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Thursday, April 02, 2009


the cult of zero imbalances

too good to fall down the memory hole -- marshall auerback at credit writedowns.

To me, the central risk is that the US private sector is shifting to a net saving position in a dramatic way for the obvious reasons - loss of wealth, precautionary saving given recession, etc. Arguably, this needs to happen if households are going to pay down debt and reduce debt burdens, and if they are realizing capital gains are not guaranteed.

The risk of this necessary adjustment arises because if the private sector moves to a net saving position - spending less than it earns - the income level in the US will fall unless the trade deficit turns quickly enough, and unless the fiscal deficit expands commensurately. In other words, we should be applauding this increased fiscal deficit because the alternative would be disastrous, not just for the US, but the world as a whole.

For every net saver, there must be a net deficit spender, or else the net saving cannot be accomplished without an adjustment of incomes. This is where the so called paradox of thrift comes from, as you well know. If incomes fall, debt defaults and delinquencies will increase more dramatically, and there is a good chance of heading into a debt deflation spiral, a la Irving Fisher.

In Q4 2008, US nominal GDP fell. Incomes have started to fall. That indicates the private sector is trying to net save more than is feasible given the shrinkage of the trade deficit and the expansion of the fiscal deficit, largely through so called automatic stabilizers, to date.

I suppose you could argue that from a US only perspective, ideally all of the increase in the private sector net saving position would come from a reversal of the trade deficit, but this isn’t going to happen. ... [I]n a world where global trade is collapsing, in part because export dependent economies have just had the rug pulled out from underneath them as US consumers (and others) try to save, it is a fantasy to think the adjustment process can be done entirely through trade. The only way to avoid a debt deflation outcome, as long as the private sector is trying to increase its net saving, is through an expanding fiscal deficit.

auerback's points are very well taken. this is not, as he says, the Great Depression -- the united states is in a very different position vis-a-vis government size and spending, not to mention trade balance. it could very well be a depression, however, if government is panicked into fiscal austerity at a time when the private sector is moving to considerable net savings and trade volume is cratering. we must have large government deficits -- every bit as large as private flows into the banks.

auerback further helpfully provides a crude model of what is happening and must continue to happen.

To illustrate ... the current account deficit has already gone from about 6% of GDP to 4% of GDP. Let’s say further consumer and inventory contraction gets us to 2% of GDP by year end. The CBO suggests the federal fiscal deficit will be out to 12% of GDP. I think that’s a bit high, as it incorporates TARP [ie, capital transfers, not consumptive spending -- gm]. But even assuming a trailing deficit of 8% (which is roughly what we’ve got now in the US), the private sector can net save around 7-8% of GDP without nominal incomes falling in the economy. At the depths of the 1973-5 recession, private sector net saving hit a post WWII high of nearly 9% of GDP. Maybe it needs to go higher this time because of the larger shock to household balance sheets with home and equity price deflation. But at least we can say the fiscal deficit is now programmed to scale up fast enough to reduce or contain the risks of US income deflation, and hence a runaway debt deflation process. To me this is crucial.

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As I added there, on the monetary side, inflation is an "output gap" versus "inflation deanchoring" scenario similar to what Simon Johnson says and Richard Koo alludes to as a currency crisis issue too.

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And something like this would be just the sort of thing neither Obama nor the country needs, would it?

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Our enormous trade deficit is rightly of growing concern to Americans. Since leading the global drive toward trade liberalization by signing the Global Agreement on Tariffs and Trade in 1947, America has been transformed from the wealthiest nation on earth - its preeminent industrial power - into a skid row bum, literally begging the rest of the world for cash to keep us afloat. It's a disgusting spectacle. Our cumulative trade deficit since 1976, financed by a sell-off of American assets, exceeds $9.1 trillion. What will happen when those assets are depleted? Today's recession is the answer.

Why? The American work force is the most productive on earth. Our product quality, though it may have fallen short at one time, is now on a par with the Japanese. Our workers have labored tirelessly to improve our competitiveness. Yet our deficit continues to grow. Our median wages and net worth have declined for decades. Our debt has soared.

Clearly, there is something amiss with "free trade." The concept of free trade is rooted in Ricardo's principle of comparative advantage. In 1817 Ricardo hypothesized that every nation benefits when it trades what it makes best for products made best by other nations. On the surface, it seems to make sense. But is it possible that this theory is flawed in some way? Is there something that Ricardo didn't consider?

At this point, I should introduce myself. I am author of a book titled "Five Short Blasts: A New Economic Theory Exposes The Fatal Flaw in Globalization and Its Consequences for America." My theory is that, as population density rises beyond some optimum level, per capita consumption begins to decline. This occurs because, as people are forced to crowd together and conserve space, it becomes ever more impractical to own many products. Falling per capita consumption, in the face of rising productivity (per capita output, which always rises), inevitably yields rising unemployment and poverty.

This theory has huge ramifications for U.S. policy toward population management (especially immigration policy) and trade. The implications for population policy may be obvious, but why trade? It's because these effects of an excessive population density - rising unemployment and poverty - are actually imported when we attempt to engage in free trade in manufactured goods with a nation that is much more densely populated. Our economies combine. The work of manufacturing is spread evenly across the combined labor force. But, while the more densely populated nation gets free access to a healthy market, all we get in return is access to a market emaciated by over-crowding and low per capita consumption. The result is an automatic, irreversible trade deficit and loss of jobs, tantamount to economic suicide.

