Americans are justifiably confused by what they hear from economists. On one hand they are repeatedly told that America has a saving shortage problem and it must increase national saving. On the other hand, no sooner do households increase saving and reduce consumption, economists start worrying about recession and possible need to lower interest rates to maintain spending.
This contradiction stems from economists’ deep misunderstandings about the nature and determination of saving. Clarifying these misunderstandings is too big a task for a short policy brief, but I can tackle the saving shortage theory of the trade deficit. That theory claims the trade deficit is due to inadequate saving, and it is very popular in Washington DC. The Economist (September 17, 2005, p.80) concisely summarized the theory in an article on the China deficit rejecting exchange rate adjustment as a cure:
“In any case, a revaluation of Asian currencies would have little impact on America’s current-account deficit. The only real cure is for Americans to save more.â€
The logic behind such thinking is that if households increase saving and reduce consumption, imports will fall by the fraction of consumption spent on imports. That is true, but the reduction in spending will also reduce demand for domestically produced goods, causing job loss and recession. This is a case of the trade deficit cure being worse than the disease.
And what about exports? Solving the trade deficit involves lowering imports and increasing exports, but increasing household saving does nothing to increase exports. That will only happen if we induce foreign buyers to purchase more U.S. made goods.
Some back of the envelope calculations show the weakness of the theory. On average every dollar of consumption spending generates two dollars of income since the money initially spent circulates and creates jobs and more spending. Households also spend about fifteen percent of their income on imports. Now, suppose Americans increased their saving by three hundred billion dollars. That would initially reduce consumption spending by three hundred billion dollars, causing an ultimate six hundred billion dollar drop in income. As a result, imports would decline by ninety billion dollars, reducing the trade deficit to around six hundred billion dollars. Thus, a major increase in saving triggers a deep recession, and causes a modest dent in the trade deficit. Clearly, lack of saving is not the primary cause of the trade deficit.
Reducing the trade deficit requires increasing exports and decreasing imports. That requires inducing foreigners to buy more U.S. made goods, and inducing Americans to “switch†their spending from imports to domestic made goods. How do market economies accomplish this? They do it by changing relative prices, making foreign goods more expensive for American consumers, and American goods cheaper for foreign consumers.
To get concrete, improving the trade deficit begins with shoppers at Wal-Mart buying American goods rather than imports. They don’t do this because they have decided to save more. They do it because American goods are cheaper than foreign goods, and they therefore switch spending to American goods. That is where exchange rates enter. A depreciation of the dollar makes foreign goods more expensive to Americans, and it also makes American goods cheaper to foreigners. Which is exactly what the doctor ordered.
If exports go up, the trade deficit will improve. Interestingly, that will show as increased foreign sector saving, which increases national saving. Saving will have increased, but not because households made a decision to save more. Rather, it is because the exchange rate changed, changing relative prices and increasing exports, and those exports are accounted for as increased saving.
The trade deficit is principally determined by our trade policies and those of other countries that affect tariffs and non-tariff barriers; exchanges rates which determine the prices of exports and imports; the state of the U.S. economy which affects our demand for imports; and the state of the rest of the world’s economy which affects their demand for U.S. exports. Trade policy and exchange rates are the way to affect the trade deficit while retaining high employment. The focus on saving is a pure distraction.
There is one rub. If exports go up and consumers switch from buying imports to buying domestically made products, the U.S. economy could eventually hit a manufacturing capacity barrier. At that stage, we would risk inflation, and the Fed might need to raise interest rates to restrain consumer spending. Two things. First, the U.S. economy is not there yet. Second, how soon the barrier is hit depends on how much manufacturing capacity we have. And guess what. America has been following international economic policies that have gutted manufacturing capacity. Contrary to proclamations of economists, manufacturing does matter.
To close on a political note, most Democrats seem to understand all of this, though too many appear “lite†on policy conviction. For Republicans, the problem is that they have become the party of big business, and big business finds importing off-shored production highly profitable and therefore opposes exchange rate adjustments.
Interesting article. I think that saving money needs to be viewed as a positive step to be taken by the marketplace – in other words, the market has to view saving as being a worthwhile activity, as opposed to spending. In this sense, saving is in competition to spending. The way to increase saving is to make money more valuable, so that the market will hang on to it longer, which obviously means that the best way to increase saving is to increase interest rates.
Increasing interest rates will lead to a lowering of the current account deficit. While the higher interest rates will make the dollar more valuable and decrease the cost of imports, the overall dampening of economic activity will more than compensate for this.
Of course, in order for the Fed to increase interest rates they would need to change their preferred method of monetary policy – specifically a much lower inflation target.
I personally think that monetary policy should aim for zero inflation since absolute price stability allows money to function properly as a method of exchange. See my article here:
http://one-salient-oversight.blogspot.com/2005/07/zero-inflation-monetary-policy.html
nice expose
two words are used in economics to conceal
a corporate profit motive behind a pair of household virtues
work and save
like the docs
call for
diet and exercise
the board room paid econ con
calls for more savings and harder longer job work
both are often pure purest pulpit turpitude
my god they make save to be a panacea
for what working harder can’t cure
when the north south forex tilt built right into the international capital export sysytem
causes high north industrial imports and high north trans nat corporate profits
the systemic massive re adustment of the two blocks (north vs south)
with respect to each other
is the only cure for the slow draining away of the north industrial base
and its premium wage rates
no the dems are not doing this
they are bashing one culprit…china
as if the rupee is …okay
its the system stupid
>There is one rub. If exports go up and consumers switch from buying imports to buying domestically made products, the U.S. economy could eventually hit a manufacturing capacity barrier.
somehow my comment didn’t show up. There’s another rub: (all else equal) falling US living standards as imports become more expensive in dollar terms.
