The Slack Wire

A Bit More on China

Mike Konczal points me to this interesting piece by Walker Frost in The American Scene, on the Chinese currency peg. I asked earlier how much Chinese appreciation would boost US demand (more on that below). But there’s a prior question, which is whether an end to Chinese currency intervention would lead to appreciation at all. As Frost points out, the dollar purchases by the central bank coexist with restrictions on private investment abroad and strong incentives for FDI by foreign firms. These policies increase net capital inflows and therefore tend to raise the value of the Chinese currency; the Chinese central bank then pushes it back down with its dollar purchases. It’s far from clear which of these effects is stronger, and therefore, whether an across-the-board liberalization would lead the Chinese currency to rise against the dollar, or to fall. In short, we should see Chinese currency interventions not as part of an export-led growth strategy that requires a current-account surplus, but as part of an investment-led growth strategy that would otherwise tend to produce a current-account deficit. [1]

This is a point Anwar Shaikh has also made, when I’ve discussed this stuff with him. Don’t talk about undervaluation, he says, that implies some known free-market equilibrium exchange rate, and there isn’t one; talk about stabilization instead.

Another interesting discussion of the Chinese currency peg is in this Deutsche Bank report, which tends to confirm my skepticism about the effect of currency adjustment on US-China trade flows. They note that “RMB appreciation tends to … reduce nominal wages in the export sector,” confirming my sense that exchange rate changes don’t reliably move relative costs. And they use an estimate of -0.6 for exchange rate elasticity of Chinese exports. I don’t want to put too much weight on this number — I’m not sure how it’s derived — and they don’t give any estiamtes for US-China flows specifically; but given the well-established empirical fact that exchange-rate elasticity is unsually low for US imports, we have to conclude that the number for Chinese exports to the US is substantially lower. So if you believe the Deutsche Bank number for Chinese exports as a whole, my estimate of -0.17 for Chinese exports to the US is probably in the right ballpark. Which, again, means that even a very large Chinese appreciation would have only a trivial impact on US aggregate demand.

[1] The same goes for tariffs and other trade restrictions imposed by Latin American countries as part of import-substitution industrialization.

… and How About a Higher Yuan?

Another day, another Paul Krugman post blaming China for US unemployment. And maybe he’s right. But it would be nice to see some numbers.

On the same lines as my earlier post about the effect of dollar devaluation on aggregate demand, we can make a rough estimate of trade elasticities to calculate the effect of a Chinese revaluation.

Unfortunately, there aren’t many recent estimates of bilateral trade elasticities between the US and China. But common sense can get us quite a ways here. In recent years, US imports from China have run around 2 percent of GDP, and US exports to China a bit under 0.5 percent. So even if we assume that (1) a change in the nominal exchange rate is reflected one for one in the real exchange rate, i.e. that it doesn’t affect Chinese prices or wages at all; (2) a change in the real exchange rate is passed one for one into prices of Chinese imports in the US; (3) Chinese goods compete only with American-made goods, and not with those of other exporters; and (4) the price elasticity of US imports from China is a very high 4.0; then a 20 percent appreciation of the Chinese currency still boosts US demand by less than 1 percent of GDP.

And of course, those are all wildly optimistic assumptions. My own simple error-correction model, using 1993-2010 data on US imports from China and the relative CPI-deflated bilateral exchange rate, gives an import elasticity of just 0.17. [1] If the real figure is in that range, then a Chinese appreciation of 20 percent will reduce our imports from China by just 0.03 percent of GDP — and of course much of even that tiny demand shift will be to goods from other low-wage exporters.

I don’t claim my estimate is correct. But is it too much to ask that Krugman tell us what estimates he is using, that have convinced him that the best way to help US workers is to foment a trade war with China?

[1] This is a real exchange-rate elasticity, not a price elasticity, so it accounts for incomplete passthrough and offsetting movements in Chinese real wages. It assumes, however, that changes in the nominal exchange rate don’t affect inflation in either country; to that extent, it’s more likely an overestimate than an underestimate

How Much Would a Lower Dollar Boost Demand?

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

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

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

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

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

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

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

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

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

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

Robert and Frank

Quote of the day: “Robert and Frank were like two peas in a pod — only they were like the peas in Mendel’s genetic crosses , one smooth and one wrinkled.” From an LRB review of a new biography of Frank Oppenheimer, brother of Robert, CP member, experimental (rather than theoretical) physicist, and — I had not known this; I have fond memories of my visit there when I was 12 or 13 — founder of the Exploratorium.

The reviewer was presumably thinking of Genesis 27 as well as Mendel. Certainly there’s something biblical about the Oppenheimer brothers. At Trinity, Robert famously quoted, or anyway later recalled or imagined quoting, the Upanishads: “I am become death, destroyer of worlds.” Frank recalled it differently: “I think we just said: ‘It worked.'”

