I’ll be talking on this topic to the Economic Society of Australia (Queensland branch) on Thursday night at the Exhange Hotel, a well-known Brisbane cultural centre. I’m preparing a presentation and I found this graph of the US trade balance at the St Louis Fed
The graph is in billions of dollars per quarter, unadjusted for inflation, so the pattern is exaggerated. Still it’s a good illustration of how the recent massive deficits are historically unprecedented, something which is true even when the more appropriate measure of percent of national income is used.
Australia’s experience is less dramatic, but we are, nonetheless hitting new records in terms of deficits and debts.
fn1. No animals were harmed in the preparation of this talk.
John Quiggin 
The appropriateness of measuring it as a percentage of national income depends on what question you are trying to answer. That ratio is a good one to answer questions about how the trade deficit will affect the domestic economy in the future since we will eventually have to pay back the money we are borrowing and so will have to generate a surplus of appropriate size one of these days. However, if you are asking a different question you need a different measure. For example, suppose your question were how willing the various foreigners are going to be to keep absorbing our ever mounting need for credit (which the trade deficit is a major influence on). In that case you would want to divide the trade deficit by the foreigners’ GDP or some other measure of the size of their appetite. Or if you wanted to know what the trade deficit (or the current account) was doing the value of the dollar you might want to know how many dollars are already out there in the hands of the foreigners among other things.
Bottom line, it looks bad for the US though the Chinese still seem to have a pretty healthy appetite for US paper. I expect pretty soon they will start buying up more concrete stuff like buildings, land and companies. That will start to get the attention of the public even if Congress seems immune to factual information from the real world.
John, can non ESA members come to your talk at the Exchange?
I don’t think there would be a problem with that, Mark
JQ, could you please post your speech on this site as I am interested to know why they are unsustainable.
In the days when gold was the international currency, trade deficits couldn’t really exist. If you wanted to import more cheese from New Zealand you would have to export more gold. The effect would be a dampening of domestic price pressure. And if New Zealand was importing too much gold than the price of New Zealand goods would be rising.
In other words the trade deficit was balanced by on the capital account and monetary policy was managed accordingly.
Within a single currency zone this is pretty much how it works today. If Dubbo runs a trade deficit with the rest of Australia then it tends to self correct through localised price adjustment. Intuitively we expect boom towns to have rising prices and depressed towns to have falling prices. The exception to the rule is when government transfers are involved (ie exporting votes) or when currencies float.
The problem today is that the US dollar is the worlds preferred currency and the most dominant currency for international trade. 90% of pure currency trades involve US dollars on one side or the other. As the world economy grows there is a strong demand for US dollars. To counter balance this export of US dollars, goods must flow into the USA.
One might question whether stable money is possible when you export paper in exchange for consumer goods. Long term it may be more prudent to export paper notes for assets like gold than can be used to defend the stability of your currency in a future crisis. Consumer goods get used up so they are available for resale to defend your currency. And government debt is not as risk free as some might assume. In a crisis governments may try to defend their debt paying ability by increasing taxation, only to find that in the process they kill the goose that lays the golden egg.
The US and Australia both have current account deficits around 6% of GDP. The big difference is that in the US case, the trade deficit by itself explains the current account deficit, whereas in Australia the lion’s share of the current account deficit is net investment income rather than the trade deficit.
This could be seen in two ways. On the one hand, Australia’s problem is potentially much more intractable, whereas the US could in principle solve its problem with a few years’ fiscal austerity. By the same token, whereas Australia’s problem won’t worsen that quickly, the US’s position could deteriorate very fast.
The weird thing about the US Balance of Payments is that net investment income has remained positive, despite the fact that the ‘net external position’ is by now a deficit worth about 25% of GDP. This is because for various reasons US investments abroad yield a higher return than the incoming investments. But that income surplus, though it has proved surprisingly persistent, will be reversed any day now.
Combined with the already big trade deficit it will push the current account deficit toward 10 percent, precipitating a rapid acceleration of the US foreign debt. And since the world financial system could not countenance the prospect of the US getting into a debt trap, the only option will be a sharp monetary contraction to defend the dollar, and a severe recession. If it has to happen, let’s hope it’s on Bush’s watch.
“If Dubbo runs a trade deficit with the rest of Australia then it tends to self correct through localised price adjustment.”
If Dubbo (like the US or Aus) want to invest more than they save, then they will run a trade deficit (assuming no net income flow). Price adjustment will make it so, not “correct” it.
In theory a trade deficit is sustainable indefinitely if economic growth in the country running the deficit increases the total capital stock at a sufficiently rapid pace that the sale of capital items can fund the deficit.
James Farrell Says: November 24th, 2005 at 12:43 am
https://johnquiggin.com/index.php/archives/2005/11/22/the-unsustainability-of-trade-deficits/#comment-37586
“This is because for various reasons US investments abroad yield a higher return than the incoming investments. But that income surplus, though it has proved surprisingly persistent, will be reversed any day now.”
I guess “incoming” means “RoW owned – US domiciled”. Conversely,
“outgoing” means “US owned – RoW domiciled”. This implies that RoW investors earn less off the US than US investors earn off the RoW, per dollar invested.
I am guessing that this is due to the relatively low rate of return on US bonds, shares and currency over the past few years. Why have so many RoW investors plunged into the US securities and equities market over the past few years if their returns were less than what US investors were earning in the RoW?
And why will the US’s “income surplus…be reversed any day now”? I have been listening to “tunnels at the end of the light” stories for the whole naughties. I know that Stein’s Law states that “If something cannot go on forever, it will stop.” And yet the sky persistently refuses to fall.
“Combined with the already big trade deficit it will push the current account deficit toward 10 percent, precipitating a rapid acceleration of the US foreign debt.”
Can someone explain the mathematical economics (not too complex please!) of runaway debt traps once the CAD/GDP rises over the magic figure of 10%. Buffet and Gates* made the bet that the USD collapse would come this year, but they appear to have taken a bath.
