break-of-bulk blogging

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.

Davies on the Disorder in Europe

My friend Jen writes about informal labor markets in South Africa. She was telling me the other day about street vendors who make their living buying packs of a dozen pairs of socks and selling them pair by pair. In that same spirit of finding a niche in the very last step of the distribution network, I thought I would pass on some material from a talk I attended last week by Sir Howard Davies. It’s below the fold, with occasional comments from me in brackets. A lot may seem familiar, but enough was new to me — and Davies is high enough up in this world; he’d had dinner the night before with Charles Dallara — that I think it’s worthwhile to put down my notes in full.

There are six and half questions to ask about the Euro system. Is the crisis over? Why did anyone think it would work? Why did it take so long to fall apart? Are the responses to date sufficient? What more is needed? Why even bother? And the half question, what’s it all mean for the UK?

To question 1, no surprise, the answer is No. “The ECB has been making really good policy for a country that doesn’t exist.” The fundamental problem of pan-European banks with no pan-European regulator or lender of last resort is no closer to being resolved; “some sticking-plaster has been applied,” that’s all.

On question 2, there were three reasons:

Some people said, “Yes, you will need a fiscal authority, but it will happen.” Europe policy in general has developed through a process of leap forward, then retrofit. And after all, it says right in the treaty “Ever closer union.”

Other people thought the stability and growth pact would ensure appropriate policy.

A third group of people, including Davies, believed something like, “Yes, these economies are very different, with different labor market institutions and so on, but without the option of devaluation they will be forced to converge.” Periodic devaluations had allowed southern European countries to avoid structural reform, but now everyone would have to behave like the Germans.

Well, all these views were wrong. Why? Three reasons:

– Maastricht turned out to be the high point of enthusiasm for federalism. Every single vote on additional federalism has said, No.

– The SGP turned out to be both too tight, in that it didn’t leave enough space for countercyclical fiscal policy, and too loose, in that it had no enforcement mechanism. [So it sounds like Davies would be on board with John Quiggin’s “hard Keynesianism.”]

– Lower interest rates were not used for fiscal consolidation. [This seems wrong to me, at least for Italy and Spain.] And there was no convergence to German levels of productivity.

On question 3, the first answer was that the first decade of the euro was, in Mervyn King’s unfelicitous coinage, NICE — Non-Inflationary with Consistent Expansion. And the ECB, while prohibited from buying government bonds directly, bought them in secondary markets at equal rates, meaning there was no pressure for fiscal discipline on member states. [Again, I’m resistant to this story, except for Greece and maybe Portugal.] Davies recalls talking to a Morgan Stanley bond dude, explaining how he marketed Greek debt: “A Greek bond is just like a German bund, except with an extra three points of interest.” There was a real market failure here, says Davies, and the banks that ended up holding this stuff (all European, by the way, American institutions have successfully elimianted almost all their exposure) deserve their haircuts.

[It would be interesting to explore the idea that an unsustainable current account deficit is precisely one that can only be financed with an interest rate premium.]

Question 4, the adequacy of the response. “The problem is that they are focused on the last crisis and the next crisis, but not on the current crisis.” By which he means that they are putting in place rules that would have helped if they’d already been in place years ago, while ignoring the ways in which “responsible” fiscal policy will exacerbate the current downturn. The problem right now is that austerity just makes the growth picture worse, and that the European “rescue capacity” is too small.

Question 5, what more is needed. In the short run, a better firewall is needed to prevent contagion from the worst-hit countries and institutions. In the longer run, Europe needs (a) some system for Europe-wide public borrowing (one idea would be for debt up to, but not above, the SGP levels to be backed by the community as a whole); and (b) a pan-European bank regulator and lender of last resort. But the Germans won’t go for it.

Which brings us to Question 6. Wouldn’t some countries be better off leaving? Greece’s departure is probably inevitable, he said. But it poses major challenges — even if you had an agreed-on procedure for converting Greek euros to the new Greek currency, which euros are the Greek ones? “If the coin says Greece, no problem. Greek government bonds, ok, those are Greek. And if you are living in Greece and have an account in a Greek bank, then that is probably a Greek euro. But, I have a boat in Greece and an account at Barclay’s in Athens. Are those Greek euros? I hope not. How about someone living in Athens but with a bank account in London, is that a Greek euro?” And beyond those technical problems, there are even worse political problems, that should make exit the last possible resort. Because, who will benefit from the failure of the euro, politically? In France, the fascists — Marie le Pen based her whole campaign around it. “In Greece, it would be the anarchists and the communists, they’re the only ones who have been against the euro.” [OH NOES the anarchists.] The communists in Hungary, Sinn Fein in Ireland, etc. “Only in the UK can you say that the Euro-skeptics are not mad people.”

Nonetheless, Greek exit is probably unavoidable. “My hunch is that Greece will not make it,” because they lack social capital. The Irish are stoic, they will accept lower pay and higher taxes. They say, ah well, we had a good few years but it had to end. Not the Greeks, they won’t pay taxes. [There was a shaggy-dog story in here about local officials in Spain and Greece competing to see who can waste more EU money.] Gas costs $6 a gallon in Greece because it’s almost the only thing the government can reliably tax. “Latvia could make austerity work because they’d been in the USSR for 50 years, they were used to unpleasant and dramatic things happening. The population would accept incredible privation.” The Greek population, sadly, will not.

And on the last half question: If the solution is “more Europe,” that will be a big problem for the UK. Cameron is a Euro-skeptic; it’s not just because he’s responding to popular opinion, but nonetheless popular opinion is heading that way. The UK is going to face increasing pressure to detach itself from the EU.

And a few other observations, from the Q&A:

“You can’t imagine Italy having an unelected government for long, but they are urgently engaged in some necessary reforms that would otherwise be impossible.”

There has never been a referendum in favor of the euro.

German wages have not gone up, German property values have not gone up, why should ordinary Germans feel like they are the beneficiaries of the euro and want to do more to save it? [Sounds like an argument for Thomas Jørgensen’s “Drink finer wines, drive nicer cars, and party harder!” platform.]

Most likely, Greece will have a disorderly exit, and that will concentrate the minds of European policymakers to take the necessary steps to prevent a repeat. Avoiding future defaults will require some kind of collective guarantee of Euro-area bonds, but Germans won’t accept that until it’s clear that the altenrative is catastrophe. So, “Greece may have to perform this service.”

The alternative is for Greece to do what Latvia did, structural reforms, get rid of anti-competitive policies. The problem is, you don’t have a full technocratic government in Greece, you still have elected officials with real power. [And that, I think, is what it all comes down to.]