Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Wednesday, August 25, 2010

Global Imbalances: Good for the World?

You are a (small) open economy.  If you borrow, you are a net importer of goods and services--you run a trade deficit. You may want to run a trade deficit for a long time, but ultimately, creditors will expect you to pay back what you owe. To make good on your promises, you will have to run a trade surplus at some point in the future. (Alternatively, you may wish to default, but let me ignore this possibility for now).

Setting the problem of default aside, the example above highlights a key property of what economists call an intertemporal budget constraint. Fancy words, but all it really means is that if you borrow today, you will have to pay back tomorrow. Applying the same principle to nations, it means that a trade deficit today will have to be matched by a trade surplus tomorrow.  This principle suggests that "imbalances" in a country's international trade account are expected to be "temporary" (kind of like the "temporary" income tax measure of 1913?).

Sounds like good ol' common sense. And it probably applies to most countries. Except, maybe, for big and powerful economies, like the USA?

The US has had a growing trade deficit for the better part of the last 20 years; see Chart a (source). (The trend appears to have reversed a bit during the recent recession, but the most recent data show a move back to pre-recession levels.)  For the most part, the flip side of the US trade deficit corresponds to a Chinese trade surplus. In short, the Chinese are working their pants off producing stuff and then exporting it to the US. In return, the US sends small denomination paper notes called USD (or US treasuries, representing promises to deliver future USD). 

There is, as far as I can tell, no consensus on what is driving these interesting trade flows. Almost everyone seems to think that this imbalance is bad. Bad, bad, bad. (I mean, how can imbalance ever be good?). Someone must be getting screwed. Some believe that the American worker is the victim (see how clever those Chinese are...they have attained a full employment sweatshop equilibrium!). Others question the wisdom of Chinese trade policy (let's see, they ship us goods, we ship them paper, they ship us goods, we ship them more paper...hmm).

Well, maybe they're right. But before we capitulate to consensus opinion, I want to explore another possibility. Could it be that this exchange of goods for assets is mutually beneficial for the countries involved? (I abstract, of course, from the inevitable mix of winners and losers that are produced with any trade liberalization). And if so, how might this be?

In my previous post, I pointed to Ricardo Caballero's "Asset-Shortage Hypothesis" as one way to understand the "global imbalance" phenomenon. The basic idea is that there is a world "shortage" of assets that are perceived to be good collateral objects and/or good stores of value. The source of these shortages may ultimately be related to cross-country differences in property rights regimes (relatedly, the degree of financial development). If so, then local governments should address the problem directly. But if they do not, or if it takes time, then local agents may exhibit a demand for foreign-produced assets, like US dollars and US treasuries. Of course, to acquire such assets they will have to purchase them with exports of goods and services. This is not crazy; after all, there is also a huge domestic appetite for US treasuries in local repo and credit derivatives markets.

And so, perhaps countries like China simply find the USD useful and are therefore willing to pay for it (with exports). The US values foreign produce and so imports it (by exporting USD). Both countries experience gains from this trade.

A Simple Model

Let me describe one way to formalize the argument above. Consider a world consisting of two economies; a "domestic" economy and a "foreign" economy. Each country is populated by 2-period-lived overlapping generations (and an initial old generation, that lives for one period only). I use an OLG model for its analytical tractability--nothing I have to say here depends on the OLG structure, so don't get hung up on interpreting the model structure too literally.

The young in each country have a nonstorable endowment of output, y. The young derive a "little bit" of utility from consuming their endowment; but they would really rather consume output when they are old (i.e., they really value the output produced by the next generation of young people). This OLG structure is useful because it models a complete lack of double coincidence of wants among agents (and so, bilateral quid pro quo barter in goods is ruled out).

For the purpose of exposition, I take the asset shortage friction to an extreme. In particular, assume that there is only one asset, a fiat object called the USD, which is produced only in the domestic economy. For simplicity, I assume that the aggregate nominal stock of USD M remains fixed forever (it is easy to relax this assumption). Let pt denote the price of output at date t measured in USD (i.e., the price-level).

