Taming The Twins

The trade deficit and fiscal (federal budget) deficits are sometimes referred to as the "twin deficits." They are linked by the identity: NX + NFP + Tr = NS - I; where NX is net exports (if negative, a trade deficit), NFP is net income from abroad and Tr is international transfers. Together, they are the current account, of which NX is by far the largest part - i.e. the US trade deficit drives the US current account deficit. The other side is national savings (NS) less investment (I), where national savings is private savings and government savings. The fiscal deficit is negative government savings; NS can therefore be thought of as the savings left after subtracting the part borrowed by the government. So, ceteris paribus, the trade deficit (-NX) and the fiscal deficit (which reduces NS) move together - hence the "twin deficits."

Last week brought news that both of deficits are shrinking. The CBO reported preliminary estimates that the federal deficit decreased to $161 billion in fiscal year 2007, from $248 billion the year before (the federal fiscal year ends in September). The biggest change in the spending side was a $65 billion decrease in "other programs and activities" (i.e. not defense or entitlement programs), which the CBO attributes to some one-time-only events:

The decrease in outlays for "other programs" was mainly due to unusually high spending in 2006 for activities related to the 2005 Gulf Coast hurricanes and for the subsidy costs recorded for student loans. Payments received in 2007 for licenses auctioned in 2006 for use of the electromagnetic spectrum further reduced net outlays. Excluding those three activities, spending for this category rose by about 1 percent.

On the revenue side, income tax revenue surged by $118 billion - partly this is the "automatic stabilizer" effect (taxes rise as incomes rise). A large part of the increase came from "nonwithheld income":

Nonwithheld income and payroll tax receipts gained about $55 billion (or 13 percent) in 2007. The two main components, quarterly estimated payments and final payments with tax returns, both grew at about that same rate. Nonwithheld receipts grew more slowly than the 19 percent rate recorded in 2006. The double-digit growth in 2007 probably reflects continued strong growth in income from sources other than wages and salaries.

Presumably, that would mostly be "capital income" like dividends, interest income and capital gains - growth in this type of income is consistent with the rising inequality reported by the IRS (see previous post).

As for the trade deficit - the BEA and Census Bureau reported exports of $138.3 billion and imports of $195.9 for a deficit of $57.6 billion for the month of August. That's $1.4 billion less than July and $10 billion less than August, 2006. This may, in part, reflect the continuing decline the in the value of the dollar, which makes US products cheaper to foreigners (increasing exports) and makes foreign products more expensive to Americans (decreasing imports). By country/region, the largest deficits were with China ($22.5 billion), OPEC ($11.4 billion) and Europe ($11.1 billion). Here's the NY Times story.

Income Inequality Update

The Wall Street Journal reports:

The richest Americans' share of national income has hit a postwar record, surpassing the highs reached in the 1990s bull market, and underlining the divergence of economic fortunes blamed for fueling anxiety among American workers.

The wealthiest 1% of Americans earned 21.2% of all income in 2005, according to new data from the Internal Revenue Service. That is up sharply from 19% in 2004, and surpasses the previous high of 20.8% set in 2000, at the peak of the previous bull market in stocks.

The bottom 50% earned 12.8% of all income, down from 13.4% in 2004 and a bit less than their 13% share in 2000.

International Agreements as Commitment Mechanisms

One argument for trade agreements is that they tie the hands of governments, and may provide a way to "lock in" market-oriented economic reforms. The reforms may lead to higher investment, but only if businesses are confident that the policies will stay in place - the trade deals improve the credibility of the policies (that is, they are a "commitment device"). A similar argument has been made for fixed exchange rates - they are a way for a previously inflation-prone government to credibly commit itself to a more stringent monetary policy (which is necessary to maintain the currency peg). Much of this argument derives from Kydland and Prescott's study of the "time consistency" problem - the Nobel Prize site has a good description. But isn't it anti-democratic for a current government to tie the hands of its successors? On his blog, Dani Rodrik explains how to tell the difference between "the good and bad kind of external discipline."

