Monday, April 26, 2010

How Not to Counter the Trade Deficit Redux

We have the identity: (I - S) + (G - T) + (X - M) has to equal zero. Investment - Savings + Government Expenditures - Taxes + EXports - IMports is equal to zero. So if (X - M) is seriously negative, (G - T) has to be seriously positive for there to be any net investment in the private sector. (Unless there is dissaving. The national Savings rate is now about equal to zero.) The government has to run a deficit, and it has to be larger than the trade deficit. Current trade deficit is about 5% GDP, so for investment to run 3% above private savings, the government has to run a deficit of about 8% GDP. Savings are future inflationary, since they represent consumption in the future, so you want investment to out pace savings. $1.2 Trillion deficit then is what the government should be running now. So only with a significant trade surplus can you allow government to run a surplus.

Can't run up debt, though. That would outstrip GDP growth. So you have to 'print' it. Would be inflationary but the extra goes to foreign countries, who can't get rid of it very easily. They have to spend it. Here. It would be like they had it in a savings account, if they buy bonds. Or like a checking account if they hold onto the cash. So one of the purposes (the purpose?) of selling bonds is to keep the money out of circulation, until the bond matures.

So, with deflationary pressure from the trade deficit uncompensated for because of inadequate government deficits a good investment strategy would be to short US industry. If you were a ...what? Traitor? How is investing betting of the failure of your neighbor? Or your own failure, for that matter. But the losing strategy results from the government inadequacy of spending.

Still not a very good way of compensating for the trade deficit, though.

Friday, April 23, 2010

On Rights

These truths are self-evident:

All rights are the creation of men. It is the desire of men to have rights, which creates rights. Rights derive from the relations between men, and the resources available to men. Men give rights, so that they may have them. They are property, which each man possesses to one degree or another. Rights have value. The value of a right is not its formality, but its effect. Each man values each right, to one degree or another, according to its effect on his life.

All rights are by the consent of others. Since the consent of others is always contingent, no right can be absolute or inalienable.

Each society has available to it, even where it extracts rights from other societies, only so many rights to distribute among its members. A society with more resources has the potential for more rights. It may have less.

Each right that a person has is a limitation on the rights of others. Each right is a burden on others.

Rights incur responsibilities. The failure to meet those responsibilities is a cause tor the alienation of those rights. The first responsibility is the granting of rights to others. The second responsibility is their enforcement. The third responsibility is mercy. Since the responsibility of rights represents a burden, the fourth responsibility is the minimization of that burden, given the maximization of those rights, given the resources available. The fifth responsibility is the education to those rights, and their responsibilities, and their burden.

The people of a society grant rights for their own benefit. Rights are granted where the effective benefit of those rights is greater than the real burden of the responsibilities. Where the people benefit less than the burden, those rights will be discarded.

The people of a society develop institutions for securing their rights. These institutions formalize the granting of rights, and their enforcement. These institutions are themselves granted rights, to the benefit of and at the expense of the people. Such institutions necessarily also increase the rights of a few. To such degree as they use force, or are inefficient, they reduce the rights available to the people and increase the burden of those rights.

In a society, there is a natural distribution of rights, which depends on the resources available to that society, demanding the least force and incurring the least inefficiency, which maximizes the value of rights available to the people. The institutions chosen by the people need not guarantee that distribution, and indeed may be chosen to impose distributions of rights different from this natural distribution. The additional expense, the loss of rights to a society, will be more than proportional to the deviation from the natural distribution.

So by consent, the members of a society may make certain rights universal, and held in equal quantity by all, and inalienable except for failure to meet the incurred responsibilities. These certain rights then represent a form of property which cannot be bought or sold. A society may consent to this, at the expense of other rights, that the few more fortunate of more able, shall not otherwise acquire those certain rights of the many less fortunate or less able.

And by consent a society may make certain rights held by a few, who incur greater responsibilities. It may assign these rights, and those responsibilities, to the few, in
various manners. These certain rights then represent a form of property, which may also be bought and sold. A society may consent to this, at the expense of other rights, if the many choose to not effectively exercise themselves those responsibilities these rights incur.

