Krugman's Deficient Analysis

by Don Boudreaux on April 24, 2006

in Myths and Fallacies, Trade

In his column in today’s New York Times, Paul Krugman worries about the trade deficit.  As regular Cafe visitors know, I do not worry about the trade deficit — and I seldom lose an opportunity to explain why I believe that concern over the trade deficit is misplaced.  (Coyote blog is also wisely unconcerned about the trade deficit.)

There’s nothing new or compelling in Krugman’s worry.  He wrongly claims, for example, that a trade deficit means that Americans must “sell stocks, bonds and businesses to foreigners.”  But this claim is untrue.  The U.S. trade deficit rises even when foreigners make new investments in the U.S. — when foreigners create in the U.S. productive assets that never before existed.

And Krugman’s answer to a question that he correctly anticipates his critics asking is facile.  The question is, in Krugman’s words, “if things are really that bad, why are so many foreign investors still buying U.S. bonds?”  Krugman’s answer is: “I have two words for those who place their faith in the judgment of investors, and believe that a few good years are enough to prove the skeptics wrong: Nasdaq 5,000.”

First, the collapse of the Nasdaq is hardly a sufficient basis on which to generalize about investors’ judgments.  Yes, bubbles exist — but this fact hardly means that all steady investment is the result of a bubble.

Second, the U.S. has run a current-account deficit every year for nearly thirty years.  Indeed, more generally, America ran a current-account deficit for pretty much the entire period ranging from the English settlement at Jamestown in 1607 until World War I.  (See William A. Niskanen, “The Determinants of US. Capital Imports,” Annals of the American Academy of Political and Social Science, July 1991, pp. 36-49.)

Those 300+ years — and the past thirty years — are much more that a mere “few good years” that can be dismissed as flukey.

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{ 18 comments }

iceberg April 24, 2006 at 1:27 pm

To ask oneself why the media employs worry-ers from all walks of life, is to answer your own question.

It's time for the mainstream reader to ask cui bono? when a disproven economist is still employed at the so-called bastion of truth-seekers.

Hint: Yellow journalism (calling for more economic intervention) is alive and well.

Matt McIntosh April 24, 2006 at 3:27 pm

Lordy. And Krugman somehow thinks the trackrecord of macroeconomics gurus is any better? Motes, planks, etc.

BTW Don, what do you think of this?

http://www.chinadaily.com.cn/china/2006-04/24/content_574705.htm

mvpy April 24, 2006 at 5:26 pm

Hi Don,
Though I almost always disagree with Krugman, I think your analysis that foreigners are investing in US "productive assets" is a little off. I believe that they're purchasing enormous quantities of US Treasuries; that is, theyre lending to the US government. As a fellow libertarian, I dont regard this in any way "productive". Au contraire. Indeed, I think the lack of any discipline on the fiscal front is largely attributable to the US trade deficit. The Asians' willingness to lend to the gov so willingly has prevented the usual adjustment mechanisms from working, that is, the usual attendant rise in interest rates.

MjrMjr April 24, 2006 at 6:34 pm

I tend to come down on the side of Krugman or DeLong in this debate, although Don has made some persuasive arguments on the other side in the past few months.

iceberg:I was assigned Krugman's _Accidental Theorist_ by a libertarian-anarchist professor in an econ class at GMU and found Krugman to be a relatively strong and articulate defender of free markets. I've not, however, followed his NYT column that closely since it went subsription only.

mvpy:I'm somewhat on the left, but I think you raise a pretty sharp point. If the bulk of the assets that foreigners were purchasing was an investment in some sort of new productive capacity or technology I'd be more inclined to say that it's not a problem. But SE Asian central bankers as the enablers for Bush to go on a crusade in the Middle East and pay for the disastrous Medicare Part D? Even if we were able to borrow that money dirt cheap I don't think any case can be made that it was spent wisely.

Aaron Krowne April 24, 2006 at 9:15 pm

Don, the line you keep repeating in this debate remains specious.