I agree with the idea that “savings increases” will do little to reduce our trade deficit. And I also agree with the stance that Thomas takes on our “economic” policies–which aim to reduce costs for businesses regardless of how it affects our trade numbers (hence the large and ever increasing trade deficit). Being a young person, I have great difficulty seeing the positive affects these “policies” will on our country. Although it is my hope the government (and our representatives) will wake up and focus on our country’s wellbeing (and not that of big businesses) I fear that action will take place well after the pain has already arrived.
Good point as always Tom.
I would add (and I’m sure you’ll agree) that changing exchange rates in itself will not solve this problem. Ultimately it requires increasing demand and wage levels in China and other developing countries and this requires a global campaign to raise working standards and minimum wages (so other low wage producers won’t move in to replace China for example).
Since we don’t have a “world government” willing and capable of doing this (certainly not the WTO which consistently pushes in the opposite direction) – an alternative (which you have raised in your Plenty of Nothing book as I recall) is for high standard countries to impose “solidarity tariffs” (I think you called this “fair trade”)These would penalize low-wage and low social and environmental standard production that was not improving at an acceptable rate. These tariffs could then be rebated to developing country NGOs or Unions, or producers, or governments to do just that.
How would this affect consumer prices in the U.S.? Another well kept secret is that most of the price of what we buy is mark-up by traders, the largest share of it going to US companies and retailers (see references in my soon to be published unequal exchange paper in the Review of Radical Political Economics). So really what we’re taling about is cuting back on the mark-up for rentiers and using it to incrfease wages and standards in developing countries. In the 60’s almost all goods were produced at (higher) US real wages – but consumer prices were quite affordable (with lower productivity) – go figure!
Best,
Ron
You are correct that there is no relation between savings rate and the trade deficit. This should have been two separate articles:
Debunking the trade deficit “Problem”, and debunking the saving shortage problem. Both are way overblown and misunderstood.
Some premises often accepted:
Premise: We should decrease consumption in order to reduce imports.
Fact – any policy designed to force Americans to get by with less is an abomination.
If we want to increase domestic production then we should try to increase domestic production. This will also decrease imports. Imports are driven by insufficient domestic availability.
“We should reduce imports in order to increase domestic production. ”
Restricting imports will not result in increased domestic production. It will force reduced consumption and higher prices.
A strong dollar is bad – causes more imports
A week dollar is good – less imports more exports
Facts
The stronger the dollar, the less we pay for imports, the more we receive for exports.
The weaker the dollar, the more we pay and the less we receive.
A week dollar allows American manufacturers to compete in foreign markets. True, but this is because it makes exporting more attractive than selling domestically – this can lead to a point where we can no longer afford to buy the fruits of our labor.
The trade deficit concept is archaic and largely irrelevant. Maybe it made some sense under the gold standard and under government run mercantile economies, but not today. Imports and exports are two different and unrelated concepts in the modern era (but only for countries with strong, universally accepted currencies.) If the dollar weakens or is largely replaced in international trade we will be limited to balanced trade and limited growth.
Imports – Individuals and corporations import things only when doing so results in a benefit. If you are better off buying a shirt made in china than keeping your $10, then you will keep your $10 and vice versa.
Exports – If a person or business is better off selling something overseas than in the U.S., they will. If better off making and exporting than not making, they will export.
Belief: Big business loves and benefits form free trade. Workers and consumers benefit from trade restrictions.
What nonsense. For one thing, remember whose activities are being restricted Trade restrictions only apply to those who want to buy goods produced oversees – they forbid consumers to buy from who they choose and force them to buy only the goods of domestic producers. Are you telling me that Ford is a promoter of free trade? How about U.S. Steel?
Consider the exchange value between euros and $, the level of imports, and the price of imports
Late 90’s $1 = 1.2E oil $25 or 30 euros
today $1 = .8E oil$50 or 40 euros
OUR cost for oil has risen 100%, Europe’s cost has risen 33%.
we ARE PAYING MORE FOR DOMESTIC AS WELL AS FOREIGN OIL.
The level of imports has risen dramatically because we are paying more for the same things, not so much because we are getting more things.
My biggest difference with most commentors is that they see the past 5 years as the result of too little government influence, I see it as too much, or at least too many attempts, at government interference.
All of these policies and actions have been attempts to influence or manage the private sector:
Tax cuts to spur consumption.
Tax incentives to spur investment.
Monetary easing to spur demand and investment.
And now we blame the private sector for the results and shout for more interference. I don’t so much blame these policies for the problems, but they have certainly failed to achieve the goals.
Government policy should stop trying to make individuals and companies do what the government thinks we should do, and focus on what the government should do:
fed policy:
Instead of radical swings in rates to try and control pricing and activity – which result in high debts, asset bubbles, etc. from increasing the money supply when there is enough money, then restricting money and raising rates when the economy is growing and needs more money,
Monetary policy should Maintain relatively stable rates so that people wouldn’t suffer the asset price bubbles and the economy could add capacity and grow rather than stagnate.
Tax Policy
Instead of cuts to increase demand, the money should have been invested in real economic assets – Power grids to modern rail lines or whatever – owned by all citizens. This would keep manufacturers running at capacity, employment near capacity, increase the common wealth, and allow for rising quality of life.
P.S. – Modern liberals think we should force companies in increase domestic capacity and conservatives think we need to encourage them to due so. The fact is we need to stop discouraging them and start allowing them to. Why are we importing so many cars and so much steel? Remember this has always come from markets with much higher labor costs (Germany, Japan.)