Beware of Celebrating Decreases in the Current-Account Deficit

by Don Boudreaux on May 20, 2011

in Balance of Payments, The Economy, Trade

Keynesians – or, more generally, economists obsessed with aggregate demand – are fond of exports because foreigners’ expenditures on exports are demand for ‘our’ country’s goods and services.  Aggregate-demand-obsessed economists also dislike imports because ‘our’ consumers’ expenditures on imports is demand, not for output produced at home but, rather, for output produced abroad.  Unless that ‘demand’ returns to the home economy in the form of foreigners’ demand for ‘our’ exports, then aggregate-demand-obsessed economists are unhappy because the sum of C+I+G+[Xports-Mports] goes down.

This obsession with aggregate demand leads to a special fear of trade deficits because, by definition, a trade deficit occurs whenever Mports > Xports.  The term in the bracket (in the equation above) is negative!  Aggregate demand is less than C+I+G.

But not so fast….

Suppose this year Americans spend a total of $1M on imports.  Foreigners, in turn, immediately spend this entire $1M buying Texas land from a Texan living in Texas.  Mr. Texan then spends the entire $1M of his land-sale proceeds buying South Carolina peaches, California wines, Massachusetts web-designs, and oodles of other American-made (and only American-made) goods and services.  In this case, America will run a $1M trade deficit, but C will, as a result, rise by exactly the same amount that (X-M) falls: by $1M.

Now consider a second scenario.  As before, Americans this year spend $1M on imports, but now foreigners spend this entire $1M buying American exports.  America, in this second scenario, runs no trade deficit.  Unlike before, C doesn’t rise; but also unlike before (X-M) doesn’t fall by $1M.

The total dollar value of C+I+G+[X-M] is the same in the second scenario as it is in the first.

Even within the excessively simplistic C+I+G+[X-M] framework, therefore, the issue of trade deficits misleads.  Even if all you care about is aggregate demand, then you should still be aware that a current-account (or ‘trade’) deficit is not necessarily a ‘leakage’ of aggregate demand from the domestic economy.

Therefore – and this point gets to the little debate that I had with Pingry in the comments section of this earlier post – a change in the trade deficit, by itself, tells you nothing of the larger picture; it tells you nothing about what’s happening to aggregate demand.

Perhaps a lower trade deficit results in higher aggregate demand, but – as the two altnerative scenarios above show – this relationship is hardly necessary.  In the second of the above scenarios, the trade deficit is lower than in the first scenario by $1M – indeed, in the second scenario, trade is “balanced.”  But aggregate demand in the second scenario is neither higher nor lower than it is in the first scenario.

So Paul Krugman’s celebration of a falling manufactured-goods trade deficit (even if we follow Pingry’s interpretation of this celebration as being, really, a celebration of a falling trade deficit more generally rather than being a Donald-Trumpian celebration of the ‘return’ of American manufacturing) is inappropriate.  How does Krugman know that the higher demand for American exports results in higher aggregate demand for the American economy?  He doesn’t know.  He can’t possibly know.

Indeed, in today world of national currencies foreigners who sell things (“imports”) to Americans but who do not buy (as many) things (“exports”) from Americans are likely investing in dollar-denominated assets whatever dollars they don’t spend on American exports.  This fact means that much, if not all, of America’s trade deficit manifests itself in America as investment spending.

So to the extent that investment spending in America today is composed of dollars that foreigners could but don’t use to purchase American exports, a decrease in America’s trade deficit tomorrow might not increase aggregate demand in the U.S. even if it does increase demand for goods and services recorded in America’s current account.

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{ 157 comments }

Slappy McFee May 20, 2011 at 4:49 pm

I was told there wouldn’t be any math in this class.

DG Lesvic May 20, 2011 at 5:10 pm

Slappy,
I agree with you.

The formulas marred what was otherwise a magnificent and rare exercise in real economics.

Prof Boudreaux is to be congratulated and thanked for his rare, real economics, but it would have been better without the folderol.

Don Boudreaux May 21, 2011 at 7:36 am

Do you not understand that it is effective to criticize Keynesians on their own terms – and those are their terms?

Don Boudreaux May 21, 2011 at 7:39 am

And would you have been more pleased had I ‘unmathed” my post by writing “consumption spending plus investment spending plus government spending plus the excess of export sales over spending on imports.” What that manner of expression – which is exactly the same thing as C+I+G+[X-M] – have improved my post?

Please lose your hostility to math, and – in this case – even to expression using short-hand symbols rather than words.

DG Lesvic May 21, 2011 at 12:42 pm

My hostility is not to math but to the confusion of it with economics. it has nothing to do with economics. Absolutely nothing. It is a distraction and an obfuscation. Period.

Economics is always simple. I repeat, always simple. And when it isn’t simple, it isn’t economics.

When you really have something to say, you always manage to say it in plain and simple terms, and, when your writing is consused it’s a sure sign that your thinking is confused too.

Stephen A. Boyko May 21, 2011 at 9:50 am

@ DB “criticize Keynesians on their own terms”

Agreed!

I feel that the same is true with capital market governance where I argue that one-size-fits-all governance metrics are too loose an operational tolerance to be functional because they lack clarity and precision due to non-correlative information such as Too-Big-To-Fail (TBTF) financial institutions that are, in reality, Too-Random-To-Regulate (TRTR).

vidyohs May 21, 2011 at 9:58 am

What’s this math thing, did I sleep through something in school?

muirgeo May 21, 2011 at 10:36 am

In your scenario when the land is sold doesn’t “I” (investment) effectively go down by 1M ?

Sam Grove May 21, 2011 at 10:37 am

The money does not disappear.

LowcountryJoe May 21, 2011 at 1:11 pm

There’s always new I or new C. And of course you’re beloved G is going to get a piece of that action. And the more well-to-do the seller’s of I are, the more you’d like to see that piece of the action be. Right ducktor?

Methinks1776 May 20, 2011 at 5:50 pm

Damn poli sci majors.

Rob May 20, 2011 at 8:49 pm

What’cha got against poli sci majors?

Methinks1776 May 20, 2011 at 8:55 pm

I was kidding :)

Mesa Econoguy May 21, 2011 at 12:34 am

A lot.

That’s what they told me I “should be” when I entered university.

A) political + B) science = not.

PoliSci is a shitty merger of economics and history.

Marcus May 21, 2011 at 12:54 pm

“A) political + B) science”

They cancel each other out because “political” is a negative term.

Bill May 20, 2011 at 5:04 pm

Don, thanks for this post. You’re a good teacher.

Rafael De Anda May 20, 2011 at 5:16 pm

Thanks for the explanation. Sometimes, as Americans, we have to remind ourselves that since foreigners are purchasing American assets, and thus investing in our country, well then we must be doing something right.

GEORGE May 20, 2011 at 5:21 pm

Don,

I need to ask a serious question which is meant in a respectful way, but I fear it could be misconstrued… I have an advanced degree in engineering and have published math-oriented papers in the past. Out of interest, I have perused papers in economics, since I’m able to understand the math – if not always the econ. I am perplexed that economists have focused on math models (not often derived from first principles) to try and analyze some concept in econ. What I can’t figure out is why the heavy focus on advanced math when it is obvious that economists don’t agree on what seem like basic principles in econ. Aggregate demand, or the benefits of imports and exports are still debated. It feels like too much of what economists believe begin with their political beliefs (left or right).

I tend to agree with pretty much all of your posts. Paul Krugman hasn’t written much in the NY Times that rings true to me. Yet you are both respected economists. Is there any hope of deriving models from agreed-upon first principles, or being able to arrive at a consensus on what constitutes “truth” in economics?

Octahedron May 20, 2011 at 5:31 pm

I’m interested in hearing the response to this. One of the main criticisms I saw about a Human Action when I first picked it up was that it he rejected using math in economics for some of the reasons you pointed out above. I know that the field has changed since it was written but I figure part of the reason is because of the availability aggregate data that we have ability.

DG Lesvic May 20, 2011 at 9:08 pm

Octane or Hot Air Man,

Mises had a good reason for rejecting math from economics.

There is no such thing as math in economics.

If you think so, show me.

And, here’s the deal.

If you can do it, I’ll never post another thing here.

indianajim May 21, 2011 at 12:20 pm

I’m not sure why you/Mises might reject using mathematics as a tool for understanding human action (after all, acting humans do make calculations and do act upon them); is this what you are saying? Can you explain a bit more what you mean please?

