New-Old Paper on the Balance of Payments

Four or five years ago, I wrote a paper arguing that the US current account deficit, far from being a cause of the crisis of 2008, was a stabilizing force in the world economy. I presented it at a conference and then set it aside. I recently reread it and I think the arguments hold up well. If anything the case that the US, as the center of the world financial system, ought to run large current account deficits indefinitely looks even stronger now, given the contrasting example of Germany’s behavior in the European system.

I’ve put the paper up as a working paper at John Jay economics department site. Here’s the abstract:

Persistent current account imbalances need not contribute to macroe- conomic instability, despite widespread claims to the contrary by both mainstream and Post Keynesian economists. On the contrary, in a world of large capital inflows, a high and stable level of world output is most likely when the countries with the least capacity to generate capital inflows normally run current account surpluses, while the countries with the greatest capacity to generate capital inflows (the US in particular) normally run current account deficits. An emphasis on varying balance of payments constraints is consistent with the larger Post Keynesian vision, which emphasizes money flows and claims are not simply passive reflections of “real” economic developments, but exercise an important influence in their own right. It is also consistent with Keynes’ own views. This perspective helps explain why the crisis of 2008 did not take the form of a fall in the dollar, and why reserve accumulation in East Asia successfully protected those countries from a repeat of the crisis of 1997. Given the weakness of the “automatic” mechanisms that are supposed to balance trade, income and financial flows, a reduction of the US current account deficit is likely to exacerbate, rather than ameliorate, global macroeconomic instability.

You can read the whole thing here.

Stimulus Around the World

Interesting new working paper out from the NBER today, on Net Fiscal Stimulus During the Great Recession. It purports to compare the level of fiscal stimulus across 28 rich and developing countries, with results that are decidely gratifying for a Keynesian.

Purports, I say, because unfortunately their chosen measure of fiscal stance makes it hard to know how seriously to take their results. They look only at final expenditures by government, ignoring both transfers and taxes. While there are certainly contexts in which this is the right approach — where the alternative would be double-counting with private expenditures — it’s not at all clear that it’s right for the questions they are trying to answer. From the stimulus side, in theory one would expect the demand effect of final government purchases to be qualitatively greater than the effect of transfers or tax cuts only if the recipients of the latter don’t face credit constraints, so that temporary changes operate only through wealth effects. And while I do think that the importance of credit constraints in the Great Recession may be overstated for businesses, they’re clearly very important for households, especially the ones most likely to receive transfers like UI. On the debt burden side, obviously deficits add the same whatever their source. On the other hand, it may well be that changes in final expenditure by government is a good proxy for the fiscal stance in general, and perhaps a better one for discretionary stimulus spending. It would be nice to see the paper redone with other measures of stimulus, but let’s tentatively accept their findings. What do they show?

First, as Krugman says, if stimulus didn’t work in the US, it’s because it wasn’t tried. The US ranks 9th from the bottom of the 28 countries in the growth of government spending, and even that is only thanks to spending in 2007-08; taking all levels of government together public consumption and investment didn’t rise at all in 2009. Of course we knew that already (And we also knew, as Aizenman and Pasricha seem not to, that the earlier increase was almost all military spending.) But it’s useful to see it in comparative perspective.

Second, the most interesting finding, that countries with the biggest increases in public spending did not see any larger increase in real interest rates on public debt, either contemporaneously or in the following year, but they did see faster growth. This means the real debt burden – measured as (r – g) * d, where r is the real interest rate on public debt, g is the real GDP growth rate, and d is the debt-to-GDP ratio – fell in those countries where public spending rose the most. If it holds up, this is obviously a very interesting result.

Finally, there’s a point they don’t make. They observe, correctly, that the US is far from any objective financial constraint on public spending. And they observe; also correctly, that the most aggressively countercyclical fiscal policy is found in middle-income countries like Korea, in sharp contrast to previous downturns, especially the late 90s. But they don’t offer any explanation for this change except a vague suggestion that countries chastened by the Asian crisis got their fiscal houses in order, leaving them plenty of space for stimulus. But that’s obviously not right. As they themselves note, there’s no correlation between the public debt burden prior to the crisis and the trajectory of government spending over the past few years. As I’ve pointed out before, what’s different in countries like Korea in the period before this crisis compared with the Asian Crisis isn’t the fiscal balance, but the external balance. They were running external deficits then, external surpluses this time. That’s what created the extra space for stimulus. (Same thing in Europe: public-sector surpluses in Spain and Ireland didn’t matter because the countries had big current account deficits. It was the corresponding private liabilities thy ended up on public balance sheets in the crisis and created the pressure for spending reductions.) Which brings me to the punchline: If the US had had a smaller trade deficit with,say, Korea in the past few years, that would have had a negligible direct effect on US demand and there’s no reason to believe that it would have created space for more expansionary fiscal policy, since we’re using nowhere near the space we have. But it very well might have forced Korea to adopt a more contractionary policy, just as other not-exorbitantly-privileged countries without external surpluses have had to. In that sense, though they certainly don’t draw this conclusion, I think this paper supports the view that global imbalances have moderated rather than exacerbated the crisis.

