Friday, March 31, 2006

Is the U.S. Trade Deficit a Problem?

An important issue facing the U.S. economy today is the trade deficit. There are at least three points of view among professional economists about the trade deficit and the associated inflow of capital that the United States has experienced in recent years.

One point of view suggests that the trade deficit is no big deal. If Japan were to start buying large quantities of steel, lumber, glass, and furniture from the United States, we would call that an export and our trade deficit would shrink. But if instead Japanese investors buy office buildings in New York made of American steel, lumber, glass, and furniture, that purchase is a capital account transaction. Because there no reason to prefer that Japanese buyers take delivery of their steel, lumber, glass, and furniture in Tokyo rather than New York, one can argue that we shouldn’t be terribly concerned about the trade deficit.

As far as I can tell, this is close to the view that Ben Bernanke has expressed when he suggested that the U.S. trade deficit reflects a “global saving glut.” With so much saving in the rest of the world, it is natural that foreigners would want to invest some of that saving in the United States rather than on their own shores. And there is no particular reason that we should object to their doing so. (A similar view is expressed in this article by economist Donald Boudreaux.)

A second point of view is that the trade deficit and the accompanying capital inflows are a problem because they are a financial crisis waiting to happen. Paul Krugman has pushed this perspective in his New York Times column. More than two years ago (January 6, 2004), Krugman wrote:

"The traditional immunity of advanced countries like America to third-world-style financial crises isn't a birthright. Financial markets give us the benefit of the doubt only because they believe in our political maturity — in the willingness of our leaders to do what is necessary to rein in deficits, paying a political cost if necessary….If this kind of fecklessness goes on, investors will eventually conclude that America has turned into a third world country, and start to treat it like one. And the results for the U.S. economy won't be pretty."

In essence, Krugman is saying that we risk a hard landing of sudden capital flight. Of course, this catastrophe scenario hasn’t materialized, lending some credibility to the Bernanke “What-me-worry?” hypothesis. The nice thing about such crisis predictions, however, is that they are probabilistic, so Paul would surely just say we’ve been lucky—so far.

My own view of the trade deficit and capital inflows is somewhere between Bernanke’s and Krugman’s. I don’t rule out the Krugman financial crisis scenario, although I would bet against it. In fact, I am betting against it in my personal portfolio, where I am happily holding U.S. equities and dollar-denominated bonds. But I am not quite as sanguine as Bernanke has been.


The Chinese Exchange Rate

An ec 10 student draws my attention to a recent editorial in the NY Times about the Chinese exchange rate. Here is an extract:

Mr. Schumer Goes to China

The good news is that Senators Lindsey Graham and Charles Schumer have started to inch away from their misguided attempt to club China for its currency policies. At the end of a fact-finding trip last week, Mr. Schumer told reporters he was no longer sure he would push for a vote to impose tariffs on Chinese imports into the United States....

China clearly needs a more flexible currency, both for the sake of trade relations and to gain more control over its economy. But moving the yuan could cause pain in the United States. America's lack of savings is the biggest contributor to global imbalances, making it necessary to "import" billions of dollars of foreign capital daily to cover budget and trade deficits. China is America's second-most-important lender, after Japan.

The student asks for some clarification about this issue. As it turns out, I have recently written a case study on exactly this topic for the new edition of my intermediate macroeconomics textbook, which is due for publication in about a month. I happy to share a sneak preview with you:

Case Study
The Chinese Currency Controversy

From 1995 to 2005 the Chinese currency, the yuan, was pegged to the dollar at an exchange rate of 8.28 yuan per U.S. dollar. In other words, the Chinese central bank stood ready to buy and sell yuan at this price. This policy of fixing the exchange rate was combined with a policy of restricting international capital flows. Chinese citizens were not allowed to convert their savings into dollars or Euros and invest abroad.

Many observers believed that by the early 2000s, the yuan was significantly undervalued. They suggested that if the yuan were allowed to float, it would increase in value relative to the dollar. The evidence in favor of this hypothesis was that to maintain the fixed exchange rate, China was accumulating large dollar reserves. That is, the Chinese central bank had to supply yuan and demand dollars in foreign-exchange markets to keep the yuan at the pegged level. If this intervention in the currency market ceased, the yuan would rise in value compared to the dollar.

The pegged yuan became a contentious political issue in the United States. U.S. producers that competed against Chinese imports complained that the undervalued yuan made Chinese goods cheaper, putting the U.S. producers at a disadvantage. (Of course, U.S. consumers benefited from inexpensive imports, but in the politics of international trade, producers usually shout louder than consumers.) In response to these concerns, President Bush called on China to let its currency float. Charles Schumer, Senator from New York, proposed a more drastic step— a tariff of 27.5 percent on Chinese imports until China adjusted the value of its currency.

In July 2005 China announced that it would move in the direction of a floating exchange rate. Under the new policy, it would still intervene in foreign-exchange markets to prevent large and sudden movements in the exchange rate, but it would permit gradual changes. Moreover, it would judge the value of the yuan not just relative to the dollar but relative to a broad basket of currencies. Five months later, the exchange rate had moved to 8.08 yuan per dollar—a 2.4 percent appreciation of the yuan, far smaller than the 20 to 30 percent that Senator Schumer and other China critics were looking for.

