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Watch Carefully, Grasshopper...

The fear is that the large current U.S. trade deficit--$800 billion a year or do, 6% of GDP plus--is setting us up for a possible big financial crisis. Large trade deficits, the argument goes, don't stay large for long periods of time. When they shrink, they often shrink because of (a) sharp currency declines or (b) deep recessions.

CEA Chair Eddie Lazear uses misdirection to try to calm this fear. And he manages to snooker Greg Mankiw--which is, as a rule, quite hard to do.

Greg writes:

Greg Mankiw's Blog: Lazear on the Trade Deficit: CEA Chair Eddie Lazear testified at the Joint Economic Committee today. An interesting excerpt:

I would like to point out the historic record suggests that countries can be in a current-account deficit or a surplus situation for very long periods of time. New Zealand and Australia have had deficits for decades. Australia in particular has been running a current account deficit that has created a level of foreign indebtedness equal to about 72 percent of their GDP, whereas our foreign indebtedness was only about 21 percent of GDP in 2004 (most recent available published data). Yet, the Australian economy has been very strong and growing at robust rates over the past decades. Australia's real GDP has grown at an average rate of 3.5 percent over the last decade.

Note that Eddie is not saying that a country can run a very large trade deficit "for very long periods of time... decades.... Australia in particular..." He is saying that a country can run a very large current-account deficit--the sum of the trade deficit plus the net flow of income payments on net domestically-owned capital located abroad. Australia has a large current account deficit: 5.9% of GDP. Australia has a relatively small trade deficit: 1.9% of GDP. The difference--4% of Australian GDP--is the net flow of interest, dividends, and retained earnings that Australia pays to foreign owners of Australia-located capital.

Why does this matter? Let me turn the microphone over to the excellent John Quiggin:

The Economists' Voice: John Quiggin, University of Queensland: [M]uch analysis confuses the current account deficit and the goods and services deficit.... A number of countries — notably Australia and New Zealand — have run current account deficits of this magnitude for years.... This has led some commentators to suppose that the present U.S. position can be sustained indefinitely. But as time passes and income payments owed to foreigners mount, the current account deficit will become larger than the goods and services deficit. In order to have a stable current account deficit, a country must run a goods and services surplus to keep its net foreign debt from growing faster than GDP.... A substantial current account deficit can continue indefinitely. A substantial goods and services deficit cannot, because it generates an exploding current account deficit.... The U.S. current account deficit must be stabilized relative to GDP, and this means that the goods and services account must sooner or later return to balance or surplus. But what will the adjustment process look like?... Any significant reduction in the [trade deficit]... appears likely to require very large changes in market prices or U.S. income levels...

Let's back up. What's going on here? Eddie Lazear and his political masters hope that listeners will take Eddie's (correct) statement that countries can run large current-account deficits for a long time, infer (incorrectly) that the large U.S. trade deficit can also be sustained for a long time, and conclude that there is today little reason to fear that the U.S. trade deficit might trigger a macroeconomic catastrophe.

Did it work? Yes--at least on Greg Mankiw. For the title of Greg Mankiw's post is "Lazear on the Trade Deficit." Not "Lazear on the Current Account Deficit." Lazear says the current account deficit can continue for a long time. Mankiw hears him to be saying that the trade deficit can continue for a long time. The statement Lazear says is true. The statement Mankiw hears is false.

Pay close attention, Grasshopper. See the misdirection? Watch carefully, and you too might grow up to be Chair of the Council of Economic Advisers under a Republican president...