Obviously if we knew the answers to these questions we would not be idling away time on a blog. But no one seems to have a clue. If they dont know whats going on, who does?
http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2005/11/24/ccfed24.xml&menuId=242&sSheet=/money/2005/11/24/ixcoms.html
Given the forecasts for US GDP growth exceeding 3.5% in the next year, falling government deficit, falling oil prices, improved consumer confidence, can someone please tell me why the current US trade deficit is unsustainable?
I’ve studied a economics and finance at under-graduate level and read economic outlook reports almost everyday as part of work and I just ain’t seeing the picture being painted above where it matters – in the markets. Either you guys are a sh$t load smarter than the professionals or you have your own little axes to grind about the US.
Terje – your analysis is almost intelligible to me and I don’t think I am that thick.
“And why will the US’s “income surplus…be reversed any day nowâ€?? I have been listening to “tunnels at the end of the lightâ€? stories for the whole naughties. I know that Stein’s Law states that “If something cannot go on forever, it will stop.â€? And yet the sky persistently refuses to fall.”
Jack, saying the US surplus will be reversed means that US income from overseas investment will no longer exceed the income paid to foreing investors on US investors.
1. “US GDP growth exceeding 3.5% in the next year,”
For the past several years (at least) US GDP growth has been driven by higher consumer demand which pushes up the current account deficit;
2. “falling government deficit,”
Medicare drug benefit kicks in January 1.
3. “falling oil prices,”
Assuming they continue -and even with the falls to date heating oil prices will be much higher in the US this year;
4. “improved consumer confidence,”
Seen the latest unemployment registration figures? how about the real estate prices and clearance rates. Actually as I noted previously, higher growth in the US tends to increase the CA deficit rather than reduce it so these make actually be positives;
The US has been able to run large government deficits and CA deficits without significant economic pain (i.e. high interest rates and inflation) because East Asian countries have been intervening massively to push down the dollar by buying T-bills.
This is as unsustainable as the policy those same states pursued in the 90’s of holding their own currencies artificially high.
“Either you guys are a sh$t load smarter than the professionals or you have your own little axes to grind about the US.”
That’d be the same market that took a bath on Enron shares, I assume.
I just get very skeptical when I hear talk of a “new economy” or that a country- any country – can consume more than it makes on a continual basis.
The asian nations in question were not trying to hold their currencies high. They were trying to maintain a fixed exchange rate with the US dollar. Its just that the USA was running a “strong dollar” policy and the deflation was being transmitted by virtue of the fixed exchange rate.
A fixed exchange rate is a good monetary policy (and fantastic trade policy) except when the target currency is not a stable reference in terms of value. The world would be better off with fixed exchange rates however the US dollar is too unhinged to server as a stable reference. The Malaysians had the right idea when they were promoting the Islamic Dinar a couple of years back.
Jack,
Perhaps the answer to the problem of the persistence of this is the old market wisdom that the market can stay insane longer than you can stay solvent.
Yes, this will probably reverse at some stage and the transition will be either painless or painful – but I, for one, will not bet a substantial amount on it happening soon. These things can continue for a long time. They normally reverse just after the last person betting on it goes bust.
Terje,
It is understood that the gold-standard provides an upper and lower bound on the variability of relative prices of currencies, called exchange rates. The bounds are given by ‘gold-points’, which are a function of the costs (in gold) associated with the prevailing transport technology.
The gold-standard provides stability in a sense akin to an error control model. Fine.
The central research question of economics, concerned with non-dictatorial resource allocation systems (with the assumption that people prefer to survive), is not concerned primarily with ‘error control’ of one set of relative prices but with the material (as distinct from spiritual) welfare of humans (see models of ‘competitive private ownership economies’ I’ve referred to in previous posts).
[Parenthetically, the separation of material from spiritual welfare of humans may not be acceptable to all cultures or even to all people within one culture – but I am writing here merely from a position of what is conceivable rather than a position of extensive knowledge of cultural differences and their histories. In other words, there is an empirical question and I don’t have the answer to it.]
The gold standard has nothing to offer regarding the primary question of interest in economics. To be more explicit, the gold standard has nothing at all to say on what is known as the ‘minimum wealth constraint’. That is, the error control system you are advocating can work very nicely until the world population is reduced to 2 people – everybody else died of starvation. This is an illustration by means of reasoning by the absurd, the purpose of which is to make a point on the properties of the system you are advocating rather than a prediction.
You state: “If Dubbo runs a trade deficit with the rest of Australia then it tends to self correct through localised price adjustment. Intuitively we expect boom towns to have rising prices and depressed towns to have falling prices.”
‘A boom’ is characterised by rising prices. A characteristic of something (ie a definition) cannot be simultaneously an explanation of the something. I think this point has been made already on this tread.
Your statement is an example of what I would call a hypothetical empirical result of ones choosing. ‘Adjustment’ is not through prices alone, as you suggest, but through quantities. People move! Within one currency area people are usually allowed to move from locations where incomes decline to locations where incomes rise. What would be the equivalent in the international arena? It would be the abolition of immigration laws, wouldn’t it? So, to advocate one but not the other is an error in ‘systems design’, setting everything else aside.
But this is not all, there are ‘boom towns’ where the boom is a bubble – and some of these bubbles are no more than financial bubbles (ie created by debt in its various forms). Moving to one of those boom towns would not help much, would it? – the hypothetical emigrants from the proverbial Dubbo would ‘buy expensive’ and ‘sell cheap’.
What happens to the debts of people in the proverbial ‘Dubbo’? (A trade account deficit usually entails debt although it is conceivable that the financing of the trade account deficit is done via equity shares or trade credits). Assuming the banks in Dubbo operate like those in Auckland, Birmingham, …, Sydney, the amount of debt (face value) does not ‘adjust’, while the prices of houses, farms, tractors, horses, cows, fruit, machinery may decline along side with wages in the adjustment process you are talking about. So, one of the many possible reasons for people to emigrate from the hypothetical Dubbo is because they have gone bust – can’t pay their debts.
Finally, a known source of potential financial instability in theoretical models of ‘competitive private ownership economies with securities markets’ is due to an ‘unboundedness’ problem. There is no natural limit on short selling of securities. These models do not contain a government – hence you can’t blame ‘the government’ for the outcomes you may not like. ‘Securities markets’ involve things like options, shares, debentures, IOYs, etc., issued by ‘private’ agents.
