Hey everybody, time for a quiz. Here’s 15 graphs of the pound’s exchange rate vs. the dollar. The scale is the same on all of them: 60 days on the horizontal axis, from 100 (the initial value) down to 75 on the vertical axis. So, which one is the past two months?
Answer below the fold.
Roosevelt Institute has a new roundup of policy advice for the next administration. There is a lot of useful stuff in there, which perhaps I’ll post more on later. My own contribution is on international trade. Here’s the summary:
It is natural to look to measures to improve the trade balance — through a weaker dollar, or through tariffs or other direct limits on imports — as a way to raise demand and boost output and employment. While the U.S. has done little to boost net exports in recent decades, there is increasing public discussion of such measures today…
We argue that while the orthodox view is wrong about trade being macroeconomically neutral, measures to improve the U.S. trade balance would nonetheless be a mistake. All else equal, a more favorable trade balance will raise demand and boost employment. But all else
is not equal, thanks to the special role of the U.S. in the world economy. The global economy today operates on what is effectively a dollar standard: The U.S. dollar serves as the international currency, the way gold did under under the gold standard. In part for this reason, the U.S. can finance trade deficits indefinitely while most other countries cannot. For many of our trade partners, any reduction of net exports would imply unsustainable trade deficits. So policies intended to improve the U.S. trade balance are likely to instead lead to lower growth elsewhere, imposing large costs on the rest of the world with little or no benefits here.We do not deny that the trade deficit has negative effects on demand and employment in the U.S., but we argue this is only a reason to redouble efforts to boost domestic demand. The solution to the contractionary effects of the trade deficit is not a costly, and probably futile, effort to move toward a trade surplus, but rather measures to boost investment in both the public and private sector.
You can read the rest of my piece here.
There were a couple figures that didn’t make it into the final piece. Here is one, showing the stability of the international role of the dollar over the past 20 years.
The dotted line shows the share of central bank reserves held in dollars (source). The heavy line shows the share of foreign-exchange transactions that involve the dollar (source). About two-thirds of foreign exchange reserves are held in dollars, and close to 90 percent of foreign-exchange transactions involve the dollar and some other currency. These shares have not diminished at all over the past 20 years, despite continuous US trade deficits.
In my opinion, the international role of the dollar makes it exceedingly unlikely that the US could face a sudden outflow of foreign investment. (And given that US liabilities are overwhelmingly dollar-denominated, it is not clear what the costs of such an outflow would be.) It also makes it highly unlikely that the US can achieve balanced trade through conventional measures, unless we come up with some other mechanism to provide the rest of the world with dollar liquidity.
My dinner with Axel. Last fall, Arjun Jayadev and I had a series of conversations with Axel Leijonhufvud at his home in California; videos and transcript are now up at the INET site, along with a collection of his writings. I’m very grateful to have had this chance to talk with him; Leijonhufvud is one of two or three economists who’ve most influenced my thinking. He’s also a charming and delightful storyteller, which I hope comes through in the interviews. I’ll be writing something soon, I hope, about Axel’s work and its significance, but in the meantime, check out the interview.
The mind of Draghi. This speech by Mario Draghi offers a nice glimpse into the thinking of central bankers circa 2016. The fundamental point is the idea of a long run “real” or “natural” rate of interest, which policy cannot affect. This idea, and the corollary that the economic world we actually observe is in some sense a false, unreal, artificial or “distorted” sublunary version of the true ideal, is, I think, the central site of tension between economic ideology and economic reality today. But there are other particular points of interest in the speech. First, the frank acknowledgement that the big problem with zero rates is that they reduce the profitability of financial institutions. (By the same logic, Draghi should want to do away with public education since it reduces the profitability of private schools, and with law enforcement since it reduces the profitability of private security firms.) And second, the claim that one reason for the problem of low interest rates is … excessive government debt!
A temporary period of policy rates being close to zero or even negative in real terms is not unprecedented by any means. Over the past decades, however, we have seen long-term yields trending down in real terms as well, independent of the cyclical stance of monetary policy.
The drivers behind this have been, among others, rising net savings as ageing populations plan for retirement, relatively less public capital expenditure in a context of high public indebtedness, and a slowdown in productivity growth reducing the profitability of investment.
Yes, for years we have been warned that excessive government debt is that interest rates will get too high, increasing borrowing costs for the government and crowding out of private investment. But now it turns out that excessive government debt is also responsible for rates that are too low. Truly, to be a central banker in these times one must be a Zen master.
Business cycle measurement ahead of theory … or heading in an entirely different direction. I’m very excited about a series of posts Merijn Knibbe is doing for the World Economics Association. They are on the incompatibility of the concepts used in the construction of national accounts and other macroeconomic data, with the concepts used in macroeconomic theory. I’ve wanted for a while to make the case for a consistent economic nominalism, meaning that we should treat the money payments we actually observe as fundamental or primitive, and not merely as manifestations of some deeper “real” economy. Knibbe is now doing it. The first installment is here.
Kaminska on “deglobalization”. Izabella Kaminska is always worth reading, but this piece from last week is even more worth reading than usual. I particularly like her point that the international role of the dollar means that the US is to the world as Germany is to the eurozone:
the dollarisation of the global economy … has created a sort of worldwide Eurozone effect, wherein every country whose own currency isn’t strong or reputable enough to be used for trade settlement with commodity producers is at the mercy of dollar flows into its own country. Just like Greece, they can’t print the currency that affords them purchasing power on the global market.
The logical corollary, which she doesn’t quite spell out, is that the US, thanks to its willingness to run trade deficits that supply dollars to the rest of the world, has fulfilled its international role much more responsibly than Germany has.
Imagine this set of transactions.
1. A bank in rich country A makes a loan of X to the government of poor country B. Let’s say for concreteness that A is the United States, B is Nigeria, and X is $1 billion. So now we have a liability of $1 billion of the Nigerian government to the US bank, and deposit of $1 billion at the US bank owned by the government of Nigeria.
(Nigeria might just as well be Egypt or Mexico or Argentina or Greece or Turkey or Indonesia. And the United States might just as well be Germany or the UK. )
2. The deposit at the bank is transferred from ownership of the government to ownership of some private individual. It’s easy to imagine ways this can be done.