Can 'Free Traders' Handle Competition?

Dean Baker, an economist from a left-ish think tank, says that free trade is "The Best Weapon Against the Free Traders." He writes:

...[Trade Liberalization] has had exactly the effect that trade theory predicts. It has lowered the wages of less-educated workers relative to workers with college degrees and especially workers with advance degrees. We can reverse this upward redistribution by adopting trade policies that subject the most highly educated workers to the same sort of international competition that textile workers and autoworkers now face....

The big winners in this story are the workers who manage to keep themselves protected from international competition. As a result of recent trade and immigration policy, these highly paid professionals can buy low cost furniture, cars, and clothes. They can also have their homes renovated and their gardens maintained at low prices. They can even get cheap nannies for their kids.

But the key to the success of these highly paid workers is maintaining their own protection from international competition. There are long list of professional and immigration barriers that protect doctors, lawyers, and even economists and journalists from the same sort of international competition faced by textile workers and dishwashers.

There is a basic truth here: it is quite easy to be in favor of "competition," "free markets" and "capitalism" as long as its happening to somebody else, but when it happens to us, we suddenly become concerned about "fairness."

But Baker is mistaken on his trade theory (despite his Michigan PhD!). The Stolper-Samuelson theory, part of standard neoclassical trade theory, says that trade increases the returns to the "abundant" factor of production. If the US is abundant in skilled labor (i.e. compared to other countries we have a higher ratio of skilled labor to other factors like unskilled labor, land and capital) the theory predicts exactly that skilled labor will gain; no selective protection from trade is necessary.

And as for economists: while the immigration system certainly creates unconscionable hassles, we are competing in a global labor market (at least, those of us without tenure are!). Roughly 70% of the doctorates in economics awarded in the US (where most of the world's best programs reside) go to non-Americans, many of whom take jobs at American colleges and universities.

August Job Loss - Not!

Last month, we were spooked by a report from the Bureau of Labor Statistics that "nonfarm payroll employment" had declined by 4,000 in August. At the time, I noted that "the payroll employment figure is preliminary and subject to revision" (handiness with caveats is an important professor skill).

Revise they have - now the BLS reports that August saw a gain of 89,000 jobs (and September, preliminarily, 110,000). The unemployment rate edged up slightly in September - from 4.6% to 4.7% - but this partly reflects entry into the labor force; labor force participation increased from 65.8% to 66.0%.

The revision is a useful reminder that we - and, more crucially, policymakers - never know the true current state of the economy - the (imperfect) statistics we have are retrospective. This is part of what is sometimes called the "recognition lag" in economic policy.

On his blog, Paul Krugman looked at "The Revision Thing" (and found the appropriate Keynes bon mot - there's one for every occasion!).

A Big Problem We Ignore

The insanely high rates of incarceration in the United States may be our most unheralded social (and economic) problem - perhaps because there is very little political gain (and much political risk) in taking it on. Nonetheless, last week, Senator Jim Webb of Virginia held a Joint Economic Committee hearing on the subject. According to the committee:

The United States has experienced a sharp increase in its prison population in the past thirty years. From the 1920s to the mid-1970s, the incarceration rate in the United States remained steady at approximately 110 prisoners per 100,000 people. Today, the incarceration rate is 737 inmates per 100,000 residents, comprising 2.1 million persons in federal, state, and local prisons. The United States has 5 percent of the world’s population but now has 25 percent of its prisoners.

Senator Webb also posted some facts about the prison system in the United States. Among them:

The U.S. prison system has enormous economic costs associated with prison construction and operation, productivity losses, and wage effects. In 2006, states spent an estimated $2 billion on prison construction, three times the amount they were spending fifteen years earlier. The combined expenditures of local governments, state governments, and the federal government for law enforcement and corrections total over $200 billion annually. In addition to these costs, the incarceration rate has significant costs associated with the productivity of both prisoners and ex-offenders. The economic output of prisoners is mostly lost to society while they are imprisoned. Negative productivity effects continue after release. This wage penalty grows with time, as previous imprisonment can reduce the wage growth of young men by some 30 percent...
The prison system has a disproportionate impact on minority communities. African Americans, who are 12.4 percent of the population, are more than half of all prison inmates, compared to one-third twenty years ago. Although African-Americans constitute 14 percent of regular drug users, they are 37 percent of those arrested for drug offenses, and 56 percent of persons in state prisons for drug crimes...
Prisons are housing many of the nation’s mentally ill. The number of mentally ill in prison is nearly five times the number in inpatient mental hospitals. Large numbers of mentally ill inmates, as well as inmates with HIV, tuberculosis, and hepatitis also raise serious questions regarding the costs and distribution of health care resources.

As far as I can tell, the hearing didn't get any attention from the press (I learned about it from Ezra Klein's blog), but the Times has an article on the racial disparities in our legal system. The census recently reported that the number of Americans living in college dorms has surpassed the number in prison, but what does it say that this is considered news?

People Will Bet on Anything

including the Nobel Prize* in Economics, which will be announced Monday, Oct. 15. According to Ladbrokes, the favorites are:

Christopher Pissarides (4:1 odds)
Dale Mortensen (4:1)
Paul Krugman (5:1)
Peter Diamond (5:1)
Paul Romer (6:1)
Elhanan Helpman (8:1)
Gene Grossman (8:1)
Robert Barro (8:1)

Presumably Mortensen and Pissarides would receive the award jointly, mainly for their work on unemployment theory (if they win, someone might recall the copy of Pissarides' "Equilibrium Unemployment Theory" I have checked out from the library....). I'm pulling for Krugman, if only because we are studying his seminal "Increasing Returns, Monopolistic Competition and International Trade" paper in Econ 441 ("see, I told you it was important!"). Romer is one of the pioneers of endogenous growth theory - some of which relies on the same imperfect competition/scale economies mechanism used by Krugman (for an excellent account of Romer's contribution, see David Warsh's book "Knowledge and the Wealth of Nations"). The device they both use (and everyone uses now) - is the "Dixit Stiglitz" technology - Stiglitz already has a Nobel (can't get it twice), and the odds on Dixit are 20:1. Grossman and Helpman have both done important work (much of it together) in both growth and trade theory.

*The prize was established "in memory of Alfred Nobel" by the Swedish central bank in 1968, so its technically not a "real" Nobel Prize (if you look carefully at the Nobel Prize web site, you'll notice its referred to as the "Prize in Economics" not "Nobel Prize in Economics")

Wile E. Coyote Moments

As I mentioned recently, Paul Krugman has expressed a concern that we may experience a "Wile E. Coyote Moment" in regards to the dollar and the current account deficit. At VoxEU, Richard Baldwin responds to Krugman. Setting aside the substantive issue, I am intrigued by the possibility that "Wile E. Coyote Moment" may be entering the lexicon of economic jargon. Here's Baldwin's explanation:

...the markets are due for what Krugman calls a 'Wile E. Coyote' moment – a reference to the Warner Brothers’ cartoon where a greedy, shortsighted coyote chases a roadrunner off a cliff but doesn’t start falling until he looks down and realizes he’s left solid ground. Up until this 'Wile E. Coyote' moment, his belief that he’s on solid ground prevents him from falling. For investors in dollars, the 'Wile E. Coyote' moment comes when they realise that their expectations are inconsistent with any feasible adjustment path.

So, I wonder if in a few years I will be attending (or giving!) presentations at academic conferences with titles like "Wile E. Coyote Moments in a 2-Country DSGE Model," "Estimating the Probability of Wile E. Coyote Moments: A Bayesian Approach" and "Can Wile E. Coyote Moments Explain the Equity Premium Puzzle?"

If the "Wile E. Coyote Moment" becomes part of our language, it will eventuallly show up in our textbooks. I'm no theorist, but here's how I think the standard PhD micro text, Mas-Colell, Whinston and Green's Microeconomic Theory, which is beloved in some (but not all) quarters for its "rigor and generality," might define it:

If there are any theorists reading this, perhaps you can suggest some related theorems, lemmas and corollaries...

