Friday, April 16, 2010

On how not to counter the trade deficit

The thrust of our previous post was that mercantilist policies work, promoting economic expansion in the country running the export surplus, to the enormous detriment of the industry of the country running the trade deficit. This involves the exporting nation acquiring a surplus of the importing country’s money. The rosy idea that the system of free trade cannot be exploited to one country’s advantage is, on the face of it, absurd. No economic system has ever been developed which has not been abused. History has shown, those countries which adopt an export oriented posture prosper, those that do not decline. One may ask, why did the European powers prosper, while their colonies remained stagnant or declined?(They still practice it, in the form of foreign aid.) How did the Asian Tigers arise? Why does China prosper, while the US declines? Why is Germany tasked with ‘rescuing’ Greece? The answer is always the same. One country runs a trade surplus, while the other runs a deficit.

Warren Mosler, at
suggests, however, that we counter China’s policies simply by giving money to consumers sufficient to overcome its effects, and create sufficient demand to sustain domestic industry, as well as the excess in imports. He proposes a tax holiday, distribution of Federal money to the states, and national service employment.

His proposals have other significant merits. However, his proposals will not change the relationship between the Aggregate Supply curve provided by domestic industries, and the augmented Aggregate Supply curve provided by the combination of domestic industries and imports. The augmented Aggregate Supply curve will always be to the right, and the equilibrium price level will always be less than the price level in the absence of imports.
The revenue received by domestic industry will thus on average, always be less than the cost of its production, despite any overlay of inflation caused by giving money to consumers. Domestic industries will be under persistent competitive disadvantage.

Compare with balanced trade, where only some industries experience competitive disadvantage, but the others experience competitive advantage. The two even out, and the economy as a whole is helped. ( Although there is increased 'creative' destruction, as the economy adjusts. Do the costs of this balance with the benefits of trade? This seems to be just a transition state, however and in the long term balanced free trade will be mutually beneficial.)

An influx of cash shifts the demand curve to the left. The Aggregate Supply curves for just domestic production, or for balanced trade, and domestic production plus imports, do not change. With imports, price moves down the AD curve to the AS curve for domestic production plus imports, at the lower price. Solid lines. However, domestic revenue goes down the Aggregate Supply curve to the new equilibrium point at both the reduced price and a reduced quantity, and so is also reduced. Domestic industry, with reduced revenue, contracts. With an influx of cash, the same phenomenon repeats itself, but just at a higher price level. Dotted lines. But see Redux.

A reminder that might be pointed out is that the problem with deflation is that in general it reduces nominal profits and, at least in perfect competition, nominal costs are greater than nominal revenues.

A comment: The Aggregate Supply curves in this diagram could be vertical, or curved, for those who consider that an influx of cash is itself unlikely to cause an increase in production, but merely cause an inflationary increase in the price level, at least in the long term. The basic argument is the same. The country with deficit clearly declines both in quantity and price, and certainly could produce more at higher price levels, having idled capacity. The country with surplus is continually expanding, and its growing capacity must always outpace production.

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