Tag: international finance and trade

What Drives Trade Flows? Mostly Demand, Not Prices

I just participated (for the last time, thank god) in the UMass-New School economics graduate student conference, which left me feeling pretty good about the next generation of heterodox economists. [1] A bunch of good stuff was presented, but for my money, the best and most important work was Enno Schröder’s: “Aggregate Demand (Not Competitiveness) Caused the German Trade Surplus and the U.S. Deficit.” Unfortunately, the paper is not yet online — I’ll link to it the moment it is — but here are his slides.

The starting point of his analysis is that, as a matter of accounting, we can write the ratio of a county’s exports to imports as :

X/M = (m*/m) (D*/D)

where X and M are export and import volumes, m* is the fraction of foreign expenditure spent on the home country’s goods, m is the fraction of the home expenditure spent on foreign goods, and D* and D are total foreign and home expenditure.

This is true by definition. But the advantage of thinking of trade flows this way, is that it allows us to separate the changes in trade attributable to expenditure switching (including, of course, the effect of relative price changes) and the changes attributable to different growth rates of expenditure. In other words, it lets us distinguish the changes in trade flows that are due to changes in how each dollar is spent in a given country, from changes in trade flows that are due to changes in the distribution of dollars across countries.

(These look similar to price and income elasticities, but they are not the same. Elasticities are estimated, while this is an accounting decomposition. And changes in m and m*, in this framework, capture all factors that lead to a shift in the import share of expenditure, not just relative prices.)

The heart of the paper is an exercise in historical accounting, decomposing changes in trade ratios into m*/m and D*/D. We can think of these as counterfactual exercises: How would trade look if growth rates were all equal, and each county’s distribution of spending across countries evolved as it did historically; and how would trade look if each country had had a constant distribution of spending across countries, and growth rates were what they were historically? The second question is roughly equivalent to: How much of the change in trade flows could we predict if we knew expenditure growth rates for each country and nothing else?

The key results are in the figure below. Look particularly at Germany,  in the middle right of the first panel:

The dotted line is the actual ratio of exports to imports. Since Germany has recently had a trade surplus, the line lies above one — over the past decade, German exports have exceed German imports by about 10 percent. The dark black line is the counterfactual ratio if the division of each county’s expenditures among various countries’ goods had remained fixed at their average level over the whole period. When the dark black line is falling, that indicates a country growing more rapidly than the countries it exports to; with the share of expenditure on imports fixed, higher income means more imports and a trade balance moving toward deficit. Similarly, when the black line is rising, that indicates a country’s total expenditure growing more slowly than expenditure its export markets, as was the case for Germany from the early 1990s until 2008. The light gray line is the other counterfactual — the path trade would have followed if all countries had grown at an equal rate, so that trade depended only on changes in competitiveness. When the dotted line and the heavy black line move more or less together, we can say that shifts in trade are mostly a matter of aggregate demand; when the dotted line and the gray line move together, mostly a matter of competitiveness (which, again, includes all factors that cause people to shift expenditure between different countries’ goods, including but not limited to exchange rates.)
The point here is that if you only knew the growth of income in Germany and its trade partners, and nothing at all about German wages or productivity, you could fully explain the German trade surplus of the past decade. In fact, based on income growth alone you would predict an even larger surplus; the fraction of the world’s dollars falling on German goods actually fell. Or as Enno puts it: During the period of the German export boom, Germany became less, not more, competitive. [2] The cases of Spain, Portugal and Greece (tho not Italy) are symmetrical: Despite the supposed loss of price competitiveness they experienced under the euro, the share of expenditure falling on these countries’ goods and services actually rose during the periods when their trade balances worsened; their growing deficits were entirely a product of income growth more rapid than their trade partners’.
These are tremendously important results. In my opinion, they are fatal to the claim (advanced by Krugman among others) that the root of the European crisis is the inability to adjust exchange rates, and that a devaluation in the periphery would be sufficient to restore balanced trade. (It is important to remember, in this context, that southern Europe was running trade deficits for many years before the establishment of the euro.) They also imply a strong criticism of free trade. If trade flows depend mostly or entirely on relative income, and if large trade imbalances are unsustainable for most countries, then relative growth rates are going to be constrained by import shares, which means that most countries are going to grow below their potential. (This is similar to the old balance-of-payments constrained growth argument.) But the key point, as Enno stresses, is that both the “left” argument about low German wage growth and the “right” argument about high German productivity growth are irrelevant to the historical development of German export surpluses. Slower income growth in Germany than its trade partners explains the whole story.
I really like the substantive argument of this paper. But I love the methodology. There is an econometrics section, which is interesting (among other things, he finds that the Marshall-Lerner condition is not satisfied for Germany, another blow to the relative-prices story of the euro crisis.) But the main conclusions of the paper don’t depend in any way on it. In fact, the thing can be seen as an example of an alternative methodology to econometrics for empirical economics, historical accounting or decomposition analysis. This is the same basic approach that Arjun Jayadev and I take in our paper on household debt, and which has long been used to analyze the historical evolution of public debt. Another interesting application of this kind of historical accounting: the decomposition of changes in the profit rate into the effects of the profit share, the utilization rate, and the technologically-determined capital-output ratio, an approach pioneered by Thomas Weisskopf, and developed by others, including Ed Wolff, Erdogan Bakir, and my teacher David Kotz.
People often say that these accounting exercises can’t be used to establish claims about causality. And strictly speaking this is true, though they certainly can be used to reject certain causal stories. But that’s true of econometrics too. It’s worth taking a step back and remembering that no matter how fancy our econometrics, all we are ever doing with those techniques is describing the characteristics of a matrix. We have the observations we have, and all we can do is try to summarize the relationships between them in some useful way. When we make causal claims using econometrics, it’s by treating the matrix as if it were drawn from some stable underlying probability distribution function (pdf). One of the great things about these decomposition exercises — or about other empirical techniques, like principal component analysis — is that they limit themselves to describing the actual data. In many cases — lots of labor economics, for instance — the fiction of a stable underlying pdf is perfectly reasonable. But in other cases — including, I think, almost all interesting questions in macroeconomics — the conventional econometrics approach is a bit like asking, If a whale were the top of an island, what would the underlying geology look like? It’s certainly possible to come up with a answer to that question. But it is probably not the simplest way of describing the shape of the whale.
[1] A perennial question at these things is whether we should continue identifying ourselves as “heterodox,” or just say we’re doing economics. Personally, I’ll be happy to give up the distinct heterodox identity just as soon as economists are willing to give up their distinct identity and dissolve into the larger population of social scientists, or of guys with opinions.
[2] The results for the US are symmetrical with those for Germany: the growing US trade deficit since 1990 is fully explained by more rapid US income growth relative to its trade partners. But it’s worth noting that China is not: Knowing only China’s relative income growth, which has been of course very high, you would predict that China would be moving toward trade deficits, when in fact it has ben moving toward surplus. This is consistent with a story that explains China’s trade surpluses by an undervalued currency, tho it is consistent with other stories as well.