So, how can we get stability in financial markets? By deregulating labour markets? I suppose there would be little wrong in some people’s mind if a medical doctor would cut off the left leg if the right leg is gangrenous, right?
I don’t have a panacea for the world’s problems. However, I can refer to Oliver Hart’s 1974 and 1975 papers in Journal of Economic Theory. Hart provides two conditions (strict risk aversion on part of all members of the society and price expectations being not ‘too different’; ie in a closed cone) under which it can be shown that the model of a ‘competitive private ownership economy with securities markets’ has a solution without requiring an externally determined bound. Hart’s results were published before the financial markets were ‘deregulated’. To the best of my knowledge of the literature at the time of financial deregulations in the early 1980s, the deregulation proceeded on the assumption that an institutional environment which works well for the manufacture of cars and sausages also works for the manufacture of financial contracts (ie another example of moving forward to the past; substitute the believes of the 18th and 19th century for knowledge available in the mid-20th century). The sector was re-regulated rather quickly, wasn’t it? Not the same regulation as before, true, but a more complex system of bounds was introduced (eg Basel III) and the process is going on.
The only reason I can think of for anybody to advocate the gold standard is if they are ‘long in gold’.
And, the reason why I respond in detail is because Economics is in a sense a very difficult area – everybody is part of ‘the economy’ but not everybody is an ‘economist’, and, speaking primarily for myself, not every ‘economist knows everything’ in relation to Economics.
I have some difficulties with the word ‘economist’. In contrast to a chemist or a pharmacist, who can apply his or her knowledge to material of which he or she is not part of, ‘everybody’ is part of ‘the economy’, including ‘the economists’. It seems to me there is a very fine line between ‘applying economic knowledge’ and becoming dogmatic or dictatorial. To illustrate the difficulty, Milton Friedman is ‘an economist’ and Nobel Prize (Bank of Sweden) winner. Gerard Debreu is ‘an economist’ and a Nobel Prize (Bank of Sweden) winner. Milton Friedman toured the world to tell governments and the public (TV) what to do. Gerard Debreu toured the world and did not tell governments (or the public) what to do. He presents his research findings and leaves it to the public to decide what to do with it. Who of the two is more credible when it comes to ‘freedom of choice’, and ‘freedom’ in general and ‘democracy’ and other big words?
I prefer to be a permanent student of Economics rather than ‘an economist’.
Jack
1. Foreign owners of shares in US companies get capital gains instead of divdends, and capital gains aren’t counted as investment income in the balance of payments. I don’t think the return on US bonds is particularly low, however. In fact the discrepancy applies more to direct rather than to portfolio investment. This is probably because the outbound direct investment is perceived as riskier and therefore requires a higher rate of return. But it might also be due to transfer pricing by multinationals.
2. The above reasons explain why the US can still maintain an investment income surplus despite having negative net foreign assets. But it is only possible because foreigners’ claims on US citizens don’t exceed US citizen’s claims on foreigners by too much. Very approximately, the returns on the former and the latter are 3% and 4% respectively. Therefore the flow of income to Americans will exceed the flow from Americans to foreigners only as long as the foreigners’ claims don’t exceed the Americans’ claims by more than one third. It will only take a few more big current account deficits, and this threshold will be crossed. Net investment will become negative, and strongly so.
3. Everything that Andrew says above is right, but I’d rather be wrong than equivocal.
Ernestine
I don’t find you argument against ‘economists’ convincing. Gerard Debreu is engaged in interesting but pointless pure research. He is no more likely to come up with useful policy suggestions than, say, Benoit Mandelbrot. Friedman, by contrast is interested in fixing real economic problems. You may not like his particular suggestions or his tone – I sure don’t – but that doesn’t mean we shouldn’t try to work out how to fix inflation and unemployment.
Damn. For ‘Net investment will become negative…’, read ‘Net investment income will become negative…’
Ernestine,
The length of your piece makes it hard to be conversational in style. However you are an academic so I will forgive you and persist.
QUOTE: The gold-standard provides stability in a sense akin to an error control model. Fine.
RESPONSE: Which is pretty much what “Inflation Targeting” attempts to do with CPI numbers and Internest rate targets.
QUOTE: The central research question of economics, concerned with non-dictatorial resource allocation systems (with the assumption that people prefer to survive), is not concerned primarily with ‘error control’ of one set of relative prices but with the material (as distinct from spiritual) welfare of humans (see models of ‘competitive private ownership economies’ I’ve referred to in previous posts).
RESPONSE: When you have paper fiat money, the supply of which is dictated by the policy of a dictatorial entity (ie government central bank) then its no longer a question of free markets. You could advocate a government retreat from the money business, and I could see ways to make that work, however it is a larger question than the choice between “Inflation Targeting”, “A fixed US dollar exchange rate policy”, “a gold standard” etc. My concern is one of policy by a dictatorial entity.
QUOTE: The gold standard has nothing to offer regarding the primary question of interest in economics. To be more explicit, the gold standard has nothing at all to say on what is known as the ‘minimum wealth constraint’. That is, the error control system you are advocating can work very nicely until the world population is reduced to 2 people – everybody else died of starvation. This is an illustration by means of reasoning by the absurd, the purpose of which is to make a point on the properties of the system you are advocating rather than a prediction.
RESPONSE: In essence you are saying that the gold standard might cause us all to starve. I think you would need to ellaborate. “Inflation Targeting” might also cause us all to starve. So long as we have fiat money we still need to make a choice about monetary policy. Are you saying that the gold standard is inferior to the other policy options and causes starvation?
QUOTE: ‘A boom’ is characterised by rising prices. A characteristic of something (ie a definition) cannot be simultaneously an explanation of the something. I think this point has been made already on this tread.
RESPONSE: We had rising prices in the 1970s even as we had economic contraction. In the middle ages during the plague prices rose as large swags of people died and output plummeted. China had falling prices in the 1990s even as production output was growing at 10% pa. Without monetary adjustments (ie money flows) contractions are in fact inflationary and expansions are in fact deflationary. So I think you are off the mark.