I assume that the domestic population remains constant over time (normalize the population of domestic young agents to unity). I assume that the foreign population grows over time. Let Nt denote the population of foreign young agents at date t and assume that Nt+1 = nNt where n  > 1 denotes the (gross) foreign population growth rate.

Note: we need not interpret N literally as population. It is simply a parameter that will index the foreign demand for USD. Likewise, n represents the rate of growth in that demand. A financial liberalization in the foreign sector, or some other innovation, can be modeled as a change in these parameters.


Things are grim in the foreign sector; there is no trade at all. The young simply consume their endowment (they derive little pleasure from this) and the old go wanting. This is also an equilibrium outcome in the domestic economy. But there is also another equilibrium--one in which the fiat object is valued. In this equilibrium, the young sell their output to the old for USD (we endow the initial old with M). Hence, pt y = M for all t > 1. The young use the money accumulated in this manner to purchase the good they really desire (next period output). In this manner, money circulates as it facilitates welfare-improving trades. The (stationary) equilibrium price-level is constant over time,
p = M / y. (Note: this is an example of a welfare-improving asset price bubble -- a result that commonly emerges in environments with asset-shortages).

Free trade

Well, if an asset price bubble (defined as an asset that trades above its fundamental value) is good for the domestic economy, might it also be good for the foreign economy (hence good for the world economy)? The answer is yes.

Imagine that trade is suddenly allowed to occur between these two economies at date 1. I like to think of the foreign sector at this point as being small relative to the domestic sector, so that 0 < N1 << 1. Of course, since n >1, the foreign sector is growing faster than the domestic economy. Left unchecked, this implies that the foreign sector will eventually swamp the domestic economy in size.

The date t foreign young agents will want to acquire USD. So they export their output y to the domestic economy for USD. The aggregate foreign demand for USD, measured in units of output, is Nt y.  The domestic demand for USD is simply y. Hence, the relevant market-clearing condition at date t is now given by:

[1]  M = (1 + Nt )pt y  for all t = 1, 2, 3, ...

At date 1, following the trade liberalization, the price-level jumps down (reflecting the sudden appearance of a foreign demand for USD). That is, equation [1] implies p1 = M / [ (1 + N1 )y ]  <  M / y (the domestic price-level in autarky).

Since condition [1] must hold at all dates, it must also hold in period t + 1. Hence, M = (1 + Nt+1 )pt+1 y . This latter equation, together with [1], allows us to derive an expression for the equilibrium inflation rate:

[2] pt+1 / pt = [ 1 + Nt ] / [ 1 + nNt ] < 1 (since n > 1 )

Condition [2] implies that the trade liberalization induces a deflation (a falling price level). In the limit, the deflation rate (the inverse of the inflation rate) approaches  n from below. (Keep in mind that I am keeping the nominal supply of debt fixed in this experiment). Deflation in this model is neither good nor bad; it simply reflects the growing demand for USD and implies that the purchasing power of money rises over time.

Let me now examine trade flows. At date 1, the foreign young demand F1 = p1 N1 y dollars. Since p1 = M / [ (1 + N1 ) y ], this implies that the initial foreign dollar demand is given by:

[3]  F1 = [ N1 / (1 + N1) ] M

That is, they will demand a fraction of the outstanding money supply (which is initially in the hands of the date 1 domestic old agents). To acquire these F1 dollars, they must export N1 y units of output to the domestic economy (to be consumed by the domestic old).  The result is a trade balance surplus for the foreign economy and an offsetting trade balance deficit for the domestic economy.

As an aside, it is of some interest to note what happens next in the case of n = 1. What happens is that all international trade ceases. The USD acquired by foreigners in the initial period simply continue to circulate in the foreign economy as currency. Absent any changes, the domestic economy will forever be a debtor nation; and the foreign economy will forever be a creditor nation. On the other hand, it's not like the domestic economy "owes" the foreign economy anything. They did, after all, export USD, an asset that foreigners evidently find useful.

