Grasping Reality with Both Hands: The Semi-Daily Journal Economist Brad DeLong

DeLong Smackdown Watch: John Yoo's Torture Memo and Academic Freedom

David Levine writes:

The Torture Memo: The Torture Memo and Academic Freedom: Consider Professor Left, on leave at CEA, who went on national TV to argue that a rise in the minimum wage would not reduce employment, increase prices, or harm small business's profits. Professor Left knew that at least one of these effects was essentially certain to occur, but had a political job to do.

Consider Professor Right who, a few years later, went on national TV to argue that a cut in capital gains tax rates would raise tax revenues. He knew full well that the short-term boost in tax revenue will be overwhelmed by revenue cuts in later years. He hid that fact on TV, in Congressional testimony, and in memos to executive branch decision-makers.

Professor Center is more mainstream than his colleagues on the left and right. He goes on national TV to argue that a free trade pact will increase U.S. employment. In fact, Professor Center believes unemployment will be roughly unchanged as it is largely determined by the Federal Reserve. Employment will probably be lower, Prof. Center believes, because the free trade pact might increase employment with the trading partners and reduce immigration to the United States.

Assume that each policy in fact had (somewhat predictable) harmful consequences: job loss for minority teens, massive budget deficits, and a financial crisis in the southern trading partners that reduced their ability to purchase U.S. exports. Was it professional misconduct to push these policies while declining to mention (and sometimes implictly denying) the downsides? Do those recommendations disqualify the professors from teaching? Would it matter if the economists had line authority and made policy decisions, or were trusted advisors who were very influential with both parties, not just standard wonk advisors?

I mention these cases not to defend Professor Yoo or the despicable U.S. policy of torture. I mention these cases to suggest the issues of academics acting as political advisors and decision-makers are tough.

I agree that the questions are tough. I do think that:

• Left-wing economists should not say that minimum-wage increases would neither (a) decrease employment, (b) rise prices, nor (c) diminish profits.
• Right-wing economists should not say that capital gains tax rates would raise tax revenues--unless they in fact do believe that the short-term boost in tax revenues outweighs properly-discounted revenue losses in the out-years.
• Centrist economists should not say that free trade will boost U.S. employment--unless they believe that free trade will make the country richer and so actually boost labor supply and demand.

But neither left-wing, right-wing, nor centrist economists say such things in the classroom: in the classroom we all teach what we believe. At what point do violations of intellectual integrity by economists under message discipline become grave enough to warrant some kind of sanctions--that is not a question I know the answer to. I think that there is a line that should not be crossed, and that some form of responsibility for line-crossing would be a good thing, but I am not at all sure where the line is or what the sanctions should be.

Menzie Chinn Watches the Turnaround of the U.S. Current Account

The U.S. current account turns around:

How far does it have to turn around? One unresolved issue is how much of the oil trade deficit will ever have to be repaid--if oil wealth is going to be invested in the U.S. in dollars in order to give princelings and dictators a political-risk insurance policy, the oil part never has to be "paid back" in a foreign-exchange sense. If foreign oil wealth is going to be used to buy imports of capital goods and raw materials from the U.S., to fuel industrialization, the answer is quite different...

Globalization 1.0

Paul Krugman reads books on his Kindle:

Fruits of globalization: [A] book recommendation: I’m reading Dan Koeppel’s Banana at Bedtime (yes, on my Kindle), and it’s great. Right now I’m in the midst of the rise of the modern banana trade, and of United Fruit.

One message from this story is that globalization as a profound source of change is nothing new. In fact, the combination of things that made the widespread consumption of bananas in America possible — railroads, steamships, refrigeration, and, not least, regime change often backed by American military might — where do you think banana republics came from? — makes containerization and the Washington Consensus look low-key by comparison...

Eichengreen (1997): The Baring Crisis in a Mexican Mirror

Barry Eichengreen (1997), "The Baring Crisis in a Mexican Mirror" http://repositories.cdlib.org/cgi/viewcontent.cgi?article=1031&context=iber/cider:

Conventional wisdom has it that the Mexican crisis of 1994-5 was "the first financial crisis of the 21st century." In this paper I argue that it may be better understood as the last financial crisis of the 19th. The crisis in Mexico exhibits striking similarities to the Baring Crisis of 1890, an event that did much to shape modern opinion about the causes and consequences of financial crises and the role for official management.

Parallels between the two episodes are extensive.... Mexico was the benchmark for investors in emerging markets in the 1990s (it was the single largest borrower, and the spreads it commanded set the floor for other borrowers), Argentina, the country whose financial difficulties ignited the Baring Crisis, was commended to investors as "The United States of South America"... the single most important destination for British capital outside the United States and the British Empire... the wheels of international finance were greased by declining interest rates worldwide, associated with Goschen's debt conversion in the 1880s and recession- induced cuts in interest rates by the Federal Reserve in the 1990s. In both cases investors who had been slow to join the bandwagon climbed on board in the final stages of the boom.

While foreign borrowing was portrayed as financing investment in productive capacity, in both cases capital inflows fueled rising levels of consumption. Foreign capital flowed through the banking system, and bank lending financed purchases of luxury imports as well as capital goods. Governments failed to boost their savings to offset dissaving by the private sector. In both cases powerful opposition existed to the government in power, leaving officials reluctant to tighten monetary and fiscal policy for fear of alienating their core constituencies. Hence, they did little to damp down the impact on the economy of international capital flows.

But increased demand did not automatically elicit increased supply. Investment in capacity took time to translate into improved export performance.... Political shocks (strikes and an incipient coup in Buenos Aires in 1889-90, the Chiapas revolt and Colosio assassination in 1994) then raised doubts about the ability of the government to carry out adjustment. Better-informed investors grew wary significantly in advance of the crisis.

The crisis itself drove the Argentine government, like the Mexican government after it, to the brink of default. The fallout destabilized the banking system. It provoked a major recession. And it spilled over to other countries. In 1995 the Tequila Effect was felt in Argentina, Brazil, Thailand and Hong Kong. In the wake of the Baring Crisis, interest rates rose in Brazil, Uruguay, Venezuela and Turkey. Countries as far afield as Australia and New Zealand found it difficult to access external finance....

At the same time there are important differences.... Monetary and fiscal excesses were more clearly evident in Argentina in the 1880s than in Mexico in the 1990s.... In 1995 the Clinton Administration and the IMF saw the need to help Mexico avert a suspension of debt-service... in 1994 there was no single financial institution as exposed as Baring Brothers. In 1890 the fear was for the stability of financial markets in the First World, not the Third. Where the U.S. government's first reaction in 1994 was to assemble financial aid for Mexico, in 1890 the Bank of England and the British Government arranged a rescue fund for Baring Brothers, not for Argentina....

Where the Bank of England could make arrangements with other financial institutions before news of Baring's difficulties became public, the 1995 crisis was a very public affair....

In a sense, then, the Mexican crisis is both the last financial crisis of the 19th century and the first financial crisis of the 21st. Its implications resemble those of the Baring Crisis.... But today's international financial today being even more nimble and decentralized than that of the 1880s, it anticipates the kind of crises that will become increasingly prevalent in the 21st century....

Information on the recent Mexican episode is abundant, and interpretations abound. Hence, I assume that the reader is familiar with the outlines of the Mexican crisis. I concentrate mainly on Argentina in the 1880s, providing just as much information on the Mexican crisis as is needed to place the comparison in relief...