A Greek Myth

Most days, I’m a big fan of Paul Krugman’s columns.

Unlike his economics, which makes a few too many curtsies to orthodoxy, his political interventions are righteous in tone, right-on in content, and what’s more, strategic — unlike many leftish intellectuals, he clearly cares about being useful — about saying things that are not only true, but that contribute to the concrete political struggle of the moment. He’s so much better than almost of his peers it’s not even funny.

But — well, you knew there had to be a but.

But this time, he’s gotten his economics in his politics. And the results are not pretty.

In today’s column, he rightly dismisses arguments that the root of the Euro crisis is that workers in Greece and the other peripheral countries are lazy, or unproductive, or that those countries have excessive regulation and bloated welfare states. “So how did Greece get into so much trouble?” he asks. His answer:

Blame the euro. Fifteen years ago Greece was no paradise, but it wasn’t in crisis either. Unemployment was high but not catastrophic, and the nation more or less paid its way on world markets, earning enough from exports, tourism, shipping and other sources to more or less pay for its imports. Then Greece joined the euro, and a terrible thing happened: people started believing that it was a safe place to invest. Foreign money poured into Greece, some but not all of it financing government deficits; the economy boomed; inflation rose; and Greece became increasingly uncompetitive.

I’m sorry, but the bolded sentence just is not true. The rest of it is debatable, but that sentence is flat-out false. And it matters.

The analysis behind the “earning enough” claim is found on Krugman’s blog. He writes,

One of the things you keep hearing about Greece is that if it exits the euro one way or another there will be no gains, because Greece basically can’t export — so structural reform is the only way forward. But here’s the thing: if that were true, how did Greece pay its way before the big capital flows starting coming? The truth is that before the euro and the capital flow bubble it created, Greece ran only small current account deficits (the broad definition of the trade balance, including services and factor income)…

And he offers this graph from Eurostat:

The numbers in the graph are fine, as far as they go. And there is the first problem: how far they go. Here’s the same graph, but going back to 1980.

Starting the graph ten years earlier gives a different picture — now it seems that the near-balance on current account in 1993 and 1994 wasn’t the normal state before the euro, but an exceptional occurrence in just those two years. And note that that while Greek deficits in the 1980s are small relative to those of the mid-2000s, they are still very far from anything you could reasonably describe as “the country more or less paid its way.” They are, for instance, significantly larger than the contemporaneous US current account deficits that were a central political concern in the 1980s here.

That’s the small problem; there’s a bigger one. Because, what are we looking at? The current account balance. Krugman glosses this as “the broadest measure of the trade balance,” but that’s not correct. (If he taught undergraduate macro, I’m sure he’d mark someone writing that wrong.) It’s broad, yes, but it’s a different concept, covering all international payments other than asset purchases, including some (transfers and income flows) that are not trade by any possible definition. The current account includes, for example, remittances by foreign workers to their home countries. So by Krugman’s logic here, the fact that there are lots of Mexican migrant workers in the US sending money home is a sign that Mexico is able to export successfully to the US, when in the real world it’s precisely a sign that it isn’t.

Most seriously, the current account includes transfer between governments. In the European context these are quite large. To call the subsidies that Greece received under the European Common Agricultural Policy export earnings is obviously absurd. Yet that’s what Krugman is doing.

The following graph shows how big a difference it makes when you call development assistance exports.

The blue line is the current account balance, same as in Krugman’s graph, again extended back to 1980. The red line is the current account balance not counting intergovernmental transfers. And the green line is the current account not counting any transfers. [*] It’s clear from this picture that, contra Krugman, Greece was not earning enough money to pay for its imports before the creation of the euro, or at any time in the past 30 years. If the problem Greece has to solve is getting its foreign exchange payments in line with with its foreign exchange earnings, then the bulk of the problem existed long before Greece joined the euro. The central claim of the column is simply false.

Again, it is true that Greece’s deficits got much bigger in the mid-2000s. I agree with Krugman that this must have ben connected with the large capital flows from northern to peripheral Europe that followed the creation of the euro. It remains an open question, though, how much this was due to an increase in relative costs, and how much due to more rapid income growth. By assuming it was entirely the former, Krugman is implicitly, but characteristically, assuming that except in special circumstances economies can be assumed to be operating at full capacity.

But the key point is that the historical evidence does not support the view that current account imbalances only arise when governments interfere in the natural adjustment of foreign exchange markets. Fixed rates or floating, in the absence of very large flows of intergovernmental aid Greece has never come close to current account balance. According to Krugman, Greece’s

famous lack of competitiveness is a recent development, caused by massive post-euro inflows of capital that raised costs and prices. And that’s the kind of thing that currency devaluations can cure.

The historical evidence is not consistent with this claim. Or if it is, it’s only after you go well beyond normal massaging of the data, to something you’d see on The Client List.

* * *
So why does it matter? What’s at stake? I can’t very well go praising Krugman for writing not only what’s true but what is useful, and then justify a post criticizing him on the grounds of Someone Is Wrong On the Internet. No; but there’s something real at stake here.

The basic issue is, does price adjustment solve everything? Krugman won’t quite come out and say Yes, but clearly it’s what he believes. Is he being deliberately dishonest? No, I’m sure he’s not. But this is how ideology works. He’s committed to the idea that relative costs are the fundamental story when it comes to trade, so when he finds a bit of data that seems to conform to that, he repeats it, without giving five minutes of critical reflection to what it actually means.

The basic issue, again, is the need for structural as opposed to price adjustment. Now if “structural adjustment” means lower wages, then of course Godspeed to Krugman here. I’m against structural whatever in that sense too. But I can’t help feeling that he’s pulling in the wrong direction. Because if external devaluation cures the problem then internal devaluation does too, at least in principle.

The fundamental question remains how important are relative costs. The way I see it, look at what Greece imports, most of it Greece doesn’t produce at all. The textbook expenditure-switching vision implicitly endorsed by Krugman ignores that there are different kinds of goods, or accepts what Paul Davidson calls the axiom of gross substitution, that every good is basically (convexly) interchangeable with every other. Hey Greeks will have fewer computers and no oil, but they’ll spend more time at the beach, and in terms of utility it’s all the same. Except, you know, it’s not.

From where I’m sitting, the only way for Greece to achieve current account balance with income growth comparable to Germany is for Greece to develop new industries. This, not low wages,  is the structural problem. This is the same problem faced by any developing country. And it raises the same problem that Krugman, I’m afraid, has never dealt with: how to you convince or compel the stratum that controls the social surplus to commit to the development of new industries? In the textbook world — which Krugman I’m afraid still occupies — a generic financial system channels savings to the highest-return available investment projects. In the real world, not so much. Figuring out how to get savings to investment is, on the contrary, an immensely challenging institutional problem.

