The International Economy magazine (Winter 2013) asks 16 authorities, “Can Changes in Exchange Rate Valuations Affect Trade Imbalances?“   It is referring to the claim in a recent book by Stanford economist Ron McKinnon that pressure on China to let the renminbi appreciate against the dollar is fundamentally misconceived because such a movement in the exchange rate would not reduce China’s trade surplus nor American’s trade deficit.  This is part of an old debate that pre-dates the rise of the China trade problem.  Ron has long claimed that exchange rates don’t determine trade balances because they are “instead” determined by national saving versus investment.   I thought Paul Krugman demolished the argument pretty effectively 25 years ago, with a textbook graph of internal balance versus external balance.   But evidently many still fall for the argument (including some of the experts in the TIE symposium).   So I try again:

Ron McKinnon has made many important contributions to international macroeconomics over the years. But on this issue, he is simply wrong.

It goes without saying that the current account is equal to the difference between national saving and investment. But it does not follow that we should try to improve the current account in the short run by increasing national saving. Under current conditions, that would send the United States back into recession.

The national saving identity is a tautology: it does not in itself imply causation. True, many of the big movements in the U.S. current account deficit can be explained by changes in national saving: the fiscal expansion of the early 1980s, the investment boom of the late 1990s, and the new fiscal expansion of the 2000s. But the important point is that we care about a lot of things besides just external balance (the trade balance and current account). We care at least as much about internal balance (growth, employment, and inflation). To say that an increase in the budget balance and national saving would improve the trade balance does not imply that this would be good policy or that it is the only way to improve the trade balance.

Of course we need to address the budget deficit in the long run, in balanced sensible ways.  But under current circumstances — a still-weak economy, high unemployment, low inflation, rock-bottom interest rates — a reduction in public or private spending would send the economy straight back into recession. That is why the fiscal cliff of January 1, 2013, was such a danger. To observe that the trade balance would have improved if the sharp fiscal contraction had gone fully into effect would have been small consolation for the self-inflicted recession.

The U.S. trade deficit and Chinese trade surplus have diminished and so are today not quite the problems that they were five years ago. But if improving the U.S. trade balance is considered an important goal, then a devaluation or depreciation of the currency is a better tool for the job. (This proposition does not violate the national saving propositions. Nor, on the other hand, does it justify China-bashing.) Because a real devaluation would also raise demand for U.S. products — admittedly with a lag — and thus move us closer to internal balance, it would be a far more appropriate tool for improving the current account under present-day conditions than would cutting national spending or raising taxes.

    
      In 2008, the global financial system was grievously infected by so-called toxic assets originating in the United States.  As a result of the crisis, many have asked what fundamental rethinking will be necessary to save macroeconomic theory.  Some answers may lie with models that have in the past been applied to fit the realities of emerging markets — models that are at home with the financial market imperfections that have now unexpectedly turned up in industrialized countries.  The imperfections include default risk, asymmetric information, incentive incompatibility, procyclicality of capital flows, procyclicality of fiscal policy, imperfect property rights, and other flawed institutions.   To be sure, many of these theories had been first constructed in the context of industrialized economies, but they had not become mainstream there.   Only in the context of less advanced economies were the imperfections undeniable.  There the models thrived.     
 

     An analogy can capture the apparently novel suggestion that emerging markets may have important lessons for advanced countries.   In the latter part of the nineteenth century most of the vineyards of Europe were destroyed by the microscopic aphid Phylloxera vastatrix. Eventually a desperate last resort was tried: grafting susceptible European vines onto resistant American root stock.   Purist French vintners initially disdained a strategy that they considered would compromise the refined tastes of their grape varieties. But it saved the European vineyards, and did not impair the quality of the wine. The New World had come to the rescue of the Old World.

     The academic literature on macroeconomics and finance in developing countries hardly existed 30 years ago.  But by now it has grown very large — large enough to deserve a survey of its own.  I review much of this research in a survey titled “Monetary Policy in Emerging Markets.”  It appears as a chapter in the Handbook of Monetary Economics, edited by Ben Friedman and Michael Woodford, which has just this week become available from Elsevier Publishing.   Among the hundreds of authors represented in the survey are Caballero, Calvo, Dooley, Dornbusch, Edwards, Reinhart and Velasco, as well as many younger scholars.  Again, although financial opening gave capital flows a central role in the emerging market models, the need to allow for imperfections in these markets has always been clear.   It is also what gives the models so much relevance today, not just for theory but for policy as well.   Raghu Rajan and Simon Johnson point out that some of the institutional failings that we associate with financial sectors in developing countries, such as distorted incentives and undue political influence, also apply to the United States and other advanced countries.  Among other areas of economic policy where the North could draw useful lessons from small countries in the South as to how to address the problems, in earlier blogposts I have given the example of the procedures that Chile has used over the past decade to achieve countercyclical fiscal policy.  

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