implosion when that happens. Still, this probably won’t be fun.
4 comments:
Hi Ami,
I haven't read that paper yet (but will ASAP)...
It reminds me of an article I recently read in a newsletter called "Imprimis" which summarises speeches given at Hillsdale College. I had intended to mention for your opinion and this seems to be right on subject.
Steve Forbes suggests that the trade deficit is at worst overstated, and at best completely meaningless. His statement is that trade isn't between countries, it's between individuals and that as long as the individuals are profiting, the trade deficit doesn't matter. Then he gives a specific example. When he buys paper from a supplier in foreign country, he contributes to the trade deficit. However, he prints his magazine on that paper which adds value to it. Then he sells it at a profit. Both his paper supplier and he make a profit from the transaction that is counted as trade deficit. Since the transactions that produced the trade deficit add value and increase the GDP (of both countries), they are actually GOOD for the country.
I found a link to the whole article here.
http://www.hillsdale.edu/imprimis/default.asp
The topic is "collectivism vs. capitalism" and the bit about the trade deficit is only a small part, but it was an idea that caught my attention. If his idea is correct, it may go a long way toward explaining why the dollar hasn't collapsed even though we've run trade deficits for decades.
Hi Brian,
Thanks for the link, I will read the article a little later. But I think I can address the general idea as you present it in your comment, as I've encountered similar arguments before.
The example you give is fine as it stands. Yes, as long as the transaction is voluntary, both parties benefit. This is why I'm a big supporter of international trade and (believe it or not) of relatively free markets.
You could also rightly say that if an individual is voluntarily borrowing money to finance current consumption, then he must be doing it because it increases his utility. Nobody should complain about that.
But if a group of individuals who are linked together financially do this without coordinating their plans, then there's the potential for a problem: If I borrow money to buy a new car based on the assumption that I can do some extra work for you later on to help pay for it, that's great as long as you didn't have the same idea. If you also bought a car today, based on the assumption that you could somehow get the money from me later on, then one or both of us is going to be in for a surprise.
So the notion of individualism is great to an extent, but you can't ignore the real ties that exist within communities.
I'll try to read the article tomorrow and see if I can extract some material for a proper post (it's a bit later here now - have to get to bed).
... Ami.
Hi Ami,
The article I linked to didn't have much detail on the idea. It was just something he presented that clicked for me. I included the link in case I was missinterpreting what he said. I think the idea is that as long as the person creating the current account deficit is adding value and making a profit, that contribution to the deficit is meaningless.
He didn't address it, but I think that if it's a straight consumption transaction, then his idea doesn't work. In other words, if I buy finished goods from Japan, then the current account activity can cause problems later.
I think Krugman's paper was hinting at these ideas when he stated that if the rate on foreign debt was less that the rate of GDP growth, forgeign debt as a percentage of GDP would fall.
Brian,
Yes, the foreign debt can grow forever as long as the average rate of growth of the debt isn't more than the average rate of growth of the economy. This isn't a controversial statement.
So for the U.S. a trade deficit of 3%-3.5% would be sustainable forever. It can even be for consumption.
If you borrow for investment, and that investment pays off sufficiently, then of course you can borrow as much as you like. But if that were the case then GDP growth should increase due to the investment, so this statement is actually equivilent to what I said in the previous paragraph: you can borrow as much as is covered by your GDP growth.
I read the Forbes speech on my way home. As I suspected, he's pushing the libertarian view that only individuals matter, and aggregate trade data is meaningless. I'll try to put a post together to address this more clearly.
... Ami.
[really going to bed now]
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