DG Lesvic May 21, 2011 at 1:16 pm

That’s a good question.

Economics is a science not of the passing data of economic action but the eternal truths of economic theory. Since there is none of the passing data in the eternal truths, it is irrelevant to them, a distraction from them and an obfuscation of them.

anthonyl May 22, 2011 at 3:18 am

I think it has to do with subjective value. Value is determined by a humans. It’s what goes on between the ears that determine value. So you can’t measure value nor perform mathematical operations on value. Without this mathematics becomes nearly worthless for the study of economics. Don’t tell anybody else this! They will be devastated!

DG Lesvic May 22, 2011 at 12:14 pm

Jim,

I might not have my point as clearly as I should have.

Since there is no data in economics, there is nothing to calculate.

Anthony

You’re almost right. Mathematics is not “nearly worthless for the study of economics,” but completely worthless, and worse, a detraction from it.

Frank33328 May 20, 2011 at 5:38 pm

“It feels like too much of what economists believe begin with their political beliefs (left or right).” Right on brother…… (is that still said?)

(Oddly) My background is also engineering and I have often thought the exact same question but my wordsmithing would be: Does what an economist believe begin with his/her politics/morals or do they instead derive their politics/morals from their economic beliefs? Which is the cause and which is the effect?

Dan May 21, 2011 at 12:41 am

Not an economist, but my views were derived by studying some economics and political ideologies. Then the application of those basics and more into society. I have no doubts as to the greater prosperity in application of more ‘wealth of nations’ as opposed to any coerced associations like socialism, communism or the like.

Richard Stands May 21, 2011 at 1:46 am

Also not an economist, but my views came from decades of watching the effects of the Soviet command economy (and others) and comparing those to the effects of freer markets in the U.S.

The results were stunningly obvious.

So while my current perspective is political, its origins were from empirical history.

Dan May 21, 2011 at 1:57 am

What was communism successful at, except to cement capitalisms superiority?

Richard Stands May 21, 2011 at 2:04 am

Communism was like the drug-addicted uncle I used to have: great to learn from as a bad example.

As for what was successful about it, I’d say the few in power had some nice perks. But of course, that can be asserted every political system that has ever existed.

Pfloyd May 21, 2011 at 3:50 pm

It wasn’t until I formally studied economics that my political leanings (on fiscal matters anyway) started leaning more and more to the right.

Marcus May 20, 2011 at 7:30 pm

“I am perplexed that economists have focused on math models (not often derived from first principles) to try and analyze some concept in econ.”

I believe Hayek referred to it as “scientism”.

DG Lesvic May 20, 2011 at 8:38 pm

George,

The disputes are not so much over economics as economics and non-economics.

“Falling prices, or ‘deflation,’ is the Keynesians’ greatest fear. But, if the prices at which you bought were falling along with those at which you sold, your real wages, profits, and purchasing power would be the same. So, why wouldn’t commerce go on as before, at lower prices?

Because, Keynes argued, wages and prices were ‘sticky.’ Granted that, if they fell to the levels reflecting the new monetary reality, all would be well. But, in a money-mad capitalist society, people thought more in terms of money itself than what it would buy, and would hold out for the old wages and prices even as they were unemployed and starving. And since they hadn’t the sense to save them-selves, we had to save them, by keeping the money supply and prices from falling.

That was his famous ‘money illusion’ theory of unemployment, and the basis of the inflationist ‘demand management’ or ‘monetary equilibrium’ theory that has dominated thinking not just in the Keynesian but even in much of the Austrian School, and driven policy in Western Europe and America over the last 75 years.

It was not actually a theory of economics but of psychology, and a denial of economics, which must presume that people are not entirely mad.

Keynesian was really Madman Economics, for what Keynes was really saying was that people were mad, that they cared more for money than the things it bought, and would rather starve than live even better at lower nominal wages.”

See Macro Schmacro at

http://econotrashtalk.org/#Macro_Schmacro_

Dan May 21, 2011 at 12:45 am

I am not convinced of the theory of deflation spiraling an economy into a depression or worse.

DG Lesvic May 21, 2011 at 12:27 pm

You’re absolutely right, if the deflation was market generated.

Joshua May 22, 2011 at 1:25 am

Deflation is just bad, more so in a debt ridden society such as ours. The national debt is set in nominal terms, so it would be disaster for government revenue and fiscal soundness. The same goes for households. Income would decrease, your mortgage would not. Also the argument that it slows the velocity of money, people postponing purchaces, causing more layoffs. Negative and positive feedback are quite easy to think about happening in economics, I think.

Dan May 22, 2011 at 11:47 am

What goes up, must come down.

Methinks1776 May 21, 2011 at 12:08 pm

George, I believe Russ Roberts provides an answer to your question in an interview with Reason TV a couple of weeks ago. This much disagreement in the academy nearly 80 years after the publication of The General Theory indicates what they’re doing is not science.

The use of advanced math gives economists the illusion that it is. Happily (for them), there’s virtually no conclusion to which you can’t eagerly data mine.

Methinks1776 May 20, 2011 at 5:39 pm

Beautiful.

DG Lesvic May 20, 2011 at 9:02 pm

It should be pointed out that Methinks was not referring to my post.

DG Lesvic May 20, 2011 at 9:03 pm

For she’d rather see an atom bomb fall from the sky than any original thinking, and a socialist dictator than an amateur teaching the pros their business.

DG Lesvic May 21, 2011 at 3:28 am

Methinks,

I’m sorry I jumped on you like that. I was in a bad mood and ready to strike out at the first person who got in my way.

You’re great and I love you.

DG

PrometheeFeu May 20, 2011 at 5:44 pm

Don, you’re forgetting something important. Mr. Krugman is a big advocate of the government borrowing and spending huge amounts as a magical cure for recessions. In such a situation, export revenue is not spent on peaches. It is (partially) loaned to the government who then spends it on… Well, whatever random stuff the government thinks we should buy… (Probably peaches subsidies actually…)

Andrew_M_Garland May 20, 2011 at 5:51 pm

You too can do economics on a cocktail napkin, just like the guys from Harvard Business School. Don’t be afraid of a few equations. They are only addition in a form that will impress your friends and the general public.

DIY Stimulus Policy
06/26/10 – Easy Opinions → DIY Stimulus Policy

– –
Fred:  What is your analysis of stimulus spending?
Economist:  “4=2+2″ so stimulus will increase GDP and jobs.
Fred:  Are you nuts?

Economist:  Oh, I meant to say “GDP = All production in the U.S.”, so stimulus will increase GDP and jobs.
Fred:  I don’t get it. That’s just a definition.

Economist:  Oh, I meant to say “GDP = C + I + G + (X – M)”, so stimulus G will increase GDP and jobs.
Fred:  That’s better.
– –

LowcountryJoe May 20, 2011 at 5:52 pm

I enjoy confronting xenophobes who carp about the so-called trade deficit. I tell them: “Look, if you really want to decrease the trade deficit, purchase foreign assets instead of domestic ones.” When they incredulously ask why, and then I explain the mechanics behind it, I enjoy their discomfort at realizing the implications of their previous ignorance. Some will actually quit listening to me before they have an understanding. It’s funny they bizarre looks they’ll give — as if I had just told them something as insane as the Earth being spherical in shape or something.

Ryan Vann May 20, 2011 at 7:29 pm

Do elaborate. Putting capital in foreign markets would seem to increase their capital account on first review.

LowcountryJoe May 20, 2011 at 8:32 pm

Yes, exactly correct. Net exports are exactly equal to net capital out-flows [absent foreign aid]. In other words, and it does not matter which drives which, the more aggregate exporting (or investments abroad), the more investments that occur abroad (or the more that gets exported).

The opposite is true as well — this means that the more that a country imports, the more capital will flow into it from abroad [of course this means that foreigners will have future claims to the assets of the country].

Here’s a very good explanation as to why this is the case.

Marcus May 21, 2011 at 7:35 am

It does. But it also reduces ours, making the “trade deficit” appear more balanced.

LowcountryJoe May 22, 2011 at 7:44 am

I replied to this comment yesterday; to elaborate further as you suggested. For some reason I can see it from the computer I posted it from with a notation saying, “Your comment is awaiting moderation.”