Econ 101b: April 23: The Chinese Economy

April 23: The Chinese Economy

Notes: Slides: http://delong.typepad.com/delongslides/2008/04/econ-101b-april.html; Lecture Audio: http://www.j-bradford-delong.net/2008_mov/20080423_091349.mp3

Readings:

• Barry Eichengreen,"China's Exchange Rate Regime: The Long and Short of It" http://www.econ.berkeley.edu/~eichengr/research/short.pdf
• C. Fred Bergsten, "The Dollar and the Renminbi" http://www.iie.com/publications/papers/paper.cfm?ResearchID=747
• Institute for International Economics, "China: The Balance Sheet" http://www.petersoninstitute.org/publications/chapters_preview/04648/01pa04648.pdf

April 14: Econ 101b: Risks of International Financial Crisis

April 14: Risks of International Financial Crisis

Notes:

• Lecture Audio: http://www.j-bradford-delong.net/2008_mov/20080414_091122.mp3
• International Financial Crises: http://delong.typepad.com/delongslides/2008/04/foreign-exchang.html
• Global Imbalances: http://delong.typepad.com/delongslides/2008/04/global-imbalanc.html

Readings:

• "The International Financial Crises of the 1990s" http://j-bradford-delong.net/macro_online/ifc.pdf
• "Simple Analytics for a Hard Dollar Landing" http://www.j-bradford-delong.net/movable_type/pdf/hard_landing.pdf
• DeLong and Olney, chapter 15.

Argentina: We Have Seen This Movie Before

Dani Rodrik says that Argentina's future is bright--if only they could get their fiscal balance in order. Strangely, he doesn't seem to recognize that he is echoing every single Argentina-optimist for more than a century:

Dani Rodrik's weblog: Will Argentina waste a historic opportunity? Rarely do you see a country where the mood among business people tells such a different story than the statistics. Now, in Argentina there are statistics are then there are damn lies--inflation figures are made up--but the broad contours of the economic performance of the last few years are not in dispute. Argentina has been growing at Asian rates, its investment rate has risen to levels not seen in decades, national saving is at record levels, and TFP growth has been stellar. By their own admission, Argentine businessmen are making more money now than they ever have in recent memory.

Yet business people are somber, bitter, and angry at the government. The general sense, even among those that supported Nestor Kirchner's policies, is that the government is frittering away a golden opportunity. Worse, the government has authoritarian--some would say thuggish--tendencies that portend ill for the future of Argentina's democracy.

What is going on?

First, the good news. Recent economic growth, unlike that of the 1990s, is of the good kind and it not just the result of high commodity prices. The investment boom of the last few years is supported by high saving.... [R]ecent growth has been fueled by a competitive currency, which increased the relative profitability and output of a wide range of tradables.... Unemployment and poverty rates have come down.... The weak currency has stimulated the right kind of structural change--from lower productivity activities to higher-productivity tradables--which is the source of the economy-wide increases in TFP we have seen. This is a textbook illustration of the magic of sustained currency undervaluation....

Now the bad news. In a growing economy, the tendency for the real exchange rate is to appreciate.... While the peso is stable against the dollar in nominal terms, the overheated economy has generated inflationary pressures (over 20% annually at present) which are being grossly mismanaged.... [T]he government has been resorting to ad hoc and temporary measures: price controls, export taxes, and intervention in currency markets. It has no coherent plan to deal with inflation and no strategy for sustaining competitiveness in the face of the real appreciation that will take place even in the best of circumstances.

Even worse is the growing disconnect between the government and the business community. In its approach to the private sector, the government is developing a reputation for being abusive, threatening, and intimidating. The Kirchners' strategy seems to be to play to their main political power base while assuming that growth will continue. But in the current environment it is difficult to imagine that the private sector will continue to invest as strongly as it has.

In the early 1990s, after years of mismanagement and hyperinflation, the binding constraint on Argentinean growth was lack of confidence in macroeconomic policies. The Convertibility Law was an ingenious short-cut for overcoming this constraint. But as circumstances changed and the binding constraint became lack of competitiveness instead, the Convertibility Law turned into a liability.... The post-2002 policies were in turn successful because they removed the competitiveness constraint. But the growing gulf between the private and public sectors has put lack of confidence and credibility once again front and center--now as the binding constraint on sustaining Argentina's growth.

And that is a pity, because there is a lot that is going right with the Argentine economy today. The underlying model is much more sound than anything in memory. There is nothing wrong with it that a larger fiscal surplus and a bit of dialog between the public and private sectors would not cure.

Confusion in Economic Policy

Dean Baker mocks Henry Paulson and Ben Bernanke:

The High Dollar: Wasn't Bernanke Trying to Stimulate the Economy?

Last weekend, Federal Reserve Board Chairman Ben Bernanke and Treasury Secretary Henry Paulson said they would take steps to prevent the dollar from falling further. This is strange, because the dynamic duo had previously indicated that they wanted to stimulate the economy with policies like interest rate cuts and the tax rebate plan.

There is probably no more effective mechanism for stimulating the economy at this point than a decline in the value of the dollar. This will make imports more expensive, causing people to buy more domestically produced goods. It will also make our exports cheaper for people living in other countries which will naturally cause them to buy more American goods. The effect is a reduction in our trade deficit which is an essential part of any recovery plan.

There is a -- slight -- degree of non-insanity in what Paulson and Bernanke are saying. They want a weak dollar to stimulate exports, true. But they also want a dollar that is not expected to fall any further. In our economic models, the two automatically go together. But Paulson and Bernanke fear that in reality they do not.

Michael Mussa's Take on Global Imbalances as of Early 2004

He wrote:

Paper: Global Economic Prospects: Bright for 2004 but with Questions Thereafter: More generally, while global economic prospects look quite bright through 2004, there are important imbalances in the global economy that raise concerns for the longer term. It is useful to reflect briefly on these concerns before turning to a region-by-region assessment of near-term prospects.

Policy interest rates are exceptionally low in most industrial countries: zero in Japan and Switzerland, 1 percent in the United States, 2 percent in the euro area, and at or near historic lows in the United Kingdom and Canada. Inflation rates also are generally very low in the industrial countries, but, even taking this into account, short-term real interest rates are very low. (Realized short-term real rates went negative during some periods of rapidly rising inflation in the 1970s, but this was an anomaly that is not comparable to the present situation of low anticipated real interest rates.)

The very low level of policy interest rates is an imbalance (relative to normal conditions) that reflects exceptionally easy monetary policies to combat economic weakness. This policy imbalance poses an important challenge for the future conduct of monetary policy. Situations of low policy interest rates and low inflation tend to be associated with unusual inertia in the processes of general price inflation, which makes traditional indicators of rising inflationary pressures less reliable as measures of the need to begin to tighten monetary conditions. Also, these situations tend to be associated with high valuations of equities, real estate, and long-term bonds, which can become fertile ground for large, unsustainable increases in asset prices. In this situation, if monetary policy is tightened too much too soon (perhaps because of worries about unsustainable increases in asset prices), the result can be an unnecessary asset market crunch and economic slowdown, and monetary policy may have relatively little room to ease in order to counteract this outcome.

On the other hand, if monetary policy remains too easy for too long (perhaps because subdued general price inflation gives no clear signal of the need for monetary tightening), then large asset price anomalies may develop before corrective action is taken. The monetary authority would then confront the grim choice of trying to keep an unsustainable asset price bubble alive or trying to combat the collapse of such a bubble without a great deal of room for monetary easing.