Was the yuan really undervalued by such a large amount? To answer this question, we must first ask, compared to what? The critics of Chinese policy may well have been correct that the yuan would have appreciated substantially if the Chinese had stopped intervening in foreign-exchange markets while keeping their other policies the same. But a movement to a fully floating exchange rate could well have been coupled with a movement toward free capital mobility. If so, the currency implications could have been very different, as many Chinese citizens might have tried to move some of their savings abroad. While the central bank would no longer have been demanding dollars to fix the exchange rate, private investors would have been demanding dollars to add U.S. assets to their own portfolios. In this case, the change in policy could well have caused the yuan to depreciate rather than appreciate.

As this book was going to press, it was unclear whether China would continue on the path toward a floating exchange rate and freer capital mobility. The issue remains a topic of intense international negotiation.

The Economics of Obesity

The new NBER Digest is out, covering these topics:

(1) Economic Explanations of Increased Obesity
(2) Medicare and Its Impact
(3) Is There a Housing Bubble?
(4) What Undermines Aid's Impact on Growth?
(5) The Effects of Communism on Popular Preferences

Here is the skinny on obesity:

The authors...note that technological change has reduced the amount of physical effort that people expend in their jobs, and that "the ready availability of inexpensive restaurants has not only caused people to consume more, but has made them less active - less likely to prepare food at home or travel further distances to obtain a healthy meal." The cigarette tax and smoking prohibition laws are included to account for the possibility that the increase in U.S. BMI may be related to the success of public health efforts to decrease smoking. When people quit smoking they often gain weight.

Two lessons:
1. People respond to incentives. When gaining weight is cheaper, people gain more weight.
2. Government policies can have unintended consequences.

Question for ec 10 students: What do you think about a "fat tax" to encourage healthier eating? Feel free to post your opinion in the comments section.

The State of the Labor Market

The U.S. unemployment rate is now low by historical standards. Is this because the economy is operating near capacity or because so many workers are discouraged that they have given up looking for a job? The Fed staff has an answer. Here is an excerpt from an article in today's Wall Street Journal.

Fed Analysts Say Low Jobless Rate Doesn't Mask Labor Market Woes

U.S. unemployment really is low and the jobless rate hasn't been artificially depressed by a failure of many discouraged workers to be counted as unemployed, Federal Reserve researchers say....

The study wades into a controversy over the failure of more people to seek work since the recession ended in 2001. The "participation rate" -- the proportion of working-age people working or looking for work -- peaked at 67.3% in 2000, fell to 65.8% in March 2005, and has since recovered to 66.1%, below where it stood for most of the 1990s.

Some economists argue the low participation rate means many people aren't seeking work because they believe no desirable work is available and aren't counted as unemployed....The latest Fed report disagrees.

"The low level of the participation rate is not artificially masking the extent of unemployment," said the study by Fed staff economists Stephanie Aaronson, Bruce Fallick, Andrew Figura, Jonathan Pingle and William Wascher.


The labor-force participation rate may well continue to trend downward over the coming decade, as the baby-boom generation starts to retire in greater numbers.

Update: You can find the Fed study here.

Thursday, March 30, 2006

Corruption as an Impediment to Economic Growth

When we studied long-run economic growth and development in ec 10 a few weeks ago, we discussed how corruption is one of the factors holding back many poor countries. One person studying this issue is Ben Olken, a junior fellow at Harvard and recent graduate of the Harvard PhD program. Here is a summary of his work in Indonesia, excerpted from a recent article in The Economist:

Some of the World Bank money allocated to village infrastructure ends up greasing palms not smoothing gravel. But how much? In a remarkable study backed by the bank, Ben Olken, of Harvard University, dug deep into the sand and stone to find out. He reports the gap between what a village claims it spent on a road, and what he and his engineers reckon the road really cost. They left little to guesswork. To discover prices and wages, they surveyed quarries, labourers, truckdrivers and suppliers. To get a fix on quantities, they dug holes in the roads, taking a sample of the material that had gone into their construction. And then they built their own “test roads”, to find out what it cost to do the job properly.

Mr Olken calculates that on average 28% of reported spending went missing, mostly because roadbuilders skimped on materials. (Not all of the gap can be put down to venality, though: some of the gravel, for example, was probably worn away.) Thanks to his measure of corruption, Mr Olken can weigh up different strategies to fight it.

He reaches an unfashionable conclusion. The bank puts great store by “empowering” the poor to keep their officials honest. In Indonesia, villages must hold public hearings before they get the second and third slices of their money. In a random sample of villages, Mr Olken tried to stir up a bit of Tocquevillean spirit (“Town meetings are to liberty what primary schools are to science...they teach men how to use and how to enjoy it”) by sending out hundreds of invitations to villagers to attend the public hearings. His efforts raised attendance, but this had little measurable effect on corruption.

