The Macroeconomic Situation

Paul Krugman offers an assessment of our current macroeconomic troubles. He says there are basically two problems. One is that the economy is "unbalanced," with unusually high consumption and a large trade deficit. That is, in terms of Output = Consumption + Investment + Government + Net Exports, the fact that net exports (i.e. the trade balance: exports - imports) is negative allows the other three components to add up to more than 100% of output, and for consumption to be unusually large relative to GDP. In the BEA's advance estimate of 2007 GDP, consumption was 70.3% of GDP, while net exports were -5.1%. Another imbalance Krugman notes is that, as a share of GDP, residential investment (new housing) has been unusually high, while nonresidential investment (new capital) has been lower than its average. The other problem, which has grabbed more headlines lately, are the troubles in the financial system, which may be creating a "credit crunch," making it harder for individuals and firms to borrow. Here's Krugman's take on what's ahead:

What we want, and will eventually get, is a rebalancing: smaller trade deficits, consumer spending more in line with income, more normal housing spending. The trouble is in getting there. At the moment it seems likely that consumption and housing investment will fall faster than net exports can rise — probably with additional downward pressure from at least some types of business investment, especially commercial real estate. The result will be a recession or at least something that feels like one.

The goal of monetary and fiscal policy should be to bridge the gap — to sustain spending until a falling trade deficit comes to the rescue, and to hasten the rise in net exports (remember, in the current context a weak dollar is good.)