Saturday, June 12, 2010

The World in Decession, Analytical Version

. Saturday, June 12, 2010

While Brad de Long (and everyone else) beats up on Will, let me say what Will would have said had he not been wasting his time watching soccer games that fail to produce either goals or victors.

Paul Krugman took a break from his bicycle tour to voice concern about the direction of global economic policy and the global economic recovery. His post raises three distinct issues:

  1. The nascent global recovery is stalling.
  2. Germany (the EU generally) is playing a beggar-thy-neighbor (BTN) strategy, counting on US as consumer of last resort to offset the negative impulse of fiscal consolidation.
  3. China is playing a BTN strategy by manipulating its currency.

Krugman suggests that the US should threaten to impose anti-dumping duties to induce Germany and China to change policy. He does not indicate whether he believes the US should follow through on this threat if Germany and China fail to alter their policy. Nor does he indicate the likelihood that Germany and China will change policy in response to the threat and therefore the odds that the US would have to follow through on the threat. Should we endorse this policy recommendation?

  1. This policy is more likely to generate an outcome we do not want than an outcome we do want.
    1. Would following through on the threat make the United States worse off or better off than the status quo? A world in which the US protects and everyone else contracts is the 1930s. This seems worse than the status quo.
    2. Would the US threat to impose AD duties be credible, given that implementing the threat would make the US worse off than the status quo? I think the answer here is “No.”
    3. If the threat is not credible, would Germany and China change policy in response? No, they would not change policy in response (see point 3 below for elaboration).
    4. Do we want the US to follow through on its threat, thereby worsening an already bad situation when it fails to induce policy change in Germany and China? I do not want this.
    5. Thus, a threat to impose protection seems unlikely to generate a good outcome and quite likely to generate a bad outcome. Hence, I don’t think this is a good policy option.
  2. Although it is not a good option, it may still be the best option. So, does a better option exist?
    1. Can the US ease the magnitude of the slowdown in the EU’s economic recovery by acting as consumer of last resort? Why yes, it can.
    2. Does US consumption from the EU help sustain economic recovery in the United States? I believe the logic of circular flow would suggest that it does. Maybe I am mistaken.
    3. If exports generate growth, would EU governments become more or less concerned about their fiscal position? I believe they would be less concerned.
    4. Does playing consumer of last resort cost the US anything? The interest rate on the debt from the marginal current account deficit. Maybe there are other costs? Perhaps we lose jobs that might otherwise have been created in a world in which Germany expands and China revalues. But that world does not exist and cannot be brought into existence (see “1” above) and thus isn’t a relevant point of comparison. We lose the opportunity to establish a commitment to no longer be the consumer of last resort?
  3. Why do German politics generate an obsession with austerity that makes it highly unlikely that threats will induce policy change?
    1. History—hyperinflation, great depression, political instability, Hitler.
    2. Postwar success rested on the single-minded focus on what is right for Germany (see 1978/79 (Bonn Summit); macroeconomic policy coordination during the late 1980s (remember October 1987?); the 1991-92 EMS crisis; etc.). These episodes have revealed Germany to be quite skeptical of American policy coordination initiatives.
    3. Germany risked its postwar achievements by pooling monetary authority and is now discovering that legal prohibitions on fiscal bailouts in EMU are not credible.
    4. Recognizing that Germany’s implied fiscal burden is Greece + Spain + Portugal + Italy + Ireland + ….
    5. Given this, what is the probability that Germany changes its mind in response to the threat to impose AD duties? Zero.

Would it be nice to have a coordinated global fiscal stimulus? Sure, but trying to bring this about by threatening to blow up the world and then being put into a position where you have to choose between actually blowing up the world and backing down seems ill-considered.


Anonymous said...

prof. oatley:

your tone is much better than Will's, and your post is much more enlightening than his. In my eyes, however, this post hurts you in a number of ways:

1.) sounds like you are his mentor, which means that you haven't done a good job socializing him about proper blogosphere etiquette and what the academe is mostly about: publishing papers. Where are his publications?
2.) professors should let their grad students stand up for themselves. students don't grow when professors do their work for them. Let Will defend himself.
3.) it's disingenuous (and thus lacking in scientific standards) for you to claim that what you wrote is "what Will would have said" without giving us any evidence for why this would be the case. Looking at Will's previous posts, this claim seems highly implausible.

Thomas Oatley said...

Thanks Anon; re point 3, I actually intended that phrase as a slap at rather than a defense of Will. Perhaps I should have written "should have" than would have. Sorry that it lacked clarity.

As for defending Will, that wasn't my goal. Apologies again for lack of clarity. My goal is to defend the blog as a place I would like people to visit. I leave it to Will to defend his thoughts.

As for mentoring, well, all I can say is, sometimes it occurs in public.

dm301060 said...
This comment has been removed by the author.
dm301060 said...

Dear Mr.Oatley,

Kudos for making the analysis in a simple but crystal clear way. With respect to the three broad issues discussed, I fully agree with the first one ("We shouldn't endorse Krugman's policy recommendation") and partly agree with the third one ("reasons underlying German behavior"). But I'm afraid I don't buy the second point.

Essentially, if I understand you correctly, you are making an argument based on the following assumptions. First, the United States should resume playing "the consumer of the last resort." Second, US consumption would help Europe's economic recovery and allay some of their fiscal concerns. Third, this might stimulate economic activity in America. Fourth, playing the consumer of the last resort has only marginal costs.

Granted, the argument is intriguing. But the more I think about it, the less convinced I'm about its feasibility.

To begin with, it would be a huge understatement to say that the United States is reluctant to resume playing the consumer of the last resort. Washington is furious that China and the Europeans aren't doing their bit to shoulder the burden of global rebalancing. Indeed, China refuses to revalue the renminbi and the Europeans - led by Germany - have embarked on fiscal austerity in the midst of high unemployment and anemic growth prospects. Understandably, the United States is reluctant to bear the brunt of correcting global imbalances alone.

Furthermore, even if we assume that Americans tacitly agree to play the consumer of the last resort, I doubt that the Europeans would gain significantly. China and other Asian exporters are more likely to get a bigger chunk of the pie.

Also, even if we assume that the Europeans might draw some benefit from US consumption, distributive concerns would emerge. Ironically, only Europe's surplus countries (e.g. Germany, Netherland, and so on) benefit from the current depreciation of the euro. The deficit countries (e.g. the PIGS), instead, don't gain much from the lower value of the common currency, because most of their trade is intra-European. All this suggests that higher US consumption is highly unlikely to help Europe's deficit countries grow out of their alarming fiscal predicament.

The assumption that the United States playing the consumer of the last resort would help solving both Europe's and its own problems is a beguiling idea, but in fact it's potentially only a delusion.

Even more importantly, asking the Americans to resume their borrowing and consumption binge is deeply problematic. Indeed, I see it as the ultimate form of moral hazard. The Chinese and the Europeans would infer the lesson that they don't have to get their house in order so long as the Americans continue with their proligate ways. The US consumer of the last resort is to China and Europe what the government safety net is for big banks. As the severe financial and economic crisis has painfully showed, this incentive system is patently flawed and hardly sustainable.

In sum, resuming the role of the consumer of the last resort would only exacerbate US problems, and this in turn would threaten to derail the timid economic recovery. The search for a better paradigm for global economic growth continues.

The World in Decession, Analytical Version
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