Let us now return to the case of n > 1. This case is even more interesting, because it implies that trade will continue into the indefinite future.

At date 2, the foreign demand for USD grows (in real terms) by (n - 1)N1 y.  At date 3, this foreign demand will grow by (n -1)n N1 y.  At date 4, it will grow by (n -1) n2 N1 y, and so on. For any arbitrary date > 1, the additional real foreign demand for USD will grow by:

[4]  xt = (n - 1) nt-2 N1 y

Assuming that the foreign sector keeps its borders open to international trade, equation [4] describes the flow of exports to the domestic economy in each period t. What is remarkable here, I think, is the theoretical possibility that these exports continue in perpetuity -- there the possibility of  persistent and growing global imbalances in this world economy. Of course, going the other way are exports of USD. In the equilibrium under consideration, domestic residents peel away ever thinner slices of their remaining USD holdings and ship them to the foreign economy for imported goods. These thinner slices are able to buy the available imports because of the deflation, which increases the purchasing power of USD over time.

It would be of some interest, of course, to extend the model in a variety of ways. We might let the domestic government alter the supply of its assets (collecting seigniorage from the rest of the world). We might imagine a date at which the foreign demand for USD reverses, or even collapses. Etc., etc.

It's important that we not get carried away with a simple model, or ascribe too much importance to the Asset Shortage Hypothesis. There are almost certainly many other factors contributing to the phenomena we see developing around us.

Nevertheless, the hypothesis -- and the way in which I formalized it here -- may be an important contributing factor to the "global imbalances" phenomenon. If it is, then perhaps this is one way to interpret low US inflation rates (as opposed to a competing hypothesis, which explains inflation as the product of "output gaps"). Moreover, as the analysis above makes clear, global imbalances and asset price bubbles are not necessarily a "bad" thing. This does not, of course, mean that we can safely ignore these phenomena as they develop over time. Things might change and bubbles can burst. These are contingencies that policymakers need to plan for.


  1. Another economist lacking in common sense. Are we surprised?

    You and your fellow travelers in corporate American and academe have destroyed the Great American Jobs Machine.

  2. Minka: please feel free to elaborate. You obviously have a penetrating insight to share with the world.

  3. See

    Look at what happens to American manufacturing employment when China joins the WTO.

    Global imbalances mean America looses a huge chunk of its tradeable sector, with corresponding employment and salary slumps. All we got in exchange was debt fueled bubbles. Not sustainable.

    Welcome to the aftermath. Not getting better, is it? Or course not. Free trade and globalization busted the Great American Jobs Machine by destroying the economic rationale for locating jobs in this country.

    This was not necessary.

    In academe you don't see the real life consequences. They are what make this farce practically criminal.

  4. Minka:

    Thanks for the link to Johnson's article. I am familiar with, and have some sympathy for, these sorts of arguments. May I recommend a book by Ian Fletcher "Free Trade Doesn't Work: What Should Replace it and Why." While some of his arguments are lame, on the whole he raises some very good points. By the way, I am aware of a large body of economic models where the application of a trade restriction may improve economic welfare.

    Let me now reply to your specific comments.

    You want me to look at US manufacturing employment since China joined the WTO. OK. Now I want you to look at what happened to US agricultural employment since the invention of synthetic nitrogen fertilizers. What's your point?

    You say that "All we got in exchange was debt fueled bubbles. Not sustainable." What on earth are you talking about? What about all those goods that China has been shipping to the US for "free?" (i.e., for paper). And as for unsustainable, the USD, a fiat currency since at least 1971, continues to have market value. It continues to be the world's reserve currency. This is a pretty long-lived bubble! Will it end one day? Sure, even the Roman empire came to an end (without the aid of a financial bubble, I might add).