Marcus May 22, 2011 at 7:50 am

Does your reply have a link in it? That happened to me a few days ago with a post in which I included links.

Jay May 20, 2011 at 6:42 pm

You missed the best example for the Keynesians. We run a $1M trade deficit. The $1M difference is loaned to the federal government through the purchase of T-notes. The $1M is spent by our congress critters increasing G by $1M.

Ryan Vann May 20, 2011 at 7:24 pm

I don’t think the supposed “AD fetishism” stems from esoteric mysticism of the GDP function forming an enticing mist that enraptures math lovers. Rather, the proposition, that domestic production aught to be propped up, stems from some of the same old mercantilist arguments. Even if the GDP construct didn’t exist, I still think there would be those who encourage domestic production over imports. I’m personally ambivalent on the issue. Obviously zero exports suggests an economy that is probably not very productive (or lacking in any sort of cash crops). Being a net importer doesn’t necessarily imply anything though.

Dan May 21, 2011 at 12:30 am

Propping up production is likely to misallocate resources and be wasteful and for naught once the ‘propping up’ ceases as the production will cease at the ‘propped up’ amount and find the markets unforgiving realities.

Andrew_M_Garland May 20, 2011 at 7:39 pm

You too can do economics on a cocktail napkin, just like the guys from Harvard Business School. Don’t be afraid of a few equations. They are only addition in a form that will impress your friends and the general public.

http://easyopinions.blogspot.com/2010/06/diy-stimulus-spending.html
06/26/10 – Easy Opinions – DIY Stimulus Policy

– –
Fred:  What is your analysis of stimulus spending?
Economist:  “4=2+2″ so stimulus will increase GDP and jobs.
Fred:  Are you nuts?

Economist:  Oh, I meant to say “GDP = All production in the U.S.”, so stimulus will increase GDP and jobs.
Fred:  I don’t get it. That’s just a definition.

Economist:  Oh, I meant to say “GDP = C + I + G + (X – M)”, so stimulus G will increase GDP and jobs.
Fred:  That’s better.
– –

Mesa Econoguy May 21, 2011 at 12:44 am

Yes, but those napkins are from Club 21.

Mesa Econoguy May 21, 2011 at 1:03 am

And I believe – don’t quote me on this – that Art Laffer’s napkin was from the 2 Continents Hotel:

“As recounted by Wanniski (associate editor of The Wall Street Journal at the time), in December 1974, he had dinner with me (then professor at the University of Chicago), Donald Rumsfeld (Chief of Staff to President Gerald Ford), and Dick Cheney (Rumsfeld’s deputy and my former classmate at Yale) at the Two Continents Restaurant at the Washington Hotel in Washington, D.C. While discussing President Ford’s “WIN” (Whip Inflation Now) proposal for tax increases, I supposedly grabbed my napkin and a pen and sketched a curve on the napkin illustrating the trade-off between tax rates and tax revenues. Wanniski named the trade-off “The Laffer Curve.”"

http://www.heritage.org/research/reports/2004/06/the-laffer-curve-past-present-and-future

Such an evil napkin.

Mesa Econoguy May 21, 2011 at 1:11 am

Sorry , yes that was huge sarcasm.

Or as you kids say,

/sarc

Peter May 20, 2011 at 8:40 pm

I’ve said it before and I’ll say it again.

Paying dollars for imports is no long term loss whatsoever of “aggregate demand.”

U.S. Dollars are useless to foreigners unless they either 1) Intend to use them to purchase U.S. goods or 2) intend to trade them with or loan them to someone who does intend to do #1.

All exported dollars will inevitably make their way back to the U.S. or be malinvested. While I make no claim that malinvestment would cease to exist, I do claim that it will be minimal in the freest market.

W.E.Heasley May 20, 2011 at 8:59 pm

“Keynesians – or, more generally, economists obsessed with aggregate demand…..”.

In the long run, Keynesianism is dead.

indianajim May 21, 2011 at 12:24 pm

I hope I live long enough to see it! :)

Joshua May 20, 2011 at 11:37 pm

Aside from the point Don made, which I agree with, is more simply the fact that the housing bubble itself and all the spin off activity of that malinvestment (caused by the human psycology of irrational exuberance/greed inherint in all unregulated market schemes since the Dutch East India Company, not by low interest rates) amounted to 6-7 percent of GDP at the height of the bubble. It is now below 2%. So, of course manufacturing is a greater part of the GDP pie now. That dosen’t indicate a great recovery of any kind.

And how do you fix that? All together now: More deficit stimulus spending!

Dan May 21, 2011 at 12:20 am

Still with the deregulation as basis for housing bubble? Nonsense!

Joshua May 21, 2011 at 9:40 am

Congres said it was a factor. Of course, bubbles still happen even in more regulated markets, no one can say Japan isn’t interventionist, and look at the causes of the lost decade. It’s a catch 22, either you kick the can down the road, have non lending zombie banks, slow growth etc or you have a depression. Whatever the response is, people aren’t going to be happy.

Sam Grove May 21, 2011 at 10:48 am

Congress said…”not our fault”.

Dan May 21, 2011 at 1:01 pm

Oh, congress said so. Must be true! Important to scapegoat something less congressional members involved be found out and excoriated for their direct involvement……. Cough…. Ahem….. Barney frank….. Cough….. Ahem….

Dan May 21, 2011 at 1:13 pm

Banks want to make money…… And greed(not the treacherous evil liberals are taught) will push them to make more loans. But, loans should not be like welfare, given out on the basis of ‘need’. It’s like applying for a job. Either you meet bank qualifications or you don’t.

Dan May 21, 2011 at 12:25 am

Defect spending as solution? More utter nonsense?
Can be helpful in a market that has govt spending of GDP way down around 10%( an arbitrary number meant to represent very low govt spending and theft of property).
Like a glass of wine had every few days having benefits to the circulatory system. But, Obama stimulus is more like reasoning of ‘if glass a every few days is helpful, then 4 bottles a day must do wonders’.

Ken May 21, 2011 at 12:58 am

Josh,

“inherint in all unregulated market schemes”

Are you unaware that real estate and mortgage lending is one of the most, if not the most, regulated industry in this country? Your comment is simply ignorance at best and an outright lie at worst.

“So, of course manufacturing is a greater part of the GDP pie now.”

Don is not claiming that manufacturing is a bigger part of the pie; as a percentage of GDP manufacturing has been declining for decades. He is claiming that in absolute terms, manufacturing is at an all time high. Claiming manufacturing is in decline because there are fewer manufacturing jobs or that as a percentage of GDP manufacturing is getting smaller ignores the FACT that the US manufactures more today than at any other time in history. The question is the US manufactures more today than at any other time in history, how can anyone claim it’s in decline?

Regards,
Ken

Dan May 21, 2011 at 1:38 am

The claim is made by the perceived lowered amount of union jobs associated with manufacturing or the less amount of total employed in manufacturing. This completely ignores the increased output of manufacturers and efficiencies by the increased use of technologies and mechanizations.

Dan May 21, 2011 at 2:06 am

Sorry! Just noticed Don posted this, albeit more articulately, in his ‘Krugman’ blog.
Luddites of the world unite….. We can regain the losses by taking out the machines and other tools.

brotio May 21, 2011 at 12:59 am

this point gets to the little debate that I had with Pingry

What debate? He replied to a question you posed, but didn’t really answer it. Then he ducked out like he and Yasafi usually do when the follow-ups become inconvenient to their Statist narrative.

Mesa Econoguy May 21, 2011 at 1:19 am

LCD.

Lowest common denominator.

Muirgeo wins.

Our legal system, distorted by leftists, is now in play and fully funded by “others.”

Charlie May 21, 2011 at 1:14 am

It seems like in both posts you ignored this line.

“First, what’s driving the turnaround in our manufacturing trade? The main answer is that the U.S. dollar has fallen against other currencies, helping give U.S.-based manufacturing a cost advantage. A weaker dollar, it turns out, was just what U.S. industry needed.”

It’s not like we’re working in a ‘what the heck happened’ environment. It’s pretty clear why manufacturing was stimulated and the trade deficit came down.

You’re in a very silly way arguing that in some general case we don’t know when a trade deficit goes down, whether it’s necessarily a good thing or bad thing. Krugman is arguing a very specific case where as part of our recovery, our currency weakened, our exports got cheaper, and thus were stimulated by demand in foreign markets, and that this was a good thing. He closes with how ridiculous it would be to try to target a currency as to not “debase it.”

