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Monday, December 19, 2011

Hiding Behind Links

A recent email prompts me to explain something.

I post lots of excerpts from articles about economics, but one thing you can't read at this site is the stuff I write for other outlets, instead I mostly link (e.g. the links to CBS, The Economist, and FDL from the last day or so in the posts below, and there will be a link to a column tomorrow).

I should explain the reason, because it may not be what you think. It's not an attempt to send traffic to the other sites. It's because I am one of those people who never, ever thinks the things they write are any good. Thus, when I'm done with a piece I never think it is good enough to post here. So I try to hide behind links. And sometimes, I don't even link (occasionally I find the courage to post things, but mostly I don't, and I can hardly read the comments when I do).

Deep down I hope you'll click through and not hate what you read, and it's always a big relief when the response is positive. That keeps me going. But I always fear otherwise -- that the dumb-ass of the day award is surely coming my way (perhaps for this post).

Anyway, because of the email I thought I should explain why I mostly link to my own stuff instead of highlighting it on my site. It's just me and my silly self-consciousness -- me thinking my stuff isn't good enough to post on my site.

Against my better judgement, here are the two posts I linked to earlier today:


Will the economy turn around in 2012?, by Mark Thoma, CBS News [link]

(Federal Reserve Bank of San Francisco)

(MoneyWatch) With the latest sightings of green shoots in the economy, it's natural to ask how long it will be until the economy recovers. Is an acceleration in economic activity just around the corner? Are we anywhere near the end of the long road back to a more normal economy?

UCLA's Edward Leamer provides a nice summary of the typical way in which the economy exits from a recession. The first and most important two sectors to pick up after a recession are housing construction and household consumption. Once the recovery is fully underway, business investment picks up as well, but that doesn't happen until housing and consumption lead the way.

The problem we face is that the sectors that generally lead us out of a recession are the sectors that were most damaged from the collapse of the housing bubble and the subsequent recession. Housing construction is unlikely to increase anytime soon, and households are still struggling to pay off their debt, debt that was made worse by the unemployment, stock crash, and housing price crash that came with the recession. (The automobile sector is also important in recoveries, but the signs there aren't any better.)

Recessions have different causes, and some types of recessions are easier to recover from than others. An increase in oil prices or an interest-rate hike by the Federal Reserve can be reversed quickly, and the recovery time is generally relatively fast. But as Carmen Reinhart and Kenneth Rogoff explain in their book This Time is Different, recessions that are caused by financial collapses are among the most difficult to recover from. When this type of a recession hits an economy, lost decades are not at all unusual.

Unfortunately for us, both housing markets and household balance sheets were severely damaged by the recession, and repairing them will take time. Housing values remain depressed with no sign of a robust recovery in sight, and households continue with the debt deleveraging process. Neither sector seems poised to lift us out of the doldrums in the near future.

These two graphs give a good indication of where things currently stand:

Is there anything else that could lead us out of the recession? Recall that aggregate demand is the sum of household, business, government, and foreign demand for our goods and services. As just noted, households are in no position to help, businesses -- including housing construction -- are also unlikely to provide the needed boost, so what about government and the foreign sector? Can they provide the needed demand? We certainly can't expect expansionary policy from government, if anything the size of government will contract, and with all the uncertainties in Europe the foreign sector is not the answer either. The Fed is another potential source of help, but it's given little reason to expect it will take additional steps to try to simulate the economy.

In short, no matter which sector you point to, government, business, households, or foreigners, there is little reason to expect the large increase in demand needed to drive an economic recovery. Things are looking better, and the green shoots might just be real this time around, but we are still a long, long way from returning to whatever our new normal might be.


Persistent trade gaps leave economies vulnerable, by Mark Thoma, The Economist [link]

A country that runs a current account deficit is borrowing money from the rest of the world. As with any loan, that money will need to be paid back at some point in the future.

The cost of these loans is the interest that must be paid, and any vulnerabilities to speculative attacks that come with them. But so long the benefits from the investment of the borrowed money exceed the costs, then there is no reason to be concerned about running a deficit. The profits from the loans will be more than sufficient to pay back the interest and principle.

There is another reason a country might want to run a current account deficit. For example, if there is a recession from, say, unexpected bad weather wiping out crops, a country may wish to borrow from foreigners in order to smooth output and avoid a large drop in consumption. As Krugman and Obstfeld note in their discussion of this topic in International Economics: Theory and Policy (6th ed.), "In the absence of this borrowing, the price of present output in terms of future output would be higher in the low-output country than abroad, so the intertemporal trade that eliminates this price differential leads to mutual gains."

Thus, it should be clear that trade deficits, at least on a temporary basis, are justified in many instances. Insisting that trade is balanced at all points in time would give up the opportunity to pursue profitable investment and to stabilise the economy during bad times.

However, although current conditions may justify a deficit, conditions can change rapidly—this is a lesson many countries in the euro have relearned recently—and when they do it can be difficult to adjust the current account quickly enough to avoid problems. This is why governments tend to avoid large and persistent current account deficits.

For one, large and persistent deficits may signal that a government has not been careful to invest the money it borrowed wisely. If the loans are used to fund extravagant spending by the powerful within the country and do nothing to raise productive capacity, then it will be difficult for the country to repay the money it has borrowed. Even with the best intentions, i.e. money borrowed to fund infrastructure projects, projections of the benefits are often overly inflated and when the reality hits—when the projects fail to deliver the promised benefits—countries can find themselves with debts that exceed their ability to meet their obligations. Once it becomes clear to financial markets that a country is headed for default, creditors become reluctant to lend to it driving interest rates up, and this brings on the speculators who can then drive the country's financial system to collapse.

What about large and persistent surpluses, are they safe? If the money is invested wisely, yes, but it can put a substantial fraction of a county's wealth at risk. If those who borrowed from you don't pay off, the wealth could be lost. In addition, countries that run a large surplus are often accused rightly or wrongly of following protectionist policies, and they face the potential for retaliatory action. However, for the most part a surplus is more acceptable than a deficit.

There are reasons to run an unbalanced trade account in the short-run, and a fairly large deficit can be justified if the money is being put to good use. The investments pay for themselves through the benefits they bring. But when the a trade deficit is large and persistent, it's generally a sign that the money is not being used productively and that at some point the country will not be able to meet its obligations. The loans may continue to be available in the short-run as interest rates rise and creditors are compensated for the risk they are taking—if you expect default in two years there is money to be make in the intervening period. But if the debts continue to pile up, at some point markets will say enough is enough and the end can come suddenly and swiftly as the loans needed to finance the deficit are no longer available.

    Posted by on Monday, December 19, 2011 at 12:24 PM in Economics | Permalink  Comments (30)


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