November 14, 2006
Current Account Imbalances, Again
There is the tendency to view the U.S. current account imbalance as one that is becoming less pressing, with the September trade release, which showed a stabilization in the trade balance. However, a glance at the longer term trends reminds one that we still face the prospect of large imbalances going forward -- as pointed out by Brad Setser.
Figure 1: Current account and net exports to GDP ratios. Source: BEA, October 27 release.
As Blanchard notes in the Mundell-Fleming lecture, entitled "Currenct Account Deficits in Rich Countries":
"... I take up a specifc question, namely: Assume that current account deficits reflect private saving and investment decisions. Assume rational expectations. Is there any reason for the government to intervene, and what is the optimal form of that intervention?
It is clear that the answer depends on the existence and the specifc form of distortions present in the economy. Thus, I start from a benchmark in which such distortions are absent, the equilibrium is the first-best outcome, and there is no role for government intervention. I then introduce various distortions, which are often thought to be important in this context. In each case, I characterize the effect of the distortion on the equilibrium, and discuss the role of policy. Optimal policy is never geared to decreasing deficits per se; it may increase or decrease deficits."
Possible distortions include sub-optimal governmental policy in the United States or China. One specific distortion may involve financial imperfections, such that business fixed investment has to be financed primarily by internal funds; this he relates to concerns about the long-term battering of the tradables sector I've discussed in previous posts here and here.
"Adjustment in the first best [case] implies first a decrease, then an increase (equal to twice the initial decrease) in tradables output. One worry is that it may indeed be diffcult for the tradables sector to expand after a long period of appreciation and low production.
One may think of a number of reasons why this may be. Internal costs of adjustment are not the issue: These will indeed affect the adjustment, and thus affect in turn first-period decisions and the current account deficit; but, absent other considerations, the outcome will still be the first best outcome, and there is no role for government policy. Other distortions may however be relevant. Krugman (JDE, 1987) emphasized for example external learning by doing, and the fact that a long period of low production may lead to permanently lower productivity. Others have emphasized financial constraints, the fact that the tradables sector may not, after a long period of low profits, have the funds needed to invest and increase production later on."
In the context of his model, he finds that there is a role for government spending policy. The policies should be aimed at increasing total spending on tradable goods, so as to mitigate the reduction in tradables in the second period. Since the model is one with a balanced budget (spending equals tax revenues), one can't directly discuss whether budget deficits are a good idea or not. But the point of the lecture is not to provide specific prescriptions. Rather it is to highlight that, in order to argue for policy actions aimed at reducing the current account imbalance, one has to be clear about the source and magnitude of the distortions that drive the imbalance.
In my opinion, there are ample enough candidate distortions; a reckless U.S. fiscal policy, central bank intervention abroad (after all the Chinese and oil exporters' saving and investment decisions are not wholely private sector-determined), negative externalities associated with oil consumption, and so forth. That is why sensible policies aimed at reducing the current account imbalance should focus on the sources of the deficit. Hence, like Blanchard, [I believe] trade restrictions are almost assuredly counterproductive. Unlike Blanchard, I think the budget deficit is a major source of the current account deficit.
[Late Addition 11/16 6:30am Pacific: New Economist also discusses Blanchard's speech}.
Posted by Menzie Chinn at November 14, 2006 07:10 AMdigg this | reddit
Was that supposed to read "Hence, like Blanchard believes..."
Hence, like Blanchard, trade restrictions are almost assuredly counterproductive.or was Blanchard not even a useful example in our continuing education?
Very sobering Fig 1, cutting through some of the navigational hazards of the prose, the economist's prose for we recreational economists. Thank you Menzie.
Posted by: calmo at November 14, 2006 09:03 AM
Calmo: Thanks for the grammatical correction. Fixed now.
Posted by: menzie chinn at November 14, 2006 11:46 AM
Let's say China makes advance moves that are clearly precusive to reuniting Taiwan with the mainland by force. Then lets say the US intervenes and says "No can do!" Then China says "And who's going to stop us? You send one aircraft carrier anywhere near there and we will unload every US dollar/bond/treasury that we own in a week. Checkmate!
Foreign debt as a weapon - imagine that!
Posted by: Lawrence at November 14, 2006 12:02 PM
Oops! Above post should read "precursive," if there even is such a word.
While I'm at it, just in case my point is too obscure, what I'm trying to suggest is that the classical views of economics as reflected by the points of the post may not be broad enough to cover the concept of economic weaponry. After all, destroying your enemy's economy while merely debilitating yours is still better than total nuclear war.
