James Kwak responded in Baseline Scenario to some of the points that I raised in the review of the new book he co-authored with Simon Johnson, White House Burning. I want to focus on one issue in particular because it is really central to how we understand the economy.
I argued in my review that the fundamental imbalance in the U.S. economy is the trade deficit. This deficit is in turn caused by the over-valued dollar. The latter is a direct result of the decision of developing countries to accumulate massive amounts of foreign exchange reserves (i.e. dollars) in the wake of the East Asian financial crisis.
Developing countries saw the harsh treatment of the East Asian countries following the crisis and decided that they did not want to be in the same situation. Their protection against this event was the stockpiling of huge amounts of reserves. They acquire the reserves by running trade surpluses, which they use to acquire dollars. The decision of foreign central banks to buy and hold dollars keeps up the value of the dollar against their own currencies. If they didn't buy dollars, the value of the dollar would fall relative to their currencies.
This matters for our trade deficit because the higher valued dollar means that imports are cheaper for us, which leads us to buy more imports. In addition, the high dollar means that our exports are more expensive for people in other countries. Therefore they buy less of our exports. If we import more and export less, then we get a trade deficit.
This matters for the budget deficit story because if the United States runs a trade deficit, then it means that the United States has negative national savings. This is definitional; as a country we are buying more than we are selling.
If we have negative national savings, then either the private sector must have negative savings or the public must have negative savings or some combination where they both run deficits. All of this is definitional; it necessary follows from the trade deficit.
Right now we are offsetting the trade deficit with large budget deficits. The private sector actually is a net saver at the moment. The combination of business and household savings exceeds annual investment.
However this was not true before the crisis. In 2007, the budget deficit was actually relatively small at just over 1 percent of GDP. Instead we had a very large deficit on the private side of the ledger. This deficit corresponded to the housing-bubble-driven construction boom (residential construction is a component of investment) and the consumption boom that was driven by housing-bubble-generated equity. The household saving rate fell to near zero at the peak of the bubble in the years 2004-2007. I comment in passing in my review that no one could reasonably want to go back to this situation.
Kwak picks up on this issue in his blogpost and holds up 1999 as a model. In that year the government had a budget surplus of 1.4 percent of GDP. The country had a trade deficit of 2.8 percent of GDP and the economy grew at a 4.8 percent rate, so what's the problem? He points to the 2011 trade deficit of 3.8 percent of GDP and says things should not be that different now.
There are two points to make on this. First, the current deficit is lower than it otherwise would be because the economy is operating well below its potential. Imports always fall in a downturn, lowering the trade deficit, and this one was no exception. The trade deficit fell from 5.0 percent of GDP in 2008 to 2.8 percent of GDP in 2009. The main factor behind this drop was the steep recession. If we were back near full employment, the trade deficit would again be close to 5.0 percent of GDP. This leaves us with negative net foreign savings that are roughly 2.2 percentage points of GDP (@$330 billion) higher than what we were looking at 1999.
But the other part of the story is that 1999 was not quite so great. While we had good growth and low unemployment, both great achievements, we also had very low household saving. The measured household saving rate that year was just over 2.0 percent of disposable income. This compares to an average of 8.0 percent in the years before stock and housing bubble generated wealth drove savings rates through the floor.
Furthermore, there is evidence that a mis-categorization of capital gains income as ordinary income overstated actual income in the peak years of the 90s stock bubble. This would imply that savings was overstated, with the actual rate being close to zero at the end of the decade.
This low savings rate matters because it means that people on aggregate are not putting aside any money for retirement. This cannot be considered a desirable situation.
The other part of the story is that investment was in part inflated by the tech frenzy that was causing people to throw money at anything involving the Internet. This was not a healthy situation, as large amounts of this capital was wasted and investors ended up being burned. The NASDAQ fell from a peak of 5000 in March of 2000 to a trough of less than 1200 in the summer of 2002, wiping out more than three quarters of the paper wealth of shareholders.
So, we didn't balance our trade deficit in an especially good way back in 1999 and now we are looking at a trade deficit in the neighborhood of 5.0 percent of GDP, instead of the 2.8 percent deficit we faced in 1999. That doesn't look a pretty story to me.
This is why the over-valued dollar is the fire that I most believe needs to be addressed. In the short-term, it is perfectly reasonably for us to run large budget deficits, ideally building up infrastructure and improving the education and skills of the workforce so that we will have lasting benefits from this boost to demand. However in the longer term, a rich country like the United States should not be running large trade deficits. We should be an exporter of capital to poorer countries where it can help finance development. That would be much better than trying to sustain demand through yet another asset bubble.
I'm sure that Kwak does not actually want another asset bubble, but I don't see any other way to get us the negative national savings that goes along with a trade deficit, if we do not have a budget deficit. Remember, you can never win a fight with an accounting identity.
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