3. The residents of Nigeria, via their government, still have a liability of $1 billion to the bank, obliging them to make annual payments equal to the interest rate times the principal. In this case, let’s say the interest rate is 5%, so debt service is $50 million.
4. The payments can be met by running an annual export surplus of $50 million. As long as this $50 million annual payment is maintained, interest payments can be made and the principal rolled over; the debt will remain forever.
5. The private individual from step 2 moves from Nigeria to the United States, eventually becoming a citizen there.
The result of this: a family in the United States has wealth of $1 billion (plus whatever they already had, of course). Meanwhile, the people of Nigeria make payments of $50 million each year to the United States forever, in the form of uncompensated exports. In their important book Africa’s Odious Debts and related work, Boyce and Ndikumana demonstrate that this story describes much of sub-Saharan Africa’s foreign debt. It applies elsewhere in the world as well.
I wonder how various people evaluate this scenario. Do we agree there is something wrong here? And if so, what, and what is the solution?
The orthodox view, as far as I can tell, is: what’s the problem? People should pay their debts. Nigeria (or Argentina etc.) is a person, it has borrowed, it must pay. The fact that some private individual chooses to hold their wealth in one country rather than another has nothing to do with it.
More generally, the dominant view today is that the ability to carry transactions like those describe above is an unmixed blessing; in fact it’s the whole point of the international system. The three pillars of the European union are free movement of people, free movement of goods, and free movement of finance. Argentina’s Macri is hailed as a hero — by Obama among others — for removing capital controls. If you are committed to capital mobility, then it’s hard to see where the objection would be. Third World governments and New York banks are consenting adults and can contract on any terms they choose. And of course the fact that a possessor of wealth happens to be located in one country cannot, in a liberal order, be an objection to them owning an asset somewhere else.
Maybe it’s the last step that is the issue? Outside of Europe, the free movement of people does not have the same place in the economic catechism as the free movement of money or goods. And even in Europe it’s a bit shaky. Still, most governments are happy enough to welcome rich immigrants. (A few months ago, my FT dislodged a glossy pamphlet, a racially ambiguous woman in a bikini on the cover, advertising citizenship by investment in various Caribbean countries.) This post was provoked by a Crooked Timber post by Chris Bertram; I’d be curious what he, or other open-borders advocates like my friend Suresh Naidu, would say about this scenario. Does an unrestricted right of human beings to cross borders imply an unrestricted right to transfer property claims across them also?
If the solution is not limits on movement of people, perhaps it is limits on cross-order transfers of financial claims, that is, capital controls. This used to be common sense. It’s not entirely straightforward where capital controls would operate in the sequence above; the metaphor of “capital” as a substance that moves across borders is unhelpful. But in some way or other capital controls would prevent the individual in country B from coming into possession of the bank deposit in country A.
There are two problems with this solution, one practical and the other more fundamental. The practical problem is that many routine transactions — payment for imports say — involve the creation of bank deposits in one country payable to some entity in another. It is hard to distinguish prohibited financial transactions from permitted payments for goods and services — and as Boyce and Ndikumana document, capital flight is usually disguised as current account transactions, for instance by over-invoicing for imports. Eric Helleiner [1] quotes Jacob Viner: “Because of the difficulty of distinguishing between capital account and current account transactions, capital controls could be made effective only by ‘censorship of communications and by crushing penalties for violation.'” [2]
The more fundamental problem is that these transactions — and capital flight in general – may be perfectly legal by the rules in force when they take place. Or if formally illegal, they are usually carried out by high government officials and/or members of the country’s elite. So the government of the poor country is unlikely to aggressively apply any restrictions that do exist. A subsequent government might well feel differently — but what claim do they have on a private bank account in a foreign country?
The problems with making capital controls effective were recognized clearly in the runup to Bretton Woods. In White’s 1942 draft for the agreements — again quoting Helleiner — “governments were required (a) not to accept or permit deposits or investments from any member country except with the permission of the government of that country, and (b) to make available to the government of any member country at its request all property in form of deposits, investments or securities of the nationals of the member country.” Even this wouldn’t be enough, of course, in the case where the wealthowner ceases to be a national. And it might not help in the case of a corrupt government that doesn’t want to repatriate private funds — though it might, if (as was also discussed) countries with balance of payments problems were required to draw on foreign exchange in private hands before being granted official assistance. In any case, it seems challenging to impose effective capital controls without granting the government control of all foreign assets — which will often require the cooperation of the country where those assets are held.
Needless to say nothing like this was included in the Bretton Woods agreements as signed. The US government would not even accept its allies’ pleas to assist in repatriating flight capital to help with the acute balance of payments difficulties following the war. Now it’s true, Second Circuit Judge Griesa recently claimed even more extensive authority that the government of Argentina would have had under White’s proposals, seizing the US assets of third parties who’d received payments from the Argentine government. But that was strictly to make payments to creditors. No such access to foreign assets is generally available.
This situation can arise even if governments themselves don’t even have to borrow abroad. As we recently saw in the case of Ireland, a government can strictly limit its debt and still find itself with unmanageable foreign liabilities. If private institutions — especially banks, but potentially nonfinancial corporations as well — borrow abroad, government that wishes to keep them operational in a crisis may have to assume their liabilities. Or at least, they will be strongly urged to do so by all the guardians of orthodoxy. What, are you going to just let the banks fail? Meanwhile, any foreign claims generated by the activities of the banks before they failed are out of reach.
Financial commitments create obligations; when circumstances change, sometimes they can’t be met. Someone isn’t going to get what they were promised. In modern economies, the state (often in the guise of the central bank) steps in to assume or redenominate claims, to impose an ex post consistency on the inconsistent contracts signed by private agents. But with foreign-currency commitments to foreigners the authorities’ usual tools aren’t available. And just as important, there are other authorities — the ECB in the case of Greece, the US federal court system in the case of Argentina — that are ready to use their privileged position in the larger payments system to enforce the claims of creditors. In effect, while domestic contracts are always subject to political renegotiation, foreign contracts are — or can be made to seem — objective fact.