Posted by: Lawrence at November 14, 2006 12:43 PM
I have a bit of a problem with the practive of only comparing the trade deficit to total GDP.
Imagine that the USA didn't produce one manufactured good. Imagine we imported every single product...every chair, every barrel of oil, every car...etc. So our entire GDP was domestic services...health, finance, gov't etc.
By comparing the trade deficit to GDP only, that seems to imply that the above configuration of the US economy would be every bit as good as the current one where we do produce significant amount of goods. I have a hard time believing this, so it seems to me that the structure of the GDP is also very important.
The conventional wisdom seems to be to compare the trade deficit with GDP, but I believe that sort of analysis is shallow and misrepresents the true situation.
I have yet to hear one economist comment on this question. It's almost as if they prefer not to think about it.
Posted by: vorpal at November 14, 2006 12:50 PM
Lots of people have wondered the same thing. Before pushing the analysis too far, there are some points to consider. You have said that China could destroy our economy while only debilitating its own. How do you come to that conclusion? Why is it that a severe blow to the US financial economy would necessarily lead to total destruction of entire US economy. Why would China, in surrendering billions of dollars in the value of financial assets, shutting itself off from its major export market and very likely incurring a reaction from the US in the form of some sort of economic warfare, be in better shape than the US?
China still suffers vast unemployment and underemployment, governs through a political system that, for all our faults, seems more prone to domestic resistance than ours, and has a still very thin managerial class. China still has a long way to go to get to where the US is today. Why is China in a more powerful position than the US?
Posted by: kharris at November 14, 2006 02:00 PM
I probably should not be saying what I am saying below being a central banker, but I find it hard to justify that you blame US fiscal deficit for creating global imbalances. Fed Sigma model shows 20 cent trade defict widening per one dollar of fiscal deficit widening (Alan Greenspan referred to this figure in 2005 speech as well), Corsetti, Muller (2005) use DSGE model to show that when economy is relatively closed and fiscal shock is believed to be temporary the trade account reaction is small amid ivestment crowding out effect. This evidence suggest that we "should not be very serious about twin deficits", although balanced budget (accounting for social and healthcare liabilities) is a good this as such.
Richard Fisher recently suggested that maybe another policy was to blame. I keep wondering, if Fisher is right (and we have endogenous bubble in US) maybe Don Kohn (2006) extra action policy would be needed to deal with issue.
Posted by: Rybinski at November 14, 2006 03:01 PM
1) We depend on a steady stream of foreign investors willing to buy in USDollars.
2) We are dependnet on massive amounts of foreign oil.
3) We are the world's largest debtor nation.
4) We have a massive budget deficit.
5) We have an expensive foreign war that we are ineffectively fighting.
So their are a few chinks in Uncle Sam's armor.
Posted by: vorpal at November 14, 2006 03:05 PM
Lawrence: Ever since (at least) Albert Hirschman wrote National Power and the Structure of Foreign Trade, it's been clear that economics can be a tool of foreign policy. But in this case, I'm not certain whether the Chinese threat to dump dollars is sufficiently painful to the U.S. (or credible, given the self-inflicted damage that would accompany such an act) to deter U.S. military action (so in this respect I'm with kharris.
vorpal: I agree that dividing the trade balance by GDP is only one way of normalization. But it's not clear what would be better. Dividing by tradables output, or final demand, are plausible alternatives, but each answers a slightly different question.
Rybinski: I'm well aware of these other estimates, which I critique in my Council on Foreign Relations Special Report, as well as this recent post. Let me re-state, the 0.20 estimate is based on dynamic stochastic general equilibrium models calibrated to mimic the data -- not econometric estimates. Econometric estimates, in contrast to such calibrated model-based results, often suggest higher coefficients. My estimates suggest elasticities as high as 0.45, while the OECD's Interlink macroeconometric model implies something like 0.38. Hence, I would take 0.20 as only one of many estimates in circulation.
Posted by: menzie chinn at November 14, 2006 04:27 PM
I think the issue is "What is the proper metric for a nations ability to pay back it's debts?"
Clearly, a nation like Russia, is very capable of payong off debts. They produce much more value than they consume in the form of energy.
But what about the USA? We consume more than we produce in virtually every sector? What value can we give back to foreign entities for their dollars?
The conventional wisdom is that GDP is a reasonable metric for a nations abiltiy to pay back it's debts. Conventional wisdom is often wrong. Conventional wisdom, i.e. 'the domino theory' got us mired in Vietnam.
I just think that it is time for respected economists to reexamine their asssumptions. The current global economic configuration is out of charted territory. Now is not the time to be imprecise about assumptions or conclusions.