QUOTE: What would be the equivalent in the international arena? It would be the abolition of immigration laws, wouldn’t it? So, to advocate one but not the other is an error in ‘systems design’, setting everything else aside.
RESPONSE: I do advocate free immigration laws with many other economies. I think we should negotiate reciprocal work rights in nations such the USA, Europe, Japan etc in the way we have done with New Zealand.
QUOTE: But this is not all, there are ‘boom towns’ where the boom is a bubble – and some of these bubbles are no more than financial bubbles (ie created by debt in its various forms).
RESPONSE: Bubbles are a fanciful concept. I have yet to find a useful analysis based on the concept. The followin article on the Dutch Tulip Bubble is worth a read.
http://www.slate.com/id/2103985/
QUOTE: Finally, a known source of potential financial instability in theoretical models of ‘competitive private ownership economies with securities markets’ is due to an ‘unboundedness’ problem. There is no natural limit on short selling of securities. These models do not contain a government – hence you can’t blame ‘the government’ for the outcomes you may not like. ‘Securities markets’ involve things like options, shares, debentures, IOYs, etc., issued by ‘private’ agents.
RESPONSE: More info please.
QUOTE: So, how can we get stability in financial markets? By deregulating labour markets? I suppose there would be little wrong in some people’s mind if a medical doctor would cut off the left leg if the right leg is gangrenous, right?
RESPONSE: Such a doctor would have a poor reputation. However I don’t know how we suddenly lept to labour market regulation after discussing alternatives for monetary regulation.
QUOTE: The only reason I can think of for anybody to advocate the gold standard is if they are ‘long in gold’.
RESPONSE: I advocate it because I think gold is a stable reference. Not one prone to rising rapidly in value. I own less than a gram of gold in an e-gold account and I wear a wedding ring. Other than that your logic of imputed motives fails.
QUOTE: And, the reason why I respond in detail is because Economics is in a sense a very difficult area – everybody is part of ‘the economy’ but not everybody is an ‘economist’, and, speaking primarily for myself, not every ‘economist knows everything’ in relation to Economics.
RESPONSE: Yes.
QUOTE: He presents his research findings and leaves it to the public to decide what to do with it. Who of the two is more credible when it comes to ‘freedom of choice’, and ‘freedom’ in general and ‘democracy’ and other big words?
RESPONSE: The world has always need advocates and academics. To suggest that one is superior to the other is naive.
ASIDE: e-gold now has 2.5 million account holders. Each day people buy and sell things with e-gold. The value of such purchases is approaching US$10 million daily. And use of the private currency grows at 40% per annum. http://www.e-gold.com
Terje: “In the days when gold was the international currency, trade deficits couldn’t really exist. If you wanted to import more cheese from New Zealand you would have to export more gold.”
In the days when the gold stardard existed major countries cheated.
During the 1920s the US and France refused to reflate to reflect the trade surpluses they were experiencing.
Milton Friedman discusses the final demise of the gold bloc in 1934:
“From January 1933 to September 1934 the rise [against the US dollar] was 70 per cent for [France and several other continental currencies], and less than 50 per cent for the pound sterling. … The differential appreciation measured the special impact of [the US] gold-price support program on the position of the gold standard countries. The fact that they lost gold meant that they bore, as it were, a larger part part of the effect of the expansion of US exports and contraction of US imports other than gold than other countries did…”
[Milton Friedman, “A Monetary History of the United States, 1867-1960”.]
The insuperable problem of any attempt to fix currencies against any stardard, whether gold or tulip bulbs, is that the temptation to “cheat” is irresistable, both in “good” times, as during the 1920s and during “bad” times, as during the 1930s.
When the power to cheat is given to governments, the temptation to maintain conditions of full employment in the short term (i.e., between now and the next election) is much stronger than the enlightened self interest desire to maintain freedom of the movement of goods and services and capital across international boundaries. The latter may be better for the voters in the long term, but in the short term the government will be voted out of power.
It is therefore much more elegant for governments to allow private entrepreneurs and arbitrageurs to assume the risk of capital movements across international boundaries.
Moreover, the power of private capital markets provides governments with two very potent weapons:
1. A motive to discipline credit creation and currency policy which blunts the demand for inflationary policies that are favourable to debtors, which is most of us.
2. A common enemy to complain about when unfavourable exchange rate movements throw into question an admittedly atavistic sense of national virility (vide, repeated references to the Aussie $ as the Pacific Peso.)
In a reasonable world the gold standard would work, but in a reasonable world we wouldn’t need any rules at all.
James,
“I don’t find you argument against ‘economists’ convincing.”
I don’t think I put forward an argument against ‘economists’ in the sense of an argument against people who choose this title. My point was that the role of people in society, who are knowledgeable in the area of Economics, is more complex than that of say practising chemists. For example, how do ‘economists’ avoid being put into an ideological box in the public arena? It seems to me it is with great difficulty. So, my problem is with the word ‘economist’ – and I don’t have a better one.
“Gerard Debreu is engaged in interesting but pointless pure research. He is no more likely to come up with useful policy suggestions than, say, Benoit Mandelbrot.” Friedman, by contrast is interested in fixing real economic problems. You may not like his particular suggestions or his tone – I sure don’t – but that doesn’t mean we shouldn’t try to work out how to fix inflation and unemployment.
Which ‘real economic problem’ did Friedman fix? Did Friedman fix the asset market bubbles? Bankruptcies? Corporate fraud? Did Friedman fix the unemployment problem? I am not convinced by Friedman because he has not produced a coherent theoretical model from which his policy advice follows logically. That is all.