What’s insane is you agree with him. You aren’t for some absurd artificial strengthening of the dollar. You have to go off some completely tangential point just to try to find disagreement.

Dan May 21, 2011 at 1:24 am

Oh……..thanks…….I appreciate being poorer for the weaker dollar.

robert_o May 21, 2011 at 1:31 am

I can’t wait until the dollar reaches 0. Then we’ll be so rich, we’ll be able to afford to burn money to keep warm.

Side question: how did US manufacturing do when the US dollar was at its relatively recent strong point, in the mid 1980s? Did it also happen to be at a record high output, still?

A weakening currency takes a few months/years to have all relative prices readjust, at which point there are no longer any arbitrage opportunities and we’re back to where we were initially (except with the local population poorer than they would otherwise be).

The only way to sustain such an advantage is with a perpetually accelerating depreciation. Great for exporters, but not so great for anyone who’s not an exporter.

Don Boudreaux May 21, 2011 at 7:41 am

I’m not obliged to respond to every mistake Krugman makes. I responded to two of them. I did not respond to the one that especially agitates you. Chill out.

DG Lesvic May 21, 2011 at 12:32 pm

Charlie made a good point. I hadn’t thought of that. And it adds a new dimension to my thinking on the subject. And we’re certainly better off understanding it from all angles.

Charlie May 22, 2011 at 11:19 pm

No, now you are misunderstanding my point and PK’s point.

PK is arguing: The U.S. dollar declined relative to some other major currencies. This stimulated our exports and with it our manufacturing. Further, this is a good, natural part of recovery that shouldn’t be undermined by some misguided strong dollar policy.

You are arguing, not all declines in the trade deficit are good.

Do you see the difference? He is arguing THIS is good. You are making a true, but irrelevant point that SOME OTHER THING might not be good. It reminds me of the Big Lebowski quote, “No, your’re not wrong, Walter…you’re not wrong, you’re just an a-hole.”

And of course, it’s telling that some of the readers think our national wealth should be measured by the exchange rate.

Dan May 21, 2011 at 1:48 am

Great way to put more people into whatever would constitute poverty. Considering govt will declare ‘poverty’ as lacking ownership of particular products like flat panel tvs.
I don’t own one.

SheetWise May 21, 2011 at 3:29 am

What if I believed that all trade made people richer, and I really didn’t give a damn where they lived? Is there some way I can stop reporting?

muirgeo May 21, 2011 at 3:55 am

Seems like an obvious flaw in Don’s argument. He seems to be equating the selling of an asset with the production and sale of something of equivalent value.

If businesses, families and governments did nothing but buy things and sell off assets they would not last too long… and thus the booming private and public debt of our trade deficient …manufacturing deficient economy.

LowcountryJoe May 21, 2011 at 5:42 am

Any day now you’ll move the dimmer switch and let the filament in the bulb take more of the load! Ask yourself why the assets are continuously there to be purchased and what different types there are for purchasing [e.g. the shares of company stock made available through a broker; the property with a built structure which an owner puts on the market; the business which tries to finance expansion through floating a bond at a particular interest rate so as to attract a lender; a reckless spending government which seeks to fund their deficit spending with promises to pay back the money in the future].

Ask why the assets are being bought in the first place — what’s in it for the purchasers [ask that question for each of the asset types that are made available for purchase because the answers could vary widely for each type]?

Ask why — if manufacturing is so deficient in this country — that your top-down-thinking self is not publicly advocating that more young people should seek out manufacturing opportunities and eshew high-paying service professions like the one you’ve chosen as a career? Is the ‘flaw’ that you thought you saw still there? Is your flawed contention still with you [I'll limit the discussion to just one flaw for the moment]?

Ken May 21, 2011 at 6:37 pm

muirgeo,

“equating the selling of an asset with the production and sale of something of equivalent value.”

Funny how that works. Which is heavier a pound of lead or a pound of air? Of course they way the same. Which is more valuable: $1 of gold or $1 of sand? Of course they are equally valuable.

Yes, selling something for a net profit of $X is just as valuable as producing something and selling it for a profit of $X. How do you think Wal-Mart, in fact ALL retailers earn their money? They buy and sell things, without producing anything. They provide a service by giving consumers choices they otherwise wouldn’t have and increasing the exposure of products for producers.

You seem to equate production with wealth. If I spend $1,000,000 to produce buggy whips, have I created any wealth? Is there a demand for buggy whips? Wealth is only produced when something people want is created. Value means that there are people willing to pay for it. If no one buys any of my buggy whips, there is no creation of wealth. No one has a need for buggy whips, despite the fact that I spent $10,000,000 to manufacture them.

However, if I go to Japan and buy 100,000 Toyota Matrixes, bring them to the US, and sell them, I have created wealth.

Why are you so dumb? You say such stupid things like “If businesses, families and governments did nothing but buy things and sell off assets they would not last too long” when there are trillion dollar industries devoted to doing nothing but buying and selling things. You’re worried about not enough production because too many people start buying and selling, but the market takes care of that too. When there is a demand for product Y, but not enough people are producing Y, the price of Y increases encouraging lowering the demand of Y. Also, the increase in price of Y increases the profitability of Y, so more people start to produce Y.

This is what markets do. Prices are signals to consumers and products to consume more or less or to produce more or less. This is something that you resist understanding with all of your being. Why? You seem to think that no one will notice that there isn’t enough Y and won’t start increasing prices or producing more. As if out of 6,000,000,000 no one will notice this. That everyone is just a giant dumbass and should be told what to do by muirgeo the clown.

Do you really think that people are mindless zombies completely oblivious to the world at large, incapable of adapting to changing circumstances? You really do have a dim view of humanity don’t you?

Regards,
Ken

Marcus May 21, 2011 at 6:45 pm

What muirgeo doesn’t grasp is that it is all part of capital and assets finding their most valuable uses.

muirgeo May 21, 2011 at 4:01 am
LowcountryJoe May 21, 2011 at 6:00 am

Why didn’t Buffet show the piles of cash coming back over to purchase the assets?

Why didn’t he show the various types of assets and how the availability of each type seem to multiply and become more numerous — especially for a country that supposedly doesn’t make anything any longer?

It showed the guy putting for sale signs in the Earth as just some guy doing nothing. Perhaps there should be more than one guy; the other could look more like the caricature of Uncle Sam doing what he does (complete with him reaching in your pocket to see if you’re willing to pay for all the spendingright now! — so that he doesn’t have to sell assets today).

muirgeo May 21, 2011 at 10:48 am

Oh he did…. that’s right at 0:30.

And note Buffet produced this when unemployment was 4.8% in July 2006 when all was booming. That’s called having street cred… which is not existent here at Cafe Hayek where they continue to cheer like Wile E Coyote suspended over a cliff.

http://delong.typepad.com/sdj/2006/07/cleaning_out_th_3.html

LowcountryJoe May 21, 2011 at 1:20 pm

Me: “Why didn’t Buffet show the piles of cash coming back over to purchase the assets?”

You: “Oh he did…. that’s right at 0:30.”

It has been a while since I’ve attempted to get through to you and ended up just talking past you. I guess I just needed that reminder that you don’t have the capacity to hang in these discussions. Your quote above was the reminder that I needed to re-confirm that you’re out to (free) lunch.

carlsoane May 21, 2011 at 3:04 pm

Buffett is, of course, right. If you consume more than you produce, you eventually end up in thrall to creditors.
But, Krugman’s celebration of devaluing currency as a remedy is problematic. The ultimate danger faced by the Squandervillians is that their island is purchased by the Thriftvillians. The devaluing of Squanderbucks would only make it easier for Thriftvillians to buy Squanderville assets. Also, if Squandervillians need to import fertilizer from OPECia to grow food, they will be put at a competitive disadvantage to Thriftvillians buying OPECia fertilizer in the more valuable Thriftvillebucks.

Marcus May 21, 2011 at 3:12 pm

“Buffett is, of course, right. If you consume more than you produce, you eventually end up in thrall to creditors.”

Buffett is portraying it as through there is a collective decision to made for all, and there isn’t. Individuals are fully capable of evaluating their own financial situation and making their own decisions for themselves. So no, Buffett isn’t right.