We know foreigners aren't spending much of this deficit money on much of anything useful in this country… unless you consider government securities useful. And I'll bet you don't.

There's probably something to be gained from viewing the deficit as either "push" or "pull".

If its a "pull" deficit, foreigners are falling over themselves to buy into lucrative investment opportunities. Foreigners scramble to acquire dollars, bidding up their exchange value on the world market.

In a "push" deficit, the fundamental phenomenon is our consuming, as in petrol and cheap Chinese goods that we need in order to pretend there's no inflation. The secondary effect is that foreigners consequently need someplace relatively brainless to park the excess dollars: enter government and questionable mortgage-backed securities.

Completing the symmetry, you would probably expect to see dollars fall on the world market in a "push" deficit.

But you say there's no difference. From what I can gather, this requires a belief that there is no such thing as malinvestment. Do you really believe that?

Aaron Krowne April 24, 2006 at 9:41 pm

Regarding the Xinhua article (funny, the Chinese wanting to show the trade deficit isn't so bad?)…

As Krugman points out, if you are going to start including profits of transnationals, the deficit gets worse. You cannot simply add in to actual trade repatriatization of profits and only go one way with this calculation.

We could add up all repatriated corporate profits to try to determine "for real" what the balance sheet is–or we could just look at the anomolous surge in takeup of basically unproductive US securities, which are what is ultimately left at the end of the day.

It is also worth noting that trade has a 100% influence on the capital account, whereas profit repatriatization has a much smaller influence, on the order of the size of profit margins (5-10%).

E.g., if Coke does $20 billion (equivalent) of business in China, that can only help our capital account by a few billion. On the other hand, if Chinese semiconductor companies sell us $20 billion of goods, thats a $20 billion hit to the balance sheet.

So we have to "work a lot harder" to squeeze enough money out of China (for instance) to balance things out without utilizing trade.

I still maintain that there is no reason to pontificate endlessly about these things. Does anyone really think its healthy for the federal government to add $4 trillion in debt, largely through securities, in four years?

Not an Economist April 24, 2006 at 9:50 pm

As I understand a couple of the objections here, foreigners investing in something "productive" (I guess this would be Hyundai or Toyota building car factories in Alabama) is a good thing, but that buying government debt is not since the money is being wasted on things the writers don't approve of. I wonder though: if foreigners weren't funding these "crusades" would we be better off? Or would "American" capital (which, since the foreigners are kind enough to lend us their money at low rates, is now presumably being used for useful things instead of being paid into the treasury through higher taxes or domestic purchase of bonds) then be unavailable for useful things? In other words does it really matter whether the "foreigners" do productive things directly, or whether they buy governmentt bonds and so free "domestic" capital to be productive?

anon April 24, 2006 at 11:38 pm

The money invested by foreign entities in the US over the past six years has been a complete dead weight loss for the US economy.

Yes, the interest rates have been half the level they would otherwise have been. But the same have caused housing to double.

Commodity prices have quadrupled.

Real wages and personal income have been reduced.

The Federal government debt has increased to over 6 % of GNP which will have it's real impact when interest rates normalize and the true cost of government borrowing is realized.

The neo-fascists have been able to wage war and pay off their well-heeled handlers without experiencing the gut wrenching rebalancing, that is likely to come, on their watch.

The list goes on.

What happens when the Keynsian stimulus of huge Federal deficit spending is withdrawn at the same time the Fed is forced to increase rates and reduce money supply to deal with the white elephant in the living room (hint: inflation).

I believe that the value of the US, as a going concern, the future prospects of the country, and our current, overall standard of living has been reduced by at least 25 % over the past six years.

John Pertz April 25, 2006 at 1:44 am

This is simply breathtaking.

"The money invested by foreign entities in the US over the past six years has been a complete dead weight loss for the US economy.

Yes, the interest rates have been half the level they would otherwise have been. But the same have caused housing to double.

Commodity prices have quadrupled.

Real wages and personal income have been reduced.

The Federal government debt has increased to over 6 % of GNP which will have it's real impact when interest rates normalize and the true cost of government borrowing is realized.