    What farce are you speaking of exactly? You know, I'm not sure that you read my post very carefully. Why don't you go back and read it, but this time with a more open (and relaxed) mind. Thanks.

  5. David,

    I'll read the whole post later, but I do find this topic interesting. Just wanted to make a couple of quick comments now.

    1) I see you are starting to attract the ideologues. This is a sign of success, I think. Congrats!

    2) I find the idea of "country" or "nation," as a political construct, to be entirely artificial. As such, the idea of international trade balances is, to me, just a construct of artificial divisions.

    Is there any some sense that we can think about trade and avoid discussion of countries? To me it seems more natural, as an economic construct goes.

  6. Prof J:

    1) Thanks (I think).
    2) I hear you. This is partly what motivated me to introduce the reader to the concept that he/she is a small open economy. An economy is just a collection of agents and we are free to divide agents up into whatever groupings we find interesting or useful. Since USD and treasury debt seems to play such an important role in the world economy, I thought it useful to group agents into countries. One could, however, equally well speak of "regional imbalances" within a country. Or "interpersonal imbalances," etc. etc.

  7. David,

    I see why it's sort of easy to use countries as agents. You don't want to fight too many battles at once.

    I like your model, and it has an easy intuition. The crux, as I see it, is that the foreign entity finds value in holding the domestic currency (USD). The Chinese may want to hold USD in its capacity as a reserve currency. There might be other reasons, aside from "flight to quality" stuff that doesn't matter too much on the long run.

    The point is, as foreign entities find less value in continuing to hold or in accumulating domestic currency, then the trade imbalance might become a problem. Not necessarily because there is an imbalance, though, but because the foreign entity isn't willing to sell its goods to cheaply anymore. It could get so bad that they won't sell goods in exchange for USD.

    The other issue is that trade imbalance is a flow measure, but the flow results in "stockpiles" of USD while purchased goods often get used up. I don't see where this comes in, but do you think it matters at all? What I'm getting at is that we're trading investment goods for consumption goods, and those investment goods are (apparently) yielding some valuable dividend.

  8. Prof J:

    Paragraph 3: Correct. Indeed, China may want to repatriate their USD holdings for US goods at some point. Whether this is "good" or "bad" depends, I suppose. It could possibly increase US employment, for example. And if working for the Chinese is in your social welfare function, then reversing the imbalance would be a good thing.

    Paragraph 4: Yes, I have given this some thought, but haven't worked it out fully. It seems more sensible to ship out USD in exchange for Chinese assets (not consumer goods, which get used up). But then again, the whole premise of the argument is driven by a severe "shortage" of "good" Chinese assets (what would prevent them, one day, to nationalize all foreign holdings, a la Castro?)

  9. There's a working paper by Mendoza, Quadrini and Rios-Rull that takes the same position you do (that the imbalance is good). Here's one version of it:

    The crux of the paper is that China's financial markets are less-developed, making it harder for Chinese to insure against idiosyncratic risks. At the equilibrium interest rate, Americans are happy to to borrow from the Chinese, investing the proceeds in risky Chinese capital. If the return on Chinese capital is sufficiently high, the US will have a negative net foreign asset position but positive net foreign payments (which we see in reality).

  10. Joe,

    Thanks very much for the link...I am eager to check it out.

    Prof J: If the last part of what Joe reports is true, then we'll have to reassess our impression that USD are being used to finance consumption.

  11. David,

    (This is in response to your question over at Steve Williamson's blog. I posted the below twice there but they somehow disappeared. So I am posting my reply here.)

    Probably the best real activity data for this period is Joseph H. Davis (2004) industrial production series. Robert Gordon and Christina Romer have created GNP estimates for this period too, but I believe the Davis' series is the best since it uses consistent underlying data to estimate IP. (Here is a post of mine where I plot all three series.)  In terms of interest rates and prices check out the NBER Macrohistory database. Micheal Bordo has done alot of interesting work on this period such as this, this, and this.  Inspired by his work I did this piece on the postbellum deflation.