Liberal : theoretical : classicist :: communist : experimental : pragmatist. Doesn’t one major axis of the 20th century lie right down that line? Frank described his job on the Manhattan Project as “training people to fix what broke, redesigning things when necessary, and ensuring that no one slacked off on the job.” Mutatis mutandis, wouldn’t most communists have described their work the same?

Disagreement with the World

There’s a very fine interview with Argentine historian Adolfo Gilly in the new New Left Review. I especially liked this:

One is led to rebellion by sentiments, not by thoughts. At the end of his statement to the Dewey Commission, Trotsky described being drawn to the workers’ quarters in Nikolayev at the age of eighteen by his “faith in reason, in truth, in human solidarity,” not by Marxism. But perhaps the most crucial sentiment is that of justice — the realization that you are not in agreement with this world. There is a story that Ernst Bloch was once asked by his supervisor, Georg Simmel, to provide a one-page summary of his thesis before Simmel would agree to work on it. A week later, Bloch obliged with one sentence: “What exists cannot be true.”

Yes. The sense that there is something radically wrong, something intolerable, about the world as it exists, is the deep spring from which the strongest political commitments flow.

(I was also interested by Gilly’s claim that in 1960, when he became involved with the Algerian struggle for independence, official Communist parties were hostile because “Moscow characterized the Algerian war of independence as a bourgeois nationalist movement which deserved no backing.” It’s certainly true that the Soviet Union was very slow to support the Algerians; but Alistair Horne argues, I think plausibly, that this was mainly because they wanted to build on a their good relationship with De Gaulle’s France, and also because the French CP, with its strong base among working-class pied noirs, was divided on the war; and not because of any judgment about the character of the Algerian independence movement itself. It’s characteristic — and not unappealing — that a Trotskyist downplays these practical-political considerations and instead sees a difference of ideology.)

Wind, Rising

Here’s an interesting datapoint: According to the US Energy Information Agency, fully 50 percent of the net new electricity generation capacity added in 2008, was from wind power. (8,300 megawatts of a total of 19,000 megawatts of new capacity; but 2,600 megwatss worth of fossil-fuel capacity was retired.) This is very exciting; it’s clear that, despite some truly foolish opposition (what’s wrong with those people? wind turbines are beautiful), wind power has reached takeoff as a commercially viable industry.

If we are going to preserve a habitable planet, a big challenge is threading the line between complacency and despair. So it’s important to balance the bad news about the scope of the problem, with good news about its solvability.

(If you want to bend the stick back the other way, you could pick up James Hansen’s Storms of My Grandchildren and read the chapter on the Venus syndrome. Terrifying.)

Roubini, Deflationist

Last week, Nouriel Roubini wrote a somewhat puzzling op-ed in the Washington Post, in support of a payroll tax cut as a stimulus measure.

It’s a rather strange argument, or mix of arguments, since he’s never clear whether it’s a demand-side or supply-side policy. For example, he argues both that the cut should be higher for low-income workers (since they have a higher propensity to consume), and that “to maximize the incentives for private-sector hiring, there should be sharper reductions to the payroll taxes paid by employers than for those paid by employees.”

But let’s take the supply-side half of Roubini’s argument at face value. Suppose a payroll tax cut lowered the cost of labor to employers. Is it so obvious that would increase employment?

The implicit model Roubini is using is the one every undergraduate learns, of a firm in a perfectly competitive market with increasing marginal costs. But in the real world firms face downward-sloping demand curves, especially in recessions. So the only way a reduction of labor costs can increase hiring is if it allows firms to lower costs, i.e. contributes to deflation. Does Roubini really think that more deflation is what the economy needs? (Does he even realize that’s what he’s arguing?)

This, anyway, was my reaction when I read the piece. But it wouldn’t be worth dragging out a week-old op-ed to take shots at, if my friend Arin hadn’t pointed out a recent NY Fed working paper by Gauti Eggerston making exactly this point. From the abstract: “Tax cuts can deepen a recession if the short term nominal interest rate is zero, according to a standard New Keynesian business cycle model. An example of a contractionary tax cut is a reduction in taxes on wages. This tax cut deepens a recession because it increases deflationary pressures.” The paper itself involves building up a complicated model from microfoundations (that’s why Eggerston gets paid the big bucks) but the underlying intuition is the same: The only way a decrease in labor costs can lead to increased hiring is by lowering prices, and under current conditions lower prices can only mean lower aggregate demand.