A further concern related to the general monetary policy imbalance in the industrial countries is its effect on emerging market economies. Interest rate spreads for emerging market borrowers have contracted substantially and flows of new credit have increased. The boom in emerging market credit has not yet reached the frenzy of the first half of 1997, but it is headed in that direction. Another major series of emerging market financial crises (such as 1997-99) does not seem likely in the near term in view of the very low level of industrial country interest rates and the favorable global economic environment for emerging market countries. By 2005 or 2006, however, either upward movements in industrial country interest rates or deterioration of market perceptions of the economic and financial stability of some emerging market countries could trigger another round of crises.

Another important policy imbalance of global significance is the medium- and long-term fiscal imbalance of most industrial countries. Ratios of government debt to GDP are high in several countries, most notably Japan and Italy. Fiscal deficits are large in Japan and the United States and above the desired ceiling of 3 percent of GDP in Germany and France. Most important, industrial countries generally face enormous fiscal challenges from financing social benefits for aging populations that will materialize during the next two to three decades. These problems imply that, even in the near term, expansionary fiscal policy cannot prudently be used as a significant means for stimulating more rapid growth of aggregate demand in the industrial countries. To the extent that such stimulus may be needed, monetary policy is the prudent tool. But, as just noted, monetary policy does not at present have much remaining capacity to play this role and may not regain this capacity any time soon.

The other key global imbalance is the massive US current account (and net export) deficit and the corresponding surplus of the rest of the world. While it is plausible to suppose that the United States can continue to attract voluntary net capital inflows sufficient to finance a current account deficit of 2 to 2½ percent of its GDP, continuing deficits of 5 percent of US GDP are not plausible. The global adjustment necessary to reduce the US current account deficit by roughly half involves three essential elements.

First, in order to shift world demand toward US goods and services and away from those of the rest of the world by $250 billion to $300 billion, the real effective foreign exchange value of the US dollar needs to decline from its peak in 2000/01 by roughly 30 percent. Substantial downward corrections of the US dollar against the euro, sterling, and the Canadian and Australian dollars, and lesser correction against the Japanese yen, have now delivered somewhat less than half of the total required correction. Some further depreciation of the US dollar against these (aforementioned) currencies, particularly the Japanese yen, is needed over the next couple of years. However, the key remaining challenge for exchange rate adjustments is securing appreciations in the exchange rates of key emerging market currencies, especially in Asia. The exchange rate of the Chinese yuan has rightly received much recent attention in this regard (and Nicholas Lardy will comment further on this issue). But the issue is much broader. For most of emerging Asia, there has been little or no currency appreciation against the US dollar since 2000/01 (implying effective depreciation of the trade weighted exchange rate), and most of these countries have recently been intervening massively to resist market pressures for appreciation. These policies need to change to allow a broader downward correction of the value of the US dollar.

Second, for the US current account deficit to decline, domestic demand in the United States must grow more slowly, by a corresponding amount, than US output (real GDP). (This is the reverse of the pattern of recent years, when the excess of domestic demand growth over real GDP growth has accounted for the large deterioration in the US current account.) Getting this to happen in the United States, while also keeping US output close to potential, poses some difficulties. If domestic demand growth falls below potential output growth, the improvement in US net exports must step in to keep total demand for US output growing in line with potential. Otherwise, margins of slack will increase in the US economy. On the other hand, if output (and, hence, income) growth matches potential (with the level of output near potential), then there must be something to depress the growth of US domestic demand below the growth of US income. Otherwise, if US net exports are improving (due to the effects of a weaker US dollar and stronger demand growth abroad), then there would be undesirable overheating of the US economy. The necessary depressing force on US demand growth could come from a progressive tightening of US monetary policy. But this would depress domestic demand growth primarily by slowing private investment, thereby slowing the longer-term growth rate of the US economy. The preferable policy solution would be for the reversal of the fiscal expansion of 2001/04 to provide the desired negative impetus to domestic demand.

Third, for the rest of the world, the counterpart of US adjustment must be that domestic demand grows more rapidly than output. The amount of this difference corresponds to the deterioration of the current account in the rest of the world, which must match the improvement in the US current account. (Since the US economy accounts for about one-quarter of world output at market exchange rates, an improvement in US net exports equal to 3 percent of US GDP requires a worsening of net exports in the rest of the world of about 1 percent of GDP.) In recent years, however, the rest of the world has had difficulty generating sufficient demand growth to keep output growing at potential—and has relied on a net contribution of demand from the growing US net export deficit. Thus, securing a boost to demand growth in the rest of the world over the next couple of years poses a challenge, particularly so because, as previously noted, fiscal policy is generally not available to provide much demand stimulus, and monetary policies (at least in industrial countries) are already quite easy. At a minimum, it would appear desirable to keep monetary policies easy to support demand growth, but not so easy as to frustrate the exchange rate adjustments that are also a necessary factor in correcting global payments imbalances...

April 11: Econ 101b: International Finance and "Global Imbalances": Introduction

April 11: International Finance and "Global Imbalances": Introduction

Notes: Lecture Audio http://www.j-bradford-delong.net/2008_mov/20080411_091301.mp3

Readings:

• Raghuram Rajan, "Global Current Account Imbalances: Hard Landing or Soft Landing?" http://www.imf.org/external/np/speeches/2005/031505.htm
• Maurice Obstfeld, "Global Imbalances" http://www.econ.berkeley.edu/~obstfeld/280c_sp07/adjustment.pdf
• Hamid Faruqee, "Narrowing Global Imbalances?" http://www.imf.org/external/pubs/ft/survey/so/2008/RES021908A.htm

W. Arthur Lewis: Evolution of the International Economic Order

W. Arthur Lewis (1978), Evolution of the International Economic Order (Princeton: Princeton University Press).

Perenially out of print, and perhaps the finest work of economic history ever.

http://j-bradford-delong.net/2008_pdf/Lewis_Evolution_A.pdf http://j-bradford-delong.net/2008_pdf/Lewis_Evolution_B.pdf

DeLong Smackdown Watch: Effects of Sterilized vs. Non-Sterilized Policy Moves

Paul Krugman writes:

Why sterilization matters: Brad DeLong, commenting on my last post, misses the point, I think:

Foreign exchange markets are so large that even big exchange intervention efforts look like a drop in the bucket. But domestic financial markets are even larger--so that even big open-market operations not just look like but they are a drop in the bucket. Yet open-market operations are highly effective in changing interest rates.

The reason open-market operations are highly effective is that they change the monetary base -- and the monetary base is only $822 billion (yes, "only" -- we are in the land of Very Big Numbers here). Whatis more, there are no close substitutes for monetary base. So there, an intervention of a few tens of billions of dollars has a big effect.

But a sterilized intervention means an intervention that doesn%u2019t affect the monetary base %u2014 swapping dollar t-bills for euro T-bills, or T-bills for mortgage-backed securities. And here the numbers are much bigger: $11 trillion in home mortgages, for example. And home mortgages are a better substitute for, say, long-term government debt than either is for green paper bearing portraits of dead presidents.

The point is that the effectiveness of conventional open-market operations offers very little reason to be optimistic about the super-TAF, or whatever they are calling the Fed's new role as pawnbroker of last resort.

