October 06, 2014
I am not usually inclined to defend the economics profession, but Robert Samuelson brings out my defensive impulse in his discussion of Financial Time columnist Martin Wolf’s new book (which I have not read). Before getting to the main matter at hand, it’s worth making a couple of other points.
First, Samuelson tells us that Wolf’s explanation of the financial crisis goes via the way of the U.S. trade deficit:
“The trade-surplus countries couldn’t spend all their export earnings, so they plowed the excesses into dollar investments (prominently: U.S. Treasury bonds) and euro securities. This flood of money reduced interest rates. The resulting easy credit induced dubious lending, led by housing mortgages.”
This is partly right and partly wrong. (I don’t know if the problem is in Wolf’s book or Samuels’ retelling.) The wrong part is the claim that the trade surplus countries couldn’t spend all their export earnings. This makes no sense on its face. They have no need to spend their export earnings. If they have dollars that they don’t want they just dump the dollars. It’s just like if someone who has shares of a stock they don’t want. They dump the stock.
What happened in this period is that foreign central banks bought the dollars from their exporters and then used the money to buy up U.S. government bonds. This was a conscious decision to prop up the value of the dollar against their currencies. This was done to preserve their export advantages.
If they had just sat back and let the market clear, the dollar would have fallen and the U.S. trade deficit would have shrunk. This is all pretty much econ 101 stuff that Wolf should have gotten straight (perhaps he did).
The part that is completely right is that the gap in demand created by the trade deficit (our spending was creating demand in Europe and China, not the United States) created a huge hole in demand that could be filled by the housing bubble. If we had something closer to balanced trade back in the middle of the last decade then the buildup of a housing bubble would have almost certainly led to higher interest rates and higher inflation. This would have choked off the bubble before it grew too large. So in this sense, Wolf is 100 percent on the money in blaming the bubble on the trade deficit.
The other point worth correcting is Samuelson’s claim that the bubble was due to the drop in inflation from the late 1970s through the last decade. Samuelson tells readers:
“In 1980, annual consumer price inflation was 13 percent. By 1999, it was 3 percent. As inflation fell, interest rates followed. From 1981 to 1999, mortgage rates dropped from 15 percent to 7 percent. Declining interest rates caused stocks and home prices to soar.”
Actually, it is real, not nominal interest rates that are the main determinant of stock prices, if not home prices. This point is straightforward. If people are considering stock as an investment they would look at the real rate of interest they can get on alternative investments, not the nominal rate. They would expect, other things equal, that stock prices rise more or less in step with the overall rate of inflation.
In principle this would be true of housing also, except that many people are up against budget constraints. They have to pay the nominal interest rate every month. It doesn’t help them meet their budget if the house price rises 0.5 percent every month because the overall inflation rate is 6.0 percent. For this reason, it is likely that house prices would be affected to some extent by lower nominal interest rates, even if real interest rates are unchanged. So his declining inflation gave us the stock and housing bubble story really doesn’t make much sense.
Now let’s get to Samuelson’s big error. He tells us:
“My main takeaway from Wolf is that economics is in disarray. He spends much space refuting or ridiculing ideas that he rejects. The point is not who is or isn’t correct; the point is that there’s no consensus on how to proceed. In two decades, we’ve gone from the blissful assumption that the Federal Reserve (and other governments’ central banks) could ensure fairly stable economic growth to a state of desperate experimentation where policies struggle to make a bad situation slightly better — or at least not worse.”
Actually, there is a reasonably good consensus among economists who believe in evidence. We had very specific predictions from policy, which were tested. Some were right and some were wrong. For example, the claim that quantitative easing would lead to run away inflation was wrong. The claim that austerity would foster growth was wrong. As research from the I.M.F. and others shows, reducing budget deficits in a downturn slows growth and raises unemployment.
There is zero ambiguity on these points. Samuelson may not like the conclusions of the research, but that is his problem. We know the earth is round and that expansionary fiscal policy can boost us back to full employment (as will a lower dollar and shorter workweek). If Samuelson doesn’t like this reality the fault lies with him, not the economics profession.
Addendum — China and the Dollar
From the comments it seems that Samuelson and his ilk have continued to spread confusion on China and the dollar. The continued over-valuation of the dollar has nothing to do with the distribution of income in the U.S., in China, or the market.
The basic point is simple. Chinese exporters accumulate large amounts of dollars from selling stuff to us. If they acted like exporters in Germany, France, or most other countries they would simply sell these dollar on international currency markets and get their own currencies to spend domestically. This process would drive down the dollar against the Chinese currency and move our trade closer to balance. (Sorry folks — there is vast amounts of data to show that a lower currency reduces the trade deficit. That is not some invention of economists.)
However China does not want the value of its currency to rise against the dollar because it wants to preserve its competitive advantage. Therefore the central bank requires that its exporters sell their dollars to the central bank. The central bank then buys up vast amount of U.S. assets (bonds, mortgage backed securities, and more recently shares of stock). This is a conscious decision of the central bank — it has zero to do with the market or income distribution. That is why Samuelson is what we call in the economics profession “wrong.”
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