Properties are rights, and by the consent of others. Therefore, no property is absolute or inalienable. Others consent to properties, so that they may also have properties. Those who consent to have less, do so in the expectation that they may attain more, either in the present, or in the future. Since properties are rights, those with more properties have more rights than those who have fewer. Those with more properties also impose greater burdens on their society, and incur greater responsibilities. Since there is a natural distribution, those with more properties may impose a disproportionately large burden of their society, and incur disproportionately greater responsibilities.

There will always be those with many rights. There will always be those with few. When those with few are many, and those with many few, a society is poor.

Where many rights are narrowly held, where the many have few, either the few exercise their responsibilities, and impose the lesser burden on society, or they impose the greater burden of society, and the consent of the many is obtained and maintained through fraud and excess force. The many may either shake off their burden, or succumb to it. The resources taken to enforce fraud and excess force take away from the rights available to society.

That distribution of rights which maximizes the value of rights, and minimizes fraud and force, is most just, and most merciful.

Subject to revision.

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.

Thursday, April 8, 2010

The Effects of Unbalanced Trade

The United States trade imbalance has long been an unresolved issue. Some claim that barriers to free trade are necessary, others that they are not only unnecessary, but harmful, and even immoral, since they would force higher prices on otherwise uninvolved consumers.

Those who claim that current trade policies are harming the US have, to our knowledge, proposed no clear mechanism. We propose one here.

We show that, while balanced free trade may be beneficial to all, or at least not harmful, when trade is not balanced, the net exporting country grows at the expense of the importing country. That is, the net importing country’s economy undergoes deflation, and erodes. The demand of the importing country’s economy is driven down, and its industry is increasingly idled. Since this affects labor, even many of those consumers enjoying the immediate benefits of lower prices, may pay a greater price, in lower wages and higher unemployment. Consumers are involved, whether they want to be or not.

We should also expect erosion of the tax base. There is, in the economy as a whole, more pain than gain. We model the mechanism.

The basic idea is that the price level in the importing country goes down, decreasing the revenue available to its industries. However, that country’s demand is ultimately equal to the revenue of its industries. That is the key relationship. The country's demand declines with the decline of the revenue of its industries. With continued imports, the price level continues to go down, as does revenue and demand, along the Aggregate Supply curve. With the continued erosion of revenue, industries are increasingly idled, and unemployment increases. The importing country is forced into a deflationary spiral.

In the exporting country, on the other hand, the price level goes up, and including the revenue from its exports, so does the revenue of its industries, and ultimately the country’s demand. Its industries, with increased revenue, grow, as does the country’s demand, along the Aggregate Supply curve. With continued exports and continuing increases of revenue, industries continue to grow. So does demand, and employment.


The unbalance of trade has been an issue for some time. When one is not doing well, one looks around for someone to blame. One also looks for causes. When one finds both, one must act- wisely.

Note that when trade is balanced, there is, here, no effect. Only when there is an imbalance in trade, where one country is a net exporter, and the other country a net importer, does the importer’s economy erode, and the exporter’s economy grow. There is a certain symmetry: The exporter benefits at the importer’s expense, despite the apparent benefits to the importing country, and the apparent costs to the exporting country.

Monday, April 5, 2010

In Praise of Smoot-Hawley?

Smoot-Hawley may have helped reduce the depth of the Great Depression.

The Smoot-Hawley Tariff Act was passed in response to protectionist sentiments at the beginning of the Great Depression in June of 1930. US tariffs, already averaging 40% due to previous legislation, were increased an average of 20% or so, initiating retaliatory tariff increases by US trading partners. It is generally credited with worsening the international economic situation, and aggravating the Great Depression.

We will consider a depression to start with an excess of supply over demand, due to a contraction in demand. Excess inventory leads producers to cut back on production, and further to cut back on factors of production, particularly labor. However, labor is the ultimate consumer, and by cutting back on labor, producers ultimately cut back on the final demand for their own products. This leads to a vicious cycle: Job cuts lead to reduced demand leads to job cuts etc.