If the ‘real economic problem’ of the day is whether or not the Reserve Bank should increase the discount rate by 0.5%, leave it unchanged, or reduce it by 0.5%, then I would agree that ‘pure research’, like Debreu’s, is of no assistance at all. However, if the ‘real economic problem’ of the day are major changes in the institutional environment (eg micro-economic reform) then I would suggest Friedman’s work is entirely useless (because of the absence of a theoretical framework; one has to ‘believe’). By contrast, the ‘pure research’ program, of which Debreu’s work is part, (Walrasian and non-Walrasian general equilbrium theory, applications of game theory) is mighty helpful in reducing the risk of confusing wishful thinking with theoretical knowledge. Empirical data has limitations in providing guidance in situations of ‘system changes’. Long term data is of limited usefulness if one wishes to maintain the argument that there has been ‘technological progress’ and one takes note of historical records of past ‘system changes’. Short term data is of limited usefulness because it belongs to a system which one is about to change.
I would have thought Mandelbrot’s work is particularly relevant for complex processes.
.
Are you saying that under the current monetary regime governments can’t cheat?
Of course governments try, but when they are found out (vide Nigel Lawson) the taxpayer is punished.
Retribution comes swifter and surer than under any system of managed exchange rates.
Then it’s up to the taxpayer, when she puts her voter’s hat on, to decide whether such cheating should be punished.
Terje : I presume you haven’t lived in a country with a fixed currency that has had ridiculous sized bubbles as a result. If you think that, say, the average small apartment costing $800,00 isn’t a bubble (HK in 1997), then I wonder what you would call it ? Or if you think this isn’t bad economic policy, then you might like to dig up the HK goverment criticizing itself over these problems.
It also isn’t just deflation after bubbles which is a pain, but inflation too. For instance, I think you’ll find that the average persons who actually wants to live in the place they buy finds it quite a pain to find out things like the apartment they were going to buy went up 20% in the month they proscrastinated over buying it (or the week, for that matter). Having a fixed currency might not be responsible for all of these annoyances, but it is certainly a decent part.
Katz,
“In a reasonable world the gold standard would work, but in a reasonable world we wouldn’t need any rules at all.”
I should think it is very reasonable to have road traffic light rules. These rules communicate information efficiently among road traffic participants and resolves conflicting interests without requiring individually negotiated settlements at every intersection. True, sometimes the participants “cheat” with horrific consequences.
May I ask for a reference in Friedman’s writings where he deals with trade restrictions in the form of market segmentation and transfer pricing by multinational firms? I can’t find any.
EG, Friedman’s “Monetary History” was almost entirely concerned with political and central banking decisions.
Not even US tariff policy is discussed in any detail.
The actions of private corporations, such as transfer pricing, therefore, lie beyond the purview of Friedman’s “Monetary History”.
Of course traffic signals are reasonable, given the *unreasonable* nature of our species. The red lights you mention could exist and work without any rules being enunciated. Reasonable people could arrive at appropriate behaviour in regard to the operation of these signals without ever being informed of any rules. This is how people learned their native language for millennia before the invention of formal laws of grammar.
(I’m not suggesting this as public policy.)
Katz,
Under a gold standard it is exceedingly simple to see if the government is cheating. All you do is open a newspaper and look at the gold price. If it is still within the range defined by the gold window then you are still on a gold standard. If it is outside the gold window range then they are cheating. Any deviation is immediately obvious. Governments that commit to a gold standard are highly accountable for that commitment because there is simply nowhere to hide.
Contrast this with “Inflation Targetting”. Consumer prices have such an institutionalised component that monetary errors may not show up for a year or two. They can play mischief with Interest rates in the short term and only the very perceptive might notice. Even then the perceptive can be dismissed as being merely of a different opinion. The current system is heavily lacking in accountability compared to a gold standard or an exchange rate standard.
The only valid criticism that I can see for a gold standard is that the value of gold may prove to be unstable. However having reviewed the empiracle history of golds value, and considering the natural stabilisers in the global production and trade in gold, I find this complaint to be without much practical basis. During the 1800s in Britian the gold standard (or metalic standards) meant a gentle and mostly benigh deflation such that the price level halved over a century. A gold based currency did cause a localised inflation in Europe during the plague in the middle ages but the recovery was quick and the circumstances extreme.
Regards,
Terje.
P.S. I agree with Ernestine that Friedman did not contribute much to the world. The quantity based rules that he advocated for monetary policy were discredited extensively during the 1970s and 1980s and even the man himself admits that he was wrong in this arena. I suppose he did make a valuable contribution in advocating a role for the private sector and private action when such a view was out of favour.
Ian Gould – what the hell has the fraudulent activities at Enron and macro-economics got in common?? And if you held Enron as part of a well diversified portfolio, then the impact should not have been huge.
And who is talking about a ‘new economy’? Last time I heard that type of talk was 1999-2000.
You also said:
“East Asian countries have been intervening massively to push down the dollar by buying T-bills.”
I generally avoid being nit-picky but you have redefined demand and supply economics – perhaps a Nobel Prize is in order! Demand for a thing pushes it’s price up. In your example demand by non-US investors for T-Bills would increase demand for USD, which pushes the price up. At the same time, you don’t buy T-Bills if you are trying to move currency prices – you buy the currency, or futures or options or swaps or some other derivative. Do you think there is some sort of international conspiracy to keep the USD down? This is not in the interest of those who export to the US – they want a high dollar. Demanding T-Bills would also push their price up and therefore decrease interest rates. This would be logical if you expect inflation to decrease, however the yield curve at the moment ain’t showing that.
As you can see – my normal understanding of demand and supply and financial markets puts me at a loss to understand your claims that “East Asian countries have been intervening massively to push down the dollar by buying T-bills.” Please expand so that I can see the light.
Terje,
The length of my post in reply to yours is the outcome of adopting a conversational style rather than an academic one.
To illustrate the difference. In reply:
1. In previous posts (concept of money) I have provided all necessary information for you to find the article where the ‘unboundedness problem’ shows up.
2. Bubbles: Look for “Sun-spot equilibria” models.
3. I don’t accept the blanket statement that governments are dictatorial. (See for example Katz’ post on another thread on the complexities introduced by ‘advocates’)
4. Reputational effects may at most (ie not necessarily) prevent unlimited repeats of the same action by the same person or, with a bit of luck, for one successor generation (didn’t work with Milton Friedman). There is no assurance that intergenerational learning is linear. I think we have been on this topic before in an earlier sequence of posts.