So, first step dealing with it, you should read Gerschenkron. We know, anyway that probably the rich prefer to hold their wealth in liquid form, or overseas, or both. And we know that even if — unlikely — they want to invest in domestic industries, they’ll choose those that are already cost-competitive, when, we know, the whole point of development is to do stuff where you don’t, right now, have comparative advantage. So, again, it’s a problem.

There are solutions to this problem. Banks, the developmental state, even industrial dynasties. But it is a problem, and it needs to be solved. Relative prices are second order. Or so it seems to me.

[*] Unfortunately Eurostat doesn’t seem to have data breaking down nongovernmental transfer payments to Greece. I suspect that the main form of private transfers is remittances from Greek workers elsewhere in Europe, but perhaps not.

Prices and the European Crisis, Continued

In comments to yesterday’s post on exchange rates and European trade imbalances, paine (the e. e. cummings of the econosphere) says,

pk prolly buys your conclusion. notice his post basically disparaging forex adjustment solutions on grounds of short run impact. but long run adjustment requires forex changes.

I don’t know. I suppose we all agree that exchange rate changes won’t help in the short run (in fact, I’m not sure Krugman does agree), but I’m not convinced exchange rate changes will make much of a difference even in the long run; and anyway, it matters how long the long run is. When the storm is long past the ocean is flat again, and all that.

Anyway, what Krugman actually wrote was

We know that huge current account imbalances opened up when capital rushed to the European periphery after the euro was created, and reversing those imbalances must involve a large real devaluation.

We “know,” it “must”: not much wiggle room there.

So this is the question, and I think it’s an important one. Are trade imbalances in Europe the result of overvalued exchange rates in the periphery, and undervalued exchange rates in the core, which in turn result from the financial flows from north to south after 1999? And are devaluations in Greece and the other crisis countries a necessary and sufficient condition to restore a sustainable balance of trade?

It’s worth remembering that Keynes thought the answer to these kinds of questions was, in general, No. As Skidelsky puts it in the (wonderful) third volume of his Keynes biography, Keynes rejected the idea of floating exchange rates because

he did not believe that the Marshall-Lerner condition would, in general, be satisfied. This states that, for a change in the value of a country’s currency to restore equilibrium in its balance of payments, the sum of the price elasticities for its exports and imports must be more than one. [1] As Keynes explained to Henry Clay: “A small country in particular may have to accept substantially worse terms for its exports in terms of its imports if it tries to force the former by means of exchange depreciation. If, therefore, we take account of the terms of trade effect there is an optimum level of exchange such that any movement either way would cause a deterioration of the country’s merchandise balance.” Keynes was convinced that for Britain exchange depreciation would be disastrous…

Keynes’ “elasticity pessimism” is distinctly unfashionable today. It’s an article of faith in open-economy macroeconomics that depreciations improve the trade balance, despite rather weak evidence. A recent mainstream survey of the empirical literature on trade elasticities concludes,

A typical finding in the empirical literature is that import and export demand elasticities are rather low, and that the Marshall-Lerner (ML) condition does not hold. However, despite the evidence against the ML condition, the consensus is that real devaluations do improve the balance of trade. 

Theory ahead of measurement in international trade!

(Paul Davidson has a good discussion of this on pages 138-144 of his book on Keynes.)

The alternative view is that the main relationship is between trade flows and growth rates. In models of balance-of-payments-constrained growth, countries’ long-term growth rates depend on the ratio of export income-elasticity of demand and import income-elasticity of demand. More generally, while a strong short-run relationship between exchange rates and trade flows is clearly absent, and a long-run relationship is mostly speculative, the relationship between faster growth and higher imports (and vice versa) is unambiguous and immediate. [2]

So let’s look at some Greek data, keeping in mind that Greece is not necessarily representative of the rest of the European periphery. The picture below shows Greece’s merchandise and overall trade balance as percent of GDP (from the WTO; data on service trade is only available from 1980), the real exchange rate (from the BIS) and real growth rate (from the OECD; three-year moving averages). Is this a story of prices, or income?

The first thing we can say is that it is not true that Greek deficits are a product of the single currency.  Greece has been running substantial trade deficits for as far back as the numbers go. Second, it’s hard to see a relationship between the exchange rate and trade flows. It’s especially striking that the 20 percent real depreciation of the drachma from the late 1960s to the early 1970s — quite a large movement as these things go — had no discernible effect on Greek trade flows at all. The fall in income since the crisis, on the other hand, has produced a very dramatic improvement in the Greek current account, despite the fact that the real exchange rate has appreciated slightly over the period. It’s very hard to look at the right side of the figure and feel any doubt about what drives Greek trade flows, at least in the short run.

Now, it is true that, prior to the crisis, the Euro era was associated with somewhat larger Greek trade deficits than in earlier years. (As I mentioned yesterday, this is entirely due to increased imports from outside the EU.) But was this due to the real appreciation Greece experienced under the Euro, or to the faster growth? It’s hard to judge this just by looking at a figure. (That’s why God gave us econometrics — though to be honest I’m a bit skeptical about the possibility of getting a definite answer here.) But here’s a suggestive point. Greece’s real exchange rate appreciated by 25 percent between 1986 and 1996. This is even more than the appreciation after the Euro. Yet that earlier decade saw no growth of the Greek trade deficit at all. It was only when Greek growth accelerated in the early 2000s that the trade deficit swelled.

I think Yanis Varoufakis is right: It’s hard to see exit and devaluation as solutions for Greece, in either the short term or the long term. There are good reasons why, historically, European countries have almost never let their exchange rates float against each other. And it’s hard to see fixed exchange rates, in themselves, as an important cause of the crisis.

[1] Skidelsky gives the Marshall-Lerner condition in its standard form, but the reality is a bit more complicated. The simple condition applies only in cases where prices are set in the producing country and fully passed through to the destination country, and where trade is initially balanced. Also, it should really be the Marshall-Lerner-Robinson condition. Joan Robinson was robbed!

[2] Krugman wrote a very doctrinaire paper years ago rejecting the idea of balance of payments constraints on growth. I’ve quoted this here before, but it’s worth repeating:

I am simply going to dismiss a priori the argument that income elasticities determine economic growth, rather than the other way around. It just seems fundamentally implausible that over stretches of decades balance of payments problems could be preventing long term growth… Furthermore, we all know that differences in growth rates among countries are primarily determined by differences in the rate of growth of total factor productivity, not by differences in the rate of growth of employment. … Thus we are driven to supply-side explanations…
The Krugmans and DeLongs really have no one to blame but themselves for accepting that all the purest, most dogmatic orthodoxy was true in the long run, and then letting long-run growth take over the graduate macro curriculum.