  12. This entire problem (for the domestic economy, the shrinking middle class, and U.S. workers could be fixed via changes in the tax code, that unfortunately haven't even cropped up due to multi-national brainwashing/purchase of Congress. Try a thought experiment:

    1. we abolish the income tax;
    2. we return to a tariff based revenue model (what we had until 1913);
    3. we impose a property tax on accumulated assets, of whatever consistency;
    4. we tax corporations, or at least withhold SS/Medicare costs that are now borne by U.S. workers, on offshored labor.

    The benefits would be:

    1. it will no longer be cheap to outsource labor costs--U.S. workers will be on a level playing field;

    2. Americans will no longer be taxed based on their skills, and how hard they work--instead they will be taxed on how much they accumulate from such work;

    3. inequality will decline;

    4. SS/Medicare will now be substantially funded from offshored labor, which would eliminate the current concerns about entitlements.

    5. it would likely lead to full employment, since there would be no benefit to hire a Chinese/Indian worker who will work for next to nothing, over an American.

    We will never get to this solution, because Congress is bought and paid for by large, multi-national corporations, who profit handsomely by paying Indian workers $15 per day.

    Would it harm world GDP? Maybe. Would it benefit the U.S. middle class? Definitely. Will China retaliate because of our new tariffs? Eventually, but since most our exports are food (which they desperately need in order to keep their government in place), intellectually profit (they pirate this already, depriving our copyright and patent holders by stealing their work) and entertainment (which is also stolen by piracy).

    My guess is that their retaliation will be unsuccessful. Will they dump all U.S. treasuries? Maybe, but that could be a good thing rather than bad if they sell them back to U.S./European investors at fire sale prices.

    Such wishful thinking could never happen here, absent a blood on the street type of demand by the shrinking middle class. Unfortunately, these ideas aren't even considered by "very smart people", who hold the reigns of power in this country.

  13. Brooks Grace III:

    That's quite the list of reforms you have in mind there! It would be interesting to work out the likely effects of these proposals in the context of an economic model, to see whether what you predict might conceivably happen (and under what circumstances).

    Just one thought though. With respect to these corporations who profit handsomely by paying Indian workers $15 per day.

    [1] $15 per day might be twice the amount they could earn in the countryside. You wish to deprive these people an increase in their living standard?

    [2] The last time I checked, everyone is free to purchase shares in these "profitable corporations," thereby sharing in the income they generate. Why not a prog

  14. Sorry...accidently posted prematurely.

    ...Why not a program to encourage/subsidize saving as well? Just a thought.

  15. I've come to the conclusion that what is wrong with our paradigm is we over value saving (of money). Why should I expect that any forgone consumption today will be able to be replaced with at least equal consumption later? What type of sacrifices do others have to make in the future to ensure me getting tomorrow what I could have had yesterday?

    Why should China be guaranteed that what they didnt get today they will get in five years? Ten years?

    It seems like we expect money to act unlike everything else in the universe. Most everything deteriorates in value over time, yet we try to insure those virtuous savers that what they forgo now will be there later. Its not a bad effort to make but what costs should we impose on everyone else to achieve this?

    Theres a reason why businesses that offer coupons and gift certificates have a redeem by date often times.

    No economists that Ive ever seen address this.

  16. gbgasser:

    I'm not entirely sure what you're trying to say here. Would you care to elaborate, after I take a shot at answering the questions you pose?

    [1] Why should I expect that any forgone consumption today will be able to be replaced with at least equal consumption later?

    Who is claiming that you should expect this? There is uncertainty in the world. And when we model uncertainty in models, the return to saving is generally risky.

    [2] What type of sacrifices do others have to make in the future to ensure me getting tomorrow what I could have had yesterday?