5. Are you saying Milton Friedman is not an academic?
6. I suspect the trade unions will be pleased to hear that you recognise a demand for advocates.
7. May I suggest that if you allow for information asymmetries (which we both recognised some time ago), then my statement that “the only reason I can think of for people to advocate the gold standard is if they are long in gold� does not necessarily entail your inference.
8. There is no government I know of which prevents you from conditioning your price expectations on what is happening in the gold market.
“I generally avoid being nit-picky but you have redefined demand and supply economics – perhaps a Nobel Prize is in order! Demand for a thing pushes it’s price up.”
I should have written “to keep the dollar up”.
Ernestine,
1. Yes but I thought you had said that it was limited to an economy that was purely market driven with no public sector so I was not sure that it would apply.
2. I’ll try and do that.
3. Governments are dictatorial to those people that don’t agree with government policy and would act otherwise if free to do so.
4. Granted.
5. In the context of your comparison and in relative terms he was an advocate. But in practice nobody is purely one thing. It would certainly be appropriate to refer to Friedman as an academic. And just to be sure please don’t think that I use the word in any derrogator manner. Academia is a most worth path to take in life. Its just that I am not an academic and the style of writing and thinking that I encounter with academics is sometimes curious and foreign.
6. I am glad that trade unions will be pleased. I have no reason to regret their satisfaction. I have no general desire to outlaw or persecute cartels.
7. I was seeking to expand your horizons. Perhaps you might try and imagine other motives.
8. No but many laws insist that I keep my books in dollars, pay my taxes in dollars etc. As a business man who needs to deal with cash flow it is not really practical to use any unit of account other than the one dictated by the authorities. Although at times I do use other measures for strategic thinking.
Let me seek clarity with a question that cuts to the heart of what I find most interesting in your comments. In your view is “inflation targeting” (as practiced by central banks in Australia and elsewhere) more or less dictatorial than a gold standard? And what is your reasoning?
Regards,
Terje.
Terje,
Is there any reason, other than the historical, why you suggest gold as the standard for value? Why not silver (the old Islamic standard) or platignum (slightly less bulky for value) or some other commodity?
OK – have a good weekend.
Terje,
1. I mentioned two authors at one stage. You asked for the reference of one. I gave to you. For the ‘unboundedness problem’ the second author is relevant (Radner, 1972, Econometrica)
2. —
3. Interesting but not helpful.
4. —
5. — Terje, I am going to venture a guess – I might be totally wrong but I’ll state my guess. You are working through introductory economics textbooks and you put the stuff on blog sites. You then get refutations or comments. The outcome should be an interesting book.
6. —
7. I don’t understand your response to my response. I did not draw the inference which you drew.
8. Yes, but how would you know whether you would have a business at all without there being a government?
You write:
” Let me seek clarity with a question that cuts to the heart of what I find most interesting in your comments. In your view is “inflation targetingâ€? (as practiced by central banks in Australia and elsewhere) more or less dictatorial than a gold standard? And what is your reasoning?”
Response: I recall you have shot down your own strawman quite well.
Regards
Ernestine
Ernestine
“I am not convinced by Friedman because he has not produced a coherent theoretical model from which his policy advice follows logically.”
Isn’t this asking a bit much, especially in macro. As I said, I’m not a fan of Friedman, but I’m willing to concede that he did a pretty good job of pulling together a number of threads – his Phillips curve, his quantity theory and his consumption theory – into a coherent story that laid a foundation for policy. Keynes did the same sort of thing. In a fast-changing environment, theories will always be constructed on the hop.
“By contrast, the ‘pure research’ program, of which Debreu’s work is part, (Walrasian and non-Walrasian general equilbrium theory, applications of game theory) is mighty helpful in reducing the risk of confusing wishful thinking with theoretical knowledge.”
Sure, general equilibrium theory is useful in the negative sense that it can strip the Friedmans of this world of their pretensions to having a solid theoretical grounding for their claims. But that’s not the same thing as generating plausible, constructive proposals.
I’d say something similar about chaos theory. It is a useful caution against interpreting the patterns we observe in terms of the equilibrating processes in our models, and also a caution against assuming that a deterministic process will be predictable. But again that’s different from furnishing useful solutions for concrete problems.
Ernestine,
1. –
2. –
3. helpful in defining the word dictatorial. However I suspect you have a differing meaning for the word that I have not yet fathomed.
4.—
5. I am not working through introductory economics textbooks and putting the stuff on blog sites. Although that might be fun.
6.—
7. You originally state that you could think of only one reason for somebody to advocate a gold standard. I just think that with imagination you might imagine other reasons. I would think that if somebody was “long on gold” that might be a good reason to argue against a gold standard.
8. Interesting comment but kind of off the topic.
9. You recall you I shot down your own strawman quite well. I think I must of missed it. So let me ask again:-
As a monetary policy choice do you think that a “gold standard” is inferior to “inflation targeting”?
Regards
Terje.
QUOTE: Is there any reason, other than the historical, why you suggest gold as the standard for value? Why not silver (the old Islamic standard) or platignum (slightly less bulky for value) or some other commodity?
RESPONSE: Partly it’s because gold is an easy talking point given its history. I would actually be content to let the market decide after withdrawing and restructuring certain laws that inhibit a free choice. I would be happy enough to have a standard based on a commodity basket of goods. Almost any commodity based standard would be better than a price basket based on consumer goods (ie CPI based inflation management).
E-Gold started in 1996 and it has always offered the following varients:-
e-gold
e-silver
e-platinum
e-palladium
Duirng that time the gold variant has always proved more popular and been massively more liquid.
If you read your Islam then you will know that it proscribed dinar and dirham. The first was gold and the latter silver. The weight of each was fixed but the market value of each was flexible relative to the other. As such it proscribed a market place where gold and silver could compete for the role of most monetary commodity.
I suppose I also advocate gold because after lots of charting I have come to the view that its a stable reference. Certainly more stable than something like the US dollar.
I think that the current monetary policy with its targeting of interest rates is inheriently disruptive.
Terje,
Your question: “As a monetary policy choice do you think that a “gold standardâ€? is inferior to “inflation targetingâ€??
