Wednesday, March 5, 2008

Bubblicious, Continued

Stephen Roach is almost right. No doubt an avid reader of EconoSpeak, he has come to see that the US has slid into the condition of a bubble economy, and that the post-bubble landscape has the potential to be chronically depressive. His article is constructed around a comparison between the US today and Japan in the wake of its own debubblization. The big difference, of course, is that Japan was and remains a major creditor nation, while the US is storming new depths in external debt.

This matters a lot. Leaving Japan aside for another day, we should note that the broad relationship between US bubbles – stocks, mortgages, creative credit packages, and the currency itself – are ultimately derived from the recycling of dollars exiting the country through the current account deficit. These returning capital inflows purchase assets that support, directly or indirectly, the ability of US consumers to enjoy consumption in excess of production. The moral of the story: the US economy, steadily drawing down its privileges from decades of producing the world’s key currency, is able to maintain otherwise impossible external deficits, and these in turn impose low or even negative savings rates. (For details, read this.)

So Roach has it backwards when he says

Like their counterparts in Japan in the 1990s, American authorities may be deluding themselves into believing they can forestall the endgame of post-bubble adjustments. Government aid is being aimed, mistakenly, at maintaining unsustainably high rates of personal consumption. Yet that’s precisely what got the United States into this mess in the first place — pushing down the savings rate, fostering a huge trade deficit and stretching consumers to take on an untenable amount of debt.

Trying to solve the underlying cause of the current account/bubble dependency problem by allowing consumption to collapse is killing the patient to cure the disease. He then partially contradicts himself and gets it right when he immediately adds

A more effective strategy would be to try to tilt the economy away from consumption and toward exports and long-needed investments in infrastructure.

Investments in infrastructure, need we point out, also support consumption, especially if they are financed by an enlargement of public debt, but they do it the right way.

His other suggestion, a weaker dollar, is reasonable as far as it goes, but it would be an exaggeration to call it a policy. There is no magic wand anyone in the US can wave to make the dollar go down: it requires accommodation from those whose currencies have to rise. Moreover, the problem at the moment is that exchange rate flexibility is grossly uneven and doesn’t correspond to trade flows. Nearly all the burden of adjustment is being placed on the dollar-euro exchange rate. This is a big problem for Europe, particularly since the RMB is tied to the dollar. So the EU racks up an ever-bigger deficit with China: how does this help the US? A dollar initiative has to be multilateral, like the Plaza Accord of old. Failing that, or as an inducement to cooperation, the US can begin to explore unilateral options to manage its current and capital accounts.

Sectoral strategies can also play a big role. Emergency action to reduce oil consumption, and therefore imports, should be high on the agenda. We can dust off perfectly reasonable ideas that were shelved at the end of the 1970's, beginning of course with much more aggressive fuel economy standards and support for residential insulation. For more particulars see organizations like ACEEE. The general point is that expenditure-switching is ultimately an investment program.

Incidentally, one of the paradoxes of this election season is the vast gulf that separates the economic pronouncements of the candidates from the actual condition of the country. No one is talking in a coherent way at the moment about the toxic stew of external deficits, bubble finance, and sputtering demand. Creative strategies that could link economic solutions to progress on climate change and other social goals are completely out of the picture. Do we expect sensible policies to just descend on us, like spores from outer space, in 2009?


kevin quinn said...


I guess I'm not convinced on your claim that the trade deficit drives the savings shortfall, rather than vice-versa, though of course I agree that this is a terrible time to push savings incentives. I agree that in the short run, with output determined by demand a la Keynes, you do get this reverse causation. But in a model with Y at its potential level, the conventional story seems plausible to me, where trade deficits are driven by either low US saving or high saving elsewhere. I can't put my finger on why I think you're wrong, but let me pull on one thread that may bring out the issue. In your Challenge piece I think you equivocate between taking: Capital outflow = Net Exports as an identity on the one hand, and taking it as an equilibrium condition in the foreign exchange market, on the other. The conventional results follow it seems to me form taking it in the latter sense, where Net exports are a decreasing function of the real exchange rate, and the *level* of capital outflow emerges from the loanable funds market equilibrium condition that Saving less investment (an increasing function of the real interest rate for given Y) must equal Capital outflow (a decreasing function of the real interest rate.) Then the amount of capital outflow (and thus the trade surplus) won't change unless either
the savings schedule, the investment schedule or the capital outflow schedule shifts. Am I hopelessly benighted?

Peter Dorman said...


I wonder how you inferred from the Challenge article that I might see the accounting identity as an equilibrium condition. The biggest point I was trying to make is that it is a mistake to conflate the two. Yes, if it's an equilibrium condition we are back in the world you describe. But I was saying two things against this: that the identity is always true, which distinguishes it from an equilibrium condition (which may not hold and has dynamics that restore/establish the equilibrium), and that, in the absence of a theoretical reason for supposing causation goes primarily in one direction or another, the empirical evidence points to the centrality of trade.

Your comment leads me to think I wasn't clear enough. Where did I get fuzzy?

J.Goodwin said...

I'm concerned that a runup in spending would increase the severity of our economic problems.

We've blown trillions in ancillary defense spending over half a decade here, and we're still lurching into a recession/depression/stagflatory scenario.

My general understanding is that deficit spending by the government in a period of economic decline is intended to hold the economy relatively steady through the downward portion of the cycle. Infrastructure spending is intended to provide a base that private companies can use as supplements (of a sort) to independent capital spending, and is expected to benefit their output in the future, driving federal revenue shares from their future profits to repay the debt expended on that investment.

But in a bubble economy model, how is this going to be appreciably different from leveraged purchases of second homes etc? Is our problem really a lack of capital spending? I'd love to see the federal government help localities pay off the debt associated with past transit improvement projects, and finance new ones (by transit I mean things other than more tollways and toll bridges, and other than freeways).

If we are really going to be making capital investments that are going to help drive private and therefore public revenues in the future, then shouldn't we be investing in more efficient capital resources? Subways, intercity rail, rail/sea links for shipping, federal takeover of rail maintenance and extension (CRX & Co. have failed miserably), internet, efficient power generation. Just building more highways is like building more coal fired power plants, we're adding inefficient capacity where none is really needed on a national level (you've got traffic issues in certain places, but they're better alleviated by moving away from individual transportation than by facilitating it).

That looks a little more rail obsessed than I intended it to, but at this point, highways are pretty much all the fed seems to think of when it comes to capital spending. They aren't going to invest in a TVA any time soon, everything's been privatized.

Maybe the highest return on our public investment is actually paying off our national credit cards to reduce future interest payments, and letting the private sector handle the things that it has seized from the commonwealth. Unless of course we intend to seize it back. Which I'm assuming isn't going to happen.

kevin quinn said...

Peter - I will read it again- sorry!