    It is clear the type of sacrifices others have to make. If I borrow a beer from you today and promise to return a beer to you next week, the sacrifice to me, next week, is a beer. This is a property of every intertemporal model that I am aware of.

    [3] Why should China be guaranteed that what they didnt get today they will get in five years? Ten years?

    Who do you claim is making such a statement? There are no guarantees to holding USD. (Also a property of the model I present above).

    Perhaps you have something like the following in mind. The current generation borrows (purchases with USD) output from China, but the next generation is expected to return the favor?

    With respect to your comment "Theres a reason why businesses that offer coupons and gift certificates have a redeem by date often times."

    I wonder what that reason is? And by the way, banks issue money (coupons) all the time with no set redemption date (demand deposit liabilities, for example).

  17. Sorry if I was a little cryptic.

    It just seems to me that all these talks about "global imbalances", trade deficits and the like really simply come down to the fact that in many trade situations I have something you like and you either dont have something I need or particularly want at the time. So we've created a system whereby I save this ability to call what you owe me.

    Much effort gets put forth to making sure those who didnt get what they could have had a few months ago get that thing or its equivalent later, as much later as they want it to be. So what must happen? The price of those things either cant change or their money appreciates at a level equal to or more than (usually its expected to be more than) the rate of price increase.

    Is this a rational expectation? Seems that after a certain period of time all bets are off and you lost your chance to get the equivalent of what you "forwent". But we ask our system to always keep those virtuous savers whole or keep those excessive producers like the Germans and Chinese whole. Germany and China expect that they will be able to call their chips in at some point or at least they will accumulate enough influence with those chips that they can bring the world economy to align with their needs. I think this is a wrong headed desire.

    Your simple beer model is reflective of what is wrong with much of modern economic thought. Individual transactions dont reflect at all what the whole of 300 million person economy interacting with a billion person economy. You wouldnt wait 10 years for that beer to be paid back and if in ten years you came to me and said "wheres my beer" and I simply gave you the money equivalent of the cost of beer ten years previous, if that money equivalent didnt pay for a modern beer (which could be the case for a variety of reason having nothing to do with my chincyness) you might feel you got gipped. You might scream about the inflation and how its deteriorated the value of your dollar.

    Your issue about banks and their coupons is a great example of the difference. Many businesses wont give you a coupon for service (which has a value of 60$) today and let you redeem it 5 years for the same service. They know the service will likely be worth more then and give you a window of time to redeem. Sure a bank will give you the $100 dollar nominal value, not caring if it gets you the same stuff it did when they issued it.

    My issue is with a system that more favors savers than consumers. All the savers say "Inflation is bad for me" but the out of work could use a little inflationary policy to become consumers again. The savers have accumulated a lot of power from our, IMO, flawed model.

  18. Why does this system change my name the second time I post?

    Its weird, I sign in as gbgasser and then when I put in a second comment it changes me to Greg.


  19. Greg,

    I've read your response over a couple of times and I'm not really sure how to respond to it.

    But we ask our system to always keep those virtuous savers whole or keep those excessive producers like the Germans and Chinese whole.

    Excessive producers? You are chiding people for working too hard and delivering their produce to you for paper?

    You say that your ultimate beef is with a system that "favors savers rather than consumers."

    For almost the entire history of mankind, the essential problem has been how to store wealth. The problem was so severe that mankind has lived at or near subsistence for most of recorded history. And now you want to go back to a system that rewards consumption (the destruction of wealth)?

    I'm sorry if I've missed your point. (Also, I'm not sure why your name changes when you post more than once. It is strange.)

  20. Thanks for your response David

    No, I dont mean to chide people for working too hard. What I'm getting at is these people made voluntary choices to be producers of excess goods and they NEED consumers. Our system seems to hold those producers out as examples for all of us. The answer, according to many, for the Euro zones problems is for the austerity plan countries to work harder and produce more and export their way to wealth. That is not a plan for everyone to use. Someone needs to be net importer for there to be a net exporter or everyone needs to be in complete balance. Neither activity exporting/importing producing/consuming is more necessary than the other.