My answer: Any monetary policy choice presupposes an adequate concept of ‘money’. I say we don’t have one.
Ernestine,
Given that we have to live in ignorance what is your hunch as to which is better.
Terje.
For practical reasons, silver makes more sense as a standard than gold or platinum (it would be easier to use for transaction purposes). That aside, there would be transitional costs of going onto a bullion standard, and these might be endemic if some countries/areas did and others did not. Since current stocks and production of bullion (more particularly gold) is effectively a government monopoly, the transition would favour governments at private expense as they diversified their holdings out of gold into a more productive asset base – they would be acquiring the assets from present holders. It would take a long time for that to wash out.
Central banks don’t need to buy any gold to go onto a gold standard. They just need to conduct open market operations (OMO) in such a manner that the exchange rate between their fiat currency and gold are essentially fixed within a narrow band. An efficient central bank could in fact go onto a gold standard and have no gold at all.
Lets say that the RBA decided to keep the Australian dollar worth between 49 milligrams of gold (mgg) and 51 mgg. It would no longer be able to use OMO to achieve an interest rate target so interest rates would need to float (as they should in a market economy). If the value of the dollar was drifting up towards 51 mgg then the RBA would need to reduce the dollars value by using OMO to buy assets (ie a monetary loosening). It could use freshly printed currency to buy gold or instead it could buy government bonds or foreign currency and leave gold out of it. If the value of the dollar was drifting down towards 49 mgg then it would need to sell assets to redeem aussie dollars (ie a monetary tightening).
There is a lot of M0 base money in existance so some people figure that a gold standard is unachievable because gold needs to replace the base and there is not enough. However this is not necessary at all. And a lot of M0 base money is simply sitting in a foreign central bank whilst we hold some of their M0 in our central bank. If the whole world went to a gold standard a lot of currency that is notionally in circulation could be simple returned home in exchange for us returning foreigners currency to them.
The only requirement for a gold standard is that a specific weight of gold becomes the national unit of account. And this is most readily achieved by using OMO to fix the domestic currency exchange rate with gold. Australia could do it in the blink of an eye if the political will existed. Likewise the entire world.
James, I’ll post my response tomorrow.
Terje, yes, we all have to live in ignorance and yes, I make hunches but this is not an ocasion when I wish to do so. I refer to my post in the thread on Bernanke a little while ago which puts my comment on this thread into perspective.
Regards
Ernestine
Ernestine,
Yes we have been over this before. However I still don’t fully understand the basis or essence of your hunches/theories/notions and so I will probably probe you again in future.
Regards,
Terje.
Terje Petersen: “Central banks don’t need to buy any gold to go onto a gold standard. They just need to conduct open market operations (OMO) in such a manner that the exchange rate between their fiat currency and gold are essentially fixed within a narrow band.”
Such a soft peg would be highly susceptible to speculative attack. In fact, without trading directly in gold, or at least in some foreign currency, I doubt the RBA would be able to keep within a 4% band during the turbulence of a fully-fledged speculative attack, even if wanted to.
“Gerard Debreu is engaged in interesting but pointless pure research. He is no more likely to come up with useful policy suggestions than, say, Benoit Mandelbrot.”
Gerard Debreu isn’t engaged in anything. He died on December 31 2004.
Standard Deviant,
A peg is a peg. Its softness is determined not so much by the technical ability of a central bank to defend it so much as it depends on the political will to defend it.
A central bank that was on a gold standard would probably be prudent to hold some gold. However that would be more to do with a potential decline in the value of other asset classes (eg foreign currencies).
A central bank has very little to fear from a fully-fledged speculative attack so long as it has a single clear objective target for open market operations. Central banks fail to defend their monetary target when they are caught between multiple objectives and they blink.
Malaysia had no difficulty fending of the speculators in 1997 despite some heated words between Mahathir (then Malaysian PM) and Soros (a prominant currency speculator).
The RBA currently targets interest rates even though it’s lending represents only a tiny proportion of lending in the broader market place. Whilst it is single minded about this target even well funded speculators have little chance of shifting the market interest rate off target.
When China fixed its exchange rate to the US dollar not even the might of the US Federal Reserve could have used a speculative attack to shake the peg so long as the Chinese remained commited.
In summary I disagree with you. The RBA would have no difficulty maintaining a 4% price band even without trading gold.
Regards,
Terje.
James,
Quote: “As I said, I’m not a fan of Friedman, but I’m willing to concede that he did a pretty good job of pulling together a number of threads – his Phillips curve, his quantity theory and his consumption theory – into a coherent story that laid a foundation for policy.�
Response: How do you know that M. Friedman produced a coherent story? How would you prove that it is a coherent story?
Quote: “Keynes did the same sort of thing. In a fast-changing environment, theories will always be constructed on the hop.�
Response: No, because:
1. Keynes (1930s) advanced knowledge. His work gave rise to many more questions and many more results (eg non-Walrasian equilibrium theory, monetary economics, the role of governments in a democratic society). Friedman went backward in time, back to 19th century neo-classical economics. IMHO, Friedman had not achieved by the middle of the 20th century what L. Walras had achieved about 100 years earlier.
2. Keynes policy advice was concerned with an imminent crisis of monumental proportions affecting huge numbers of people. His policy advice worked. Which economic crisis did Friedman solve? Indeed, what exactly is the problem to which Friedman offered a solution that is useful and in which sense is it useful?
3. To the best of my knowledge, Keynes never aimed at fixing the world’s problems once and for all. “In the long run we are all deadâ€?, he said, for the benefit of those who wanted to hear that it is the material welfare of humans – not just as a species but as individuals, each one of them having a finite life – that is the subject matter of economics. I cannot find anything in M. Friedman’s writings which would tell me what his understanding of the fundamental research question of economics is.
