Economics 101 for Deficit Hawks

There are few areas of economics more boring than accounting identities. This is really unfortunate, since it is virtually impossible to have a clear understanding of economic policy without a solid knowledge of the underlying identities.

Most of the people in Washington policy debates were apparently overcome by boredom before they could get this knowledge. As a result, we see some really silly policy debates.

The debate over the value of the dollar against the Chinese yuan is the latest episode in this silliness. The Washington tribal elite has been on the warpath against budget deficits in recent months. They have worked themselves into such a frenzy that nothing will stand in their way: neither concerns about unemployment, nor concerns about the well being of our elderly, nor even concerns about basic economic logic.

The central problem stems from the simple accounting identity that national savings is equal to the broadly measured trade surplus. A country with a large trade surplus will also have large national savings. Conversely, a country with a large trade deficit will have negative national savings. These relationships are accounting identities - there is no way around them.

This brings us to the next part of the story; where trade deficits come from. At a given level of GDP, the main determinant of the trade deficit is the value of the dollar in international currency markets. This is very basic supply and demand. If the dollar is higher in value relative to other currencies, then our exports will cost more to people living in Germany, Japan, and China.

If a car sells for $20,000 in the United States, then the price of this car to people living in other countries will depend on how much of their own currency (euros, yen or yuan) they must pay to get a dollar. The higher the dollar relative to these other currencies, the more expensive the car is to foreigners. And, the more expensive it is to foreigners, the fewer US-made cars they will buy. This means our exports will fall.

The story works in reverse on the import side. If the dollar is high and therefore buys lots of foreign currency, then imports are cheap. This means that we will buy lots of imports.

If we have low exports and high imports, then we will have a large trade deficit. End of story. We can train our workers to be more productive, urge our firms to invest more and try to improve our public infrastructure, but realistically, none of these factors can come close to offsetting the impact of a currency that is 20-40% over-valued. A severely over-valued currency virtually guarantees a trade deficit.

This brings us back to the budget deficit part of the story. If the United States has a large trade deficit, then it means that net national savings are negative. That is definitional. For net national savings to be negative, then we must have either negative private savings or negative public savings (that is, a budget deficit).

During the peak years of the housing bubble, private savings were strongly negative. This was because the wealth created by the bubble led homeowners to spend rather than save. With the collapse of the housing bubble, people are now saving much more. Furthermore, investment has fallen due to overbuilding, which means that private-sector savings are no longer negative.

This leaves us with our large budget deficit. The budget deficit follows from the fact that we have a trade deficit, which is, in turn, the result of the over-valued dollar. This brings us to the strangely paradoxical behavior of the Washington policy elite.

Many of the same people who routinely express horror over the size of the budget deficit were either on the sidelines or in actual opposition to the effort by congress to get China to raise the value of its currency against the dollar. While one can argue as to whether the bill approved by the house of representatives was the best route to go, anyone who hopes to get the trade deficit down must recognize the need to lower the value of the dollar. And, if one wants to get the budget deficit down, then it is necessary to reduce the trade deficit.

This raises the possibility that perhaps the deficit hawks don't really give a damn about the deficit. Perhaps the deficit hawks just want to cut social security and Medicare and other programmes that benefit the middle class and moderate-income people.

Of course, it is also possible that the deficit hawks are just confused when it comes to economic policy. It's hard to know for sure. But these days, ignorance and/or dishonesty appear to be the chief qualifications for entry to Washington policy debates.