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Home Publications Blogs Beat the Press Harvard Economist Robert Lawrence Asks for an Intro Econ Lesson on Macroeconomics and Trade

Harvard Economist Robert Lawrence Asks for an Intro Econ Lesson on Macroeconomics and Trade

Monday, 27 January 2014 20:10

And here at Beat the Press we are happy to oblige, at no charge to Mr. Lawrence. Brad Plumer caught Robert Lawrence claiming that increased oil production in the United States will not reduce the size of the trade deficit.

According to Brad, Lawrence said that the trade deficit is determined by the balance of domestic savings and investment. He then quotes Lawrence:

"Unless you can tell me how the oil boom will change that pattern of savings and investment ... then it's not going to change the trade balance."

Of course we can tell him how the oil boom could change the balance of savings and investment. Let's say that we had $100 billion going out of the country each year to buy oil from Canada, Mexico, Venezuela, and other foreign countries. This is $100 billion out of the pockets of U.S. consumers. It can be thought as equivalent to $100 billion tax. Consumers will reduce their spending by somewhere in the neighborhood of $90 billion (assume $10 billion of this money would have otherwise been saved) because of this drain from their pocketbooks.

Now suppose that we find some infinite pile of oil underneath Pennsylvania. Instead of sending the $100 billion to foreign countries we send it to oil companies and oil workers in Pennsylvania. While the situation of oil consumers has not changed (we're all still out $100 billion), the money is now in the hands of people who will spend a large portion of it domestically. When they spend this money it will lead to more demand, employment, and output in the United States. (Some of the spending will of course go to imports.)

With higher output, we will also see more savings. If output increases by $100 billion, then savings may increase by around $10 billion. Tax collections will also increase while government spending on programs like unemployment insurance and food stamps will decrease. This will lead to a reduction in the government deficit (i.e. an increase in public savings, on the order of $25-$30 billion). On net, we can expect to see national savings increase in this story by around $35-$40 billion. This would imply a reduction in the trade deficit of roughly this amount.

Since our assignment from Professor Lawrence was simply to show him how increased domestic oil production can increase domestic savings, we have already finished the task. But, it might be helpful to provide him some further education on this topic.

Brad describes Lawrence as saying:

"If we're buying more domestic oil instead of foreign oil, then the dollar will rise and we'll switch to spending on other imported goods."

This is not necessarily true. Many foreign countries, most notably China, have been buying up huge amounts of dollars to hold as reserves. One of their main motivations was to keep the dollar high against their currencies so as to protect their export markets in the United States. If the U.S. is sending fewer dollars abroad to buy oil, then they have to buy fewer dollars to keep a targeted value of their currency against the dollar. This means that other countries may respond to the reduced U.S. purchases of oil by buying up fewer dollars. If this proves to be the case, then there is no reason that the dollar must rise against other currencies.

So there you have it. The United States can reduce its trade deficit through more domestic oil production, as it has to some extent in the last five years. This can be associated with an increase in domestic savings and need not cause a rise in the value of the dollar. One day you may be able to learn these facts at Harvard, but in the meantime, you can get the scoop here at Beat the Press.

Comments (16)Add Comment
written by Jay, January 27, 2014 8:25
Would it really have that effect in light of OPEC?
Relative Magnitudes!
written by Dave, January 27, 2014 10:26
It is fairly amazing how much of the confusion in discussing macroeconomics comes from a blurring or complete distortion of the relative magnitudes of each effect given a certain change.

It was a distortion such as this that allowed the Republicans to claim that lowering taxes would raise tax revenues.

All of these kinds of questions could be fixed with a computerized, visual representation of the issue. It should be written in Javascript so all you have to do when a question like this comes up is send out a link with the parameters of the question at hand in the model.

Why is the economics profession so far behind in technology?
Great Article
written by jim, January 27, 2014 10:30
Couldn't this effect on the dollar be further magnified by any type of Chinese banking issue in which they would have to use foreign currency reserves to fill the plug? but then I remember you posted a link a while back that said China wanted to raise their currency so more good news for dollar whether it be currency internalization or crisis.
written by JDM, January 27, 2014 10:52
Would it really have that effect in light of OPEC?