Now, government debt is another matter.

carlsoane May 21, 2011 at 5:42 pm

I think he’s right. First, it’s a parable. That fact notwithstanding, you don’t have to be a collectivist to believe that aggregates matter. If the dollar is devalued as the result of a current account imbalance, that reduces the value of my savings regardless of how thrifty I’ve been. If my neighbor goes bankrupt and sells his house in a fire sale, that brings down the value of my house.

Methinks1776 May 21, 2011 at 5:46 pm

Carlsoane,

It does not follow that because aggregates matter they should be manipulated by a central authority and that we’re better off if they are.

Marcus May 21, 2011 at 6:02 pm

“If the dollar is devalued as the result of a current account imbalance, that reduces the value of my savings regardless of how thrifty I’ve been.”

Then put your money where your mouth is and invest in foreign assets. That’s how the market works. If you think you see an inefficiency, adjust your investment strategy to it. If you’re not certain, then hedge your bets.

Because it IS an uncertain world and advocating government intervention because you think a particular variable of a six variable equation should be higher or lower is, as Hayek calls it, a fatal conceit.

Ken May 21, 2011 at 6:45 pm

carlsoane,

“If you consume more than you produce, you eventually end up in thrall to creditors.”

Of course, this isn’t at all what a trade imbalance is. For a trade imbalance to increase or occur at all, there is no need for any accumulation of debt. I buy thousands of dollars of food from Shoppers every year, but they have never bought anything from me. By your logic, I will end up in debt to Shoppers since I have failed to sell them anything. Of course this is completely absurd.

Additionally, if I let shoppers lease part of my land to them to grow crops, that to is considered a trade imbalance since Shoppers has now invested in my land. However, does anyone think that I am more in debt to Shoppers by leasing them land?

Of course the basis your entire comment, carlsoane, is completely wrong. Since you obviously must recognize that in both scenarios above, I was not going into debt to Shoppers, you must recognize that trade imbalances as measured between nations doesn’t mean an accumulation of debt. It’s simply an accounting artifact used by people like muirgeo and Buffett to distort reality in order to garner more political power, forcing others to their will.

Hope you learned something.

Regards,
Ken

Marcus May 21, 2011 at 6:52 pm

@Ken,

That’s a very good post.

carlsoane May 21, 2011 at 7:03 pm

Methinks: I’m not advocating for a central authority to manipulate aggregates. In fact, by adding OPECia to the parable, I was highlighting the risks of manipulating the Squanderbuck to solve the imbalance. (And, to be fair to Buffett, he bemoans the possibility of a declining dollar. Krugman, on the other hand, seems to be cheering the devaluation on.)

Marcus: If anything, it is a fatal conceit to assume that you can hedge yourself perfectly against aggregate factors.

Methinks1776 May 21, 2011 at 7:22 pm

Carlsoane,

Marcus: If anything, it is a fatal conceit to assume that you can hedge yourself perfectly against aggregate factors.

Marcus never claimed perfect hedging is possible (hope you don’t mind me jumping in, Marcus). There’s no such thing as a perfect hedge, full stop. Even equity options which we say are “perfectly” hedgeable with the underlying are not perfectly hedgeable. It’s a good thing then, that you don’t have to be perfectly hedged to significantly reduce your exposure.

carlsoane May 21, 2011 at 7:30 pm

Ken: Here is what I said: “Buffett is, of course, right. If you consume more than you produce, you eventually end up in thrall to creditors.” Squanderville and Thriftville could be neighboring townships, states, countries, whatever. That statement would be true.

There is, of course, a second factor. Squandervillians and Thriftvillians have different currencies and the value of the Squanderbuck will go down as they on aggregate buy more from Thriftvillian farmers than Thriftvillians buy from Squandervillian farmers. Your Shoppers example doesn’t capture that currency exchange factor. And, it was the wisdom of Krugman celebrating the resultant currency devaluation (compounded by the currency devaluation by the Fed) that I was questioning.

I never said that a trade imbalance meant that one country was in debt to another. But as long as we’re now talking about the relationship of debt to current account imbalances, you can look at the Squandervillian problem two ways: they don’t produce enough to pay for what they consume or they consume too much for what they produce. They can thus solve the problem by producing more or consuming less (or some combination thereof, but for simplicity’s sake I’ll make it a binary decision). If you look at the problem as the latter, it is legitimate to claim that the current account imbalance represents a savings shortfall by the Squandervillians.

carlsoane May 21, 2011 at 8:25 pm

Methinks: Yes, you can reduce your exposure by hedging well. But you will still be affected by a currency devaluation because you can’t hedge perfectly. Hence you are affected by the aggregate factor of a currency devaluation. It actually seems a rather innocuous claim on my part.

I would add, too, that to the average person who doesn’t spend his/her life working in finance figuring out how to hedge well is not necessarily that easy. So, the average person will probably not end up hedging all that well. (And, in case you’re wondering, that doesn’t mean that I think the government should protect everyone from their lack of expertise.)

Methinks1776 May 21, 2011 at 9:42 pm

Oh, you think the guys in finance are so good at it ? :)

Ha!

carlsoane May 22, 2011 at 12:57 am

:-)

Ken May 22, 2011 at 1:11 am

carlsoane,

“Your Shoppers example doesn’t capture that currency exchange factor.”

Of course it does. I exchange money for meat, fruits vegetables, cream, razors, etc. Since ALL of these things can be used to barter, they are all currencies.

“I never said that a trade imbalance meant that one country was in debt to another.”

This is the entire point of Buffett’s video, which of course is wrong. His construction of Squanderville (which of course means the US) and Thriftville (which of course used to be Japan and now China is the current bogeyman) is completely artificial and doesn’t reflect international trade, even at a basic level. It’s utter rubbish. Thus any reference to Squanderville and Thriftville is an implicit argument that “a trade imbalance meant that one country was in debt to another”.

Regards,
Ken

carlsoane May 22, 2011 at 10:30 am

Ken: By the way, I didn’t watch the video. I just read Muirgeo’s later link to the Delong site that contains the written version of Squanderville vs. Thriftville and assumed the two told the exact same story. If the video tells the story differently, then my apologies for the confusion that introduced, but I generally don’t go watch linked videos because I can’t be bothered to sit all the way through them. With an article I can always just scan it.

That said, my key takeaway from Buffett’s story (at least in the written version of it) is that there is a discrepancy between what Squandervillians produce and consume. If the Squandervillians produce nothing and consume something they will end up in debt. That was what I said was right and it is right. The presence of the border between the two groups is irrelevant to that fact.

Then I went on to talk about the danger of advocating a currency devaluation to remedy the problem because, in doing so, you injure those Squandervillians who are actually doing some work and who rely on imported materials to do that work. In making that point about the danger of applying a collective solution to the problem, I began, ironically, to be criticized for advocating a collective solution.

Neither do I believe, however, that aggregate factors are irrelevant. They are relevant and currencies are a mechanism by which those aggregate factors affect individuals. The dollar is not like a banana or a razor. It is an abstraction for bananas and razors and everything that everyone within the dollar’s currency regime consumes and produces and trades and that makes it more subject to aggregate factors.

Mesa Econoguy May 21, 2011 at 6:14 am

I missed the really funny part where Buffett lost $1 billion dollars currency trading.

Can you show me where that was?

muirgeo May 21, 2011 at 10:40 am

It was right after the part where he made $20 billion…. I think you just missed it.

Mesa Econoguy May 21, 2011 at 6:19 am

And know what the really really funny part was?

When his son Peter got divorced (the first time) and had to grab a crane to get the enormous equipment out of his giant mansion on Lake Drive, right next to Corbin Bernsen’s house in Major League.

Peter is a pretty good audio engineer. Narada.

But that’s just me.

Mesa Econoguy May 21, 2011 at 6:38 am

Oh, did I mention, I recorded at Peter Buffett’s studio (waaay back when) on Jefferson Street in Milwaukee.

Nice guy, but definitely not daddy’s vision of “you’ll have to live like average US Joe”.

Peter had a $250,000 Synclavier in the studio, which we used.

Beautiful. Gorgeous orchestral strings.

Marcus May 21, 2011 at 1:41 pm

Buffet comments on imports having gone from 5% of GDP to ~15% of GDP.

But why wouldn’t it? World production has increased significantly during that same period of time. To say that increasing imports as a percentage of GDP is bad is to say that Americans should not reap any of the benefits of the global increase in production.