Posted by: vorpal at November 14, 2006 11:58 PM
Follwing up on my ealier comment, of course we know that there are elasticities that go as high as almost 50%, coming from econometric models. But econometric models failed badly in mid-90, when productivity growth accelerated, and central bankers correctly focused their attention on deep parameters (such as price and wage stickiness). Econometric models also failed badly to predict the reserves accumulation scale. Globalization has changed many parameters, including the domestic output gap impact on inflation, leading to what Janet Yellen calls a "new view" of the Phillips curve.
US fiscal defict probably played a role in global imbalances story, but it was a relatively minor role. I think that Ricardo Caballero with his recent asset shortages paper got it right. Central banks and other official institutions even they may not be too happy with global imbalances risk they have no choice, but to invest in US dollar assets, becasue they cannot invest elsewhere for various reasons. A proof, investment in US agencies by Asian and oil investors (via London) goes up despite risks of a housing bubble, largely becasue off the size and liqudity of the market. And it is not related at all to US fiscal position. I can see this changing, albeit slowly. Central banks are now looking for more return on their assets, which means that very gradually they could diversify across assets such that US assets will account for a smaller proportion, in the long run of course. The crucial factor in this process is the speed at which other markets develop liquid and investable assets, and Caballero is right here. The solution to global imbalances lies not in US cutting fiscal deficit (although it would help as well) but depend much more on the ability of other regions (Asia in particular) to develop liquid, safe, investment grade, investable markets. And by the way, when this happends, US exorbitant privilege will largely be gone.
Posted by: Rybinski at November 15, 2006 06:10 AM
Kharris, I merely used the China/Taiwan cas as an example of how there may be more to the issue of imbalances than cut and dried economic analysis would have us think.
As to the matter of who would be hurt most, I would rather expect the banker holding the loan to come out better than the borrower. Unless of course, the banker has foolishly loaned all his money to one borrower, which is where I think you're coming from.
You ask how would this lead to the destruction of the entire US economy. I would think the effect of a sudden massive dumping of US Treasuries/dollars on the $300 trillion plus derivatives market should do it rather easily. Surely this would also wreck the global economy. But, if your objective is to own Taiwan, still a better alternative than nuclear war. Hard to recover from annihilation, whereas an economy can recover within a generation.
Posted by: Lawrence at November 15, 2006 09:47 AM
All this discussion is predicated on the opening assumptions of no government intervention.
We know that government intervention is a large part of the reason the U.S. has the large trade deficit. The Japanese set out to create a trade surplus and the U.S. government tolerated it decades ago, based on cold war thinking.
A more realistic framework for discussion is needed. The only government that is not concerned with trade deficit or suplus in the one that should be - the U.S. A.
Posted by: W. Raymond Mills at November 15, 2006 01:11 PM
Dividing the trade deficit by GDP gives one measure.
I prefer goods deficit divided by goods imports. That excludes services, which are hard to measure and are mostly a wash and can safely be ignored as a first approximation.
Goods deficit divided by goods imports shows deficiency in production versus consumption. That ratio went from 23% in the four years of 1994 - 1997 (the golden years of the U.S. economy) to 46.6% in 2005 and has settled back to 45% thus far in 2006.
A balanced U.S. economy would show a ratio of less than 25%. The U.S. needs to adopt whatever drastic policy is necessary to get production closer to consumption, in this the formerly richest nation in the world.
Posted by: W. Raymond Mills at November 15, 2006 01:24 PM
Rybinski: Let me first address a minor issue. Having been in the audience, I recall the major import of Yellen's speech on the effect of globalization on the Phillips Curve rather differently. I looked back at the text, and if you see the quote I posted back in May, I think there's a rather more nuanced view about the impact on the Phillips Curve.
Second, I'm not sure that the calibrated DSGE's (Sigma, GEM, etc.) would have simulated out the events of the previous eight years any better than the macroeconometric models, although I don't know if the exercise has been done. Once one looks into the guts of these models, one realizes that a large number of ad hoc assumptions (I'm just thinking about how UIP is broken, and/or how consumption is mimicked by way of rule of thumb consumers) are imbedded in these models. I'm not against ad hoc assumptions, but they are also susceptible to the Lucas Critique. Hence, I'll stick with relying upon what the econometric estimates (including my own) say, as opposed to the econometric estimates mediated through calibrated models.
I'm not saying fiscal is everything. But in affecting GDP directly through absorption and expenditure switching, as well as determining the supply of Treasuries, it has a substantial impact.
Posted by: menzie chinn at November 15, 2006 01:48 PM