Does the Level of the Dollar Matter?

Mike Konczal has kindly reposted my back-of-the-envelope estimate of how much a dollar devaluation would boost US demand. (Spoiler: Not much.)

I am far from an expert on international trade and exchange rates. (Or on anything else.) Maybe some real economist will see the post and explain why it’s all wrong. But until then, I’m going to continue asking why Krugman and others who claim that exchange rates are an important cause of unemployment in this country, never provide any quantitative analysis to back that opinion up.

More abstractly, one might ask: Is the time it takes for demand to respond to changes in relative prices, minus the time it takes for exchange rate changes to move relative prices, greater than the time it takes for exchange rates changes to move relative costs (or to be reversed)? Just because freshwater economists say No for a bad reason (because relative costs adjust instantly) doesn’t mean the answer isn’t actually No for a good reason.

How Much Would a Lower Dollar Boost Demand?

Lots of economists of the liberal Keynesian persuasion (Paul Krugman, Dean Baker, Robert Blecker [1] — very smart guys all) think dollar devaluation is an important step in getting back toward full employment in the US. But have any of them backed this up with a quantitative analysis of how much a lower dollar would raise demand for American goods?

It’s not an easy question, of course, but a first cut is not that complicated. There are four variables, two each for imports and exports: How much a given change in the dollar moves prices in the destination country (the passthrough rate), and how much demand for traded goods responds to a change in price (the price elasticity.) [2] We can’t observe these relationships directly, of course, so we have to estimate them based on historical data on trade flows and exchange rates. Once we choose values of them, it’s straightforward to calculate the effect of a given exchange rate change. And the short answer to this post’s title is, Not much.

For passthrough, estimates are quite consistent that dollar changes are passed through more or less one for one to US export prices, but considerably less to US import prices. (In other words, US exporters set prices based solely on domestic costs, but exporters to the US “price to market”.) The OECD macro model uses a value of 0.33 for import passthrough at a two-year horizon; a simple OLS regression of changes in import prices on the trade-weighted exchange rate yields basically the same value. Estimates of import price elasticity are almost always less than unity. Here are a few: Kwack et al., 0.93; Crane, Crowley and Quayyum, 0.47 to 0.63; Mann and Plück, 0.28; Marquez, 0.63 to 0.92. [3] (Studies that use the real exchange rate rather than import prices almost all find import elasticities smaller than 0.25, which also supports a passthrough rate of about one-third.) So a reasonable assumption for import price elasticity would be about 0.75; there is no support for a larger value than 1.0. Estimated export elasticities vary more widely, but most fall between 0.5 and 1.0.

So let’s use values near the midpoint of the published estimates. Let’s say import passthrough of 0.33, import price elasticity of 0.75, and export passthrough and price elasticity both of 1.0. And let’s assume initial trade flows at their average levels of the 2000s — imports of 15 percent of GDP and exports at 10.5 percent of GDP. Given those assumptions, what happens if the dollar falls by 20 percent? The answer is, US net exports increase by 1.9 percent of GDP.

1.9 percent of GDP might sound like a lot (it’s about $300 billion). But keep in mind, these are long-run elasticities — in general, it takes as much as two years for price movements to have their full effect on trade. And the fall in the dollar also can’t happen overnight, at least not without severe disruptions to financial markets. So we are talking about an annual boost to demand of somewhere between 0.5 and 1.0 percent of GDP, for two to three years. And then, of course, the stimulus ends, unless the depreciation continues indefinitely. This is less than half the size of the stimulus passed last January (altho to be fair, increased demand for tradables will certainly have a higher multiplier than the tax cuts that made up a large share of the Obama stimulus.) The employment effect woul probably be of the same magnitude — a reduction of the unemployment rate by between 0.5 and 1.0 points.

I would argue this is still an overestimate, since it ignores income effects, which are much stronger determinants of trade than exchange rates are — to the extent the US grows faster and its trading partners grow more slowly as a stronger US current account, that will tend to cancel out the initial improvement. I would also argue that the gain to US employment from this sort of rebalancing would be more than offset by the loss to our trade partners, who are much more likely to face balance of payments constraints on domestic demand.

But those are second-order issues. The real question is, why aren’t the economist calling for a lower dollar providing quantitative estimates of its effects, and explicitly stating their assumptions? Because on its face, the data suggests that an overvalued dollar plays only a modest role in US unemployment.

[1] I was going to include Peter Dorman on this list but I see that while he shares the IMO misplaced concern with global imbalances, he says, “Will a coordinated dollar devaluation do the trick? Maybe, if you can get coordination (no easy feat), but it is also possible that US capacity in tradables has deteriorated too far for price adjustment alone to succeed.” Which is a more realistic view of the matter than the one Krugman seems to hold. On the other hand, Dorman was also writing just a couple years ago about The Coming Dollar Crash. That dog that didn’t bark is something I’ll hopefully be writing about in a future post.