What we’ve ended up with is a situation in which private parties have an absolute right to make whatever financial commitments they choose, and national governments have an absolute duty to honor the resulting balance sheet commitments. Wealth belongs to individuals, but debt belongs to the people. They are bound by past government commitments forever.
Or as Marx observed, “The only part of the so-called national wealth that actually enters into the collective possession of modern peoples is their national debt. …in England all public institutions are designated ‘royal’; as compensation for this, however, there is the ‘national’ debt. ”
[1] The Helleiner book, along with Fred Block’s Origins of International Economic Disorder, is still the best thing I know on the evolution of international monetary arrangements since World War II. Has anything better been written in the 20 years since it came out?
[2] This brings out two general points on financial regulation that I’d like to develop more. First, it is one thing to establish different rules for different kinds of activity, but the classification has to actually match up with the legal and accounting categories in which actual economic transactions are organized. The category of “banks” is a currently relevant example. This is part of the larger issue of what I call the money view, or economic nominalism — we need a perspective that regards money payments and the labels they bear as fundamental, rather than seeing them as reflections of some underlying structure. Second, and relatedly, it is hard for individual regulations to be effective in a setting in which anything that is not explicitly forbidden is permitted, since for any regulated transaction there will normally be unregulated ones that are economically equivalent.
Last week, the Washington Post ran an article by Jim Tankersley on what would happen if Trump got his way and the US imposed steep tariffs on goods from Mexico and China. I ended up as the objectively pro-Trump voice in the piece. The core of it was an estimates from Mark Zandi at Moody’s that a 45% tariff on goods from China and a 35% tariff on goods from Mexico (I don’t know where these exact numbers came from) would have an effect on the US comparable to the Great Recession, with output and employment both falling by about 5 percent relative to the baseline. About half this 5 percent fall in GDP would be due to retaliatory tariffs from China and Mexcio, and about half would come from the US tariffs themselves. As I told the Post, I think this is nuts.
Let me explain why I think that, and what a more realistic estimate would look like. But first, I should say that Tankersley did exactly what one ought to do with this story — asked the right question and went to a respected expert to help him answer it. The problem is with what that expert said, not the reporting. I should also say that my criticisms were presented clearly and accurately in the piece. But of course, there’s only so much you can say in even a generous quote in a newspaper article. Hence this post.
I haven’t seen the Moody’s analysis (it’s proprietary). All I know is what’s in the article, and the general explanation that Tankersley gave me in the interview. But from what I can tell, Zandi and his team want to tell a story like this. When the US imposes a tariff, it boosts the price of imported goods but leads to no substitution away from them. Instead, higher import prices just mean lower real incomes in the US. Then, when China and Mexico retaliate, that does lead to substitution away from US goods, and the lost exports reduce US real incomes further. But only under the most extreme assumptions can you get Zandi’s numbers out of this story.
While this kind of forecasting might seem mysterious, it mostly comes down to picking values for a few parameters — that is, making numerical guesses about relationships between the variables of interest. In this case, we have to answer three questions. The first question is, how much of the tariff is paid by the purchasers of imported goods, as opposed to the producers? The second question is, how do purchasers respond to higher prices — by substituting to domestic goods, by substituting to imports from other countries, or by simply paying the higher prices? Substitution to domestic goods is expansionary (boosts demand here), substitution to imports from elsewhere is neutral, and paying the higher prices is contractionary, since it reduces the income available for domestic spending. And the third question is, how much does a given shift in demand ultimately move GDP? The answer to the first question gives us the passthrough parameter. The answer to the second question gives us two price elasticities — a bilateral elasticity for imports from that one country, and an overall elasticity for total imports. The answer to the third question gives us the multiplier. Combine these and you have the change in GDP resulting from the tariff. Of course if you think the initial tariffs will provoke retaliatory tariffs from the other countries, you have to do the same exercise for those, with perhaps different parameters.
Let’s walk through this. Suppose the US — or any country — increases taxes on imports: What can happen? The first question is, how is the price of the imported good set — by costs in the producing country, or by market conditions in the destination? If conditions in the destination country affect price — if the producer is unable or unwilling to raise prices by the full amount of the tariff — then they will have to accept lower revenue per unit sold. This is referred to as pricing to market or incomplete passthrough, and empirical studies suggest it is quite important in import prices, especially in the US. Incomplete passthrough may result in changing profit margins for producers, or they may be able to adjust their own costs — wages especially — in turn. Where trade is a large fraction of GDP, some of the tax may eventually be translated into a lower price level in the exporting country.
Under floating exchange rates, the tariff may also lead a depreciation of the exporting country currency relative to the currency of the country imposing the tariff. This is especially likely where trade between the two countries is a large share of total trade for one or both of them. In this case, a tariff is more likely to cause a depreciation of the Mexican peso than of the Chinese renminbi, since the US accounts for a higher fraction of Mexico’s exports than of China’s, and the renminbi is actively managed by China’s central bank.
Taking all these effects together, passthrough for US imports is probably less than 0.5. In other words, the majority of a tariff’s impact will probably be on dollar revenue for producers, rather than dollar costs for consumers. So a 10 percent tariff increases costs of imported goods by something less than 5 percent and reduces the revenue per unit of producers by something more than 5 percent.
The fraction of the tax that is not absorbed by lower exporter profit margins, lower wages in the export industry or a lower price level in the exporting country, or by exchange rate changes, will be reflected in higher prices in the importing country. The majority of trade goods for the US (as for most countries) are intermediate and capital goods, and even imported consumption goods are almost never purchased directly by the final consumer. So on the importing side, too, there will be firms making a choice between accepting lower profit margins, reducing wages and other domestic costs, or raising prices. Depending on exactly where we are measuring import prices, this might further reduce passthrough.
Let’s ignore this last complication and assume that a tax that is not absorbed on the exporting-country side is fully passed on to final price of imported goods. Purchasers of imported goods now respond to the higher price either by substituting to domestic goods, or substituting to imported goods from some third country not subject to the tax, or continuing to purchase the imports at the higher price. To the extent they substitute to domestic goods, that will boost demand here; to the extent they substitute to third-country goods, the tax will have no effect here.