I think a better guide is the failure of sterilized intervention in, say, the 1992 sterling crisis: $40 billion in intervention -- about 4 percent of GDP -- blown away by the markets in a couple of weeks. That's why I'm not optimistic about the Fed's plan.

I parry in sixte with the response that while there are no close substitutes for monetary base (in a world with no excess reserves) there are very close substitutes for the liquid bank deposits those reserves enable: drop my checking balance and raise my VISA limit by $1000 and my liquidity position is unchanged.

But Paul's point that it is harder to see how sterilized interventions matter is correct.

Touche...

What Was the Industrial Revolution?

From Greg Clark (2001), "The Secret History of the Industrial Revolution":

The modest productivity growth rates of the Industrial Revolution owed mostly to productivity gains in one sector, textile manufacture. It was accidents of demand, demography, and trade that allowed innovations in this sector to have a much bigger impact than previous innovations of similar magnitude in terms of [aggregate economy-wide] productivity gains.... The southern two thirds of England saw almost no growth in output per capita or productivity growth in the Industrial Revolution.... Other places in Europe in the years 1200 to 1760 saw similar episodes of productivity growth that were as substantial as those in England from 1760 to 1860. Thus between 1550 and 1650 the Netherlands saw significant productivity advance.

The appearance that the Industrial Revolution in England represented a decisive break from the past is largely a product of the unusual demographic experience... demographic growth would have spurred industrialization absent any productivity advance... by driving up land rentals and creating urbanization... [spurring] enclosure of common lands, improvements in transportation, the expansion of coal mining, and perhaps also the fall in interest rates...

[...]

The aggregate productivity growth rate is just the sum of the productivity growth rates of individual sectors weighted by their share in national outputs.... The cotton textile industry experienced very rapid productivity growth in the Industrial Revolution era.... The estimated total factor productivity in spinning and weaving cotton cloth increased 22 fold from the 1770s to the 1860s, implying an annual productivity growth rate of 3.1% per year... cotton, and the associated industries of linen (assumed to have the same productivity growth as cottons) and woolens to overall TFP growth... of 0.26% out of 0.40%. Thus nearly two thirds of the productivity growth rate can be explained by essentially one set of innovations, and by industries that employed less than 10% of the labor force in 1851. The great mass of the economy, including agriculture, construction, services, and most manufacturing saw very little productivity increase. The gains in income per capita were thus the result of a lucky technological advance in one area....

Even with a textile revolution the effects of productivity growth in textiles on the TFP of the whole economy crucially depended on the ability of Britain to export these products on a large scale. Even though the share of cottons and woolens was never large, this share was only attained because of very substantial exports of cotton and woolen goods. Thus by the 1860s at least two thirds of English cotton goods output was exported, and about one third of woolens. These exports were traded in world markets for foods and raw materials demanded by England’s rapidly growing population. Had these industries produced only for the home market then the productivity growth rate from 1765 to 1865 would have dropped by a third....

[T]his ability to export textiles was a purely adventitious thing. Textile products were tradable, and the growing population of Britain required large imports of food and raw materials which had to be paid for by manufacturing exports....

[T]he effects of individual technical advances on aggregate productivity depend crucially on such accidental factors as the size of the sector affected and the price elasticity of demand. The nature of technological advance is generally that some new idea leads to a long period of productivity advance in an industry as the consequences of the new technique are played out. If demand is price inelastic then reductions in prices created by the early phase of a technological advance will limit or even reduce the share of expenditure on the good, so reducing the general productivity gains from further advances. Advances in cotton textiles in the Industrial Revolution had big impacts because textiles were a substantial share of expenditure by the 1760s and demand was price elastic....

Suppose that prior to the Industrial Revolution innovations were occurring randomly across various sectors of the economy - innovations such as guns, spectacles, books, clocks, painting, new building techniques, improvements in shipping and navigation – but that just by chance all these innovations occurred in areas of small expenditure and/or low price elasticities of demand. Then the technological dynamism of the economy would not show up in terms of output per capita or in measured productivity.

Thus... consider the introduction of the printed book by Gutenberg in 1445, again in the period where we can find no evidence of aggregate productivity growth, at least in England.... Output per worker increased by roughly 30 fold from manuscript production in the fourteenth century till the early nineteenth century... greater than the productivity advances achieved in the cotton textile industry over the Industrial Revolution period, though it took place over a much longer period. But the impact of these productivity gains in printing on the economy as a whole was unmeasurably small because the share of the economy devoted to printing always remained small... in 1851 only 0.8% of the population was employed in the paper making and printing businesses....

Another dramatic change in the years before 1600 was improvements in shipping and navigation which allowed access to the East by an all sea route. This was reflected in a dramatic fall in the sixteenth century in the price of eastern spices.... The price of pepper relative to English farm output prices fell to about one fifth its earlier level between 1570 and 1660. Yet again though this decline represented a host of technical and organization changes the economic impact was negligible given the dietary habits of the English....

if we want to locate the Industrial Revolution as the beginning of the era of sustained productivity growth then the [sixteenth-century] Dutch have as good a case as the British. If we want to locate it in the era of very widespread productivity growth affecting large sectors of the economy, then the US in the after the 1870s is the best candidate....

[...]

[T]he conclusion is that there was little productivity growth in the Industrial Revolution era beyond that explained by the technological revolution in textiles... the accident that textiles were exported on a large scale by 1800, explained by the need to import large quantities of food and raw materials given English population growth after 1760, accounts for a substantial fraction of the gains in productivity. The Industrial Revolution becomes very narrow. It can then be interpreted as just another isolated technological advance as European economies had been witnessing since at least the fifteenth century.

---

Stagflation Watch

Tim Duy is grim, over at Mark Thoma's Economist's View:

Economist's View: Fed Watch: Inching Closer to the Reality of Stagflation: It is increasingly obvious that the Fed is in a no-win situation. The best case scenario for the Fed is that nominal wage growth is kept in check by a deteriorating labor market. This will help contain inflation expectations and prevent a more serious 1970s type of environment. But overall, Jim Hamilton is correct; they are unable to both contain inflation and prevent a significant economic downturn:

In any case, the tightrope analogy seems a misleading way to frame the issue, in that it presupposes that there exists a choice for the fed funds rate that would somehow contain both the solvency and the inflation problems. In my opinion, there is no such ideal target rate, and the notion that we can address the difficulties with a sagely chosen combination of monetary and fiscal stimulus and regulatory workout is in my mind doing more harm than good. Better for everyone to admit up front just how bad the problem is, and acknowledge that there is no cheap way out.

The nuance I would add to Hamilton's position is... the additional problem of a fundamental imbalance between production and consumption in the US.... Global financial markets... increasingly find it difficult to sustain this imbalance. Brad Delong hit the nail on the head in 2004:

That's the thing about accounting identities like S - D - I = NX. Either you craft economic policies that make them hold at full employment, or the market takes care of making sure that they hold for you--but usually not at full employment. Stagnant or falling wages that boost corporate profits could boost savings S by boosting retained earnings. A Bush administration serious about cutting the deficit could provide financing for investment and keep interest rates from rising. Big booms abroad could raise U.S. exports and reduce investment as the Fed took steps to shrink investment to avoid inflationary overheating. Otherwise, it is indeed hard to argue with Barry just across the north wall of this office: the dollar falls; has the fall produced enough inflationary pressure to lead the Fed to raise interest rates and so reduce investment and the current account deficit? no? then repeat.