    Saving is a great thing, when you are saving resources that are scarce but hoarding and excess accumulation (especially of money) lead to imbalances in political and economic power that I think are a large contributor to our issues today.

    We know how to store wealth, thats been solved. We've gone too far in my view, in encouraging accumulation of assets, financial and real.
    In order for the accumulators to get their desired return on their savings, the system imposes too much sacrifice on the rest. Why do you think the bond vigilantes are insisting that everyone everywhere else settle for less? Why are they insisting on higher rates on their savings which come at a cost to everyone else?

    Seniors must now sacrifice some financial security and possibly medical care so we can "afford" to pay those "loaning" our govt money? These are people who have forgone consumption in the past and saved their dollars. They now want everyone else to take less so they get a "fair" return.

    I hope this clarifies my position.

  21. Greg,

    Yes, your last paragraph in particular makes it clear where you're coming from. It is a valid point, I suppose. But I am betting that, given the evolving demographic structure, seniors will have no choice but to take a haircut on their savings/entitlements.

  22. "but I am betting that, given the evolving demographic structure, seniors will have no choice but to take a haircut on their savings/entitlements."

    I have no doubt that you are correct. Where I am left with an empty feeling is that this is always presented by politicians and economists as NECESSARY. As if there is no other option. Armies of academic economists generate fancy formulas to "prove" that for our economic/monetary system to survive, this group of people must sacrifice. What about the option of actually paying the folks what has been promised to them and bondholders be damned? So what if their value is affected negatively?

    This is a pure political decision being made by people who have accumulated much and therefore they can use their power to force the change on a less represented group.

    The world wouldnt end if we continued SS as is for perpetuity?

  23. gbgasser,

    You are surely correct that politics plays a huge role in these decisions.

    I am not entirely sure of your claim: "Armies of academic economists generate fancy formulas to "prove" that for our economic/monetary system to survive, this group of people must sacrifice."

    Can you provide a quick list of (say) 10 names? I will go and check out their work.

  24. "I am not entirely sure of your claim: "Armies of academic economists generate fancy formulas to "prove" that for our economic/monetary system to survive, this group of people must sacrifice."

    Maybe I'm not framing it correctly.

    Would you agree with me if I said that a, if not the, fundamental claim of monetarist economists is that interest rate adjustments, which induce money one way or another between saving and spending (investment), is the way in which our economy manages the flow of money?? This in addition puts bond markets at the top of the hierarchy, making them the arbiter of where spending should go. It is in this paradigm that we come to the conclusions that our deficits are "unsustainable", that we cant afford our health care and SS obligations into the future and that most govt fiscal activity would be ineffective (because of investors' inflation expectations causing them to offset any spending with their own saving to prepare for future tax increases). Does this accurately describe many many economists postion today?

    On the other hand, there are those, Bill Mitchell, WarrenMosler, Marshall Auerback and Randall Wray who argue that bond markets are NOT at the top of the money food chain, govts are with their currency issuing responsibilities. And this fact changes the questions we ask considerably. We never ask can we afford, do we have the money or not, we simply ask what is the benefit of doing so. Whether or not some bond trader(s) agrees with some spending decisions by a governing body becomes irrelevant. Their bonds come from govt spending. They would have no safe bonds to trade without govts issuing them in the first place.

    You might think the term "economic/monetary system to survive" was a little dramatic, however I see a lot of talk that these austerity measures are unpleasant necessities which are the only way to preserve what we have. Its these nebulous bond markets which are "telling" greeks how much to pay their public workers, Irish how long they have to work and American seniors that what they thought they "paid" for is no longer available.

    Thanks for your discussion here.

  25. Greg,

    I can't speak for all monetary theorists, but I don't think that this is the way they think about things.

    Moreover, in my post above, I am arguing that continued deficts *are* sustainable. Did you miss that?