I think people like muirgeo and Buffet are upset that people around the world are doing better and better. And in muirgeo’s little zero-sum world, if other people are doing well then we must be doing poorly.

Marcus May 21, 2011 at 1:42 pm

“I think people like muirgeo and Buffet are upset that people around the world are doing better and better. And in muirgeo’s little zero-sum world, if other people are doing well then we must be doing poorly.”

As for Buffet, he probably just doesn’t like the competition.

Dan May 21, 2011 at 1:45 pm

Lost in buffet land………..

Marcus May 21, 2011 at 1:50 pm

Oops! LOL!

I didn’t even notice. Oh well. :-)

muirgeo May 21, 2011 at 9:21 pm

I think people around the world and in this country are upset that people like you think they are doing better. WTF planet do you live on?

If we WERE comparing say China’s improvements in living standards to ours your point is still lacking. If I have to decide to chose between which people prosper and which don’t I’ll chose my country over anothers. Especially since mine is a free country and theirs is a communist country. If you had to chose would you really support communist China’s growth over ours because they have more people?

You position is like saying Bill Gates shouldn’t be jealous or concerned with Steve Jobs success…. Yeah maybe you”re ok being a PC but I want to be a Mac.

brotio May 22, 2011 at 12:51 am

…but I want to be a Mac.

You’re not even a Commodore 64.

LowcountryJoe May 22, 2011 at 9:56 am

Especially since mine is a free country and theirs is a communist country.

In spite of the best efforts by the asshats you show your support for? I have never really took you for one to appreciate a free(er) country. And if I am wrong about you, you certainly haven’t demonstrated you know anything about keeping it free.

As to answering your silly questions I’d just like to rhetorically ask, “Why not support individuals prospering regardless of their origins?”

Marcus May 22, 2011 at 10:19 am

@brotio,

Hey man! The Commodore 64 was awesome!

He’s not even a TRS-80. How’s that?

It’s interesting that he’s a Mac guy rather than a PC guy. The PC has an open architecture that allows any one to build one. The Mac is closed and Apple imposes dictatorial control over it.

In the end, the Mac is really all about marketing. The marketing is that you’re smart and cool if you own a Mac. It’s feel good, pat yourself on the back marketing.

Which is why it appeals so well to liberals.

Dan May 22, 2011 at 11:53 am

Liberals thrive on strict control.

brotio May 22, 2011 at 11:11 pm

@Marcus

:)

Myrina Stein May 21, 2011 at 4:33 am

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After seeing this, I would like to request you something. I love to write financial articles and I would like to contribute article for your site if you’ll give me the permission. I can give you an original guest post and I assure you that it will be published only in your site. If you want, you can suggest me the topic also and I will write accordingly.

Please let me know your thoughts. Waiting for your positive reply. Reach me at: myrina (dot) stein (dot) 888 [at] gmail (dot) com

Thanks,
Myrina

Don Boudreaux May 21, 2011 at 7:42 am

Thanks, but Russ and I from the beginning of our blog have kept to a strict policy of writing our own stuff. We don’t even use guest bloggers.

Sam Grove May 21, 2011 at 10:53 am

Though they frequently link to articles by others.

juan carlos vera May 21, 2011 at 4:42 am

Keynesians are wrong from the beginning to the end. They try to explain an economic phenomenon with the magnifying glass of national accounts using what they call the basic macroeconomic identity (1): C+G+I+(X-M)=Y. They do not realize that this identity is just that, a simple identity, and say nothing about the economic phenomenon itself. This fundamental error leads them to believe that the good performance of an economy is measured and observed in terms of this identity.
It is trivial to recognize that this identity is completely ambiguous:
a) This identity makes it possible a domestic demand as large as desired while domestic production is zero. This would be an extreme situation where the Rest of World is so generous who gives us all goods that we require to meet we needs, thus Y=I=X=0, C+G=M. I don’t want to live in this Rest of World.
b) This identity also allows us to conclude that all aggregate demand can be domestic one, thus X=M=0, C+G+I=Y. This is Cuba. I don’t want to live in Cuba.
c) This identity also allows infinite combinations of aggregate demand and domestic demand for a given output value Y. Thus, given a value Y, it could be that all this production is exported and thus Y=X, C+G+I=M, or it might happen that none of this production is exported and thus X=0, C+G+I-M=Y, or it could go either of infinite intermediate possibilities without changing the domestic production Y. In this last case, a value of Y is consistent with infinite values for current account.
The basic macroeconomic identity (1) is just an accounting result. It is an insult to human intellect trying to explain a social phenomenon with this identity.

muirgeo May 21, 2011 at 10:51 am

And this is where I like to ask the Keyensian critics… ” So what IS the best measure of an economy?” and then I follow that with…” Ummm??”

Methinks1776 May 21, 2011 at 11:40 am

Ummm??

The persistent white noise in your empty skull.

LowcountryJoe May 21, 2011 at 3:15 pm

So what IS the best measure of an economy?

The freedom to be able to participate in it if one so chooses. Followed by the standard of living one can obtain through the exchanging of their labor.

muirgeo May 22, 2011 at 4:02 am

By those measures the social democracies like Denmark have better economies. Likewise for the USA in the 50′s,60′s and 70′s compared to now.

Methinks1776 May 22, 2011 at 10:16 am

Do you understand what “standard of living means” and “Freedom” means?

In the 50′s the average house was 900 sq ft. (compared to 2400 today). One car per family was the middle class norm. There were no cell phones, no ipads, no computers, no flat-screen TVs, etc.

Blacks were subject to Jim Crow laws. Only an idiot like you would describe that as “freedom”.

Women’s economic opportunities were severely limited.

Marcus May 22, 2011 at 10:23 am

@Methinks,

Yep.

The 50′s were great if you were a white suburbanite. For everyone else, it wasn’t such a great time.

muirgeo looks back fondly upon it because in the 50′s whites excluded other’s from the market place through unions and Jim Crow laws. Lot’s of control and muirgeo likes control.

muirgeo May 22, 2011 at 1:54 pm

google Fresno and tent city… how many square feet in those tents… you halacious dumbass?

Methinks1776 May 22, 2011 at 2:40 pm

Marcus,

Muirdiot doesn’t know what happened in the 1950′s and 60′s. For him, a good day is remembering last week.

He idealizes the 50′s and 60′s because Krugman does. Which reminds me….that was also a fun time to be a JOOOO.

juan carlos vera May 23, 2011 at 2:05 am

Some measures are:
-Freedom of expression
-Freedom of production
-Freedom to exchange
-Freedom to choice
-Freedom to belief
-Freedom to life
-General freedom
-The reign of peace
-The Respect for life
-The Respect for private property
-The validity of the true law (the rule of law)
-The reign of justice
-The validity of the constitution (constitutional government).

Antonio Mendes May 21, 2011 at 6:29 am

Don, you forget the most likely scenario.
The foreign exporter receives IOUs instead of dollars. So, increasingly indebted America sooner or later will have to adjust, thus reducing aggregate demand and growth.

However, the reason why a moderate trade surplus is better than a deficit is that it means that your goods and services have a higher income elasticity of demand than those of your trading partners, meaning that you will grow faster.

Moreover, there are two virtuous circles associated with export growth that work as catalysts for foreign investment and rising productivity.

Once upon a time when I worked as a professional economist I wrote a small paper explaining that: Marques Mendes, A. 1988. “The case for export-led growth”, Estudos de Economia 9, 1: 33 – 41

Stephan May 21, 2011 at 6:46 am

A lot of Keynes bashing going on here. Keynes would be delighted. Just a quick note: I think this post about aggregate-demand-obsessed economists is neither balanced nor complete.

(1) I don’t know any aggregate-demand-obsessed economists who would not acknowledge that imports are a benefit and exports are a cost. As long as foreigners are willing to ship real stuff in exchange for green paper or green digital tokens the US economy benefits. However aggregate-demand-obsessed economists also say, that the party can only last as long as foreigners are willing to trade real stuff for dead presidents.

(2) Yes. Foreigners can use their US$ to either buy real stuff from the US or invest in the USA. But there’s a third possibility. They can also save in US$. And these savings plus domestic savings are a leakage from the aggregate expenditure stream. Thus if the private sector and the foreign sector desires to save there’s only one sector left to spend: the government sector.

