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.

The Queen of England during the summer asked economists why no one had predicted the credit crunch and recession.   Paul Krugman points out that, inasmuch as economists can almost never predict the timing of recessions (and don’t claim to be able to), the real questions are worse.  The real questions are, rather how macroeconomists (most) could have gotten it so wrong as to believe that:
(i) a severe recession was not even looming ahead as a potential danger, and
(ii) a breakdown of many of the world’s most liquid financial markets, in New York and London, was impossible to imagine.

To anyone wondering about these questions, I recommend Krugman’s essay in the New York Times Sunday magazine, September 6:  “How Did Economists Get it So Wrong?” .
I think his diagnosis of the state of macroeconomic theory for the last 30 years has it right. 

I would only add that he is modest in skipping over one point:  during Japan’s lost decade of growth in the 1990s Paul himself forcefully drew from the Japanese experience the implication that a severe economic breakdown was, after all, possible in a modern industrialized economy – a breakdown that outside the ken of modern macroeconomic theory and was reminiscent of the Great Depression.   But macroeconomics went on as before.   (Likewise with the stock market correction of 1987, the LTCM crisis of 1998, and the dotcom bust of 2000-01.   I do think, however, that our field did a better job with the emerging market crises of 1994-2001, in part because it was considered permissible to argue that financial markets in this case were highly imperfect.)

The list of scholarly economists who in my view deserve kudos for getting important parts of the crisis right ahead of time also includes, among others:

• Robert Shiller – for declaring most visibly that the housing boom was a bubble,
• Ned Gramlich — for pointing out most assiduously that families were being persuaded to take out mortgages that weren’t good for them,
• Ragu Rajan — for diagnosing most accurately the problems of skewed incentives and excessive leverage in the financial system,
• Claudio Borio and Bill White at the BIS — for seeing most presciently the dangers of a monetary policy that ignored asset bubbles,
• Ken Rogoff, for warning most pithily ”This time is not different,” and
• Nouriel Roubini – for forecasting  most fortissimo how serious a future meltdown was likely to be.

Returning to Krugman’s NYT article, even the caricature drawings are good…  except that I have never seen Olivier Blanchard in a double-breasted suit.    But Robert Lucas definitely merits a place there as a leader of the orthodoxy:   When given one page in a recent  Economist essay to defend “freshwater” economic theorists regarding the crisis, he actually thought it was a useful rebuttal to point out that critics are repeating arguments they have made before.  And he also thought it was useful to explain:  “The term “efficient” as used here means that individuals use information in their own private interest. It has nothing to do with socially desirable pricing; people often confuse the two.”  — As if it is not the latter question that the public is wondering about.

(For other economists’ reactions to the Krugman piece, see the National Journal site.)

 [Any reader wishing to make comments on this post is referred to the RGE version.]

Secretary Tim Geithner announced today the long-awaited details on the financial repair plan that he promised on February 10.   Some reactions have been negative, both from the left and the right.  Paul Krugman, for example, argues that the plan does not go far enough in forcing banks to recognize the fallen value of their assets.  

But the stock market was “dazzled“ by Geithner’s explanation of the PPIP proposal, with prices up strongly.    The  plan has no shortage of defenders.  Brad DeLong makes some good points, and responds to Krugman.   The Geithner Plan is an improvement over the Paulson plan in that when ”toxic assets,” now called “legacy assets,” are bought from the banks, their prices are set by private bidding (from hedge funds and private equity companies), rather than by an overworked Treasury official pulling a number out of the air and risking that the taxpayer grossly overpays for the assets.   On similar grounds, Nouriel Roubini has surprised the cynics by giving (qualified) support for the plan, and points out that its design appears to follow a recent proposal by my Harvard colleage Lucien Bebchuk.  

Joe Stiglitz, who attacks the Administration’s proposal, offhandedly mentions “It has allowed the administration to avoid going back to Congress” to ask for more money “and it provided a way to avoid nationalization,” as if these were not key advantages for those who have to work in the real political world.  It is true that we might end up with some form of temporary bank nationalization before we are done.  And it is also true that the lesson from Roosevelt’s strategy in 1933, from the slower response to the Saving and Loan problems in the late 1980s, and from Japan’s much more delayed response to its banking disaster of the 1990s, is that biting the bullet early saves even greater expense later.  But as Alan Blinder says, it matters which bullet you bite.  He points out some neglected counter-arguments to the nationalization strategy that is newly beloved of academic critics.  It would be hard to enforce a clear drawing of the line as to which banks would be taken over.   Furthermore — even with the necessary wiping out of bank shareholders — (i) the word “nationalization” would likely violate a political constraint, while (ii) making good on the banks’ outstanding obligations would likely violate the government’s budget constraint.

My feeling is: the Geithner plan deserves to be given a chance.  I discussed it on NPR’s On Point this morning.   Some of the callers evinced the anger that the American public understandably feels against the financial sector and the understandable pain of the recession.   I made an analogy with 9/11/01, when understandable anger and pain led the American public to support presidential policies that made things worse rather then better — the invasion of an irrelevant country, plus big tax cuts for the rich — consequences that we are still living with today.   In the current crisis,it is important that the anger be channeled in directions that will make things better rather than worse.

[Readers wishing to post comments should go to the RGE Monitor version.]