  26. David

    You were talking about trade deficits only were you not? I went off topic of your post and was talking about govt budget deficits and debt levels as well.

    You seemed to be saying that the current level of trade deficit is sustainable with no comment as to whether it could be sustained at a certain rate of growth in size. IOW are you also saying that a doubling of the CAD would also be sustainable since the conditions creating it (our desire for their goods their desire for our money) would still be operative? If you are I agree, because I dont think theres any absolute level of deficit( trade or govt budget type) that is unsustainable by definition any more than a balanced current account is "sustainable" by definition.

  27. gbgasser,

    The argument developed in my post can be applied to government deficits. The government (in my model) creates new debt, which it ships abroad (or to its citizens) in return for goods and services. Under the conditions stated in my model, growing government debt is sustainable.


  28. So, at the end of the day, does American per capita wealth go up or down?

    So we have any learned papers discussing the social benefits of declining US wealth?

    I must admit that the US fed is doing one helluva job of stimulating the economies of net resource exporters. Who have known that Americans were this generous?

    P.S. In the background, 1/4 of Americans think President Barack Obama is a Muslim and Ron Paul believes that the US federal reserve is hiding critical information on gold assets and transactions.

    So David: When is the US fed going to drop the dual mandate and focus only on price stability? Or would that too much like eating and living well in a disciplined manner as opposed to the popular choice off using massive amounts of drugs and surgical intervention to resolve "lifestyle issues"?

  29. Westslope:

    Personally, I think that most people in the Fed might welcome a single mandate of price stability. Remember that the Fed (and its mandates, presumely) were created out of an act of Congress. It is not within the powers of the Fed to change its mandate. You are barking up the wrong tree.

  30. westslope

    What dual mandate? The fed gave up full employment decades ago. They have since paid people to develop theories like NAIRU to justify keeping a certain percentage of the people out of the job market....... cuz its for their own good dont you know.

  31. David

    I'm glad to see you apply your trade analysis to govt debt as well. I agree with you. So is it fair to put you into the camp of people who want economists and lawmakers to stop talking about sustainability of SS/medicare from a financial perspective?

    Lets start asking people to start arguing that old people dont deserve the amount of resources they are consuming ( and see how many GOP and Dem senators want to jump into THAT framing). There is no financial threat to these programs, they can be fully funded to perpetuity. What we have to make sure of is there are people to deliver the health care, technology to treat the medical conditions and affordable food/housing for them to be able to purchase with their SS checks. Lets stop talking about money, its created out of thin air as is already known

    best wishes


  32. David: I'm well aware that Congress sets the mandate.

    Greg: The crack-cocaine-like goal of Full Employment has been dropped but the goal of more employment has been retained and the threat of cocaine-like psychosis is on-going.

  33. Westslope,

    Back to your first post. If I print an intrinsically worthless note and use it to purchase something made in China, how does this reduce my wealth? I can see how I "stimulated" Chinese employment (some poor bugger has to make the product I purchase), but I am not entirely clear why this makes me poorer.

  34. Suppose you got a letter in the mail offering you a low interest loan, but one that could be called any time the lender wishes. You could and would turn down that offer, if it were against your interest to accept it.

    The US Fed/government cannot turn down those loan offers, even if it wanted to. It either prints more money/bonds to satisfy the foreign demand, or else there's deflation, and the real stock of money/bonds expands to satisfy the demand that way.

  35. Damn, but this is an ancient post! I followed Steve's link here. Thought it was a new one. Oh well.

  36. Nick: I get email alerts when people comment on even old posts.

    I agree with what you say. But, so what? Implicit in your statement (I could be wrong) is that the ensuing deflation (the increase in the rate of return of paper that you issue at zero cost to yourself) is a bad thing.

  37. perhaps countries like China simply find the USD useful and are therefore willing to pay for it (with exports). The US values foreign produce and so imports it (by exporting USD). Both countries experience gains from this trade. China sourcing