Ken Rogoff Thinks the U.S. Economy Will Collapse If Its Trade Deficit Declines

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Thursday, 16 June 2011 04:03

This is the implication of his statement in a NYT column that:

"loans from emerging economies are keeping the debt-challenged United States economy on life support."

Is that so? Suppose that emerging economies announced tomorrow that there will be no more loans to the United States. There would be two responses. First, interest rates in the U.S. would rise. Second, the dollar would plummet, especially against the currencies of countries like China, which have been buying U.S. bonds (e.g. lending money) as part of a deliberate policy to keep down the value of their currency against the dollar. Will these events sink the U.S. economy?

First, it's not clear how high U.S. interest rates will go, since U.S. Treasury bonds remain one of the few safe assets for investors around the world. However, if rates did start to rise precipitously then the Fed could engage in a QE3 and buy huge amounts of debt.

Could this lead to inflation? It is unlikely given the massive amount of excess capacity and huge numbers of unemployed workers in the U.S. economy. However, even if it did lead to anĀ  uptick in inflation, this would be a good thing since it would help relieve the debt burden of homeowners and help to spur growth. This argument was made not long ago by an economist named Ken Rogoff.

What about the falling dollar part of the story? Actually, this is what both the Obama and Bush administrations supposedly have been requesting/demanding from China. A lower dollar is essential for getting the trade deficit down. Everything else is chicken feed. There is nothing in any economist's bag of tricks that will have as much impact on the trade deficit as a 20 percent decline in the value of the dollar.

This should be a headline item in every newspaper every day, since the trade deficit is tied directly to the budget deficit. If the U.S. has a trade deficit, then it must have negative national saving. (It's an accounting identity.) This means either negative private savings (e.g. the zero household savings rate of the housing bubble years) or large government budget deficits.

This means that if deficit whiners understood economics, they would all be demanding a lower-valued dollar. In short, the emerging economies have no weapons against the U.S. They would do us and the world a great favor if they stopped lending us money.