Friday, September 30, 2016

Mankiw on Navarro – a Teachable Moment?

I’m not known to praise Greg Mankiw often but this post on the Navarro nonsense was worth the read:
Their analysis of trade deficits, starting on page 18, boils down to the following: We know that GDP=C+I+G+NX. NX is negative (the trade deficit). Therefore, if we somehow renegotiate trade deals and make NX rise to zero, GDP goes up! They calculate this will bring in $1.74 trillion in tax revenue over a decade. But of course you can't model an economy just using the national income accounts identity. Even a freshman at the end of ec 10 knows that trade deficits go hand in hand with capital inflows. So an end to the trade deficit means an end to the capital inflow, which would affect interest rates, which in turn influence consumption and investment. I suppose that their calculations might make sense in the simplest Keynesian Cross model, in which investment is exogenously fixed and consumption only depends on income. But that is surely not the right model for analyzing the impact of trade policy over the course of a decade.
Let’s put forth a simple example of the Keynesian Cross model that brings in some reality ala Brad Setser. Consider an exogenous increase in the net export schedule equal to $500 billion in a fixed exchange rate, fixed interest rate Keynesian model where the marginal propensity to import is 0.15 and the domestic marginal propensity to spend is 0.65, which implies a multiplier equal to two. The model suggests a $1 trillion increase in GDP assuming we have sufficient economic slack – which was one of my concerns. The model would also predict that imports rise by $150 billion so the net improvement in the current account is only $350 billion. Of course they are a host of other implicit assumptions underlying this tale. Even if the dollar did not appreciate, our rise in net exports means less net exports for places like Europe. OK – maybe Team Trump does not care about the economic woes in Europe but it is a reasonable proposition that they might respond with trade protection against us. Here is where Brad comes in:
Foreign exchange intervention to limit appreciation isn’t as prevalent it once was. More big central banks are selling than are buying. But it also hasn’t entirely gone away. Korea has plenty of fiscal space. It could move toward a better equilibrium, one with more internal demand, less intervention and less dependence on exports.
While Brad was noting that nations like the US having floating exchange rates, South Korea does peg its currency. Maybe the government fears an appreciation of the won would lower overall aggregate demand in Korea, but Brad’s recommendation is that South Korea allow appreciation and replace the lost net export demand with fiscal stimulus. Our second largest bilateral trade deficit was with Germany who likely should also follow Brad’s advice. The general point, however, is that policy makers should consider trade policy and exchange rates in a broader context that also considers monetary and fiscal policy. Alas, Trump seems to have disdain for Yellen because she is keeping interest rates low while he adores Merkel despite her fiscal austerity.