These rates of substitution are described by the price elasticity of imports, computed as the ratio of the percentage change in the price, to the resulting percentage change in the quantity imported. So for instance if we thought that a 1 percent increase in the price of imported goods leads to a 2 percent fall in the quantity purchased, we would say the price elasticity is 2. There are two elasticities we have to think about — the bilateral elasticity and the overall elasticity. For example, we might think that the bilateral elasticity for US imports from China was 3 while the overall price elasticity for was 1. In that case, a 1 percent increase in the price of Chinese imports would lead to a 3 percent fall in US imports from China but only one-third of that would be through lower total US imports; the rest would be through higher imports from third countries.
To the extent the higher priced imported goods are purchased, this may result in a higher price of domestic goods for which the imports are an input or a substitute; to the extent this happens, the tax will raise domestic inflation but leave real income unchanged. For the US, import prices have a relatively small effect on overall inflation, so we’ll ignore this effect here. If we included it, we would end up with a smaller effect.
To the extent that the increase in import prices neither leads to any substitution away from the imported goods, nor to any price increase in domestic goods, it will reduce real incomes in the importing country, and leave incomes in the exporting country unchanged. Conversely, to the extent that the tariff is absorbed by lower wages or profit margins in the exporting country, or leads to substitution away from that country’s goods, it reduces incomes in the exporting country, but not in the importing country. And of course, to the extent that there is no substitution away from the taxed goods, government revenue will increase. Zandi does not appear to have explicitly modeled this last effect, but it is important in thinking about the results — a point I’ll return to.
Whether the increase in import prices increases domestic incomes (by leading to substitution to domestic goods) or reduces them, the initial effect will be compounded as the change in income leads to changes in other spending flows. If, let’s say, an increase in the price of Chinese consumer goods forces Americans to cut back purchases of American-made goods, then the workers and business owners in the affected industries will find themselves with less income, which will cause them to reduce their spending in turn. This is the familiar multiplier. The direct effect may be compounded or mitigated by financial effects — the multiplier will be larger if you think (as Zandi apparently does) that a fall in income will be accompanied by a fall in asset prices with a further negative effect on credit and consumption, and smaller if you think that a trade-induced change in income will be offset by a change in monetary (or fiscal) policy. In the case where central bank’s interest rate policy is always able to hold output at potential, the multiplier will be zero — shocks to demand will have no effect on output. This extreme case looked more reasonable a decade ago than it does today. In conditions where the Fed can’t or won’t offset demand impacts, estimates of the US multiplier range as high as 2.5; a respectable middle-of-the-road estimate would be 1.5.
Let’s try this with actual numbers.
Start with passthrough. The overwhelming consensus in the empirical literature is that less than half of even persistent changes in exchange rates are passed through to US import prices. This recent survey from the New York Fed, for instance, reports a passthrough of about 0.3:
following a 10 percent depreciation of the dollar, U.S. import prices increase about 1 percentage point in the contemporaneous quarter and an additional 2 percentage points over the next year, with little if any subsequent increases.
The factors that lead to incomplete passthrough of exchange rate movements — such as the size of the US market, and the importance exporters of maintaining market share — generally apply to a tariff as well, so it’s reasonable to think passthrough would be similar. So a 45% tariff on Chinese goods would probably raise prices to American purchasers by only about 15%, with the remainder absorbed by profits and/or wages at Chinese exporters.
Next we need to ask about the effect of that price on American purchases. There is a large literature estimating trade price elasticities; a sample is shown in the table below. As you can see, almost all the import price elasticities are between 0.2 and 1.0. (Price elasticities seem to be greater for US exports than for imports; they also seem to be higher for most other countries than for the US.) The median estimates is around 0.5 for overall US imports. Country-specific estimates are harder to find but I’ve seen values around 1.0 for US imports from both China and Mexico. Using those estimates, we would expect a 15% increase in the price of Chinese imports to lead to a 15% fall in imports from China, with about half of the substitution going to US goods and half going to imports from other countries. Similarly, a 10% increase in the price of goods from Mexico (a 35% tariff times passthrough of 0.3) would lead to a 10% fall in imports from Mexico, with half of that being a switch to US goods and half to imports from elsewhere.
Finally, we ask how the combination of substitution away from imports from Mexico and China, and the rise in price of the remaining imports, would affect US output. US imports from China are about 2.7 percent of US GDP, and imports from Mexico are about 1.7 percent of GDP. So with the parameters above, substitution to US goods raises GDP by 7.5% x 2.7% (China) plus 5% x 1.7% (Mexico), or 0.29% of GDP. Meanwhile the higher prices of the remaining imports from China and Mexico reduce US incomes by 0.22 percent, for a net impact of a trivial one twentieth of one percent of GDP. Apply a standard multiplier of 1.5, and the tariffs boost GDP by 0.08 percent.
You could certainly get a larger number than this, for instance if you thought that passthrough of a tariff would be substantially greater than passthrough of exchange rate changes. And making US import demand just a bit less price-elastic is enough to turn the small positive impact into a small negative one. But it would be very hard to get an impact of even one percent of GDP in either direction. And it would be almost impossible to get a negative impact of the kind that Zandi describes. If you assume both that the tariffs are fully passed through to final purchasers, and that US import demand is completely insensitive to price then with a multiplier of 1.5, you get a 2.7 percent reduction in US GDP. Since this is close to Zandi’s number, this may be what he did. But again, these are extreme assumptions, with no basis in the empirical literature. That doesn’t mean you can’t use them, but you need to justify them; just saying the magic word “proprietary” is not enough. (Imagine all the trouble Jerry Friedman could have saved himself with that trick!)
And the very low price elasticity you need for this result has some funny implications. For instance, it implies that when China intervenes to weaken their currency, they are just impoverishing themselves, since — if demand is really price-inelastic — they are now sending us the same amount of goods and getting fewer dollars for each one. I doubt Zandi would endorse this view, but it’s a logical corollary of the ultra-low elasticity he needs to get a big cost to the US from the initial tariff. Note also that the low-elasticity assumption means that the tariff creates no costs for China or Mexico: their exporters pass the increased tariff on completely to US consumers, and lose no sales as a result. It’s not clear why they would “retaliate” for this.