One need look no further than the U.S.'s trade data for proof of this effect. Using 2006 data, an in-depth analysis reveals that, of our top twenty per capita trade deficits in manufactured goods (the trade deficit divided by the population of the country in question), eighteen are with nations much more densely populated than our own. Even more revealing, if the nations of the world are divided equally around the median population density, the U.S. had a trade surplus in manufactured goods of $17 billion with the half of nations below the median population density. With the half above the median, we had a $480 billion deficit!

Our trade deficit with China is getting all of the attention these days. But, when expressed in per capita terms, our deficit with China in manufactured goods is rather unremarkable - nineteenth on the list. Our per capita deficit with other nations such as Japan, Germany, Mexico, Korea and others (all much more densely populated than the U.S.) is worse. My point is not that our deficit with China isn't a problem, but rather that it's exactly what we should have expected when we suddenly applied a trade policy that was a proven failure around the world to a country with one fifth of the world's population.

Ricardo's principle of comparative advantage is overly simplistic and flawed because it does not take into consideration this population density effect and what happens when two nations grossly disparate in population density attempt to trade freely in manufactured goods. While free trade in natural resources and free trade in manufactured goods between nations of roughly equal population density is indeed beneficial, just as Ricardo predicts, it’s a sure-fire loser when attempting to trade freely in manufactured goods with a nation with an excessive population density.

If you‘re interested in learning more about this important new economic theory, then I invite you to visit either of my web sites at or where you can read the preface, join in the blog discussion and, of course, buy the book if you like. (It's also available at

Please forgive me for the somewhat spammish nature of the previous paragraph, but I don't know how else to inject this new theory into the debate about trade without drawing attention to the book that explains the theory.

Pete Murphy
Author, "Five Short Blasts"

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In case you haven't seen it, there is a new (one week old) presentation and video from Richard Koo at CSIS. Many slides are reused from last time and I haven't had time to watch the video, but I'll be curious if it adds any significant new observations.

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rb, how big a role do you think oil imports from cantarell play in the sustainability of the mexican state? is it possible that we could actually be faced with something like a failed state on our southern border within a few years? i have to admit, in light of recent developments, i can at least imagine a situation where narco trafficking supplants government and creates an economic and political "system" in the rural areas somewhat like what one sees in colombia or the tribal areas of pakistan.

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thanks hbl -- i'm going to link it in a post for future reference.

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This is a bit radical, but how about eliminating taxes altogether? That would certainly get prices rising again. . . From what I can see the federal government is only going to take in around 60% of what it's going to spend this year--if we can't pay all of the bills why pay any?

This is a bit tongue in cheek, but the idea of eliminating taxes and allowing inflation to increase was bandied about in the past by some economists. . .

Thanks for the blog--I love reading your perspective on things.

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thank you bwdik.

in the abstract, it would produce some interesting effects! i have to think that a tax cut by itself would serve to abet the private sector deleveraging -- that is, severely crunch money supply -- while creating a need to float that much more government debt. anything done to put cash in the hands of individuals increases the private sector's ability to pay down debt and is likely to be profoundly deflationary at this stage.

on the whole, i think these things are probably best addressed slowly, not quickly. radical policy tends to produce radical side effects -- the frictional and transient effects of a no-tax/max-borrow year for the government are probably much larger than for a series of years with smaller (but still significant) changes, and potentially destabilizing at that. foreign creditors, in particular, have to be assured that americans will ultimately pay tax -- i think there's some question out there now as to whether we have the national will to pay tax or whether we're trapped in a sort of collective fantasy about our responsibilites. i'd hate at this point to indicate too convincingly that we don't want to pay, you know?

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I really don't know the extent of Mexico's dependence. It seems likely that when the global economy recovers, commodity prices will start to increase and the dollar to weaken. Tim Duy seems optimistic that unless the Fed eases policy to counteract the demand degeneration in such a situation, we cannot have an inflationary spiral. If Gregor's scenario comes to pass, that thesis will be tested.

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from perrone: gm, I've lived in Mexico for six of the last fifteen years or so, and I'm heading back this summer for (god willing) three or four more. I've lived in far flung and very different parts of that country. it has little in common with Colombia (I've lived there, too), where political institutions lack vigor and credibility and where in large swaths of the national territory the state has _never_ managed to maintain a presence. and Pakistan? Mexico has virtually nothing in common with a place like that. trust me, Mexico is about as likely to become a failed state as we are. probably less likely, even -- we can't count on the catholic church as a universal, all-encompassing national reaffirmer. but there's just so many bonds holding the Mexicans and their country together -- some of those bonds were only nascient when the Mexican revolution raged, and even that couldn't rend them.

and if you want to end drug violence and the horrendous waste of life and money from the drug war, just legalize pot and cocaine. I'll tell you, that would happen way before narcos could come close to sinking Mexico, or us.

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Mexico is about as likely to become a failed state as we are. probably less likely, even -- we can't count on the catholic church as a universal, all-encompassing national reaffirmer. but there's just so many bonds holding the Mexicans and their country together -- some of those bonds were only nascient when the Mexican revolution raged, and even that couldn't rend them.

excellent, perrone, thank you.

agreed about legalization too -- one can debate the moral case, but one cannot argue the economic one. and considering the way underworld drug manufacturing and distribution has undermined societies throughout the world, from afghanistan to the united states, where the moral imperative lies is far from clear.

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