As Arin points out, the incoherence of the argument for payroll tax cuts may be precisely their appeal. People who think unemployment is the result of inadequate demand and people who think it’s the result of lazy, overpaid workers (i.e. it’s “structural”) can both support them, even though the arguments are incompatible. (People who don’t scruple too much over consistency can even make both arguments at once.) But if macroeconomic policy is limited to stuff that can be supported with bad arguments, we shouldn’t be surprised if the results are disappointing. That lower labor costs don’t help in a recession is, I guess, another lesson from the Great Depression that will have to be learned again.

As for Roubini, it’s hard to improve on Jamie Galbraith’s very diplomatic judgment: I cannot discern his methods.

What Does a Credit Crunch Look Like?


What doesn’t it look like? Krugman has a picture:

His point here is right, for sure: Business investment is being held back by weak demand, not lack of credit. Would Tufte approve of that graph, tho? (It looks like one of those images of disk usage you get when you defragment your hard drive.) And more importantly: Why does it start in 1986?

It’s an arbitrary date, and an especially weird one to pick in this context, because of what happens if you go back just a couple years. You call that a credit crunch, mate? Now this is a credit crunch:


See that spike over on the left? That’s a country full of businessmen screaming as Papa Volcker stomps on their necks. (To be fair, it’s their workers he was mainly interested in strangling, but the credit squeeze for business was no less real for that.) And that’s what a credit crunch looks like.

Macro Models and the Long Run

I was just looking at this working paper on the OECD’s new global macro model. What it is, is a set of equations relating a dozen or so macro aggregates for each major country or region in the OECD, at a quarterly timescale. OK, that sounds stupid and naive to economists, and hopelessly cryptic to everyone else. Let’s proceed. Some observations, first on structure, second on content. On form:
The equations comes in two flavors, long-term and short-term. Salient fact about the long-term ones is that most of them are imposed (singly or jointly) rather than estimated. For instance, the elasticities of consumption with respect to income and wealth are constrained to sum to one. The elasticity of employment with respect to real wages is constrained to be negative one. (Oh, that one makes me mad.) The elasticities of exports and imports with respect to their respective market sizes are constrained to be one. And so on. Meanwhile, the short-term (one- and two-year) equations are allowed to be determined by the data.

There’s a couple reasons for this, at least one of which is reasonable. The reasonable one is that they want the long-run behavior of the model to converge to an equilibrium. If, let’s say, the long-run elasticity of imports with respect to income was anything but 1, the share of imports in consumption would rise without limit over time. I’m not sure how I feel about this. (Bad blogger!) On the one hand, it’s obviously true that that imports or consumption relative to GDP, or the wage share, or relative prices among trading patterns, don’t diverge to infinity. On the other hand, time doesn’t pass to infinity either. The practical relevance of the long-run conditions is only for a period long enough that exogenous fluctuations have canceled out, yet short enough that the parameters of the model remain unchanged. It’s not at all clear to me that the set of such periods is not empty. On the other hand, there may be reasons why postulating a long-run equilibrium is useful, even if we recognize that no such equilibrium is ever reached.

The other reason for the long-run restrictions is less defensible — or, since really who cares about my opinion, let’s say it’s substantive rather than methodological. The model “combines short-term Keynesian-type dynamics with a consistent neoclassical supply-side in the long run.” (Interestingly, mainstream macro has this in common with a major strand of Marxist economics, in contrast with the (post-)Keynesians who allow a role for demand even in the long run.) So some of the long-run restrictions are imposed not simply to get an equilibrium, but to get a particular, tastes-endowments-and-technology equilibrium. There’s no reason in principle that practical macroeconomics should exclude the possibility of changes in real wages changing income shares in the long run. That the OECD does, tells you something.

On to the substance:

A couple interesting things here, which unlike the thumbsucking above, one can actually use. These are hardly gospel, of course; but enshrined in the OECD macro model they can be taken as stylized facts, in the sense that in many contexts they don’t, qualitatively, have to be explicitly argued for.
1. Wealth effects (on consumption) are largest for the US, smallest for Japan.
2. The effect of import prices on the domestic price level is negligible in the US and Japan, but substantial in Europe.
3. Trade flows are much more responsive to income changes than to relative prices. Estimated export elasticities are two to three times higher for income than for “competitiveness” [3]; estimated import elasticities are two to four times higher.
4. US export prices move with domestic prices essentially one for one; US import prices move with foreign prices only slightly. For most other countries, export pass-through is lower and import pass-through is greater.

The last two are particularly interesting.

Eventually, one would like to think through the conceptual basis, and limits, of these sorts of models. There’s that never-realized long-term. Meanwhile here in the short-term, when you’re making heterodox arguments it’s nice to get empirical backup from some place impeccably orthodox.