It wouldn't make our fuel prices lower, as the oil lobby likes to claim, because it would go into the world market. But we would be paying people here at home rather than in an OPEC country for drilling and transport etc.

Mind you, the effects of what we can reasonably expect to get in terms of oil, and how many jobs this would create, is wildly exaggerated by the local "drill 'em all" crowd, but I don't think that's what Dean is talking about here.
written by squeezed turnip, January 27, 2014 10:55
am I missing something? personal savings rate is lower than 10% ...
Savings - am I missing something? Yes you are
written by reason, January 28, 2014 3:11
You should have seen it before! (At one stage it was negative).
Ph.D., Applied Math
written by Michael Epton, January 28, 2014 3:17
For several months I had been perplexed that gas prices in Seattle had settled down around $3.50, when I expected a bit more the $4.00 at this time of year. Then I noticed what is really going on in western North Dakota and Eastern Montana: The Bakken Oil Field. Read about it in Wikipedia. The amazing thing about this field is that a technological development (circa 2008) brought it online. Specifically, directional drilling, originally developed to steal the neighbor's oil, has been refined to the point that it can produce oil from very large, yet very thin, layered deposits. This field looks like it will produce at peak for about 12 years -- 12 years for us to get our act together and move toward solar.

We've been given a reprieve: Let's use it intelligently.
Savings rate refers to the margin, not the average
written by Dean, January 28, 2014 4:36
Squeezed Turnip,

the issue is how much of an additional dollar is spent. Suppose a family has an income of $50k and spends $48k. Their saving rate is 4 percent. However if their income goes to $60k, their spending may only rise by $9k to $57k. This would mean their marginal saving rate was 10 percent.
written by JSeydl, January 28, 2014 5:45
If Lawrence said increased oil won't eliminate (rather than reduce) the trade deficit, then he would probably be in the clear. After all, I don't think we can frack our way to a trade surplus...
Accounting Identities, Full Employment and Trade Deficits
written by Last Mover, January 28, 2014 6:16

In terms of national accounting identities, Lawrence assumes ceteris paribus, increased domestic oil production won't change the trade deficit because the dollar will rise from where it was to restore the consumption of imports to where it was:
The oil boom, by itself, won't change that much. If we're buying more American oil instead of foreign oil, then we're simply likely to spend more on other imported goods.* ... For example, if U.S. national investment were unchanged following a drop in net oil imports, Americans would have to increase their national saving by the full value of the oil trade improvement.

But by definition national private investment does increase by the amount of domestic oil production so the private investment-savings identity holds at a higher level and leaves the original trade deficit undisturbed according to Lawrence.

Baker notes Lawrence's global change in dollar value can be offset by manipulations from China for example. This negates Lawrence's assertion that the trade deficit won't change because the dollar would float to a higher level offset in response to less oil imports and more domestic production.

Lawrence does provide a chart designed to show no close relation between consumption of imported oil and all other imported goods for 1969-2011, thus the implication that both are highly substitutable for a given level of trade.

Baker responds even if this narrow identity assumption held, say despite China's attempt to go around it, changes in the domestic private and government sector from more domestic oil production would still reduce the trade deficit in other ways, especially in an underemployed economy which can add net aggregate demand without inflation.

In short, at normal full employment, a trade deficit means essentially a country is consuming more than it can produce. But at substantially less than full employment it means the country could produce more but doesn't, presumably getting in return for the lost employment, lower real prices.

But as Baker explains after taking into account all three sectors of the national accounting identities:
On net, we can expect to see national savings increase in this story by around $35-$40 billion. This would imply a reduction in the trade deficit of roughly this amount.

Conclusions: At less than full employment below production capability, reducing the trade deficit acts as a stimulus over and above the usual benefits of avoiding problems with too much total consumption including imports that exceeds production capability.