The Yale Book of Quotations provides a useful service: It tabulates well-known sound-bites, but tries to get the exact quote and citation right, which is rare.    (P.T. Barnum in fact never said “There is a sucker born every minute.”    Richard Nixon never said “But it would be wrong.” Etc.)  The editor also compiles an annual list of Top Ten Quotes of the Year.   In the second week of December he released the list for 2008.  Number 1, for example, is “I can see Russia from my house” (carefully attributed to the Tina Fey parody rather than precisely what Sarah Palin originally said).

The good news is that the title line in my blogpost of July 17 was chosen as one of the top ten quotes of 2008 (tied for tenth place, it is true).    The sentence is: “If there are no atheists in foxholes, there are no libertarians in financial crises.”     The bad news is that the quote was attributed to Paul Krugman, who had used it subsequently on the Bill Maher Show.   I had originally written it in 2007 as the first line of an article in a Cato Journal issue devoted to financial crises.  Among the others who picked up on the line after my blogpost were Ben Bernanke,  Mark Shields, Bloomberg,  WSJ.com, Brad deLong, and Tom Keene – generally with attribution, when the format permitted.

The list of Top Ten Quotations of 2008 went out over AP on December 15 as it was, and appeared in lots of newspaper stories and TV broadcasts.  Krugman immediately set the record straight on his blog, as I knew he would.   AP sent out a correction on December 22.    It should be obvious that this is not a scandal of any sort and that Krugman is just as quotable as he ever was.
  

But there are some other, more interesting, aspects.

One is an illustration of how tough is the world in which highly visible columnists like Krugman live.   There are lots of Krugman-haters out there.  Of course the phenomenon originates in the fact that he consistently has been liberal and anti-Bush (not precisely the same thing).  But the antipathy goes very deep.    The Yale/AP list was originally called to my attention by one Joel West.   I told him I was indebted to him for pointing out the misattribution.   But I also told him that I was sure that there had been no desire on Paul’s part to steal my line:  TV shows like Bill Maher don’t customarily allow their guests to display footnotes.     But Mr.West must be one of the Krugman-haters, because his subsequent blogpost accused Krugman of dishonesty.   As had another Krugman-hating blogpost before that.   These people are eager for ammunition against someone of a different ideological persuasion and are not sufficiently discriminating about what they use.

Ironically, of the other two soundbites that share tenth place on the Yale/AP list with the atheists-libertarians quote, one is something else attributed to Krugman (“Cash for trash”), and the third is from the all-time champion Krugman-hater, Donald Luskin.   Luskin earned the Top Ten honor when quoted as saying “Anyone who says we’re in a recession, or heading into one — especially the worst one since the Great Depression — is making up his own private definition of “`recession’”  in the Washington Post, September 14.    This was of course after a huge fraction of economic commentators and the public had already decided that the country was probably in recession, as now turns out indeed to have been the case.   (I myself took a bit of grief on various blogs both for saying the “R word” too early and also for saying it too late.  But I have also gotten credit.)

The atheists-and-libertarians line itself has also drawn some grief from some atheists and libertarians, on various blogsites.   I don’t mean to put these two philosophies together (although that would be an interesting essay question on some exam).  Nor is it the case that either group is objecting to being associated with the other.   But both have pointed out that the statement is not literally true.   They are entirely correct:  There are plenty of atheists in the military;  and there are plenty of libertarians in a financial crisis.  But of course the statement did not literally mean there are no atheists in foxholes or libertarians in financial crises.  The claims are, rather, that on average:  (i) soldiers under fire tend suddenly to grow more religious in outlook, and (ii) policy-makers facing a financial crisis tend suddenly to grow more interventionist in outlook.    But, yes, there really are conscientious atheists in foxholes.   They are a minority, but a substantial one.   And yes there really are thoughtful libertarians in financial crises.  Again a minority, but not to be dismissed.   If anything, I admire the intellectual consistency of those who have thought through their views well enough ahead of time that they do not change them under pressure from events that, even if calamitous, were predictable. 

I wish to add my heart-felt approval to many others, regarding the awarding of the Nobel Prize in Economics to Paul Krugman.  For those readers of the New York Times who can only think of him as a columnist, let me assure you that long before he ever wrote a newspaper opinion piece, Krugman had become the leading international economist of my generation.  I leave it to others to explain the trade theory research that earned the ultimate accolade.  I will only say that (together with Elhanan Helpman) Krugman took traditional trade theory – which ever since David Ricardo had assumed perfect competition, constant returns to scale, and unchanging technology – and made it more realistic by assuming imperfect competition, increasing returns to scale, and endogenous technology.  

Paul was my classmate in graduate school at MIT in the mid-1970s.    In 1974 I departed my idyllic undergraduate institution for life in the big city (academically speaking).  My college mentor had given me some final words of advice:  not to waste much time worrying about how a position near the top of my undergraduate class would translate to the MIT Economics Department, where all the students had been at the top of their class.  He said,  “My impression is that within a few months of starting the graduate program, the students sort out for themselves who is the top student, the second student, and so on, and then they don’t worry about it from then on.”    As it turned out, it only took two weeks for us to figure out that Paul was the star of the class.   This was clear, not so much from grades on problem sets, but from the intense discussion among classmates that is the core of a good graduate program.

When it came time to write a class skit at the annual MIT Christmas party, we did a parody of the Wizard of Oz.   There was no question who should play the Wizard, who was a parody of Paul Samuelson: our own Paul.    Here are some of his lines, from 34 years ago:

“Though I made a lot of money

No one thought my jokes were funny

‘Til I won the Nobel Prize…”

“So you see you can be winners

even though you are just beginners

When you win your Nobel Prize.”

Congratulations, Paul.   We always knew you would do it !