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An Open Letter to Dean Baker

Dean Baker

Mr. Baker:

Your criticism of Greg Mankiw’s argument that the U.S. trade deficit is nothing to worry about reveals faulty logic as well as a misunderstanding of basic economics (“Trade, Trump, and the Economy: What Does Greg Mankiw’s Textbook Say?” Dec. 4).

An example of your faulty logic is your claim that “Mankiw may have missed it, but we had a long stretch of very high unemployment following the collapse of the housing bubble in 2008.  The Fed purchased plenty of financial assets in this period, it had some effect on boosting output and employment, but did not come close to getting the economy back to full employment.”

Overlook here the significant reality that the Fed’s asset purchases were driven by political and monetary-policy considerations rather than by private entrepreneurial, market considerations.  Instead, focus on the fact that Prof. Mankiw’s argument is that foreigners’ purchases of dollar-denominated assets make the American economy stronger than it would otherwise be.  Contrary to your implication, the argument is not that such purchases alone are sufficient to guarantee full employment and high growth.  Therefore, the fact that America ran trade deficits during the Great Recession does not refute Prof. Mankiw’s argument.

If you insist on drawing conclusions about trade balances exclusively from the condition of the economy, then what is your explanation for the U.S. running a trade surplus in 102 of the 120 months of the Greatly Depressed decade of the 1930s?  Or how do you explain the fact that, as my Mercatus Center colleague Dan Griswold notes in a 2011 paper, “since 1980, the U.S. economy has grown more than three times faster during periods when the trade deficit was expanding as a share of GDP compared to periods when it was contracting”?

An example of your misunderstanding of economics is your assertion that, according to “textbook” economics, “capital is supposed to flow from rich countries where it is plentiful to poor countries where it is scare.”  This assertion is nonsense.  What economics predicts is that capital will flow to where its risk-adjusted rates of return are highest.  Therefore, textbook economics predicts, accurately, that in practice rich countries will receive disproportionate inflows of capital because rich countries generally have institutions, policies, and cultures that ensure that the expected returns on capital invested there are higher than are the expected returns on capital invested in poor countries.

There’s a reason that poor countries are poor, and a big part of that reason is that investment climates in those countries are unfavorable.  So economics no more predicts that capital “is supposed to flow” from rich countries to poor countries than it predicts that capital “is supposed to flow” from thriving, well-managed, highly capitalized companies with triple-A credit ratings to struggling, poorly managed, capital-poor companies on the verge of bankruptcy.

Donald J. Boudreaux
Professor of Economics
Martha and Nelson Getchell Chair for the Study of Free Market Capitalism at the Mercatus Center
George Mason University
Fairfax, VA  22030