Home > The Economics Profession, The Economy > Trade Flows and Currency Values for the G-20

Trade Flows and Currency Values for the G-20

from Dean Baker

It would be great if the leaders of the G-20 countries knew a little economics. It might make their meetings more productive and less confrontational.

The central area of dispute at the recently concluded meeting was the decision by the Federal Reserve Board to engage in another round of quantitative easing (QE2). This is intended to boost growth by pushing down long-term interest rates. 

Lower interest rates will boost consumption by allowing people to refinance their mortgage and will also induce additional investment. QE2 will also likely have the effect of lowering the value of the dollar as investors sell dollars in search of higher returns in euros, yuan and other currencies. This fact seemed to unite the rest of the G-20 in their anger at the United States. 

There were numerous lectures coming from various countries that the United States was taking the easy way out. The argument was that the United States should be correcting its over-spending by reducing its budget deficit. The G-19 argued that this was better than trying to increase growth by using a lower-valued currency to reduce its trade deficit.

Suppose the U.S. did what the G-19 urged and quickly reduced its budget deficit. Suppose that it immediately closed its budget deficit by raising taxes by 5 percentage points of GDP and cutting spending by 5 percentage points of GDP. (We’ll ignore for now the fact that the plunge in GDP would add to the deficit.) Would the G-19 then be happy?

If we saw rapid reductions in the U.S. budget deficit then we would expect to see a substantial drop in U.S. GDP. If GDP falls, then U.S. imports will fall. This means that exports from China, Brazil and other countries will drop and workers in these countries will lose jobs. This is the primary effect that would be expected from a sharp decline in the U.S. budget deficit.

But, this is only the first part of the story. The second part of the story is the part that the advocates of fiscal austerity emphasize. A lower budget deficit should lead to lower interest rates, even if the impact will be small in the current environment. Lower interest rates will in turn spur growth in the United States by allowing people to refinance their mortgages, inducing more investment, and causing the dollar to drop and thereby improving the trade balance.

What do you know? We’re back at a lower valued dollar leading to an improvement in the U.S. trade balance.

It is difficult to imagine what economic theory the QE2 critics in the G-19 could possibly have in their heads. The United States was running large trade deficits in the years following the East Asian financial crisis in 1997. These deficits were caused by a large real appreciation in the value of the dollar against the currencies of the region and most other world currencies.

This should not have happened. In the textbook theory, rich countries like the United States and Germany are supposed to be exporters of capital. On this point it is worth distinguishing the trade surplus of Germany from the trade surplus of China. Germany is a rich country with a stagnant or shrinking labor force. We would expect Germany to be an exporter of capital. China on the other hand is a very rapidly growing developing country in which capital gets a very high rate of return. The textbook economics says that China should be an importer of capital, not a huge exporter.

The blame for this anomaly goes beyond China. The punitive measures that the IMF imposed on the East Asian countries during their financial crisis, under the direction of the Rubin-Summers Treasury, made developing countries fearful of accumulating debt.

The response of the East Asian countries and the developing world in general was to shift to a pattern of trade in which they build up huge surpluses so that they need never worry about being forced to beg the IMF for a bailout. This meant deliberately keeping currencies under-valued so that their exports would enjoy a competitive advantage.

This pattern of trade created in the wake of the East Asian financial crisis should be reversed, but there is no plausible way to get from here to there that does not involve a decline in the value of the dollar. In the system of floating exchange rates that is how trade adjusts. If the G-19 are unhappy about the necessary decline in the dollar then they are not upset with the United States, the Fed and QE2, there are upset with the logic of economics. There is not much that President Obama or anyone else can do to help them on that score.


See article on original website

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of False Profits: Recovering from the Bubble Economy. He also has a blog, “Beat the Press,” where he discusses the media’s coverage of economic issues.

  1. November 16, 2010 at 3:31 pm

    QE does not do what it says on the tin. It will either inflate asset prices (harming the US economy) and/or increase the carry trade (harming the BRIC economies). See http://michael-hudson.com/2010/11/american-monetary-institute-presentation/

  2. antonio garrido
    November 16, 2010 at 4:58 pm

    If, whatever the cause,the public deficit evaporate (ie. is cero), then, as a matter of accounting, the internal private net savings should be the same as the external (ie. the current account of the balance of payments).The question is Which one will bear the adjustment? (probably both), and at what level?

  3. Ramon Garcia Fernandez
    November 16, 2010 at 9:05 pm

    Dean Baker’s analysis is very interesting. I completely agree that the solution is not to cut the deficit of the government of the USA. I wonder, however, if he is not overoptimistic in two respects: 1)Is there much room to grow “by pushing down long-term interest rates”? Aren’t we near a kind of a liquidity trap? 2) Is it realistic to imagine that “lower interest rates will boost consumption by allowing people to refinance their mortgage and will also induce additional investment”? I would also consider the (stronger)possibility that this money does not reach the American poor or the people needing to refinance their mortgages, nor they will be used for new investment in the USA, but that these dollars wil be used by Wall Street to buy assets abroad and lead to a further appreciation of the rest of the currencies against the dollar, creating asset bubbles in other countries.

  4. Jorge Buzaglo
    November 17, 2010 at 2:05 pm

    I think that most countries, when they criticise US budget deficits, point in fact diplomatically to the military spending of one trillion dollars (half of total federal spending and half of global military spending), which largely explain in turn the big trade deficits and the huge external and internal debts. That is, US military spending amounts to the single most important global structural distortion. It is of course a most grievous distortion for the US itself, a parasitic and sterile system which has drained its productive force in desperate military adventures, instead of building a modern, just, green economy.
    The discussions in the G-20 and elsewhere reflect a diluting US hegemony and conflicting economic interests; interests that find expression in different economic-ideological explanatory frameworks and arguments. It is surprising to see Mr. Baker parting company with the orthodox when he says that his economics is the only valid. “Western” economists must understand that we are not in Kansas any more. Mr. Baker’s economic ideology is one of many possible, and it reflects — surprisingly again — the interests of one particular, dominant nation-state. We should transcend parochial/national approaches.

  5. Adhip Chaudhuri
    November 18, 2010 at 8:05 pm

    Just for Dean Baker’s information, the Prime Minister of India, Mr. Manmohan Singh, was a professor of International Finance at the Delhi School of Economics for two decades or so. He has a Ph.D. in Economics from Cambridge University, U.K.

    I do agree with Dean Baker’s analysis.

    On a slightly different topic, I also believe that China is literally looting a chunk of the United States’ GDP by keeping the Renminbi grossly undervalued.

  6. Jorge Buzaglo
    November 23, 2010 at 6:21 pm

    Sorry for the mistake above, when I wrote “It is surprising to see Mr. Baker parting company with the orthodox …” I meant to say: “It is surprising to see Mr. Baker sharing the attitude of the orthodox when he says that his economics is the only valid.”

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