[2] Many studies collapse passthrough and price elasticity into a single measure of real exchange rate elasticity. While this is a standard approach — about half the published papers take it — I would argue it’s not the right one for either analytic or policy purposes. Analytically, the real exchange rate elasticity doesn’t distinguish between the behavior of buyers and sellers: A low value could mean either that consumers are not responsive to price, or that sellers are holding price stable in the face of exchange rate changes. And on the other side, it’s the nominal, not real, exchange rate that’s accessible to policy. Policy-induced movements in the nominal exchange rate only translate into movements in the real rate if we assume that price levels (and real wages, if we’re deflating by labor costs) don’t respond to movements in the exchange rate, which is not generally a safe assumption.

[3] Price elasticities are all negative of course. I’m omitting the negative sign for simplicity.

Those Who Forget History, Are Probably Historians

There are hardly any economists or economic historians who have contributed more to our understanding of the role of international finance in the Great Depression than Barry Eichengreen and Peter Temin. [1] So it’s disappointing to see them so strenuously refusing to learn from that history.

They start by correctly observing that the fatal flaw of the gold standard was the “asymmetry between countries with balance-of-payments deficits and surpluses. There was a penalty for running out of reserves .. but no penalty for accumulating gold.” Thus the structural tendency toward deflation in the gold standard era, and the instability of the system once workers recognized that lower wages for “sound money” wasn’t such a great deal. If Temin and Eichengreen want to draw a parallel with the Euro system today, well, I’m not sure I agree, but it’s an avenue worth pursuing. But as they want to apply it, to the US and China, it’s unambiguously wrong, as economics and as history.

“The point,” say Temin and Eichengreen, “is not to let deficit countries off the hook.” Barry, Peter — read your books! Letting the deficit countries off the hook is exactly the point. If there’s one lesson in Lessons from the Great Depression, it’s that no practical response to the crisis was possible until the idea that a trade deficit represented a kind of moral failing was abandoned. The whole point, first, of leaving the gold standard, and later, of the Bretton Woods institutions, was to free deficit countries from the obligation to “live within their means” by curtailing domestic investment and consumption.

Keynes couldn’t have been clearer on this. The goal of postwar monetary reform, he wrote, was “A system which would maintain balance of payments equilibrium without trade discrimination but also without forcing unemployment .. on deficit countries,” [2] in other words, a system in which governments’ efforts to pursue full employment was not constrained by the balance of payments. We needn’t take Keynes as holy writ, but if we’re going to analyze current arrangements in light of his writings in the 1940s, as Temin and Eichengreen claim to, we have to be clear about what he was aiming for.

One would expect, then, that they would go on to show how “global imbalances” are constraining national efforts to pursue full employment. But they don’t even try. Instead, they offer ambiguous phrases whose vagueness is a sign, perhaps, of a bad conscience: Keynes “wanted measures to deal with chronic surplus countries.” What kind of surpluses, exactly? and deal with how?

The beginning of wisdom here is the to recognize the distinction between the balance of payments and the current account. Keynes was concerned with the former, not the latter. Keynes didn’t care if some countries ran trade surpluses or deficits, temporarily or persistently; what he cared about was that these imbalances did not interfere with other countries’ freedom “to pursue full employment and progressive social policies.” In other words, current account imbalances were not a problem as long as the financial flows to finance them were guaranteed.

“Creditor adjustment” is rightly stressed by Eichengreen and Temin as a central feature of Keynes’ vision of postwar monetary arrangements, but they seem to have forgotten what it meant. It didn’t mean no one could run a trade surplus, it just meant that the surplus countries would be obliged to lend to the deficit ones as much as it took to finance the trade imbalances. As Keynes’ follower Roy Harrod put it,”The most important requirement [is] to get the United States committed to creditor adjustment. …. Creditor adjustment could be secured most simply by an agreement that the creditor would always accept cheques from the deficit countries in full discharge of their debts. … So long as their credit position cannot cause pressure elsewhere, there is no harm in allowing a further accumulation.” All of Keynes’ proposals at Bretton Woods were oriented toward committing the countries with surpluses to lend, at concessionary rates if necessary, to the deficit ones.

China today accepts American checks in full discharge of our debts; they don’t demand payment in gold. The Chinese surplus isn’t putting upward pressure on US interest rates, or constraining public spending. All Keynes ever wanted was for all surplus countries to be like China.

“Sixty-plus years later, we seem to have forgotten Keynes’ point,” Eichengreen and Temin conclude. True that.

[1] The strangely forgotten Robert Triffin is one.

[2] The historical material in this post post, including all quotes, is drawn from chapters 6 and 9 of the third volume of Robert Skidelsky’s biography of Keynes.