In order for the cycle to end, supply must eventually equal demand. Since the cycle starts with an excess of supply, supply must decrease at a rate greater than demand, in order for the two to eventually become equal. This forms the bottom of the depression. One process that tends to happen is that, as the number of workers in a firm decreases, a point is reached where the marginal physical product (units per worker) decreases. Under these circumstances, supply indeed decreases faster than demand.

Other policies which help to maintain demand, such as unemployment benefits and deficit spending, also work to reduce the severity of a depression. The collapse of credit, by reducing demand, works to aggravate a depression. At the beginning of the Great Depression, between 1930 and 1933,the money supply declined by about a third.

With a reduction of trade, supply of goods and services is also effectively decreased. This is especially the case with a country operating with a trade deficit, but it is well known this decrease happens even under the conditions of balanced trade.

Consider the case of two countries, which trade two goods. If the countries impose barriers to trade, such as a tariff, each country becomes short in one good and has a surplus in the other. (To phrase it more precisely, the price of the first good goes up above the expense of production, while the price of the other good goes below its production cost. However, it is now apparent that markets do not always clear immediately, that surpluses and so also that shortages may exist, and may persist. If a good is a factor, other shortages may result.) Since the good a country is short in it produces less efficiently than the good it produces in surplus, when the now excess factors of production are transferred from producing the good in surplus to the good in shortage, the new total of production will be less than before. The combined supply of the two goods will be reduced. Further, during the transition period, the good in surplus will no longer be produced in surplus, but production of the good in shortage will not have begun, since it is still being capitalized. Also, during the transition period, the cost of the transformation of capital will increase demand.

In 1934, President Roosevelt signed the Reciprocal Trade agreement, liberalizing trade and undoing much of the tariff legislation. But by 1933, the Depression had already bottomed out.

This analysis suggests that the Smoot-Hawley Act, by helping to more rapidly reduce the surplus supply, helped supply and demand to equalize at higher price and quantity levels than they otherwise would have. Despite the negative effect the act had on business confidence, the Smoot-Hawley Act may have reduced the severity of the Great Depression.

This raises the issue of the general application of restrictions to free trade. In a sense, free trade maximizes the supply of goods and services to the world economy. It also maximizes international competitive pressures. Is this desirable? Is it desirable that only the most efficient producers survive? That is, is it desirable that the producer surplus be minimized?

It also suggests that a certain level of restrictions on trade may be beneficial for global economic stability. With some restrictions, balance of payments may be maintained. With unrestricted free trade, imbalances will almost certainly occur. Some have touted the benefits of trading goods for over-valued pieces of paper, but that paper represents debt, and the promise to repay in goods and services, which may come at an inconvenient time for a hard pressed economy.
I will not go into the well known equalization of factor prices under free trade, except to mention that it suggests US professors in economics will eventually be paid the same as their Chinese counterparts.

The analysis can be generalized to internal trade and specialization at all levels of social structure, due to the effects of comparative advantage. The relentless drive to specialization, while it increases the quantity of goods and services produced, may be socially destabilizing, and perhaps policies should be adopted that ameliorate these pressures.

I have simplified the discussion of supply and demand. The real discussion is more complicated, involving the shifting of the "Aggregate Demand curve" to the left, and the "Aggregate Supply curve" also bending to the left at the lower level of demand, so that the equilibrium point where they cross, where quantity demanded equals quantity supplied, is at a lower level, as may be the price, etc. The process stops when the equilibrium price level, which may be lower than originally the case, is greater than the cost of production, at the new price level. The reason the demand curve, and following it the supply curve, doesn't just spring back is because demand is money. No money, no demand. And money has been taken out of the demand side of the system. One answer is to gradually pump money back into the system, on the demand side. Under these circumstances, giving money to producers is useless, and worse, since they need no longer produce to make money. And so can lay off more people, etc. So is giving money to bankers. They have no reason to lend to the unemployed, nor to producers who have no demand for their product.