Friday, February 1, 2008
Alternative Trade Deficit Explanations
This editorial looks at the decline in the U.S. current account (basically, NX) and wonders whether Alan Greenspan's explanation is correct. The author describes Greenspan's theory, and then offers his own counter-theory. If you read through this, think about describing the two theories in terms of the loanable funds market. In particular, changes in the world interest rate versus changes in our savings rates.
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Richard Duncan, author and journalist for Financial Times, disputes Alan Greenspan’s autobiography, “The Age of Turbulence”, Chapter 18. Duncan claims that today's policymakers must see past Greenspan’s mistaken analysis of the causes and consequences of the extraordinary growth of the U.S.'s account deficit. According to Greenspan, high rates of saving abroad led to increased consumption in the U.S. An alternative view to the cause of the growth in the deficit is that increased globalization made trade between richer countries and poor countries possible. Rich countries began to buy cheaper goods in poor countries and poor countries continued to buy their own domestic goods because they were cheaper than those abroad. As a result, the U.S. deficit, which was balanced in 1991, rose to $850 billion in 2006. With the increased trade effects of globalization taking place, the central banks of countries which had a surplus prevented their currencies from appreciating by printing their own currencies and buying thousands of billions of dollars to sustain their competitive advantage.
Greenspan argues that no real harm has been done by these trade imbalances, and that rising debt and progress go hand-in-hand. It seems more likely that the rise of the U.S. deficit and the paper money creation have generated an economic bubble around the world that is close to imploding. In order to stave off a complete systemic meltdown, the central banks of Europe, the U.S., and the U.K. have injected billions into the credit markets. The Federal Reserve has been prompted to issue a round of aggressive rate cuts. U.S. lenders have expanded their balance sheets at an unprecedented pace and the U.S. government is currently rushing through a $150 billion emergency stimulus package in an effort to prevent a world recession.
The economy’s output is used for consumption, investment, and government purchases. Consumption depends negatively on the real interest rate. Government purchases and taxes are exogenous variables of fiscal policy. In terms of the loanable funds market, the real interest rate adjusts to equilibrate the supply and demand for the economy’s output-or, equivalently, to equilibrate the supply of loanable funds (savings) and the demand for loanable funds (investment). The world interest rate has been affected by a number of key variables that change relatively slowly over time. These variables include labor force growth, which affects investment demand, and the age structure of the world economy, which affects savings. Other variables, such as the level of financial development (reflected in the ability to mobilize savings, to allocate capital, and to facilitate risk management) also influence savings. Since these variables adjust gradually, it is unlikely that they will be a source of significant changes in world interest rates in the near future.
A decrease in national savings, perhaps because of an increase in government purchases or a decrease in taxes reduces the equilibrium amount of investment and raises the interest rate. An increase in investment demand, perhaps, because of a technological innovation or a tax incentive for investment, also raises the interest rate. An increase in investment demand increases the quantity of investment only if higher interest rates stimulate additional saving. In the short term, however, analysis implies that unexpected temporary shocks to income, due perhaps to fluctuations in oil prices, could lead to short-term fluctuations in savings behavior and real interest rates.
In this editorial author and journalist for London’s Financial Times Richard Duncan discusses Alan Greenspan’s theory regarding the growth of the United States’ trade deficit and offers a theory counter to it.
Greenspan maintained in his autobiography “The Age of Turbulence” that a high marginal propensity to save abroad led to an increase in domestic consumption. The explanation offered by Duncan claims that the cause of the rising trade gap is that increased global integration of markets to a world market—globalization—has further enabled trade between more developed countries and less developed countries. Consequent to this, the richer states noted an increase in the import of the cheaper goods produced by underdeveloped foreign states while poor nations continued to purchase only goods from poor nations because the exports of wealthy states were too expensive.
The result of this phenomenon was a rise in the trade imbalance from being neutral in 1991 to an imbalance of $850 billion in 2006. In that interim, globalization has only increased, furthering the above noted effects which in turn caused the central banks of many countries with trade surpluses to print more money and use it to purchase dollars, preventing their own currency from gaining value, in order to maintain a favorable amount of exports.
Greenspan contends that the trade imbalances are harmless and that an increase in debt, necessary for the purchase of new infrastructure and capital, is integral to progress. Duncan’s view of this is that the deficit and issuance of paper money is the marking of an economic bubble that must be prevented from bursting by the injection of large sums of money into the debt markets. This is given weight from the fact that the US government is currently doing just that: attempting to combat recession by cutting interest rates and doling out stimulus packages.
My reaction to this is curiosity more than anything. Duncan offers a compelling argument, but it is highly speculative and seems to fit less consistently with the economic models we’ve discussed in class than Greenspan’s explanation.
“Buyers, not savers, caused America’s deficit” by Richard Duncan speculates that Alan Greenspan had it wrong. Alan Greenspan believed that the deficit came about from a decline in “home bias” in foreign countries; these countries felt that their own domestic investments were unattractive and would invest abroad in the US causing a higher savings overseas, which lead to a higher US consumption.
With free trade, the emergence of developing countries like Brazil, Russia, China and India provide low cost production and limited domestic consumption. These foreign countries with lower wages offer goods cheaper to US consumers and foreign consumers. To keep the wages low and their currency stable, these foreign countries printed their own currency to buy billions of dollars, which were used to invest in US assets. Alan Greenspan believes that this debt rises with growth in a market economy. However, Richard Duncan argues that this cycle has created a bubble that will eventually pop requiring bigger government bailouts. However, despite running large trade deficits in the 1970’s, South Korea experienced a huge boom in economic growth proving there are exceptions.
Most economists like Alan Greenspan do not think trade deficits are a problem, but rather a sign of a bigger problem. Net export demand is down due to an increase in demand for imports and a decreasing or stagnant demand for exports. When net exports fall, the exchange rate falls, too. When the real exchange rate falls, foreign goods are more expensive and US goods are cheap. Net export is the difference between exports and imports or savings and investments. An increase in investment demand leads to a trade deficit and usually occurs with a decrease in national savings. With a growing foreign debt, the present consumption is high, but the future consumption will be low. When savings goes down, the marginal propensity to consume increases. Public savings falls so there is more money to spend with taxes down. However, taxes going down or government spending increasing are more likely than the marginal propensity to consume increasing.
A $150 billion emergency fiscal stimulus package is being considered and an excess of $500 billion liquidity injections from the US and various European countries was needed to keep the recession from going global. The Feds have been slashing the interest rates as well. The US funds their trade deficit mainly by selling treasury bonds or giving assets. Duncan says that the US current account deficit should be top priority in contrast to Alan Greenspan.
grandslam
Alan Greenspans' autobiography he says that he makes it very clear that he underestimated and misunderstood the consequences of the extremely fast growth in the current account deficit.
So now we must come up with new policies to counter act Greenspans miscalculations to restore our economic balance and the worlds' economic balance. And according to Greenspan the enormous deficit was caused by high savings rate from countries with budget surpluses, combined with not being able to find enough domestic products to import. Very high sasvings and very bad home investmets all happening at the same time when the economy was in a slight downturn.
grandslam
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