Don Boudreaux May 21, 2011 at 7:44 am

Even though I disagree with Keynesians that savings are a “leakage” from the economy, there’s nothing about trade deficits that uniquely drives up (or down) savings.

vidyohs May 21, 2011 at 10:56 am

People create wealth through earnings in one endeavor or the other, true?

They do that in order to be able to buy the necessities of life plus some wants as well.

Saving some of what is earned does not equate to a total ceasing of spending. I see no individual or nation that can afford to save all it earns. Savings may represent a temporary suspension of the circulation of money, but it will be spent at some point. As you see leakage from savers today, you seem to be dismissing the infusion of money that has been saved in the past and is now being put back into circulation as the time to spend has arrived for those who saved in the past, perhaps even by heirs, who knows.

Then there is this. The Federal Reserve Note (FRN) is debt paper. It is created out of thin air by fiat and has no value at all, in and of itself.

So, if China takes every second FRN it receives, puts it into a vault as savings, and never uses it; how is that a bad thing for this nation?

They take our debt, never demand payment, and the paper debt is put away as savings never to be used or called in, and the real tangible assets of the USA (land, production capabilities, labor) is not diminished in any way shape or form.

Last but not least, let China force a default on the paper and how are they supposed to collect? After the Civil War, Abe Lincoln said, “There is no force on the face of the Earth that can drink from the Ohio River, if we do not give permission.”

How is China going to take the Ohio River? Do you think that vidyohs and like minded people are just going to retreat to Canada and let China have its way?

Vidyohs and like minded people know that we didn’t create that debt paper and we certainly don’t approve of how it is spent; so, we are unlikely in the end to meekly seeing some foreign force seize our land because of the stupidity of our government.

Maybe it is just my naive ignorance but I’d rather be in the USA position in that deal rather than the China position.

DG Lesvic May 21, 2011 at 1:01 pm

Even saving money in a mattress merely forces prices downward and the purchasing power of the money remaining in circulation upward. So, though less money in circulation, there is no less less purchasing power and demand, for all of it saved is, in effect, lent to the spenders.

Bill Woolsey May 21, 2011 at 9:29 am

I think aggregate demand is important. Equilibrium requires that aggregate demand match the productive capacity of the economy.

While it is true that any imbalances between the two involve an imbalance between the quantity of money and the demand to hold it, a more detailed analysis is interesting.

Krugman’s editorial was about how conservative Republicans are griping about the fall in the exchange rate of the dollar.

Well, if the quantity of money remains in equilibrium with the demand to hold money, a shift in the domestic savings curve to the right or the domestic investment curve to the left will have a series of effects, including, quite plausibly, a reduction in the nominal and real exchange rate and an expansion of sales of manufactured goods to foreigners.

The Fed, of course, could create a shortage of money, and because of price level stickniess, cause a depression, and then only gradually would a lower growth path of prices and wages lead to the reduced real exchange rate and the expansion of sales of manufactured goods to foreigners.

While all of Krugman’s left/liberal asides were a bit irritating, this advocacy of exchange rate targeting by Ryan is surely troubling.

Don, perhaps you could do a better job explaining why exchange rates (and interest rates for that matter) are market prices, and sometimes they need to be lower to coordinate supply and demand.

DG Lesvic May 21, 2011 at 12:52 pm

Prof Woolsey is one of the Keynesian Austrians.

Here was my description of them.

“The Keynesians (including the Keynesian Austrians, Selgin, White, Horwitz, Rizzo, Garrison, O’Driscoll) see the flight to safety as an ‘excess demand for money,’ sending prices and markets into a deflationary tailspin; and, to stabilize them, would increase the supply of money until it equaled the demand for it.

Their plans are contradictory, for the monetary discipline of their Free Banking would preclude the inflation for their Monetary Equilibrium.

They are confusing the medium with the objects of exchange, and marginal with total demand for money. While the supply of oil, apples and oranges, the objects of exchange, determines our wealth, that of money, the medium of it, does not. We are richer with 100 than with 50 barrels of oil, but no richer with oil at $100 than at $50 a barrel. While the greater supply of oil renders a greater service than the lesser supply of it, the greater supply of money renders no greater service. So there will be no market demand for any greater number of dollars. The greater demand for money in the market means something entirely different, a greater marginal rather than greater total demand for money.

As production and the supply of goods goes up, and there are more goods chasing the same number of dollars, there will be a greater demand for each dollar, but not for more dollars. Or, if the greater demand for money was for more savings, increasing the supply of money and reducing the value of savings would not be meeting but thwarting the demand.

There is an excess demand for money only in the mind of a dictator, for the market and its individuals are the best judges of how much they should save.

While to Prof. Selgin, this was nothing but ‘gibberish,’ he did accept my label for him. ‘Yes, I am one of those ‘Keynesian Austrians.’ Just like Hayek.’

He may have had Hayek in his corner, but not Mises, stating that ‘All plans to render money neutral and stable are contradictory. Money is an element of action and consequently of change.’

Human Action, P 419”

From The Cause and Cure of the Depresssion at http://econotrashtalk.org/#The Cause and Cure of the Depression

Tadpole May 21, 2011 at 10:33 am

Professor,
How does your scenario account for the foreigner who , instead of buying American g/s, goes to the bank and buys his Currency with his dollars?

Sam Grove May 21, 2011 at 10:58 am

What happens next?

Either the money goes somewhere else, or it is destroyed.

Marcus May 21, 2011 at 12:47 pm

Think of when you exchange dollars for stocks, there is ultimately someone else on the other side of that exchange trading stocks for dollars.

Same thing. The foreigner is exchanging dollars for his currency and on the other side of that exchange is someone else who is exchanging foreign currency for dollars. That someone else will then spend the dollars.

The exception to this are central banks and their reserve accounts. China’s central bank can exchange yuan for dollars and then hold on to the dollars. They can do that because, just like our central bank, they can effectively “print” yuan out of thin air.

That devalues the yuan and drives up the value of dollars. It makes the dollars in your pocket worth more. Or, it would, except that we too have a central bank that likes to play exchange rate games.

Diego May 21, 2011 at 11:11 am

Investment is not everything foreigners do with their dollars when they are not spending them on American goods. The Chinese for instance lend lots of those dollars to the US government, allowing it to spend more and grow. Aren’t you worried that running a huge trade deficit with China potentially government to grow more than it otherwise would? Of course that frees up resources in for the private sector and keeps interest rates within the US low, but I do wonder what are the costs in terms of size of the public sector, if any.

John Dewey May 21, 2011 at 8:40 pm

Diego,

You seem to be saying that the U,S, government would not borrow as much if China and other nations did not buy T-bills. Why do you believe that the amount of such foreign purchases would in any way inhibit the U.S, Congress from spending.

Diego May 22, 2011 at 9:49 am

Well frankly it just seemed common sense to me. Like giving a credit card to a shopaholic.

John Dewey May 23, 2011 at 4:06 pm

Can you explain why you believe that the U.S. Government is dependent on foreign investors for funds? In other words, in the unlikely event that foreign investors stopped buying T-bills, why couldn’t Treasury simply raise interest rates to the level required to attract sufficient U.S. investors?

Diego May 24, 2011 at 6:46 am

Because I believe in downward sloping demand curves. But given that political bodies need not act like constrained optimizing individuals, I might be wrong about the US government. Perhaps you can tell me why you think that the government will spend as much no matter what the costs of borrowing.

John Dewey May 24, 2011 at 8:50 am

“Perhaps you can tell me why you think that the government will spend as much no matter what the costs of borrowing.”

I do not think that, Diego. But the costs of borrowing continue to be very low for the U.S. government. Investors such as me would have no problem moving funds from corporate bonds to U.S. Treasuries if the government raised rates just a little.

John Dewey May 24, 2011 at 8:55 am

Not sure if I explained this well enough for you,

In the highly unlikely event that foreign investors stopped purchasing U.S. Treasuries, the impact would be:

1. U.S. treasury would be forced to raise T-Bill rates by enough to attract sufficient domestiv investors;

2. Corporate debt would be priced even higher, reflecting the T-Bill rate plus the risk premium.

3. Some corporate investment would become uneconomical at the higher interest rates.

As I see it, foreign purchases of U.S. treasuries does not enable U.S. government spending. Rather, such purchases prevent the crowding out of U.S. private investment.