UPDATE: I should add that as far as the trade balance is concerned, what matters is not just a country’s growth, but its growth relative to its trade partners. This may be why rapid Greek growth in the 1970s was not associated with a worsening trade balance — this was the trente glorieuse, when all the major European countries were experiencing similar income growth. Also, in comments, Random Lurker points to a paper suggesting that another factor in rising Greek imports was the removal of tariffs and other trade restrictions after accession to the EU. I haven’t had time to read the paper properly yet, but I wouldn’t be surprised if that is an important part of the story.

Also, I was discussing this at the bar the other night, and at the end of the conversation my very smart Brazilian friend said, “But devaluation has to work. It just has to.” And she knows this stuff far better than I do, so, maybe.

Do Prices Matter? EU Edition

The Euro crisis. One thing sensible people agree on is that the crisis has little or nothing to do with fiscal deficits  (government borrowing), and everything to do with current account deficits (international borrowing, whether public or private.) And one thing sensible people do not agree on, is how much those current account deficits are due to relative costs, or competitiveness.

A thorough dissection of competitiveness in the European context is here; Merijn Knibbe has some good posts critiquing it at the Real World Economics Review. Krugman, on the other hand, defends the competitiveness story, suggesting that the alternative to believing that relative prices drive trade flows, is believing in the “doctrine of immaculate transfer.” What he means is, the accounting identity that net capital flows equal net trade flows doesn’t in itself provide the mechanism by which trade adjusts to financial flows. A country with an increasing net financial inflow must, in an accounting sense, experience an increasing current account deficit; but you still need a story about why people choose to buy more from, or are able to sell less to, abroad.
So far, one can’t disagree; but the problem is, Krugman assumes the story has to be about relative prices. It’s not the case, though, that relative prices are the only thing that drive trade flows. At the least, incomes do too. If German wages fall, German goods may become more cost-competitive; but in any case, German workers will buy less of everything, including vacations in Greece. Similarly, if Greek wages rise, Greek goods may be priced out of international markets; but in any case Greek workers will buy more of everything, including manufactured goods from Germany. Estimating the respective impacts of relative prices and incomes on trade flows, or the elasticities approach, is one of the lost treasures of the economics of 1978. Both income and price elasticities solve the immaculate transfer problem, since capital flows from northern to southern Europe were associated with faster growth of both income and prices in the south. But their implications for policy going forward are quite different. If the problem is relative prices, a devaluation will fix it; this is what Krugman believes. If the problem is income elasticities, on the other hand, then balanced trade within Europe will require some mix of structural reforms (easier said than done), permanently faster growth in the north than the south, or — blasphemy! — restrictions on trade.
Let’s pose two alternatives, understanding that the truth, presumably, is somewhere in between. In the one case, EU current account imbalances are due entirely to countries’ over- or undervalued currencies. In the other case, current account imbalances are due entirely to differences in growth rates. One thing we do know: In the short run — a year or two — the latter is approximately true. In the short run, the Marshall-Lerner-Robinson condition is almost certainly not satisfied, so a change in prices will have the “wrong” effect on foreign exchange earnings, or at best — if the country’s imports and exports are both priced in foreign currency — have no effect. In the long run, it’s less clear. Do prices or incomes matter more? Hard to say.
So what is the evidence one way or the other? One simple suggestive strand of evidence is the intra- and extra-European trade balances of various countries in the EU. To the extent that trade flows have been driven by price, the deficit countries should have seen larger deficits with other EU countries than with other countries, and the surplus countries similarly should have seen larger surpluses within the union than outside it. Those countries whose currencies would otherwise, presumably, have appreciated relative to other EU members should have shifted their net exports towards Europe; those countries whose currencies would otherwise have depreciated should have shifted their net exports away. Is that what we see?
As is often the case with empirical work, the answer is: Yes and no. From Eurostat, here are trade balances as percent of GDP, within and outside the currency union, for selected countries and selected years.
Intra-EU Trade Balance
1999 2007-2008 2011
Germany  2.0% 4.8% 2.1%
Ireland 19.0% 7.4% 12.6%
Greece -10.0% -9.6% -5.3%
Spain -2.9% -4.0% -0.6%
France -0.3% -3.1% -4.3%
Italy 0.5% 0.5% -0.2%
Netherlands 14.8% 24.5% 27.9%
Austria -3.9% -3.0% -5.0%
Extra-EU Trade Balance
1999 2007-2008 2011
Germany  1.2% 2.8% 4.0%
Ireland 6.1% 7.8% 15.1%
Greece -3.9% -9.1% -4.4%
Spain -2.1% -5.1% -3.8%
France 1.0% -0.1% 0.0%
Italy 0.8% -1.2% -1.4%
Netherlands -11.8% -17.5% -20.5%
Austria 1.4% 2.7% 1.9%
What we see here is sort of consistent with the competitiveness story, and sort of not. Germany did increase its intra-EU net exports about twice as much as its extra-EU net exports over the pre-crisis decade, just as a story centered on relative prices would predict. And on the flipside, the fall in Irish net exports over the pre-crisis decade was entirely with other EU countries, again consistent with the Krugman story. 
But for the other countries, it’s not so simple. The increase of the Euro-era Greek deficit, for instance, was entirely the result of increased imports from non-Euro countries. Euro-area trade, and non-Euro exports, were approximately constant in the ten years from 1999. This is more consistent with a story of rapid Greek income growth, than uncompetitively high Greek prices. Similarly, the movement toward current account deficit of Spain was mostly, and of Italy entirely, a matter of trade with non-EU countries. This is not consistent with the relative-price story, which predicts that intra-EU trade imbalances should have grown relative to extra-EU imbalances. Note also that today, Germany’s net exports to the rest of the EU area are no higher than when the Euro was created, while Greece and Spain have substantially improved their intra-EU balances; but all three countries have moved further toward imbalance with extra-EU countries. This, again, is not consistent with a story in which trade imbalances are driven primarily by the relative price distortions created by the single currency.
Conclusion: Krugman is right that how much relative prices have contributed to intra-European current account imbalances, is a question on which reasonable people can disagree. But as a doctrinaire Keynesian, I remain an elasticity pessimist. It seems to me that we should at least seriously consider a story in which European current account imbalances are due to relatively rapid income growth in the periphery, and slow income growth in Germany, as opposed to changes in competitiveness. A story, in other words, in which a Greek exit from the Euro and devaluation will not do much good.
UPDATE: While I was writing this, Merijn Knibbe had more or less the same thought.

Bottom Rail, Moving Up

David Harvey observed recently that this crisis was the first in modern times in which the periphery has not borne a disproportionate share of the costs. Dani Rodrik’s recent posts make a similar point.