Let’s assume, though, that China and Mexico do impose tariffs on US goods. US exports to China and Mexico equal 0.7 and 1.3 percent of US GDP respectively. Passthrough is probably higher for US exports — let’s say 0.6 rather than 0.3. Price elasticity is also probably higher — we’ll say 1.5 for both bilateral elasticities and for overall export elasticity. (In the absence of exchange-rate changes, there’s no reason to think that a fall in exports to China and Mexico will lead to a rise in exports to third countries.) And again, we’ll use a multiplier of 1.5. This yields a fall in US GDP from the countertariffs of just a hair under 1 percent. Combine that with the small demand boost from the tariff, and we get an overall impact of -0.9 percent of GDP.
I admit, this is a somewhat larger hit than I expected before I worked through this exercise. But it’s still much smaller than Zandi’s number.
My preferred back-of-the-envelope for the combined impact of the tariffs and countertariffs would be a reduction in US GDP of 0.9 percent, but I’m not wedded to this exact number. I think reasonable parameters could get you an impact on US GDP anywhere from positive 1 percent to, at the worst, negative 2 percent or so. But it’s very hard to get Zandi’s negative 5 percent. You need an extremely high passthrough for both import and export prices, plus extremely price-inelastic US import demand and extremely price-elastic demand for US exports — all three parameters well outside the range in the empirical literature. At one point a few years ago, I collected about 20 empirical estimates of US trade elasticities, and none of them had a price elasticity for US exports greater than 1.5. But even with 100% passthrough, and a generous multiplier of 2.0, you need an export price elasticity of 4 or so to get US GDP to fall by 5 points.
Still, while Zandi’s 5 percent hit to GDP seems beyond the realm of the plausible, one could perhaps defend a still-substantial 2 percent. Let’s think for a moment, though, about what this would mean.
First of all, it’s worth noting — as I didn’t, unfortunately, to the Post reporter — that tariff increases are, after all, tax increases. Whatever its effect on trade flows, a big increase in taxes will be contractionary. This is Keynes 101. Pick any activity accounting for 5 percent of GDP and slap a 40 percent tax on it, and it’s a safe bet that aggregate income will be lower as a result. The logic of the exercise would have been clearer if the tariff revenue were offset by a cut in some other tax, or increase in government spending. (Maybe this is what Trump means when he says Mexico will pay for the wall?) Then it would be clearer how much of the predicted impact comes from the tariff specifically, as opposed to the shift toward austerity that any such a big tax increase implies. The point is, even if you decide that a 2 percent fall in US GDP is the best estimate of the tariff’s impact, it wouldn’t follow that tariffs as such are a bad idea. It could be that a big tax increase is.
Second, let’s step back for a moment. While Mexico and China are two of our largest trade partners, they still account for less than a quarter of total US trade. Given passthrough of 0.3, the 45/35 percent tariff on Chinese/Mexican goods would raise overall US import prices by about 3 percent. Even with 100 percent passthrough, the tariffs would raise overall import prices by just 10 percent. The retaliatory tariffs would raise US export prices by about half this — 5 percent with full passthrough. (The difference is because these two countries account for a smaller share of US exports than of US imports). Now, let’s look at the movements of the dollar in recent years.
Since 2014, the dollar has risen 15 percent. That’s a 15 percent increase in the price of US goods in all our export markets — three times the impact of the hypothetical Mexican and Chinese tariffs. But before that, from 2002 to 2008, the dollar fell by over 20 percent. That raised the price of US imports by twice as much as the hypothetical Trump tariff. And so on on back to the 1970s. If you believe Zandi’s numbers, then the rise in the dollar over the past two years should already have triggered a severe recession. Of course it has not. It would be foolish to deny that movements of the dollar have had some effect on US output and employment. But no one, I think, would claim impacts on anything like this scale. Still, one thing is for sure: If you believe anything like Zandi’s numbers on the macro impacts of trade price changes, then it’s insane to allow exchange rates to be set by private speculators.
So if Zandi is wrong about the macro impact of tariffs, does that mean Trump is right? No. First of all, while I don’t think there’s any way to defend Zandi’s claim of a very large negative impact on GDP of a tariff (or of a more respectable, but economically equivalent, depreciation of the dollar), it’s almost as hard to defend a large positive impact. Despite all the shouting, the relative price of Chinese goods is just not a very big factor for aggregate demand in the US. If the goal is stronger demand and higher wages here, there are various things we can do. A more favorable trade balance with China (or Mexico, or anywhere else) is nowhere near the top of that list. Second, the costs of the tariff would be substantial for the rest of the world. It’s important not to lose sight of the fact that China, over the past generation, has seen perhaps the largest rise in living standards in human history. We can debate how critical exports to the US were in this process, but certainly the benefits to China of exports to the US were vastly greater than whatever costs they created here.
But the fact that an idea is wrong, doesn’t mean that we can ignore evidence and logic in refuting it. Trumpism is bad enough on the merits. There’s no need to exaggerate its costs.
UPDATE: My spreadsheet is here, if you want to play with alternative parameter values.
Some links, on short-termism, trade, the Fed and other things.
Senators Tammy Baldwin and Jeff Merkley have introduced a bill to limit activist investors’ ability to push for higher payouts. The bill, which is cosponsored by Bernie Sanders and Elizabeth Warren, would strengthen the 13D disclosure requirements for hedge funds and others acquiring large positions in a corporation. This is obviously just one piece of a larger agenda, but it’s good to see the “short-termism’ conversation leading to concrete proposals.
I’m pleased to be listed as one of the supporters of the bill, but I think the strongest endorsement is this furious reaction from a couple of hedge fund dudes. It’s funny how they take it for granted that shareholder democracy is on the same plane as democracy democracy, but my favorite bit is, “Shareholders do not cause bad management, just as voters do not cause bad politicians.” This sounds to me like an admission that shareholders are functionless parasites — if they aren’t responsible for the quality of management, what are we paying them all those dividends for?