The Fed is currently in the "then repeat" stage, although driving down the Dollar appears to have accelerated the surge in commodity prices, while the near term impact on export growth will be hindered by the need for structural adjustment (if only we could export vacant houses). At this point, more policy thrown at impeding this adjustment will only yield more inflation....

The inflation, of course, serves a purpose -- it is a market response to excessive consumption. Policymakers who want to pretend that the fundamental economic problem is insufficient demand rather than excessive demand will find the market yields a solution -- higher inflation to depress consumption via declining real incomes and wealth. Not a pretty solution, but a solution. Perhaps we are well past any other solution.

Bottom Line: I stick with the 50bp call because it is the most rational of the Fed's likely options....

---

Update: Greg Ip at the Wall Street Journal also covers the stagflation story this morning. This passage, which I agree is an accurate assessment of Fed policy, is both enlightening and scary:

Core inflation rose and fell with energy inflation between early 2006 and mid-2007, and the Fed thinks the same thing is probably happening now. If energy and food prices stop rising -- they don't have to actually fall -- both overall and core inflation should recede.

So far, they're still rising: wheat, oil and gold hit nominal records last week. But Fed officials don't think the latest jump can be justified by fundamental supply and demand. U.S. inventories of crude oil and gasoline are plentiful. Strong demand from China isn't new and should have been factored into prices long ago. A more likely explanation: investors, perhaps alarmed by the Fed's dovish stance, are pouring money into commodity funds and foreign currencies as a hedge against inflation.

Such fears can be self-fulfilling as higher food, energy and import costs work their way into consumer prices. But speculative price gains can't be sustained if the fundamentals don't support them. If the Fed and the futures markets are right, prices will be lower, not higher, a year from now.

The learning curve on Constitution Ave. is remarkably convoluted. The Fed wasn't willing to describe either the tech or the housing markets as a bubble since it is not their job to define fundamental values, but apparently is eager to define the "fundamental" value of commodities, and quick to dismiss current valuations as a bubble.

What is clear is that the Fed remains eager to dismiss any inconvenient information. And, remarkably, a basic lesson that should have sunk in over the past decade is that even if you believe an asset bubble exists, it can continue for much longer than "fundamentals" would justify. Moreover, this piece reads as if there is no fundamental reason for the Dollar to be falling; instead, we are witnessing a bubble in all other currencies. Yet if I pull any international finance book off my shelf, I am pretty sure I can find some reference that the "fundamental" value of a currency has something to do with interest rate differentials. Not to mention the yawning current account deficit.

I hope the Fed is correct, and I will be the first to admit error, but for now I am not willing to dismiss the signals commodity prices, or the Dollar, are sending.

How Large Is the Depressing Effect of Increased Trade on the Wages of Blue-Collar Americans?

Paul Krugman says that he does not know.

From his first draft for the spring 2008 BPEA:

Paul Krugman (2008), "Trade and Wages, Reconsidered": [T]he change illustrated in Figure 15 seems to resemble the actual change in North-South trade since the early 1990s.... The share of advanced country GDP spent on imports from developing countries rises sharply, because components are shipped to developing countries for assembly, and the assembled goods are then exported back tothe first world.... [T]he actual effects on workers in the advanced economy would reflect a sort of Stolper-Samuelson effect: the real wages of... unskilled workers would fall.... outsourc[ing] labor-intensive industry segments to the third world would depress the demand for less-skilled workers, a shock not captured by data that lumped labor-intensive assembly operations together with skill-intensive component manufacture [in the same industry]....

[N]ote, however, that this example does suggest that the type of calculation performed by Bivens (2007), in which the distributional effects of trade are assumed to be essentially proportional to the import share... may exaggerate the distributional effects of recent trade growth. In this example, the trade share grows fourfold, but the distributional effects do not grow in proportion.... [M]uch of the content of the new imports from developing countries is actually skill-intensive production from advanced countries.... If the United States imports computers from China, and China assembles computers largely from components made in Japan, only the assembly share of the sales price reflects labor-intensive imports....

Nonetheless... the rapid rise in manufactures imports from developing countries probably is, indeed, a force for growing inequality... factor content calculations suggesting otherwise are missing the essence of what is happening....

What really comes through from the analysis here, however, is the extent to which the changing nature of world trade has outpaced our ability to engage in secure quantitative analysis--even though this paper sets to one side the growth in service outsourcing.... Plain old trade in physical goods has become remarkably exotic. In particular, the surge in developing-country exports of manufactures involves a peculiar concentration on apparently sophisticated products, which seems at first to put worries about distributional effects to rest. Yet there is good reason to believe that the apparent sophistication of developing country exports is, in reality, largely a statistical illusion, created by the phenomenon of vertical specialization....

How can we quantify the actual effect of rising trade on wages? The answer, given the current state of the data, is that we can’t... [I]t’s likely that the rapid growth of trade since the early 1990s has had significant distributional effects. To put numbers to these effects, however, we need a much better understanding of the increasingly fine-grained nature of international specialization and trade.

Source: Paul Krugman.

Source: Paul Krugman.######

Robert Reich on NAFTA

He writes:

Robert Reich's Blog: Hillary and Barack, Afta Nafta: It’s a shame the Democratic candidates for president feel they have to make trade – specifically NAFTA – the enemy of blue-collar workers.... NAFTA is not to blame.... When NAFTA took effect, Ohio had 990,000 manufacturing jobs. Two years later, in 1996, it had 1,300,000 manufacturing jobs. The number stayed above a million for the rest of the 1990s. Today, though, there are about 775,000 manufacturing jobs in Ohio.

What happened? The economy... crashed in late 2000, and the manufacturing jobs lost in that last recession never came back... employers automated the jobs out of existence, using robots and computers... [and] shipped the jobs abroad, mostly to China – not to Mexico.

NAFTA has become a symbol for the mounting insecurities felt by blue-collar Americans. While the overall benefits from free trade far exceed the costs, and the winners from trade (including all of us consumers who get cheaper goods and services because of it) far exceed the losers, there’s a big problem: The costs fall disproportionately on the losers -- mostly blue-collar workers who get dumped because their jobs can be done more cheaply by someone abroad who’ll do it for a fraction of the American wage.... Even though the winners from free trade could theoretically compensate the losers and still come out ahead, they don’t. America doesn’t have a system for helping job losers find new jobs that pay about the same as the ones they’ve lost – regardless of whether the loss was because of trade or automation. There’s no national retraining system. Unemployment insurance reaches fewer than 40 percent of people who lose their jobs.... There's no wage insurance. Nothing....

Get me? The Dems shouldn't be redebating NAFTA. They should be debating how to help Americans adapt to a new economy in which no job is safe. Okay, so back to my initial question. The answer is HRC didn't want the Administration to move forward with NAFTA... because of its timing. She wanted her health-care plan to be voted on first...

There are other, secondary causes of declining numbers of manufacturing jobs in Ohio. The Bush budget deficits certainly don't help.

Menzie Chinn Looks at the Dollar

From http://www.econbrowser.com/archives/2008/02/musings_on_the_1.html:

Macroeconomic Rebalancing

Paul Krugman is THE EXPLAINER:

Paul Krugman - Op-Ed Columnist - New York Times Blog: As we debate interest rates, fiscal stimulus and all that, I thought it might be worth backing up to think about what our macroeconomic problem is right now.... First, in the mid-00s the U.S. economy got badly unbalanced -- too much dependence on housing and housing-inflated consumer spending, too big a trade deficit. This figure shows "deviations" in share of GDP... between 2007 and average 1980-2000 spending on consumption (C), nonresidential investment (NR), residential investment (R), and net exports (NX)... the main thing... is high consumption offset by a high trade deficit.