Krugman Gets an A

On his blog, Paul Krugman takes on Europe-bashing. "Its a fixed idea among Americans that Europe - France, in particular - is an economic wasteland," he writes. Among the bits of evidence he musters against the Euro-bashers (not to be confused with Euro-trashers):

French productivity – output per hour – is about the same as ours...
Now, it’s true that French GDP per capita is lower than ours. That reflects three things: the French work shorter hours; French people under 25 are less likely to be employed than young Americans, and the French are much more likely than Americans to retire early.

That would have been a good answer to question 3 on last Thursday's Econ 202 midterm:

(3 pts) France and the US have almost identical GDP per hour worked, but French GDP per capita is 27% lower than the US. How is this possible? In what regard does this imply that the French are better off than Americans?

Krugman goes on to explain:

Short working hours are a choice – and it’s at least arguable that the French have made a better choice than America, the no-vacation nation.

Low employment among the young is a complicated story. To some extent it may represent lack of job openings. But a lot of it is the result of good things: young French are more likely to stay in school than young Americans, and fewer French students are forced by financial necessity to work while studying.

Finally, the French retire early. That’s a real problem: their pension system creates perverse incentives. We, of course, have this superb program called Social Security, which does a much better job.

He did also mention that:

What’s more, even during the period 1995-2005 – the years when we Americans were boasting about our productivity boom – French productivity grew only half a point slower than US productivity. And the US productivity boom now seems to be over.

If he was in Econ 202 - and doing the assigned reading!* - he would also be aware that, while France lagged the US in labor productivity, it has actually done slightly better than the US in total factor productivity. [which, of course is not the correct answer to problem 3].

So maybe we shouldn't say that French economic performance is worse than the US, but we can still call them cheese-eating surrender monkeys! (though some might now think they were right about the Iraq war...)

*"A Productivity Primer," The Economist, Nov. 6, 2004.

Who Our Creditors Are

The corollary of massive borrowing by the United States - the current account deficit was $811 billion in 2006 - is accumulation of US assets by foreigners (a "capital inflow"). As I discussed recently, this has generated some worry about a crisis if our creditors lose their appetite for holding US assets.

On his outstanding international macroeconomics blog, Brad Setser looks at the data on official reserves (e.g. foreign asset holdings of central banks) and finds that "Central banks came close to financing the entire US current account deficit." He writes:

I estimate that the world's emerging economies -- if those emerging economies that don't report detailed data on the currency composition of their reserves acted like those who do report -- are now adding about $200b to their dollar reserves a quarter. That is a pace sufficient to finance the entire US current account deficit. Central banks continue to buy more dollars when the dollar is heading down than when it is going up to keep the dollar's share in the (aggregate) portfolio constant -- and effectively serve as the dollars buyers of last resort in the global financial system.

Private flows still matter, of course. But right now private inflows roughly match private outflows, so all the heavy lifting required to finance the US external deficit is being done by the world's central banks. Their willingness to hold dollars allows the US to finance itself in dollars even when there isn't a lot of global demand for dollar assets.

The tools economists use to examine exchange rates and current accounts are mostly based on optimal behavior of individuals - e.g. a European investor will make a decision about whether to hold a German bond or a US bond by comparing the return on the German bond to the expected return on the US bond, converted to euros, and the dollar-euro exchange rate is ultimately determined by the demand for dollars from such investors (and the parallel behavior of US investors on the other side of the market).

Setser's finding reminds us that governments play huge roles in foreign exchange markets, and their motives are very different. In particular, many countries - primarily "emerging markets," of which China is most prominent - intervene in foreign exchange markets to keep the values of their currencies artificially low, making their exports cheaper. This involves selling their currency (increasing the supply of it and lowering its value) for dollars. In the process, the governments accumulate dollar reserves.

We still need to be concerned that our creditors might reduce their willingness to finance our current account deficit, but it is crucial to bear in mind how much of that financing is coming from governments rather than private investors maximizing expected returns.