And it’s true — over the past 40 years, we’ve seen repeated episodes when growth has slowed in the rich world, and collapsed catastrophically in the South. Neoliberalism has meant the tools the North uses to ameliorate slumps have been forbidden to poor countries. As my friend Doug Henwood says, in each of the crises of the past two decades, “the First World banks got a Minsky bailout while the Third World suffered a Fisher deflation.” But this time really seems to be different.
It’s interesting to compare the last of those episodes, the Asian crisis of 1997, with the most recent crisis.
Whatever you think the underlying causes of the 1997 crisis were (people sure liked saying “crony capitalism”) the basic facts are straightforward. East and Southeast Asia experienced a “sudden stop” of previously large financial inflows, leaving them unable to meet their foreign-currency obligations. As a result they were forced to abandon their currency pegs, abruptly raise interest rates to unheard-of levels, and eliminate their trade deficits with extreme prejudice. The result was severe economic disruption and brutal recessions. Indonesia, for example, didn’t regain its pre-crisis level of output for a full five years.
Fast forward ten years, and the same region is a bright spot in the global growth picture. What people don’t realize, though, is that many Asian countries experienced a sudden stop of financial inflows in 2007-08 even larger than the one that caused so much destruction in 1997. Add to that a collapse in export earnings as demand in the rich countries fell, and Asian countries faced a substantially larger shock to foreign exchange earnings in 2007-2008 than ten years before.
Change in Gross Flows as Percent of Peak GDP
1997Q2-1997Q4 Peak-2008Q4
Portfolio Inflows All Forex Inflows Portfolio Inflows All Forex Inflows
Indonesia -10.6 -18.5 -6.1 -9.7
Korea -5.9 -18.0 -10.1 -29.5
Phillipines -5.4 -15.9 -9.3 -30.1
Thailand -2.5 -12.4 -6.2 -22.4
Source: IMF International Financial Statistics.
Notes: [1]
As the table shows, several of the newly industrializing countries of East Asia experienced a shock to their balance of payments in 2007-08 about double that of 1997. So why did the earlier shock have so much larger effects?
“Floating exchange rates” is the wrong answer. (“Fiscal responsibility” is worse, it’s not even wrong.) As captured in the well-known J-curve, even when exchange rates move in the right direction, they initially have the wrong effects on trade flows. Even in the most optimistic case it takes at least a year before a depreciation begins to improve the trade balance. Anyway, in the crisis this time, Asian exchange rates didn’t fall. 
In the short run at least, trade flows respond to movements in incomes, not relative prices. Replacing the trade-price relationship with a trade-income relationship is probably the key contribution of Post Keynesian analysis to the study of international finance and trade. [2] Combined with the notion of liquidity constraints — despite what the textbook says, the supply of credit is not infinitely elastic at “the” interest rate — this means there are situations where a country needs to rapidly improve its balance of payments and the only tool available (once direct import restrictions are ruled out) is to reduce income, often by some large multiple of the gap to be closed. [3] In a nutshell, that’s what happened in 1997. So why not this time?
The answer is that the Asian countries entered this crisis, unlike the last one, with large current account surpluses and foreign-exchange reserves. Countries that can respond to a negative shock to foreign exchange inflows by reducing their own accumulation of foreign assets or spending down their reserves, don’t have to reduce imports by pushing down income and output. Instead, they could and did raise domestic incomes via stimulus programs and interest-rate cuts, to offset the fall in export demand. And this is not only good news for them, it also dampens the process by which trade-induced contractions would otherwise propagate across borders.
Indeed, it’s probably precisely to be ready for this contingency that Asian countries committed themselves to running surpluses in the first place. There’s an old Martin Wolf column making this argument, which I’ll add to this post when/if I find it. It’s made more systematically in a couple recent articles by Jorg Bibow. (Bibow’s work is about the best I’ve seen on the whole question of “global imbalances”.) He argues that current account surpluses and reserve accumulation should be seen as a form of “self-insurance” by countries that have become disillusioned with the IMF as a provider of insurance against balance-of-payments shocks (its supposed raison d’etre). Bibow is fairly critical of this approach, which is natural from the point of view of someone steeped in Keynes’ ideas of a rational international order. We don’t, after all, think it would be such a great thing if people dispensed with health insurance and saved up money for future health expenses instead. But if your insurer insisted that you donate at least a kidney before they’d approve a blood transfusion, self-insurance might look like a better option.

There’s a couple important points here. First, the economic point:

The direct effects of trade flows on aggregate demand are usually dwarfed by the indirect effects, as government spending and investment adjust to accommodate the balance of payments constraint. This is why trade is not, in a Keynesian framework, a zero-sum game, and why the mewling of American economists about Asian “mercantilism” so misses the point. When capital flowed out of Asia in 1997, the whole development process had to be thrown into reverse in order to make up the shortfall in foreign exchange. That’s what happens when you’re pushed up against your balance of payments constraint. It didn’t haVppen this time because of their past ten years of self-insurance. In the US, on the other hand, the external balance doesn’t constrain expansionary fiscal policy at all, only the stupidity of our politics does.

Maybe even more important, the political point. How is it that these countries managed to reject the siren song of the Washington Consensus? After all, it promised (1) development would be so much faster with access to the savings of the rich world via unfettered financial flows; (2) if something did go wrong, the IMF loans were always available to bridge short-term foreign-exchange shortfalls; and, implicitly, (3) if things fell apart completely, unrestricted financial flows would ensure that elites could extract their wealth from a wrecked economy.

Around 1990, when I was first becoming aware of politics, we took it for granted that the IMF was one of the great forces for evil in the world. And you know what? I think we were right.

Which makes it all the more remarkable that some substantial fraction of the world has managed to tear itself free of those usurers. In principle, there’s the potential for progressive struggle whenever the sociological basis of a form of political consciousness requires it to cohere somewhere beneath the top of a value chain. But in practice, it’s hard to do. Much easier for the representatives of a subordinate class or geography to constitute themselves as an agent of the elites above rather than the masses below. So while self-insurance via reserve accumulation might seem like a small step towards socialism, I think it’s kind of a big deal. Economically, you have to recognize that Asian economies are not in depression now thanks to prudential state action, not the pseudo-logic of “conditional convergence”. And politically it’s even more remarkable, in the scale of things, that Asian elites have been able even to this extent to identify themselves with their national economies rather than the global owning class.

[1] “All Forex Inflows” is the sum of gross portfolio inflows, inward FDI, other inward investment and exports. (The gross numbers are conceptually the correct ones, for reasons I can’t explain here but hopefully are obvious.) The peak quarter is 1997Q2 for the 1997 crisis. For the recent crisis it is  2008Q2 for Indonesia, 2007Q4 for Korea, 2007Q2 for the Philippines and 2008Q1 for Thailand. The IMF does not have data for Malaysia prior to 1999.