The neo-fascists have been able to wage war and pay off their well-heeled handlers without experiencing the gut wrenching rebalancing, that is likely to come, on their watch.

The list goes on.

What happens when the Keynsian stimulus of huge Federal deficit spending is withdrawn at the same time the Fed is forced to increase rates and reduce money supply to deal with the white elephant in the living room (hint: inflation).

I believe that the value of the US, as a going concern, the future prospects of the country, and our current, overall standard of living has been reduced by at least 25 % over the past six years. "

This is an as ideologicaly self serving view of the U.S economy as one could ever dare to dream. However, I do share your concern over the current increase in the Federal debt. Like they always say government debt is nothing more than a future increase in taxes. I guess from the tone of your post that you must be a strong advocate for the gold standard. Are you an Austrian? Also you are probably a bit too self assured with your first observation.

anon April 25, 2006 at 3:15 am

I do not believe that adherence to the gold standard is a viable option.

I am not Austrian.

My argument was probably overstated and possibly self serving.

I fail to see the long run, net benefit of the liquidity induced bubble economy of the last four years.

The current and future structural deficits scare the heck out of me.

I hope my assessment is completely offbase.

Tom D April 25, 2006 at 9:55 am

…and you probably even believe that higher gas prices are tied to supply and demand!

Noah Yetter April 25, 2006 at 12:56 pm

"I believe that the value of the US, as a going concern, the future prospects of the country, and our current, overall standard of living has been reduced by at least 25 % over the past six years."

As they say on the internet, O RLY?

Read what you wrote. Read it again. Now slap yourself.

Gerry Haokip April 25, 2006 at 1:31 pm

The issues that Krugman raised are highly relevant and the federal government must take every corrective measure possible.

cb April 25, 2006 at 3:56 pm

Don,

Is there a trick to getting access to Niskanen's article? Actually the whole volume looks interesting, but I can't figure out how to get at it.

Thanks.

Aaron Krowne April 25, 2006 at 8:44 pm

From the Wikipedia article on current account deficit:

> It should be noted that a Current Account deficit is not always a problem. The "Pitchford Thesis" states that a current account deficit does not matter if it is driven by the private sector. This theory has held true particularly for the Australian economy which is always in deficit, yet has experienced economic growth for the past 14 years (91-05).

So there is a name for Don's argument: the Pitchford Thesis. It makes sense because in a free market situation, the money is forced to go to useful things due to moral hazard, and exchange rates freely adjust based on currency flows. No harm done; Pareto increases all around.

The only problem with applying this analysis to the US is that little clause about the "extra" capital being invested privately.

In a timely underscoring of my point, Australia just paid off the last of its public debt.

That milestone is going to have to wait a while here in the states. Anyone know why?

MjrMjr April 25, 2006 at 9:39 pm

I've been reading more about this issue lately and came across a paper recently published by PIMCO. Their take is roughly that the trade imbalance and fiscal deficit are indeed big problems and they're advocating a zero interest rate policy coupled with some interesting tax ideas to bring things back into balance. I don't think their ideas are politically feasible at all but it's an interesting read if you've got the time. Presumably PIMCO has some degree of credibility when it comes to analyzing bonds and treasuries.

http://randolfe.typepad.com/Documents/A_ZIRP_Remedy_to_Global_Imbalances.pdf

MjrMjr April 25, 2006 at 10:17 pm

I've been reading more about this issue lately and came across a paper recently published by PIMCO. Their take is roughly that the trade imbalance and fiscal deficit are indeed big problems and they're advocating a zero interest rate policy coupled with some interesting tax ideas to bring things back into balance. I don't think their ideas are politically feasible at all but it's an interesting read if you've got the time. Presumably PIMCO has some degree of credibility when it comes to analyzing bonds and treasuries.

http://randolfe.typepad.com/Documents/A_ZIRP_Remedy_to_Global_Imbalances.pdf

donny April 26, 2006 at 6:51 am

And what happens to the value of Pimco's existing portfolio of bonds in a zero-interest rate environment?

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