I wrote a twitter essay on why the US shouldn’t seek a more favorable trade balance.
Jordan Weissman thinks I was “a bit ungenerous” to Trump.
My Roosevelt Institute colleague Carola Blinder testified recently on reform of the Fed, making the critical point that we need to take monetary policy seriously as a political question. “Contrary to conventional thinking, the rules of central banking are not neutral: Both monetary policy and financial supervision have profound effects on income and wealth inequality … [and] are the product of political contestation and compromise.” Relatedly, Mark Thoma suggests that the Fed “cares more about the interests of the rich and powerful than it does the working class”; his solution, as far as I can tell, is to hope that it doesn’t.
Matt Bruenig has a useful post on employment by age group in the US v the Nordic countries. As he shows, the fraction of people 25-60 working there is much higher than the fraction here (though workers here put in more hours). This has obvious relevance for the arguments of the No We Can’t caucus that there’s no room for more stimulus, because demographics.
A reminder: “Ricardian equivalence” (debt and tax finance of government spending have identical effects on private behavior) was explicitly denied by David Ricardo, and the “Fisher effect” (persistent changes in inflation lead to equal movements of nominal interest rates, leaving real rates unchanged) was explicitly denied by Irving Fisher. One nice thing about this piece is it looks at how textbooks describe the relationship between the idea and its namesake. Interesting, Mankiw gets Fisher right, while Delong and Olney get him wrong: They falsely attribute to him the orthodox view that nominal interest rates track inflation one for one, when in fact he argued that even persistent changes in inflation are mostly not passed on to nominal rates.
Here is a fascinating review of some recent books on the Cold War conflicts in Angola. One thing the review brings out was how critical the support of Cuba was to South Africa’s defeat there, and how critical that defeat in turn was to the end of apartheid. We tend to take it for granted that history had to turn out as it did, but it’s worth asking if, in the absence of Castro’s commitment to Angola, white rule in South Africa might have ended much later, or not at all.
A few things elsewhere on the web, relevant to recent conversations here.
1. Michael Reich and his colleagues at the Berkeley Center for Labor Research have a new report out on the impacts of a $15 minimum wage in New York. It does something I wish all studies of the minimum wage and employment would do: It explicitly decomposes the employment impact into labor productivity, price, demand and labor share effects. Besides being useful for policy, this links nicely to the macro discussion of alternative Phillips curves.
2. I like Susan Schroeder’s idea of creating a public credit-rating agency. It’s always interesting how the need to deal with immediate crises and dysfunctions creates pressure to socialize various aspects of the financial system. The most dramatic recent example was back in the fall of 2008, when the Fed began lending directly to anyone who needed to roll over commercial paper; but you can think of lots of examples, including QE itself, which involves the central bank taking over part of banks’ core function of maturity transformation.
3. On the subject of big business’s tendency to socialize itself, I should have linked earlier to Noah Smith’s discussion of “new industrialism” (including my work for the Roosevelt Institute) as the next big thing in economic policy. Eric Ries’ proposal for creating a new, nontransferable form of stock ownership reminded me of this bit from Keynes: “The spectacle of modern investment markets has sometimes moved me towards the conclusion that the purchase of an investment [should be] permanent and indissoluble, like marriage, except by reason of death or other grave cause… For this would force the investor to direct his mind to the long-term prospects and to those only.”
4. In comments to my recent post on the balance of payments, Ramanan points to a post of his, making the same point, more clearly than I managed to. Also worth reading is the old BIS report he links to, which explicitly distinguishes between autonomous and accommodative financial flows. Kostas Kalaveras also had a very nice post on this topic a while ago, noting that in Europe TARGET2 balances function as a buffer allowing private financial flows and current account balances to move independently from each other.
5. I’m teaching intermediate macroeconomics here at John Jay, as I do most semesters, and I’ve put some new notes I’m using up on the teaching page of this website. It’s probably mostly of interest to people who teach this stuff themselves, but I did want to call attention to the varieties of business cycles handout, which is somewhat relevant to current debates. It’s also an example of how I try to teach macro — focus on causal relationships between observable aggregates, rather than formal models based on equilibrium conditions.
In the previous post, I suggested that we should think of the various trade and financial flows in the balance of payments as evolving more or less independently, with imbalances between them normally accommodated by passive buffers rather than being closed by any kind of price adjustment. In that post I focused on the prewar gold standard. Here is a more recent example of what I’m talking about.
From 2012 to 2013 there was a general “risk on” shift in financial markets, with fears of a new crisis receding and investors focusing more on yield and less on safety and liquidity. In a risk-off environment investors prefer the safety of US assets even if yields are very low; in a risk-on environment, as we were moving toward in 2013, they prefer higher-yielding non-US assets.
Now, how was this shift in asset demand accommodated in the balance of payments? Orthodox theory suggests that there should be some offsetting change in interest rates and/or exchange rate expectations to keep demand for US and non-US assets balanced. But this didn’t happen — interest rate differentials didn’t close, and “risk-on” is associated with a falling rather than a rising dollar. And in fact, there was a large net outflow of portfolio investment: Net acquisition of foreign assets was $250 billion higher in 2013 than 2012, and net foreign acquisition of US assets by foreigners was $250 billion lower. Orthodox theory also says that if there is a net shift in investment flows, there should be an offsetting change in the current account. But the US current account shifted only $60 billion toward surplus, compared with the $500 billion net shift in portfolio flows. In a country with a fixed exchange rate, we would expect the remaining portfolio outflow to be accommodated by a fall in foreign exchange reserves. but of course the dollar floats, and the Fed does not hold significant reserves.
In fact, the entire shift was accommodated within the US banking system, most importantly by a rise in foreign-held deposits of $400 billion. Now this is an increase in US foreign liabilities, but it does not reflect a decision by anyone to borrow from abroad. It simply reflects the mechanics of international financial transactions. When an American spends money to purchase a foreign asset, the “money” they are using is a deposit at an American bank. When the asset is purchased, that deposit is transferred to the foreign asset-seller (or some intermediary), turning the deposit into a foreign liability of the bank. So the shift of portfolio investment out of the US does not require any change in prices (or incomes) to generate an offsetting flow into the US. The foreign liabilities that finance the purchase of foreign assets are generated mechanically in the course of the transaction itself.