Second, in the process we also got a credit bubble that%u2019'ss now bursting, and threatening to take down spending... like business investment.

What we want, and will eventually get, is a rebalancing: smaller trade deficits, consumer spending more in line with income, more normal housing spending. The trouble is in getting there. At the moment it seems likely that consumption and housing investment will fall faster than net exports can rise.... The result will be a recession or at least something that feels like one.

The goal of monetary and fiscal policy should be to bridge the gap -- to sustain spending until a falling trade deficit comes to the rescue, and to hasten the rise in net exports (remember, in the current context a weak dollar is good.)...

The Globalization Worm Ouroboros

So, there I am, looking at Mark Thoma's weblog and thinking, "Gee, he is quoting somebody really smart":

Globalization Has Not Yet Gone Far Enough: Dani Rodrik is trying to create space in the debate over globalization for a rational middle--for positions that neither lead the cheers for the onrushing economic integration of the world, nor m mindlessly condemn international economic integration in a fit of reactionary nostalgia for a past that never was.

Dani Rodrik's argument is an updated and better-written version of an argument made by Karl Polanyi--in a book called The Great Transformation--long ago, back at the end of World War II. Polanyi argued that the developing market economy tended to destroy the web of social realtionships that held human society together. The market for labor pressured people to move around the globe to where they could earn the most--at the potentially substantial sociological price of creating strangers in strange lands. The market for consumer goods rewarded people for being fortunate or for responding to the incentives provided by factor markets--and in so doing made human status rankings the product of responsiveness to market forces rather than the result of social norms and views about distributive justice. And, Polanyi argued, in the long run this undermining of sociological order by the market economy threatened to destroy the social and institutional bases on which the market economy rested.

You can disagree with virtually all of Polanyi's argument. You can say that the market for labor offers people opportunities, not constraints. You can point out that the "social norms" and "views about distributive justice" that underlie non-market distributions of income give the most to those with the biggest spears or those who can most effectively perform the confidence trick of convincing their lessers that obedience to the powerful is obedience to God. Market distributions of income at least have a meritocratic component, as well as a positive entrepreneurial component that makes it possible to do well by doing good.

Yet there remains a sense in which Polanyi's argument cannot be dismissed. The distribution of economic welfare produced by the market economy--roughly that one's weight in the social welfare function maximized by the market is approximately proportional to the market value of your endowment--does not fit anyone's conception of the just or the best. We have considerably more confidence in the correctness and appropriateness of political decisions made by democratically-elected representatives than we do of decisions made by those with large spears or large temples. So there is a powerful place for government to manage the market--in the interest of avoding large depressions, in the interest of providing social insurance to transform the market distribution of income into one that produces higher social welfare, in the interest of avoiding pointless churning of the structure of industry produced by the fads and fashions that sweep the minds of financiers.

Post-World War II social democracy in the advanced industrial economies has produced the wealthiest, best, and most just societies the world has ever seen. You can complain that the redistributional and industrial policies of social democracy have been economically inefficient, but they have been--politically--very popular. It seems a good bet that the stable politics of the post-World War II era in the advanced industrial economies owe a good deal to the coexistence of rapidly-growing, dynamic market economies and social democratic polities.

And this is where Dani Rodrik comes in. For Dani Rodrik is concerned that economic integration is undermining the ability of countries to shape their own versions of social democracy, or indeed to shape any version of social democracy. Rodrik fears that--unless a way is found to strengthen social democracy in the face of international economic integration--that either sociology and politics will bring a halt to increasing economic integration, or increasing economic integration will erode the market economy's social foundations and lead to increasing political instability.

How does Rodrik believe that globalization undermines social democracy? First, because globalization has undermined governments' ability to carry out social insurance programs. Social insurance is the redistribution of income and wealth by transferring wealth from market winners to market losers, thus insulating domestic groups from those market risks deemed "excessive." A principal tool for funding social insurance has been the taxation of capital. Perhaps the most important aspect of globalization has been the sharp increase in the mobility of capital. This increase in capital mobility "has rendered an important segment of the tax base footloose." The consequence is that governments seeking to fund social insurance are left with the unappetizing option of increasing tax rates disproportionately on labor income.

Second, globalization has increased the degree of competition in the labor market. Most economists (me included) have argued that this increase in labor market conditions has had little impact on the wages of American workers. But as Rodrik points out, "...saying that the impact of globalization on advanced-country labor markets is quantitatively rather small in the real world and is overshadowed by other phenomena (such as technological change) is no different [in the Heckscher-Ohlin-Vanek framework] from saying that the gains from trade have in practice been small." There is a problem of cognitive dissonance here.

Many economists would look at increased labor market competition--the undermining of unions--with approval. Doesn't union monopoly create inefficiency? But as Rodrik points out, reduced union power increases economic efficiency "only to the extent that employment expands in industries in which artificially high wages previously kept employment below efficient levels.... It is difficult to make [this]... case ...in... sectors where [union] monopsony wages were ...most prevalent" in the United States.

Rodrik's conclusions are essentially those of Polanyi: create space for social democracy, recognize that markets are the servants of societies and polities, make the world economy a moral community with standards and practices of fairness.

I do not know if Rodrik will be successful in his attempt to create space in the debate over globalization for a rational middle--for positions that neither lead the cheers for the onrushing economic integration of the world, nor mindlessly condemn international economic integration in a fit of reactionary nostalgia for a past that never was. But it is an effort well worth making.

Hoisted from the archives, of course.

James Fallows Summarizes China's International Economic Strategy

Very well put:

The Atlantic Online | January/February 2008 | The $1.4 Trillion Question | James Fallows: Let’s say you buy an Oral-B electric toothbrush for $30 at a CVS in the United States. I choose this example because I’ve seen a factory in China that probably made the toothbrush. Most of that $30 stays in America, with CVS, the distributors, and Oral-B itself. Eventually $3 or so—an average percentage for small consumer goods—makes its way back to southern China.

When the factory originally placed its bid for Oral-B’s business, it stated the price in dollars: X million toothbrushes for Y dollars each. But the Chinese manufacturer can’t use the dollars directly. It needs RMB—to pay the workers their 1,200-RMB ($160) monthly salary, to buy supplies from other factories in China, to pay its taxes. So it takes the dollars to the local commercial bank—let’s say the Shenzhen Development Bank. After showing receipts or waybills to prove that it earned the dollars in genuine trade, not as speculative inflow, the factory trades them for RMB.

This is where the first controls kick in. In other major countries, the counterparts to the Shenzhen Development Bank can decide for themselves what to do with the dollars they take in. Trade them for euros or yen on the foreign-exchange market? Invest them directly in America? Issue dollar loans? Whatever they think will bring the highest return. But under China’s “surrender requirements,” Chinese banks can’t do those things. They must treat the dollars, in effect, as contraband, and turn most or all of them (instructions vary from time to time) over to China’s equivalent of the Federal Reserve Bank, the People’s Bank of China, for RMB at whatever is the official rate of exchange....