Even if imported oil and non-oil products were highly substitutable in the past on the consumption side, domestically produced oil is not highly substitutable with foreign produced oil on the production side - because of the net addition to aggregate demand by the domestic production.
written by sherparick, January 28, 2014 6:20
I think Professor Lawrence, as well as Robert Samuelson, forget that accounting identities have different ways of adjusting to zero. Just as the expanding trade deficit of the early Oughts required the U.S. savings rate to plunge (as one commentator noted going below zero during 04-05 period), a decreasing deficit allowed a partial recovery to 5% in the current period. As Bill McBride points out at Calculated Risk, the trade deficit is mostly oil and China, and is somewhat artificial due to the Chinese policy of pegging its currency to the dollar at rate advantageous to its exports (and which helps Chinese exports to 3rd countries when the dollar falls against currencies like the Yen, Euro, Real, etc.) Hence, a further fall in the dollar, particular and adjustment by China, would boost U.S. exports, encourage domestic substitution for exports, raise employment and thereby reduce Government deficits, and increase the overall personal savings rate back to 10% as accounting identity adjustments to a current account balance that is zero or in surplus, as the identity has to sum to zero. By the way, I note that one, Professor Lawrence is ignoring that the facts concerning the change in the U.S. trade and current account balance over the last 7 years (which besides the oil boom, was caused by a relative decline in consumer spending, and an internal U.S. devaluation in the real medium wages for U.S. workers), and making repeating a thought meme/moral judgement about the average American as "spendthrift" versus those "thrifty" Asians and Europeans. This is unfortunately now a common attitude among the U.S. elite, that the "average" American has it to good, despite the misery of the last seven years.
written by skeptonomist, January 28, 2014 10:18
The US could reduce its trade deficit by any kind of domestic energy production. It could also reduce the deficit by buying wind turbines, solar panels and other energy apparatus which are made in the US instead of in China. The US could also reduce the trade deficit by exporting coal or natural gas.

It should be obvious that if there were no foreign trade there would be no trade deficit. This could happen if the US were self-sufficient in everything, although it would probably not be advantageous overall because of relative costs. The main thing that the US is not self-sufficient in at the present is oil. There is some potential for increasing domestic oil production, but in the long run oil is going to fall short of satisfying energy needs, even including foreign oil.

There is no single accounting identity which dictates how foreign trade is conducted. Apparently Lawrence assumes that cost must be minimized, maybe for each commodity. You could also choose in your calculations to zero the trade deficit or to maximize the benefits to US workers (which actual policy calculations and actions certainly have not done). China and also Japan choose to maximize their trade surpluses (although it hasn't been working very well for Japan).
written by skeptonomist, January 28, 2014 10:22
I should say that domestic energy production can reduce the trade deficit if it can be substituted for oil.
written by robert lawrence, January 28, 2014 4:39
Maybe it would help if Dean Baker actually read the paper I wrote instead of feeling compelled to engage in in "gotcha" pontification. Had he done so, he would find a was careful to distiguish between the long run impact (assuming a constant level of employment) and the case as we have today, with high levels of unemployment. Indeed, my analysis of the case with unemployment is not much different than his which shows how a dollar increase in domestic oil production leads to a substnatially smaller improvement in the trade deficit.
Glad we agree
written by Dean, January 29, 2014 4:34
Professor Lawrence,

I'm glad you straightened me out. You're right that I did not look at the paper, I was relying on what was presented in the Post. Apparently you views were misrepresented.
imagine that ...
written by Squeezed Turnip, January 29, 2014 5:20
Glad we agree
written by Dean, January 29, 2014 5:34
Professor Lawrence,

I'm glad you straightened me out. You're right that I did not look at the paper, I was relying on what was presented in the Post. Apparently you views were misrepresented.

Huh. The Bezos Express-News distorting the facts. Poor Little Nemo

Well, that should teach us to never trust the WaPo for accurate reporting. Neo-journalism at it's finest rhetorical pitch.

Well, most men have bound their eyes with one or another handkerchief, and attached themselves to some one of these communities of opinion. This conformity makes them not false in a few particulars, authors of a few lies, but false in all particulars. Their every truth is not quite true. Their two is not the real two, their four not the real four; so that every word they say chagrins us, and we know not where to begin to set them right. -- R.W. Emerson

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.