Eventually, the effort to close out this residual long dollar position might produce downward pressure on the value of the dollar. And if the dollar does depreciate, that may increase demand for other US assets or for US exports sufficient to absorb the deposits. But there is no guarantee that either of these things will happen. And certainly they will not happen quickly. What we know for sure is that buffering within the banking system can offset quite large flows for substantial periods of time — in this case, a shift in portfolio flows of a couple percent of GDP sustained over a year. It might be that, with sufficient time, net sales of US assets might be large enough to push their price down, raising the yield enough to compensate for the lower safety premium. Or it might be that the downward pressure on the dollar will eventually lead to a big enough depreciation to raise US net exports enough to balance the portfolio outflow — but this will be a very long process, if it happens at all. It’s quite likely the portfolio will reverse for its own reasons (like a shift back toward “risk off”) before these adjustments even get started. Alternatively, liquidity constraints within the banking system may exhaust its buffering capacity before any other adjustment mechanism comes into play, requiring active intervention by the state or a catastrophic adjustment of the current account. (Presumably not in the case of the US, but often enough elsewhere.)
In practice, where we see payments balance maintained smoothly, it’s more likely because the underlying patterns of trade and investment are balanced and stable enough to not strain the buffering capacity of the banking system, rather than thanks to the operation of any adjustment mechanism.
There are many payments between countries — trade in goods and services, profits and interest paid to foreign capitalists, portfolio investment, FDI and bank lending, transactions between governments. All of these payments must balance out one way or another.
International-finance orthodoxy since David Hume has been about identifying an automatic mechanism that ensures that all these flows balance. This mechanism should take the form of a price adjustment, whether of the price level, the exchange rate, or the interest rate.
An alternative Keynesian approach is to make aggregate income the adjusting variable that maintains the balance of payments equality, just as it is in maintaining the domestic savings-investment balance. This is the idea behind balance of payments constrained growth.
Balance of payments constrained growth is certainly an improvement on the price adjustment mechanisms of orthodoxy. But I think it would be even better to consider both as items on a menu of things that may happen when a payments imbalance develops. The beginning of wisdom here is to recognize that there is no general mechanism that maintains payments balance. Changes in relative prices, exchange rates, interest rates or incomes may all play a role, depending on the timeframe we are considering and on the countries involved and the source of the imbalance.
Our theory of balance of payments adjustments should not begin with the universal logic of either orthodox or b.o.p.-constrained growth models, but with a concrete historical enumeration of the various sources of payments imbalance and the various kinds of adjustment in response to them.
We also need to consider other kinds of adjustment mechanisms, in particular, accommodation by buffers. This will always be the dominant mechanism if we are considering a short enough period. In the first instance, payments balance is maintained because there are some actors in the system who will passively take the other side of any open foreign exchange positions. The familiar example of this is a central bank that holds foreign exchange reserves: When it intervenes in the foreign exchange market, it passively allows its reserve position to adjust to accommodate whatever net demand there is for foreign currency. But there are also private buffers. In particular, there’s not nearly enough recognition of the special role of banks in the payments system, which requires them to take open foreign exchange positions when other units engage in cross-border transactions. An inflow of foreign investment, for instance, will in the first instance always result in a an increase in foreign assets in the banking system of the receiving country and foreign liabilities in the banking system of the investing country. How large are the imbalances that can be buffered in this way, and how long the banking system will passively maintain its open position without some other adjustment mechanism coming into play, are open questions. But there is no question that in the short run, the balance of payments is maintained through this sort of passive buffering, and not through any adjustment of either prices or incomes.
We also need to recognize the role of active policy in maintaining payments balance. We tend to think of policy “interventions” as modifications or “shocks” to an underlying structure of payments, but official actions may be an important adjustment mechanism by which that structure is maintained in the first place. This includes both bilateral or multilateral actions that generate offsetting official financial flows in the face of imbalances (important even in the19th century, in the form of central bank cooperation) and unilateral actions to limit outflows, including capital controls, import restrictions and so on.
The right starting point, I think, is to think of the various financial and trade flows as evolving essentially independently. If they happen to more or less balance, then the available buffers and whatever limited price adjustment is possible will be enough to maintain balance. If they don’t happen to balance, then the expected outcome is a crisis of some sort, ending with state intervention and/or a change in the “fundamental” parameters. There is no automatic mechanism that maintains balance. Where we see smooth payments balance over a long period time, it is probably because international payments are being actively managed by the authorities, or because productive capacities, import demands, asset preferences of foreign investors and so on have evolved to fit the existing pattern of payments, rather than vice versa.
The classic case is the London-centered gold standard system of the 19th century. Despite what someone like Barry Eichengreen will tell you, price flexibility was not an important element in the stability of this system. While prices and wages did rise and especially fall more freely before World War One, they almost always did so in parallel across trading partners, not in the opposite way that would offset trade imbalances. Instead, the system depended on the following institutionally specific features.
1. A large fraction of non-British savings, especially from Latin America and other less-developed countries, were held in London. This meant that many “international” payments simply involved a transfer from one British bank account to another, with no cross-border settlement required.
2. British foreign investment primarily funded purchases of British capital goods, so that financial outflows and exports naturally rose and fell together without the need for price adjustments.
3. The capital goods so purchased (for railroads especially) were largely used to produce exports to Britain, offsetting interest and divided payments back to London.
4. Slower growth in Britain was associated with lower interest rates there. So the slowdown in import payments abroad (due to lower incomes) was offset by an increase in foreign lending, which was quite interest-sensitive.
5. Within Europe central banks actively cooperated to offset any payments imbalances that did occur. On several occasions where there a net flow of gold from London to Paris seemed to be developing, the Bank of France made large loans to the Bank of England so that no actual gold had to move. In addition, the belief that gold convertibility would be maintained, or if suspended soon restored at the old parity, meant if a payments imbalance led to a deviation of the market exchange rate from the official parity, it would generate large speculative flows toward the depreciated currency.