The PBOC must do something with that money, and current Chinese doctrine allows it only one option: to give the dollars to another arm of the central government, the State Administration for Foreign Exchange. It is then SAFE’s job to figure out where to park the dollars... the great majority left in the boring safety of U.S. Treasury notes.

And thus our dollar comes back home. Spent at CVS, passed to Oral-B, paid to the factory in southern China, traded for RMB at the Shenzhen bank, “surrendered” to the PBOC, passed to SAFE for investment, and then bid at auction for Treasury notes.... At no point did an ordinary Chinese person decide to send so much money to America. In fact, at no point was most of this money at his or her disposal at all. These are in effect enforced savings, which are the result of the two huge and fundamental choices made by the central government.

One is to dictate the RMB’s value relative to other currencies.... The obvious reason for doing this is to keep Chinese-made products cheap, so Chinese factories will stay busy.... Once a government decides to thwart the market-driven exchange rate of its currency, it must control countless other aspects of its financial system, through instruments like surrender requirements and the equally ominous-sounding “sterilization bonds” (a way of keeping foreign-currency swaps from creating inflation, as they otherwise could). These and similar tools are the way China’s government imposes an unbelievably high savings rate on its people. The result, while very complicated, is to keep the buying power earned through China’s exports out of the hands of Chinese consumers....

The other major decision is not to use more money to address China’s needs directly—by building schools and agricultural research labs, cleaning up toxic waste, what have you. Both decisions stem from the central government’s vision of what is necessary to keep China on its unprecedented path of growth. The government doesn’t want to let the market set the value of the RMB, because it thinks that would disrupt the constant growth and the course it has carefully and expensively set for the factory-export economy.... And the government doesn’t want to increase domestic spending dramatically, because it fears that improving average living conditions could paradoxically intensify the rich-poor tensions that are China’s major social problem. The country is already covered with bulldozers, wrecking balls, and construction cranes, all to keep the manufacturing machine steaming ahead. Trying to build anything more at the moment—sewage-treatment plants, for a start, which would mean a better life for its own people, or smokestack scrubbers and related “clean” technology, which would start to address the world pollution for which China is increasingly held responsible—would likely just drive prices up, intensifying inflation and thus reducing the already minimal purchasing power of most workers. Food prices have been rising so fast that they have led to riots. In November, a large Carre four grocery in Chong qing offered a limited-time sale of vegetable oil, at 20 percent (11 RMB, or $1.48) off the normal price per bottle. Three people were killed and 31 injured in a stampede toward the shelves.

This is the bargain China has made—rather, the one its leaders have imposed on its people. They’ll keep creating new factory jobs, and thus reduce China’s own social tensions and create opportunities for its rural poor. The Chinese will live better year by year, though not as well as they could. And they’ll be protected from the risk of potentially catastrophic hyperinflation, which might undo what the nation’s decades of growth have built. In exchange, the government will hold much of the nation’s wealth in paper assets in the United States, thereby preventing a run on the dollar, shoring up relations between China and America, and sluicing enough cash back into Americans’ hands to let the spending go on...

One thing seems to me to be not quite right: sterilization bonds are not "a way of keeping foreign-currency swaps from creating inflation," they are a way of delaying that inflation.

Did Bob Reich Assassinate Tony Judt's Cat?

I was surprised to read:

'Supercapitalism': An Exchange: Tony Judt: I am surprised that Robert Reich resents my "use" of his book for the expression of some general thoughts on its topic. Taken for itself, after all, Supercapitalism would have merited at best a short notice. However, Reich's letter is welcome all the same. It helpfully reasserts the book's argument; and by its resort to invective—"jeremiad," "screeds," "emotionally gratifying," "capitalist hobgoblins," etc.—-his letter offers an instructive insight into Reich's own thought processes... his critics (me, on this occasion) are dismissed as "denigrators" of economic growth, enemies of capitalist globalization who pave the way for nativism: in short, prole-worshipping nostalgics.... If the Professor of Public Policy at UC Berkeley really thinks that we can improve upon the "cacophony" that passes for public debate with talk of "citizen values" and "leaders who inspire us" and that anything else is "brainless neo-Ludditism," then he is himself a depressing illustration of the problem he purports to address.

This visual evidence of derangement surprised me, because I remembered Tony Judt's Postwar as being rather good--and his books on the post-WWII French intellectuals, Sartre and his circle, as being excellent. And I, at least, quite liked Supercapitalism.

Clearly I am going to have to go back and read Judt's review of Reich...

Image stolen from Obsidian Wings

The Internet Gets Results!!

Dani Rodrik at http://rodrik.typepad.com/dani_rodriks_weblog/2007/12/joe-and-i.html answers the review session question I could not answer: What are the differences between Joe Stiglitz's and Dani Rodrik's thoughts on development?

PE 101 students, I advise you to take note...

---

Dani Rodrik's weblog: Joe and I: Brad DeLong reports that a student of his wants to know the difference, if any, between Joe Stiglitz's views on development and mine. Frankly, I had not thought about this quite in this way before, so the question set me thinking. I know that I have shaken my head many times at things that Joe has said or written, so I know there are differences. But what are they?

Leaving issues of rhetoric aside (which I am afraid are often important), here are a few points for future students who want to see the product differentiation a bit more clearly.

1. Joe sees the world economic system as grossly unfair to poor nations, and this unfairness as a severe constraint on their development. This has never been a big part of my own thinking, partly because I don't see things in quite the same black-and-white terms, and also more importantly because I do not believe the constraints lie in the external rules. I see the main constraints as being internal--domestic politics and policies. Consequently, our take on issues like Doha is quite different. Joe sees a one-sided set of commitments on the part of rich countries to open up their markets in agriculture and other goods as being very important. I see very little benefits from Doha for the poor countries under the best of scenarios.

2. Joe sees international organizations (in particularly the IMF) as being the driver of policy in many developing countries, with uniformly negative consequences. I think that to the extent that this is true, it is more because poor-country leaders choose to rely on their advice excessively than it is because these institutions have the power and ability to impose their will on the world.  Much of the bad economic policy in these countries has been self-imposed, and I don't think the fault should be placed at the doorstep of multilateral institutions. The truth is that developing country leaders have too often abdicated their own responsibilities. 

3. On the substance of development policy, I think Joe's approach is holistic and comprehensive, whereas mine is selective and sequential. As far as I am aware he has not articulated a vision of how developing nations should choose among competing priorities, whereas a lot of my recent work focuses on that specifically. He thinks of growth, development, and social policies as all one thing--whereas I think of them as distinct in terms of policy needs.

4. On macroeconomic policy, Joe has an instinctively dove-ish position on inflation, believing that central banks can always loosen up at the margin with little cost to overall macro stability. I think many circumstances demand a more hawkish position on monetary policy and inflation-especially when fiscal policy is not cooperative.

There. That should be enough to fill up an essay question.  

The Dollar and Its Implications: Project Syndicate

Taipei Times - archives: Is the dollar leading us into a depression?

The falling US dollar has emerged as a source of profound global macro-economic distress. The question now is how bad that distress will become. Is the world economy at risk? There are two possibilities. If global savers and investors expect the US dollar's depreciation to continue, they will flee the currency unless they are compensated appropriately for keeping their money in the US and its assets, implying that the gap between US and foreign interest rates will widen. As a result, the cost of capital in the US will soar, discouraging investment and reducing consumption spending as high interest rates depress the value of households' principal assets: their houses.