[2] As on so many topics, Joan Robinson’s contribution is essential and mostly unacknowledged.

[3] The ratio of the necessary fall in output to the balance of payments gap to be closed is equal to one over the marginal propensity to import. Countries in this situation almost always sharply raise the domestic rate of interest, which theoretically helps attract short-term financial flows to bridge the gap, but in practice is mostly just a mechanism to reduce domestic incomes.

Trade: The New Normal Was the Old Normal Too

Matthew Yglesias is puzzled by

the fundamental weirdness of having so much savings flowing uphill from poor, fast-growing countries into the rich, mature economy of the United States. It ought to be the case that people in fast-growing countries are eager to consume more than they produce, knowing that they’ll be much richer in the near future. And it ought to be the case that people in rich countries are eager to invest in poor ones seeking higher returns. But it’s not what was happening pre-crisis and it’s not what’s been happening post-crisis.

He should have added: And it’s not what’s ever happened.

I’m not sure what “ought” is doing in this passage. If it expresses pious hope, fine. But if it’s supposed to be a claim about what’s normal or usual, as the contrast with “weirdness” would suggest, then it just ain’t so. Sure, in some very artifical textbook models savings flow from rich countries to poor ones. But it has never been the case, since the world economy came into being in the 19th century, that unregulated capital flows have behaved the way they “ought” to.

Albert Fishlow’s paper “Lessons from the Past: Capital Markets During the 19th Century and the Interwar Period” includes a series for the net resources transferred from creditor to debtor countries from the mid-19th century up to the second world war. (That is, new investment minus interest and dividends on existing investment.) This series turns negative sometime between 1870 and 1885, and remains so through the end of the 1930s. For 50 years — the Gold Standard age of stable exchange rates, flexible prices, free trade and unregulated capital flows — the poor countries were consistently transferring resources to the rich ones. In other words, what Yglesias sees as the “fundamental weirdness” of the current period is the normal historical pattern. Or as Fishlow puts it:

Despite the rapid prewar growth in the stock of foreign capital, at an annual average rate of 4.6 percent between 1870 and 1913, foreign investment did not fully keep up with the reflow of income from interest and dividends. Return income flowed at a rate close to 5 percent a year on outstanding balances, meaning that on average creditors transferred no resources to debtor nations over the period. … Such an aggregate result casts doubt on the conventional description of the regular debt cycle that capital recipients were supposed to experience. … most [developing] countries experienced only brief periods of import surplus [i.e. current account deficit]. For most of the time they were compelled to export more than they imported in order to meet their debt payments.

A similar situation existed for much of the post World War II period, especially after the secular increase in world interest rates around 1980.

There is a difference between the old pattern (which still applies to much of the global south) and the new one. Then, net-debtor poor countries  ran current account surpluses to make payments on their high-yielding liabilities to rich countries. Now, net-creditor (relatively-) poor countries run current account surpluses to accumulate low-yielding assets in rich countries. I would argue there are reasons to prefer the new pattern to the old one. But the flow of real resources is unchanged: from the periphery to the center. Meanwhile, those countries that have successfully industrialized, as scholars like Ha-Joon Chang have shown, have done so not by accessing foreign savings by connecting with the world financial system, but by keeping their own savings at home by disconnecting from it.

It seems that an unregulated international finance doesn’t benevolently put the world’s collective savings to the best use for everyone, but instead channels wealth from the poor to the rich. That may not be the way things ought to be, but historically it’s pretty clearly the way things are.

Krugman: Irish Monk or Norse Raider?

Paul Krugman is fond of describing the current state of macroeconomics as a dark age — starting around 1980, the past 50 years’ progress in economics was forgotten. True that. If we want to tell a coherent story about the operation of modern capitalist economies, we could do a lot worse than start with the mainstream macro of 1978.

Thing is, as Steve Keen among others has pointed out, liberal New Keynesians like Krugman are every bit as responsible for that Dark Age as their rivals at Chicago and Minnesota. Case in point: His widely-cited 1989 paper on Income Elasticities and Real Exchange Rates. The starting point of the paper is that floating exchange rates have not, in general, adjusted to balance trade flows. Instead, relative growth rates have roughly matched the growth in relative demand for exports, so that trade flows have remained roughly balanced without systematic currency appreciation in surplus countries or depreciation in deficit countries. Krugman:

The empirical regularity is that the apparent income elasticities of demand for a country’s imports and exports are systematically related to the country’s long-term rate of growth. Fast-growing countries seem to face a high income elasticity of demand for their exports, while having a low income elasticity of demand for imports. The converse is true of slow-growing countries. This difference in income elasticities is, it turns out, just about sufficient to make trend changes in real exchange rates unnecessary.

The obvious explanation of this regularity, going back at least to 1933 and Roy Harrod’s International Economics, is that many countries face balance-of-payments constraints, so their growth is limited by their export earnings. Faster growth draws in more imports, forcing the authorities to increase interest rates or take other steps that reduce growth back under the constraint. There are plenty of clear historical examples of this dynamic, for both poor and industrialized countries. The British economy between the 1940s and the 1980s, for instance, repeatedly experienced episodes of start-stop growth as Keynesian stimulus ran up against balance of payments constraints. Krugman, though, is having none of it:

 I am simply going to dismiss a priori the argument that income elasticities determine economic growth… It just seems fundamentally implausible that over stretches of decades balance of payments problems could be preventing long term growth… Furthermore, we all know that differences in growth rates among countries are primarily determined in the rate of growth of total factor productivity, not differences in the rate of growth of employment; it is hard to see what channel links balance of payments due to unfavorable income elasticities to total factor productivity growth. Thus we are driven to a supply-side explanation…

Lucas or Sargent couldn’t have said it better!

Of course there is a vast literature on balance of payments constraints within structuralist and Post Keynesian economics, exploring when external constraints do and do not bind  (see for instance here and here), and what channels might link demand conditions to productivity growth. [1] Indeed, Keynes himself thought that avoiding balance-of-payments constraints on growth was the most important goal in the design of a postwar international financial order. But Krugman doesn’t cite any of this literature. [2] Instead, he comes up with a highly artificial model of product differentiation in which every country consumes an identical basket of goods, which always includes goods from different countries in proportion to their productive capacities. In this model, measured income elasticities actually reflect changes in supply. But the model has no relation to actual trade patterns, as Krugman more or less admits. Widespread balance of payments constraints, the explanation he rejects “a priori,” is far more parsimonious and realistic.

But I’m not writing this post just to mock one bad article that Krugman wrote 20 years ago. (Well, maybe a little.) Rather, I want to make two points.