6. Outside of Europe, crises and defaults were integral to the operation of the system. While interest-sensitive foreign lending meant that for England (and to some extent other European countries, and later the US), imports and financial outflows tended to move in opposite directions, higher interest rates could not reliably generate financial inflow for peripheral countries. Instead, the normal adjustment process for large imbalances was a catastrophic one in which large deficits periodically led to suspension of convertibility and default.
7. Over the longer run, the “fundamentals” in the periphery were shaped to produce payments balance at prevailing prices, rather than prices adjusting to fundamentals. Foreign investment financed development of export industries suiting the needs of the investing country, with higher-wage countries specializing in higher-value products. In settler colonies, migrant flows strengthened trade and financial links with the mother country.
Bottom line: there was no adjustment mechanism. Stability depended on the contingent fact that the prevailing “shocks” had roughly balanced effects on payment flows. Small imbalances were absorbed by buffers (which in the pre-WWI system included the cost of transporting gold). Large imbalances were actively managed or else led to the system breaking down, either locally, or globally as with the war.
For the gold standard era, I think the best statement of this perspective is Triffin’s “Myths and Realities of the So-Called ‘Gold Standard’.” Alec Ford’s The Gold Standard 1880-1914: Britain and Argentina is also very good (as is Barry Eichengreen’s discussion of it.) Peter Temin makes essentially this argument in his Lessons from the Great Depression — that the gold standard worked before World War I but broke down in the 1920s not because prices were more flexible before the war, but because in the prewar period it did not have to deal with big imbalances in trade and financial flows as developed after. Keynes makes the same larger point, as well as all seven of the specific points above, but at scattered places in his writing and correspondence rather than — as far as I know — in any single text. This perspective is in the same spirit as the “surplus recycling mechanism” that Varoufakis talks about in The Global Minotaur and elsewhere, the idea that there is no price mechanism that tends to bring about payments balance and so some specific institution is needed to offset persistent surpluses and deficits. (Though of course Varoufakis is focused on the more recent period.) The point that productive capacities are shaped by relative prices, rather than vice versa, was made by development economists like Arthur Lewis — it’s stated very clearly in his Evolution of the World Economic Order.
Obviously, the specifics will be different today. But I think the same basic perspective on the balance of payments still applies. Where payments balance exists, it is because of institutional factors that tend to generate offsetting disturbances to trade and financial flows, and because the international structure of production has evolved to generate balance at existing relative prices, rather than because prices have adjusted. And when imbalances do develop, they are accommodated first by passive buffers, and then either actively managed by authorities or else produce a breakdown in the system.
Note: I wrote most of this post in February 2015 and then for some reason never put it up. It really should have links, but given that it’s already sat around for over year I decided to just put it up as-is. Since the original post was very long, I’ve split it into two parts. The second half is here.
There’s nothing like trade to provoke full-throated defenses of economic orthodoxy. How many other topics are there where people would even use the phrase to mean what is correct, obvious, not to be questioned? For example, Binyamin Applebaum in yesterday’s Times: On Trade, Trump Breaks with 200 Years of Economic Orthodoxy.
Donald J. Trump’s blistering critique of American trade policy boils down to a simple equation: Foreigners are “killing us on trade” because Americans spend much more on imports than the rest of the world spends on American exports. …
Add a few “whereins” and “whences” and that sentiment would conform nicely to the worldview of the first Queen Elizabeth of 16th-century England, to the 17th-century court of Louis XIV, or to Prussia’s Iron Chancellor, Otto von Bismarck, in the 19th century. The great powers of bygone centuries subscribed to the economic theory of mercantilism…
Etc. Restrictions on trade aren’t just mistaken, they’re exotic, primitive, un-American, part of a dusty storybook world of kings and queens and whences.
I admit, this is an issue where I’m a bit of a heterodox bubble. I’ve been reading people like Ha-Joon Chang so long, I forget how pervasive is the idea that the US has always practiced free trade (except for one terrible mistake in the 1930s.) I forget how unquestioned the myth of free trade is in the larger economic conversation. Because of course it is a myth. Here is Chang:
Between 1816 and the end of the Second World War, the U.S. had one of the highest average tariff rates on manufacturing imports in the world… The Smoot-Hawley Tariff of 1930, which Bhagwati portrays as a radical departure from a historic free-trade stance, only marginally (if at all) increased the degree of protectionism in the U.S. economy…
The following quote from Ulysses Grant, the Civil War hero and president of the United States from 1868 to 1876 clearly shows how the Americans had no illusions about [free trade]. “For centuries England has relied on protection, has carried it to extremes and has obtained satisfactory results from it. There is no doubt that it is to this system that it owes its present strength. After two centuries, England has found it convenient to adopt free trade because it thinks that protection can no longer offer it anything. Very well then, Gentlemen, my knowledge of our country leads me to believe that within 200 years, when America has gotten out of protection all that it can offer, it too will adopt free trade.”
Or here’s Paul Bairoch, whose book remains the esential reference on trade policy historically:
One should not forget that modern protectionism was born in the United States. In 1791, Alexander Hamilton, the first Secretaary of the Treasury, drew up his famous Report on Manufactures, which is considered to be the first formulation of modern protectionist theory. … The major contribution of Hamilton is the idea that industrialization is not possible wothout tariff protection. He was apparently the first to have used the term ‘infant industries.’ …
… from 1861 to the end of World War II was [a period] of strict protectionism … the tariff in force from 1866 to 1883 provided for import duties averaging 45% for manufactured goods… When the United States caught up with European industry, … [that] rendered obsolete the ‘infant industries’ agument… The Republican party based its case for introducing the Mckinley Tariff of 1890 on the need to safeguard the wage levels of American workers…
The McKinley Tariff, which raised duties to an average of 50 percent, became law, and its sponsor went on to be elected president. Applebaum might have mentioned McKinley. He might have mentioned Grant. He might have mentioned Abraham Lincoln, who as Chang points out, built his early campaigns as much on support for tariffs as on opposition to slavery. He might have mentioned Hamilton — I hear he’s really hot right now. But of course he didn’t: In America we’ve always practiced free trade. So instead we get Queen Elizabeth and Chancellor Bismarck.