JF quotes EG: “By contrast, the ‘pure research’ program, of which Debreu’s work is part, (Walrasian and non-Walrasian general equilbrium theory, applications of game theory) is mighty helpful in reducing the risk of confusing wishful thinking with theoretical knowledge.�
Quote of JF: “Sure, general equilibrium theory is useful in the negative sense that it can strip the Friedmans of this world of their pretensions to having a solid theoretical grounding for their claims. But that’s not the same thing as generating plausible, constructive proposals.�
Response: I fail to see how ‘something’ that has been revealed as being ‘nothing’ (because “it has been stripped away of its pretensions�) can generate plausible constructive proposals. See questions in 2. above.
The first result of a (Walrasian) model of a competitive private ownership economy, which in a sense is consistent with Keynes writings, is the ‘pseudo-equilibrium’ in Radner (1972). The institutional change made, relative to Arrow-Debreu model, consists of introducing a sequence of markets for commodities and financial securities. Markets did not clear. Only the value of excess supply was minimized. I am using this example to substantiate my earlier remark that Keynes advanced knowledge, Friedman did not. The mid-1980s outcome of this research program is mentioned in my earlier post (Bernanke).
Do you know what the economic rationalists were reading all these years?
Quote: “I’d say something similar about chaos theory. It is a useful caution against interpreting the patterns we observe in terms of the equilibrating processes in our models, and also a caution against assuming that a deterministic process will be predictable. But again that’s different from furnishing useful solutions for concrete problems.�
Response: Suppose you are alive when ‘the economy’ goes through a state of turbulence. What would you prefer, a government that takes advice from economists whose primary research question is the ‘material welfare of individuals under alternative institutional environments’ or the advice of someone who says we are not sure whether the data shows us that we are going through an equilibrating process and we don’t know what will happen tomorrow but we believe competition and free markets is good for ‘the economy’?
Regards
Ernestine
Terje,
That’s fine. It makes the point that private individuals can also have a voluntary dialogue of the deaf.
I think competition is over rated. However we have a lot of institutions (eg ACCC) who are tasked with creating and maintaining it.
QUOTE: Suppose you are alive when ‘the economy’ goes through a state of turbulence. What would you prefer, a government that takes advice from economists whose primary research question is the ‘material welfare of individuals under alternative institutional environments’ or the advice of someone who says we are not sure whether the data shows us that we are going through an equilibrating process and we don’t know what will happen tomorrow but we believe competition and free markets is good for ‘the economy’?
RESPONSE: Either way I think that the government would find a way to screw us.
Still no information on why Trade deficits are Unsustainable for either the US or Australia. Maybe they are sustainable (well, they have been so far).
Terje,
Quote: “Its softness is determined not so much by the technical ability of a central bank to defend it so much as it depends on the political will to defend it.�
In practice this is probably generally true. I say this because the technical ability to maintain a peg is not usually a problem, but central banks don’t usually try to maintain a fixed exchange rate without (at least the option for) any foreign exchange market intervention. However, the softness also depends on the practical ability of the central bank (and on that of the government of the day) to abandon the peg quickly and easily.
Quote: “A central bank that was on a gold standard would probably be prudent to hold some gold. However that would be more to do with a potential decline in the value of other asset classes (eg foreign currencies).
“A central bank has very little to fear from a fully-fledged speculative attack so long as it has a single clear objective target for open market operations. Central banks fail to defend their monetary target when they are caught between multiple objectives and they blink.�
There are two different issues. The first is the technical feasibility of a peg. I agree that there is generally no technical barrier to maintaining a peg, provided the central bank has the ability to buy back its money base, which would best be ensured by holding sufficient gold or gold denominated assets (because of, as you point out, the potential depreciation of other assets). How narrow a band they can keep is probably not as clear, though.
The second issue is that of time consistency and credibility. Even if a fixed gold peg is considered optimal ex ante, short-term incentives to depreciate may be strong, particularly when the peg is not credible. The incentive to gain a reputation may be stronger, making the peg more credible, and reducing the problem, but it is hardly guaranteed. Yes, the problem is multiple objectives, but simply realising and acknowledging this does nothing to fix the problem. Wanting to be committed is not the same thing as being committed. Nobody could be blamed for not caring about only the gold price and nothing else (quite the opposite). A monetary authority not willing to defend a peg to gain credibility could be accused of short-sightedness and/or lacking political courage, but a time consistency problem could occur even if their preferences were perfectly aligned with those of the general population (which, of course, won’t be homogeneous in reality…). A possible solution is to impose further practical constraints (i.e. make it more difficult to abandon the peg quickly). There is a reason they brought in the Euro, rather than those countries just keeping narrow pegs. Of course if the technical ability to defend the peg is (perceived to be) jeopardised then it loses credibility, so the two issues are related.
Quote: “The RBA currently targets interest rates even though it’s lending represents only a tiny proportion of lending in the broader market place. Whilst it is single minded about this target even well funded speculators have little chance of shifting the market interest rate off target.�
I see the RBA’s cash rate targeting as somewhat different to a gold peg (or exchange rate peg generally) with respect to the issues we’re talking about. For one thing, the RBA only commits to its target for one month out (or two months after its December meeting). If something happens that makes the RBA want to change its target then it would only have to wait less than a month before it could do so without losing any credibility. Also, I don’t see how speculation on the cash rate could cause close to the amount of economic discomfort as speculation on the exchange rate could. Not to mention that funds from RBA open market operations flow more directly into the interbank funds market than the gold market.
Quote: “When China fixed its exchange rate to the US dollar not even the might of the US Federal Reserve could have used a speculative attack to shake the peg so long as the Chinese remained commited.�
If the Fed remained committed as well then there would be trouble. China imposes restrictions on international capital flows (as I understand, but I’m not aware of the details), so it’s a different kettle of fish.
Quote: “The RBA would have no difficulty maintaining a 4% price band even without trading gold.�
I don’t dispute that standard OMO, without direct gold market intervention, would always allow the RBA to push the gold price up or down (again provided they don’t run out of assets to conduct those OMO). I was disputing that they would necessarily be able to do so very precisely, especially in extreme circumstances. I imagine that OMO would affect the gold price only at a lag, as well as somewhat imprecisely. I am not an expert though, so perhaps I shouldn’t be commenting on specific band widths, but plus or minus 2% still sounds a bit narrow in particularly turbulent circumstances.