The resulting recession might fuel further pessimism and cutbacks in spending, deepening the downturn. A US in recession would no longer serve as the importer of last resort, which might send the rest of the world into recession as well. A world in which everybody expects a falling US dollar is a world in economic crisis.

By contrast, a world in which the US dollar has already fallen is one that may see economic turmoil, but not an economic crisis. If the US dollar has already fallen -- if nobody expects it to fall much more -- then there is no reason to compensate global savers and investors for holding US assets.

On the contrary, in this scenario there are opportunities: the US dollar, after all, might rise; US interest rates will be at normal levels; asset values will not be unduly depressed; and investment spending will not be affected by financial turmoil.

Of course, there may well be turbulence: When US wage levels appear low because of a weak US dollar, it is hard to export to the US, and other countries must rely on other sources of demand to maintain full employment. The government may have to shore up the financial system if the changes in asset prices that undermined the US dollar sink risk-loving or imprudent lenders.

But these are, or ought to be, problems that we can solve. By contrast, sky-high US interest rates produced by a general expectation of a massive ongoing US dollar decline is a macroeconomic problem without a solution.

Yet so far there are no signs that global savers and investors expect a US dollar decline. The large gap between US and foreign long-term interest rates that should emerge from and signal expectations of a falling US dollar does not exist. And the US$65 billion needed every month to fund the US current-account deficit continues to flow in. Thus, the world economy may dodge yet another potential catastrophe.

That may still prove to be wishful thinking. After all, the US' still-large current-account deficit guarantees that the US dollar will continue to fall. Even so, the macroeconomic logic that large current-account deficits signal that currencies are overvalued continues to escape the world's international financial investors and speculators.

On one level, this is very frustrating: We economists believe that people are smart enough to understand their situation and capable enough to pursue their own interests. Yet the typical investor in US dollar-denominated assets -- whether a rich private individual, a pension fund, or a central bank -- has not taken the steps to protect themselves against the very likely US dollar decline in our future.

In this case, what is bad for economists is good for the world economy: We may be facing a mere episode of financial distress in the US rather than sky-high long-term interest rates and a depression. The fact that economists can't explain it is no reason not to be thankful.

Felix Salmon Shakes His Head at Ben Stein

A New York Times that prints things like this from Ben Stein isn't long for this world. Just sayin'.

Let's give the mike to Felix Salmon:

Finance Blog - Market Movers by Felix Salmon: Ben Stein Watch: December 2, 2007 - Portfolio.com: The invisible government of Goldman? Do you think they have a secret handshake, too?

Stein, in this column, is accusing the honest and blameless Goldman economist Jan Hatzius of much more than mere intellectual dishonesty: he's saying that Goldman and Hatzius are using economic research notes to drive down the bond market and make profits on the firm's bearish trades. He compares their conduct to that of Henry Blodget, who was charged with securities fraud and is now banned from the securities industry for life. And he says that anyone who used to run such a shop should never have been considered for the job of Treasury secretary.

It's not illegal – in this country – for Stein to make such allegations. But it is quite shocking, and depressing, that the Gray Lady would willingly allow herself to be used as a vehicle for this kind of yellow journalism – and would place it on the front page of its business section, no less.

Do I have to slowly explain why Stein's column is in fact unmitigated garbage? Thankfully, I don't, because Dean Baker and Yves Smith have got there before me. In a nutshell: Goldman sold the CMO that Stein complains about in mid-2006; it made its big profit on subprime shorts a full year later. Stein's ridiculous assertion that a credit crunch and growth slowdown "has not happened on any scale in the postwar world" can be refuted with one word: Japan. And as for Stein's statement that a correspondent of his in Florida "may be right, but he’s not", I'm sure that that will turn out to be false as well, the minute that anybody can work out what on earth it's supposed to mean.

More generally, macroeconomic research notes do not move markets. And a mortgage-bond origination team is hardly likely to disband and retire for a life of sheep farming just because an economist employed by the same organization is bearish on the housing market. Is that really what Stein would have had them do? By all means criticize Goldman for underwriting nuclear waste, as Allan Sloan did – that's fine. But there's an oceanic gulf between that and securities fraud.

: Stein's NYT stablemate, Paul Krugman, weighs in.

Maybe I don’t have what it takes to be a serious columnist. I mean, it would never have occurred to me to suggest that the only way to explain an economic forecast I don’t agree with is to say that it must be part of an evil plot to drive down the market, so that Goldman Sachs can make money off its short position — and to suggest that Goldman should be the subject of a federal investigation.

Brad Setser Asks a Question

From Brad Setser:

RGE - A little too late ...: China's premier,  Wen Jiabao, has joined the chorus voicing concern about the dollar's recent weakness.   Cheng Siwei comments two weeks ago seem to reflect rather widespread worries among China's top leadership.  The FT reports:

Premier Wen Jiabao told a business audience in Singapore it was becoming difficult to manage China’s $1,430bn foreign exchange reserves, saying that their value was under unprecedented pressure. “We have never been experiencing such big pressure,” Mr Wen said, according to Reuters. “We are worried about how to preserve the value of our reserves.” China keeps the currency composition of its reserves a state secret, but some analysts believe that more than two-thirds are probably still held in dollars.

Wen certainly has reason to worry.   No one has made a bigger bet on the dollar that China's government.   I personally suspect that China's state -- counting the assets of the State Administration of Foreign Exchange, the China investment corporation, China's big state banks and the national social security fund -- hold around $1.2 trillion in fairly long-term dollar-denominated debt.... The capital loss on those dollars could be considerable.   The dollar hasn't held its purchasing power relative to the euro, or relative to oil.  But what should really worry China's leadership is that the dollar is very unlikely to hold its value relative to the RMB.   After all, China's government has financed its dollar purchases by issuing RMB debt.... Moreover, the Hu/ Wen policy of only allowing gradual RMB appreciation -- out of fear that fast appreciation would be disruptive -- largely explains why China now holds so many dollars.   Back at the end of 2004, China's total reserves were only around $600b ($650b counting Huiijin) and the state banks held a lot less long-term dollar debt.  China's total dollar holdings were more like $450-550b.  

The majority of China's dollar exposure comes from intervention over the last three years.

That puts Wen in a bit of a bind.  

His comments were no doubt intended to tell Washington that it need to start paying more attention to the value of the dollar. Yet domestic US conditions likely call for the Fed to cut rates to support the US economy, not raise them to defend the dollar.... [T]he "arithmetic" doesn't suggest that dollar weakness will contribute that much to inflation.... Wen cannot force the US to direct its policy at defending the dollar's external value anymore than the US can force China to stop intervening in the foreign exchange market. He could, of course, conclude that China can no longer take the risk of holding so much of its wealth in dollars, and stop adding to China's dollar portfolio. But doing so would truly cause the dollar's value to tumble....

Willem Buiter is worried about a scenario where foreign demand for all US bonds -- not just demand for CDOs and riskier bonds -- disappears. He writes: "all the ingredients for a bond-run are in place, and at some point in the near future, the gradual sale of dollar-denominated securities will become a flood." And, as Menzie Chinn notes, the US hasn't locked in low interest rates in dollars forever.  What if the US turns out to be borrowing at what amounts to a low initial teaser rate?...

The answer to Brad Setser's question is: as long as the U.S.'s external liabilities are still denominated in dollars--as long as New York hasn't sold lots of dollar puts--it is our currency, but it is their problem.