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. <\/p>\n
This contradiction stems from economists\u00e2\u20ac\u2122 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:<\/p>\n
\n\u00e2\u20ac\u0153In any case, a revaluation of Asian currencies would have little impact on America\u00e2\u20ac\u2122s current-account deficit. The only real cure is for Americans to save more.\u00e2\u20ac\u009d<\/p><\/blockquote>\n
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.<\/p>\n
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.<\/p>\n
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.<\/p>\n
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 \u00e2\u20ac\u0153switch\u00e2\u20ac\u009d 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.<\/p>\n
To get concrete, improving the trade deficit begins with shoppers at Wal-Mart buying American goods rather than imports. They don\u00e2\u20ac\u2122t 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.<\/p>\n
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.<\/p>\n
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\u00e2\u20ac\u2122s 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.<\/p>\n
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.<\/p>\n
To close on a political note, most Democrats seem to understand all of this, though too many appear \u00e2\u20ac\u0153lite\u00e2\u20ac\u009d 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.<\/p>\n","protected":false},"excerpt":{"rendered":"
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 […]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[3],"tags":[],"class_list":["post-36","post","type-post","status-publish","format-standard","hentry","category-us-policy"],"_links":{"self":[{"href":"https:\/\/thomaspalley.com\/index.php?rest_route=\/wp\/v2\/posts\/36","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/thomaspalley.com\/index.php?rest_route=\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/thomaspalley.com\/index.php?rest_route=\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/thomaspalley.com\/index.php?rest_route=\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/thomaspalley.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcomments&post=36"}],"version-history":[{"count":2,"href":"https:\/\/thomaspalley.com\/index.php?rest_route=\/wp\/v2\/posts\/36\/revisions"}],"predecessor-version":[{"id":1679,"href":"https:\/\/thomaspalley.com\/index.php?rest_route=\/wp\/v2\/posts\/36\/revisions\/1679"}],"wp:attachment":[{"href":"https:\/\/thomaspalley.com\/index.php?rest_route=%2Fwp%2Fv2%2Fmedia&parent=36"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/thomaspalley.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcategories&post=36"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/thomaspalley.com\/index.php?rest_route=%2Fwp%2Fv2%2Ftags&post=36"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}