First, this piece exhibits all the pathologies that Krugman attributes to freshwater macroeconomists — the privileging of theoretical priors over historical evidence; the exclusive use of deductive reasoning; the insistence on supply-side explanations, however implausible, over demand-side ones; and the scrupulous ignorance of alternative approaches. Someone who at the pinnacle of his career was writing like this needs to take some responsibility for the current state of macroeconomics. As far as I know, Krugman never has.

Second, there’s a real cost to this sort of thing. I constantly have these debates with friends closer to the economics mainstream, about why one should define oneself as “heterodox”. Wouldn’t it be better to do like Krugman, clamber as far up the professional ladder as you can, and then use that perch to sound the alarm? But the work you do doesn’t just affect your own career. Every time you write an article, like this one, embracing the conventional general-equilibrium vision and dismissing the Keynesian (or other) alternatives, you’re sending a signal to your colleagues and students about what kind of economics you think is worth doing. You’re inserting yourself into some conversations and cutting yourself off from others. Sure, if you’re Clark medal-winning Nobelist NYT columnist Paul Krugman, you can turn around and reintroduce Keynesian dynamics in some ad hoc way whenever you want.  But if you’ve spent the past two decade denigrating and dismissing more  systematic attempts to develop such models, you shouldn’t complain when  you find you have no one to talk to. Or as a friend says, “If you kick out Joan Robinson  and let Casey Mulligan in the room, don’t be surprised if you spend all  your time trying to explain why the unemployed aren’t on vacation.”

[1] “In practice there are many channels linking slow growth imposed by a balance of payments constraint to low productivity, and the opposite, where the possibility of fast output growth unhindered by balance-of-payments problems leads to fast productivity growth. There is a rich literature on export-led growth models (including the Hicks supermultiplier), incorporating the notion of circular and cumulative causation (Myrdal 1957) working through induced investment, embodied technical progress, learning by doing, scale economies, etc. (Dixon and Thirlwall, 1975) that will produce fast productivity growth in countries where exports and output are growing fast. The evidence testing Verdoorn’s Law shows a strong feedback from output growth to productivity growth.”

[2] Who was it who talked about “the phenomenon of well-known economists ‘rediscovering’ [various supply-side stories], not because  they’ve transcended the Keynesian refutation of these views, but because  they were unaware that there had ever been such a debate”?

Do Prices Matter?

Do exchange rates drive trade flows? Yes, says Dean Baker David Rosnick. Prices matter:

What happens to the economy as the dollar falls? …Over time, Americans notice that British goods have become more expensive in comparison to domestically produced goods. In other words, the price of U.S.-made sweaters becomes cheaper relative to the price of sweaters imported from Britain. This will lead us to buy fewer sweaters from Britain and more domestically manufactured sweaters.

At the same time, the British notice that American goods have become relatively inexpensive in comparison to goods made at home. This means it takes fewer pounds to buy a sweater made in the United States, so the British will buy more sweaters made in the United States and fewer of their domestically manufactured sweaters.

While American producers notice the increased demand for their exports, allowing them to raise their prices somewhat and still sell more than they had before the dollar fell. Similarly, for British exporters to continue selling they must lower prices.
Thus, as everyone eventually adjusts to the fall in the dollar, the trade deficit shrinks. This is not new economics by any stretch…

Indeed it’s not. Changes in prices induce changes in transaction volumes that smoothly restore equilibrium, is the first article of the economist’s catechism. But how much a given volume responds to a given price change, and whether the response is reliable and strong enough to make the resulting equilibrium relevant to real economies, are empirical questions. You could tell a similar parable about an increase in the minimum wage leading to a lower demand for low-wage labor, but as I’m sure Dean folks at CEPR would agree, that doesn’t it mean it’s what we actually see. You have to look at the evidence.

So what’s the evidence on this point? Dean Rosnick offers a graph showing two big falls in the value of the dollar after peaks in the mid-80s and mid-2000s, and falls in the trade deficit a few years later, in the early 90s and late 2000s. Early 90s and late 2000s … hm, what else was happening in those years? Oh, right, deep recessions. (The early 2000s recession was very mild.) Funny that the same guy who’s constantly chastising economists for ignoring the growth and collapse of a huge housing bubble, when he turns to trade … ignores a huge housing bubble.

Still, isn’t the picture is basically consistent with the story that when the dollar declines, US imports get more expensive and fall, and US exports get cheaper and rise? Not necessarily: Dean’s Rosnick’s graph doesn’t show imports and exports separately. And when we separate them out, we see something funny.

Click the graph to make it legible.

In a world where trade flows were mainly governed by exchange rates, a country’s imports and exports would show a negative correlation. After all, the same exchange-rate change that makes exports more expensive on world markets makes imports cheaper here, and vice versa. But that isn’t what we see at all. Except in the 1980s (when the exchange rate clearly did matter, but not in the way Dean Rosnick supposes; see Robert Blecker) exports and imports very clearly move together. And it’s not just a matter of a long-term rise in both imports and exports. Every period that saw a significant fall in imports — 1980-1984; 2000-2002; 2007-2009 — saw a large fall in exports as well. This is simply not what happens in a world where prices (are the main things that) matter.

(This discrepancy between real-world trade patterns and the textbook vision applies to almost all industrialized countries, and always has. It was noticed long ago by Robert Triffin, who brought it up to argue that movements in relative price levels did not govern trade patterns under the gold standard, as Ricardo and his successors had claimed. But it is just a strong counterargument to today’s conventional wisdom that exchange rates govern trade.)

So if changes in exchange rates don’t drive trade, what does? Lots of things, many of them no doubt hard to measure, or to influence through policy. But one obvious candidate is changes in incomes. One of the big advances of the first generation of Keynesian economists — people like Triffin, and especially Joan Robinson — was to show how, just as prices (the wage and interest rates) fail to equilibrate the domestic economy, leaving aggregate income to adjust, relative prices internationally don’t equilibrate the global economy, leaving output or growth rates to adjust. In the short run, business cycle-type fluctuations reliably involve changes in investment and consumer-durable purchases larger disproportionate to the change in output as a whole; given the mix of traded and non-trade goods for most countries, this creates an allometry in which short-run changes in output are accompanied by even larger short-run changes in imports and exports. For a country that runs a trade deficit in “normal” times, this means that recessions are reliably associated with smaller deficits and booms with larger ones. In the long run, there is also a reliable tendency for increments to income to involve demand for a changing mix of goods, with a greater share of demand falling on “leading sectors,” historically manufactured goods. (The flipside of this is Engels’ law, which states that the share of income spent on food falls as income rises.) Given that both a country’s mix of industries and its trade partners are relatively fixed, this creates a stable relationship between relative growth rates and trade balance movements. Neither of these channels is perfectly reliable, by any means — and the whole point of the industrial policy is to circumvent the second one — but they are still much stronger influences on trade flows than exchange rates (or other relative prices) are.

