links for 2007-11-22
Hoisted from Comments: Low-Tech Cyclist Watches the Utterly Disgusting Fecklessness of the Washington Post

Richard Baldwin on Martin Feldstein’s View of the Dollar

Baldwin writes:

Feldstein’s view on the dollar | vox - Research-based policy analysis and commentary from Europe's leading economists: In a May 2007 essay, Martin Feldstein argued that a drop in US mortgage refinancing would raise US personal saving and this would necessitate a fall in the dollar. That’s looking pretty good at the moment.... Something that stumps every undergraduate, and not a few PhD economists, is how a nation’s trade deficit, or more precisely, its current account deficit can be two things at once: #1) The gap between national investment and national savings, and #2) the difference between exports and imports. This is not a ‘can be’ relationship; it is a ‘must be’.

Number two requires no explanation; it’s just a definition. Number one follows from a line or two of national-accounts algebra. A nation’s aggregate purchase of goods is the sum of what its public and private sectors spend on consumption and investment. Its aggregate sales of goods equal the value of what its public and private sectors produce and this, in turn, is its aggregate income. Plainly, the difference between a nation’s spending and earning must be its trade balance with the rest of the world; if its aggregate purchases exceed its production/income, then some foreign goods must, on net, be coming in to satisfy the excess demand. Finally, since income must be either consumed or saved, the spending-earning gap is also the investment-saving gap; consumption cancels from both sides of the equation.

Feldstein makes a bold simplification that helps him to think clearly about the messy world. He takes US savings and investment as primitives and views the value of the dollar as the variable that adjusts to make things fit. As he writes it: “This line of reasoning leads us to the low level of the U.S. saving rate as the primary cause of the high level of the dollar.”... The US’s net purchase of foreign goods is predetermined by its savings/investment gap and the dollar must jump to make people happy buying and supply the necessary net flow of foreign goods.... The real explanation comes in understanding why US savings was so low relative to its investment.

Feldstein focuses on personal savings. “Two primary forces have been driving down the household saving rate,” he wrote, “increasing wealth and, more recently, mortgage refinancing.”... Feldstein not only calls the dollar’s drop, he links it to developments in the US housing market. True, his logic did not lead him to predict the subprime crisis, but that is more a matter of how, not what.... The rest of the essay discusses why the foreign exchange market didn’t anticipate the adjustment that Feldstein said must occur. His reasons are less remarkable – Asian official intervention and myopic investors....

Feldstein... also considers... that the whole thing could unwind.... “The primary risk... is that the decline of the dollar and the rise of the saving rate will happen at different speeds, leading to domestic imbalances.”... If the US saving rate rises without a dollar drop, there is no narrowing of the trade gap to offset the closing saving/investment gap. Aggregate demand falls and we get a US recession... “the domestic weakness will occur unless the dollar decline precedes the rise in saving.”

Put that way, it sounds paradoxical. It seems better to phrase it thus:

The domestic U.S. recession will occur unless the fall in the dollar and the boom in exports preceded the cutback in consumption spending...

For a rise in savings is a fall in consumption spending.