Originally published February 12, 2012 on the New Economic Perspectives blog.
Sorry for being late. There were really only two issues raised (ignoring the comment about MMR vs MMT—which I’m not going to address here).
The first concerned the orthodox belief that trade depends on comparative advantage: Italy specializes in wine because of its climate and soil. In the case of agriculture in the old days, there isn’t too much doubt about that—it was hard to grow grapes at the North Pole, so Santa traded delivery services for products made in southern climes. But once we move beyond agriculture, and after we’ve invented greenhouses and the like, there is much less truth in this. In manufacturing, a factory can be set up anywhere in the world, often in a few weeks, and it takes a couple more weeks to train the workers. And out in the real world what we find is that much of the trade in finished goods is actually between “equals”: Italy sends Fiats to Germany and Germany sends VWs to Italy. Tastes or preferences, styles, desire to be different, brand loyalty, and all that matters much more.
The second is more important and concerns the belief that economic growth is balance-of-payments constrained, as described by Tony Thirwall’s “Law”. As Neil “Ramanan” Wilson argued: “There have been some suggestions that Thirlwall’s law stops the government expanding domestic policy and will cause ‘twin deficits’ problems (increased government and external deficits). But why would that apply togovernment and not private expansion? Thirlwall’s law appears to have a fair amount of empirical data behind it, but is that curve fitting? In other words does the Law appear true because nobody dare do the domestic expansion in the correct fashion necessary to test the underlying assumptions on which it is based.”
To simplify and summarize: A country like the US that has a high propensity to import will tend to run a trade deficit if we grow faster than our neighbors who have low propensities to import. We will then run out of foreign reserves quickly so will be constrained to the extent that our neighbors won’t take our currency in exchange. Thus, our growth will be constrained—it needs to be slower than that of our neighbors.
To be sure, Thirlwall would throw in lots of caveats that are usually ignored by those who wave his “Law” about. Not all growth has the same implications for the trade balance. Income distribution matters for imports—so it depends on who benefits from the growth. We could target our growth to areas that make us more competitive internationally—increasing exports. If we do grow faster than our neighbors, their demand for our currency (to invest in the US, for example, to share in the bounteous growth) might grow as fast as our current account surplus. If we float the currency, the constraint is softened since a trade deficit might cause the exchange rate to fall and thereby increase exports and reduce imports. And we can change policy to encourage exports and restrict imports, or to encourage “capital” inflows (demand for our currency to buy assets).
So for all these reasons, there is no simple “Law”. Neil also raises an important point usually overlooked by those who advocate the “Law”: the evidence in favor of a constraint probably has more to do with policy overreaction than to any real constraint. Governments react to a current account deficit by tightening the fiscal and monetary policy screws, trying to raise unemployment and slow growth. That is a policy choice. Except for those nations that choose to peg their currencies (or adopt foreign currencies—as Greece did), it is almost always going to be a bad policy.
Indeed, pegging the exchange rate is a bad policy because it usually forces government to give up policy space. Unemployment is the normal price of pegging—and it is pegging and the reaction to a current account deficit that then makes Thirlwall’s Law “bite”. Let us say that a country does not impose the “Law” on itself, refusing to adopt austerity when a trade deficit appears. What happens? At a constant (but not pegged—this is a little mental experiment) exchange rate, for its current account to increase, there must be a demand for its currency so that its capital account surplus rises by the same amount. In other words, there are two sides to the coin, and as foreigners demand the currency, a capital account surplus is created, and as the domestic population demands the imports, a current account deficit is created. We cannot split the coin in half to blame one side or the other.
Let us say that the rest of the world (ROW) will not allow that to happen—the ROW will accept the currency only if it depreciates. OK, then, the currency falls in value to find holders of the currency given a current account deficit. And as the currency falls, exports might rise a bit, and imports fall a bit. But let us say that this will not restore trade “balance” (recall from my earlier blog however that “balance” is a misleading word—the balances always balance!). As the currency depreciates, the terms of trade turn against the country. In other words, it gives up more currency toget the same basket of imports. (Yet in real terms as a current account deficit is created, the country gives fewer exports to get imports! How ironic: the real terms of trade move in the favor of a trade deficit nation. Exports are the cost, imports are the benefit.)
If you are an Oz that imports oil and finished manufactures, a depreciating A$ raises the A$ cost of much of what you buy. And as Bill Mitchell argues, the swings of the A$ are historically large and do lead to very large fluctuations of the domestic purchasing power. But so long as Australia kept its commitment to full employment, it tolerated these swings without imposing austerity. Policymakers preferred to use their domestic policy space to maintain growth with (nearly) full employment. So Oz consumers would remain employed and would substitute out of expensive imports as best they could. And they’d probably have to reduce overall consumption when the Oz Dollar fell. Those who follow MMT and Functional Finance believe that is the best policy.
Should a nation like Oz adopt other policy in response to a trade deficit? Bill often uses the example of auto manufacture. Oz might have tried to keep out Japanese autos in order to promote Oz auto production. Bill has argued this makes little sense, and would cost Australian consumers dearly—both in terms of loss of choice but also in terms of a policy of devoting substantial real resources to produce autos at what might be a scale far too small to achieve economies of scale. I have no dog in this hunt and no particular opinion on the issue of Oz auto production. But Bill’s argument makes sense to me as a general statement. It is also related to the comparative advantage argument briefly discussed above. If you can import high quality and low cost products from abroad, it may not make sense to use government policy to block the imports and to subsidies domestic production.
Remember: imports are a benefit, exports a cost, in real terms. Of course that is only true if you have a commitment to full employment. So if auto jobs are lost government must ensure alternative employment. The immediate response always is: “but auto jobs are good; nonmanufacturing jobs are bad”. Only one who has never worked in a factory could literally believe this. (Full disclosure: I worked in a soup factory and while I liked the pay, I hated the work.) What most mean is that factory jobs pay well, many service sector jobs don’t.
The solution—of course!—is to make the service sector pay more. I am always amazed at the lengths to which people will go to offer “crazily improbable” (in Keynes’s words) solutions rather than looking to the obvious. To be clear, I have nothing against using domestic policy in a strategic manner—to target areas for expansion. All economies are always planned. The questions are: by whom and for whom. But responding to a trade deficit by imposing austerity simply imposes a “Thirlwall’s Law” growth constraint unnecessarily.
There are many other issues related to imports, exports, andexchange rates—we’ll return to some of them in the remainder of the Primer.