So with that in mind, let’s look at another version of the graph. This one shows the year-over-year change in the trade balance as a share of GDP, the same change as predicted by an OLS regression on total GDP growth over the past three years, and as predicted by the change in the value of the dollar over the past three years. [1]

It will be legible if you click it.

Not surprisingly, neither prediction gives a terribly close fit. But qualitatively, at least, the predictions based on GDP do a reasonable job: They capture every major worsening and improvement in the trade balance. True, they under-predict the improvement in the trade balance in the later 80s — the Plaza Accords mattered — but it’s clear that if you knew the rate of GDP growth over the next three years, you could make a reasonably reliable prediction about the the behavior of the trade balance. Knowing the change in the value of the dollar, on the other hand,wouldn’t help you much at all. (And just to be clear, this isn’t about the particular choice of three years. Two years and four years look roughly similar, and at a one-year horizon exchange rates aren’t predictive at all.)

Here’s another presentation of the same data, a scatterplot comparing the three-year change in the trade balance to the three-year growth of GDP (blue, left axis) and three-year change in the exchange rate (red, right axis). Again, while the correlation is fairly loose for both, it’s clearly tighter for GDP. All the periods of strongest improvement in the trade balance are associated with weak GDP growth, and vice versa; similarly all the periods of strong GDP growth are associated with worsening of the trade balance, and vice versa. There’s no such consistent association for the trade balance and changes in the exchange rate.

If you want to be able to read the graph, you should click it.

The fit could be improved by using some measure of disposable income — ideally adjusted for wealth effects — in place of GDP, and by using some better measure of relative prices in place of the exchange-rate index — altho there’s some controversy about what that better measure would be. And theoretically, instead of just the three-year change, you should use the individual lags.

Still, the takeaway, if you’re a policymaker, is clear. If you want to improve the trade balance, slower growth is the way to go. And if you want to boost growth, you probably are going to have to ignore the trade balance. Personally, I want door number two. I assume Dean Rosnick doesn’t want door one. But what I’m not at all sure about, is what concrete evidence makes him think that exchange-rate policy opens up a third door.

[1] Technicalities. I separately regressed the changes in imports and exports (as a percent of GDP) over three years earlier, on the percentage change over the same period in GDP and in the Fed’s trade-weighted major-partners dollar index, respectively. It’s all quarterly data, downloaded from FRED. The graphs shows the predicted values from the two regressions. This is admittedly crude, but I would argue that the more sophisticated approaches are in some respects less appropriate for the specific question being addressed here. For example, suppose hypothetically that a currency devaluation really did tend to improve the trade balance, but that it also tended to raise GDP growth, raising imports and offsetting the initial improvement. From an analytic standpoint, it might be appropriate to correct for the induced GDP change to get a better estimate of the pure exchange-rate effect. But from a policy perspective, the offsetting growth-imports effect has to be taken into account in evaluating the effects of a devaluation, just as much as the initial trade-balance improvement. Maybe we should say: Academics are interested in partial derivatives, policymakers in total derivatives?
EDIT: Oops! How did I not notice that this article was by somebody named David Rosnick, not Dean Baker? Makes me feel a bit better — I know Dean does share this article’s basic view of trade and the dollar, but I would hope his take would be a little less dependent on textbook syllogisms, and a little more attentive to actual patterns of trade. Clothing from the UK is hardly representative of US imports; to the extent we do import any, it’s like to be high-end branded stuff that is particularly price-inelastic.

Egypt and Exorbitant Privilege

Interesting article on how Mubarak spent his last days in office:

Hosni Mubarak used the 18 days it took for protesters to topple him to shift his vast wealth into untraceable accounts overseas, Western intelligence sources have said. The former Egyptian president is accused of amassing a fortune of more than £3 billion – although some suggest it could be as much as £40 billion – during his 30 years in power. It is claimed his wealth was tied up in foreign banks, investments, bullion and properties in London, New York, Paris and Beverly Hills. In the knowledge his downfall was imminent, Mr Mubarak is understood to have attempted to place his assets out of reach of potential investigators.

On Friday night Swiss authorities announced they were freezing any assets Mubarak and his family may hold in the country’s banks while pressure was growing for the UK to do the same. Mr Mubarak has strong connections to London and it is thought many millions of pounds are stashed in the UK.

But a senior Western intelligence source claimed that Mubarak had begun moving his fortune in recent weeks. “We’re aware of some urgent conversations within the Mubarak family about how to save these assets,” said the source, “And we think their financial advisers have moved some of the money around. If he had real money in Zurich, it may be gone by now.”

Interesting, of course, as a reminder of what it means, practically, to be “our son of a bitch.” But also interesting, if you’re an economist, for the light it throws on another exorbitant privilege — that of the dollar.

This is the empirically well-established fact that US assets abroad consistently earn higher returns than foreign assets in the US. This differential is an important pillar of the continued (and, for my money, likely to continue for some time) role of the dollar as a reserve currency: Even large US current account deficits don’t lead to cumulating interest payments abroad. But why foreign investors in the US get such comparatively low returns — in one year in the late ’90s the total return on foreign assets in the US was actually negative — remains a bit of a mystery.

Seems to me the Mubarak story points toward (part of) the answer. I have no idea how realistic the higher figure for his fortune is, but it’s a big number — roughly equivalent to a year’s worth of Egyptian imports. [1] And of course Mubarak presumably isn’t the only Egyptian whose bank balance might not go over well in Tahrir Square. For these “foreign investors”, the chance of holding onto their assets when the people they were stolen from ask for them back, has got to be a major component of expected return. And by and large, that means keeping them in forms denominated in dollars. Along with central banks reserves, I reckon this is going to be a substantial portion of net demand for US assets that is relatively insensitive to yield. Enough to explain a significant part of the lower return on foreigners’ assets here? I don’t know. Could be. But the bigger point is, reserve currency is a political status. I haven’t read Barry Eichengreen’s new book yet — it’s in the pile on my desk — but hopefully the Mubaraks of the world will get a central role in his story.

[1] It would be better to compare it to the country’s total stock of foreign assets, but I don’t know where to find that number for Egypt.

Something That Doesn’t Stop Can Go On Forever

Here’s an interesting factoid I came across, while poking around in the trade data (here):

Australia has had a a current account deficit in 48 out of the 50 years since 1960. [1]

These aren’t small deficits, either: They average 3 percent of GDP. And yet, where’s the pressure to increase net exports? Where’s the currency crisis, where’s the collapse of the Australian dollar? (In fact, it’s at its highest level in more than 30 years, per the BIS.) Where’s the unsustainable debt? I know nothing about the Australian economy, but it’s hard not to wonder, if a big current account deficit is sustainable for 50 years, why not 100? Why not indefinitely?

It’s a question that people who think that current account balance is the master key to the macroeconomy, really ought to think about.

[1] The exceptions are 1972 and 1973.