Methinks1776 May 24, 2011 at 9:41 am

John Dewey,

You’re making a couple of errors in thinking about bond rates.

why couldn’t Treasury simply raise interest rates to the level required to attract sufficient U.S. investors?

Treasury rates aren’t set by the Treasury. They’re set by the market. If bidders for Treasury debt disappear, the rate on Treasuries rate will rise. Those two things are synonymous. The Treasury does not lower and raise the rate itself.

If Treasury rates rise, the cost of borrowing also rises – not just for the United States government, but also for everyone else borrowing in USD. Which brings me to my next point…

Investors such as me would have no problem moving funds from corporate bonds to U.S. Treasuries if the government raised rates just a little.

Interest rates on corporate bonds are also set by the market and are calculated as the risk free rate plus a risk premium. The proxy for risk free rate is the appropriate Treasury bond. Thus, corporate bond rates are calculated as Treasury rate plus a spread. You will never find a corporate bond yielding less than Treasuries because no corporation is less risky than the government.

If you find yourself holding a corporate bond with an interest rate of 5% and interest rates on Treasuries rise to 8%, you can switch to Treasuries. However, the price of your corporate bond will decline to a price such that there will be no arbitrage in switching from one bond to the other. You will gain no advantage in the switch.

Of course, higher interest rates mean that the cost of capital will rise, making more investments uneconomic. This will have the effect of reducing asset prices (since asset prices are calculated as cash flow/cost of capital or discount rate). As fewer projects become uneconomic, economic activity declines and Treasury investors become nervous that the economy will not produce enough to tax to repay them and the actors in the economy lose incentive to engage in productive activity as they realize that all of the product of their labour must go toward paying for the spending of a the clowns in congress.

This is a bit simplistic, but you get the picture.

I don’t agree with Diego that China is in any way responsible for our debt problems. It can only bid for Treasuries, it can’t borrow and spend on our behalf the way the clowns in congress can and it has its own reasons for buying Treasuries.

Certainly, the government doesn’t have to stop spending. It can simply keep printing more money – but, the whole economy will collapse at some point.

You seem to contradict your previous posts in your last post, so I don’t know where the disconnect is and hopefully what I wrote was helpful.

Finally, that Treasuries are strongly bid does not prevent crowding out of private investment. Government spending is what crowds out private investment and since Treasuries trade in a very liquid secondary market, we do not need new issues for the market (foreign bidders or domestic) to set Treasury rates.

Methinks1776 May 24, 2011 at 9:43 am

as more projects become uneconomic, that is. Also, I’m obviously talking about taxable productive activity. Sorry.

John Dewey May 24, 2011 at 11:45 am

Methinks,

Thanks for the lecture.

Perhaps I should have written:

” in the unlikely event that foreign investors stopped buying T-bills, Treasury would simply beforced to pay interest rates at a level required to attract sufficient U.S. investors”

I am not so ignorant, Methinks, as to believe that corporate bonds will have yields below those of T-Bills. Still, I see no error in my statement:

“Investors such as me would have no problem moving funds from corporate bonds to U.S. Treasuries if the government raised rates just a little.”

As an investor in retirement, I will not be seeking arbitrage opportunities, but rather seeking an income level which I believe will meet my requirements. If interest rates on Treasuries are high enough to generate the income level I require, I will invest in Treasuries for that short-term income.

“You will gain no advantage in the switch.”

I disagree. Whether I gain will depend on my own personal preferences for risk. If Treasuries generate the income I require in the short term, I will gain piece of mind by switching from riskier invesments. And I believe many other investors will make that same assessment of risk and return.

John Dewey May 24, 2011 at 11:52 am

methinks: “Finally, that Treasuries are strongly bid does not prevent crowding out of private investment.”

That is true. I guess my point was that foreign investors – whether they invest in T-Bills or corporate bonds – do help keep interest rates lower than they otherwise would be. And lower real interest rates have definitely had a positive impact on investment at corporations where I made the analysis.

John Dewey May 24, 2011 at 11:54 am

Methinks: “I don’t agree with Diego that China is in any way responsible for our debt problems.”

Well, I’m glad to see we agree on something.

Methinks1776 May 24, 2011 at 12:33 pm

John Dewey,

Still, I see no error in my statement:

“Investors such as me would have no problem moving funds from corporate bonds to U.S. Treasuries if the government raised rates just a little.”

John, I was still getting my caffeine dose when I read that this morning. I couldn’t understand why you would say such a thing. I apologize for inadvertently flipping the scenario to exactly the opposite of what you illustrated. My mistake.

I’m now on the same page.

However, I’m troubled by your statement that the government will be able to borrow just as much at higher rates. Why would that be true? Certainly, some people (as you point out) will switch from corp. bonds to Treasuries, but you must understand that not enough would (I take it you do because the scenario you describe does not replace all of the lost demand as interest rates remain higher than they were before foreign bidders like China disappeared).

. I guess my point was that foreign investors – whether they invest in T-Bills or corporate bonds – do help keep interest rates lower than they otherwise would be.

No doubt. But, that’s a different argument from crowding out.

Methinks1776 May 24, 2011 at 12:45 pm

(I take it you do because the scenario you describe does not replace all of the lost demand as interest rates remain higher than they were before foreign bidders like China disappeared).

No. I’m wrong. The U.S. would be able to attract as many investors as it wants by increasing the interest rate. The government parasites will crash the economy in doing so, but they will continue to find creditors.

John Dewey May 24, 2011 at 2:36 pm

methinks: “But, that’s a different argument from crowding out.”

Would you consider that “crowding out” might have more than one definition?

Investopedia explains Crowding Out Effect

“Governments often borrow money (by issuing bonds) to fund additional spending. The problem occurs when government debt ‘crowds out’ private companies and individuals from the lending market.

Increased government borrowing tends to increase market interest rates. The problem is that the government can always pay the market interest rate, but there comes a point when corporations and individuals can no longer afford to borrow.”

Investopedia is not the only source which uses this definition.

John Dewey May 24, 2011 at 2:39 pm

“methinks: The government parasites will crash the economy in doing so, but they will continue to find creditors.”

I agree completely with this statement.

Methinks1776 May 24, 2011 at 5:30 pm

Why ask me, John? My brain is clearly on strike today. I apparently have never heard of supply and demand.

JD:As I see it, foreign purchases of U.S. treasuries does not enable U.S. government spending. Rather, such purchases prevent the crowding out of U.S. private investment.

I do not think it is the level of demand for U.S. bonds that determines whether there is crowding out or not in the credit market. I think that there is always crowding out at the margin and the level of crowding out is determined by how much of the demand for U.S. debt is met by issuing Treasuries. High demand does not prevent crowding out.

By the same logic, I don’t think it is the amount of available resources that determines crowding out of private spending. Rather, I think the level of crowding out is determined by how many of those resources are consumed by government.

Of course, as you say, relatively strong demand for U.S. bonds will reduce interest rates for all U.S. borrowers. However, strong demand lowering the cost of capital is different from the issue of crowding out. Crowding out can happen at any interest rate.

I am the source of the confusion. In my all too typical hasty fashion, I left out “borrowing” from the last sentence of my first response to you. corrected:

“Finally, that Treasuries are strongly bid does not prevent crowding out of private investment. Government [borrowing and] spending is what crowds out private investment….”

I don’t actually think much about the issue of crowding out because I don’t have to. But, this is what methinks. What do youthinks?

WhiskeyJim May 21, 2011 at 2:18 pm

Great article Don.

I contend the whole equation is nonsense, meaning nothing; one of the worst equations in all of education. Unfortunately so many social sciences teach a variety of nonsense; none of it verifiable other than through the inevitable mess it causes when we listen to them.

First, the equation has no offset; where does the spend come from? For that matters a great deal. Combining investment and consumption implies some sort of cash flow. But only a severely confused individual would compose the equation that way.

In fact, any trace of the spend sources shows how silly concentrating on only one part of a simple addition and subtraction equation (imports and exports) constitutes a failure of grade 5 math.

Second, as a practical measure of domestic ‘demand,’ it implies a brutal and impractical method. It’s shortcomings and inaccuracies are so outstanding they render the measurement useless. How can economists put up with such crap data? It calls into question the whole discipline as a serious enterprise.

It is simply beyond me how intelligent people can take such things seriously. I do not understand it. It is one of the reasons I treasure free market sites such as this one. It gives me hope.

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