For all its romantic appeal, monitoring by villagers suffers from a free-rider problem. If your neighbour keeps a beady eye on road spending, you can benefit from his vigilance without making an effort yourself. Why, then, should you bother? But by the same logic, why should he?

Mr Olken puts his faith in a less fashionable ally: auditors. A group of villages, chosen at random, were told that they would be audited at the end of the project. This threat reduced missing expenditures by about eight percentage points, to 20% or so.

The Economics of the Iraq War

Can economics shed light on whether the Iraq War was a good policy decision? Economists tend to think that economics can shed light on almost all policy decisions. After all, aren't almost all policy decisions about comparing costs and benefits? And isn't that what economics is all about?

Several economists have taken this perspective and written about the Iraq War. In today's NY Times, Princeton economist Alan Krueger provides a summary. Here is an excerpt:

"The Chicago economists [Steven J. Davis, Kevin M. Murphy and Robert H. Topel] argue that anticipated improvements in Iraq's living standard, once the country stabilizes, tip the balance in favor of invasion over containment, which in their view had costs that were "in the same ballpark." They also argue that the number of Iraqi fatalities since the invasion is probably no greater than would have been the case under Mr. Hussein.

"But even if one accepts all of their estimates, their results implicitly raise another question: Why intervene in Iraq and not a country like Sudan, where genocide and oppression are at least as much an affront as they were in Iraq, and where the cost of intervention and prospects for improving lives may offer a better benefit-to-cost ratio than is likely in Iraq?"

If you want to pursue this topic further, note that Chicago economist Gary Becker has recently written about the Iraq war on his blog here, as has his legal scholar co-blogger Richard Posner here.

If you really want to pursue this topic further, you can delve into the longer, more comprehensive studies. One of the first from 2002 was by Yale economist William Nordhaus, which you can find here. The Chicago study by Davis, Murphy, and Topel, updated in February 2006, can be found here.

A study by Linda Bilmes of Harvard and Joseph Stiglitz of Columbia can be found here. The Bilmes-Stiglitz study got a lot of media attention, such as this article, because it estimated the cost of the war could exceed $2 trillion. Krueger and Becker both discuss this study, often critically. Here is what Krueger says about the Bilmes-Stiglitz estimate:

"This is arguably too high for several reasons. First, it counts future interest payments on the debt created by military spending as well as the direct expenditures. (This is analogous to counting both the sale price of a house and the cost of future mortgage payments as the cost of buying the house.) Second, it counts elevated military recruitment costs that incorporate a premium for higher risk of death or injury because of the war as well as the predicted direct cost of the deaths and injuries; this is double counting if the risk premium is adequate. Finally, it ascribes a big increase in the price of oil to the war, and, as a result, a loss to the American economy of almost half a trillion dollars."

In the end, are we any closer to answering the question of whether the Iraq War was a good policy decision? In my view, one cannot help but agree that the subtitle of the Krueger article captures the essence of the problem: Imponderables Meet Uncertainties.

Wednesday, March 29, 2006

Problems in France

More on what's happening in France. You can read Richard Posner here, Gary Becker here, and Robert Samuelson here. Samuelson starts as follows:

To anyone who cares about Europe's future, the French demonstrations and street riots protesting the government's new labor law must be profoundly disturbing. It's the French against France -- a familiar ritual that mirrors Europe's larger predicament. Hardly anyone wants to surrender the benefits and protections of today's generous welfare state, but the fierce attachment to these costly and self-defeating programs prevents Europe from preparing for a future that, though it may be deplored, is inevitable. Actually, it's not the future; it's the present.

The dilemma of advanced democracies, including the United States, is that they've made more promises than they can keep. Their political commitments outstrip the economy's capacity to deliver. Sometimes the commitments were made dishonestly. Sometimes they were made sincerely based on foolish assumptions. Sometimes they've been overtaken by new circumstances. No matter. The dilemma is the same. To disavow past promises incites public furor; not to disavow them worsens the country's future problems.

Laffer Redux

How relevant is the Laffer curve to the current debate over fiscal policy? Economist Bruce Bartlett gives his answer in this article.

Kinsley on Billionaires and Adam Smith

One of the ec 10 teaching fellows recommends this article in Slate. Michael Kinsley asks, What motivates billionaires?, and in the process offers this summary of basic economics:

Even in its most primitive form, the invisible hand is a brilliant explanation of what motivates most of us, and how our efforts serve the common good. We work to produce things that can be traded for things we want. That trade makes us better off than we would be if we made everything we consume ourselves. The first exchange of one caveman's dinosaur meat for another's rather attractive decorative rock started a process that, after millions of years, leads to DVD players at Wal-Mart that cost less than DVDs. Or something like that.
By the way, Kinsley was an economics major at Harvard (and also editor of the Crimson).

Tuesday, March 28, 2006

French Unemployment

Economist Paul Romer examines unemployment among the young in France. Click here for his analysis.

Drug Reimportation

My colleague Jeff Miron calls attention in his blog to a Boston Globe article, indicating that the US government is stepping up enforcement of the ban on drug reimportation. The issue: Should Americans be allowed to buy prescription drugs in Canada, where they are often less expensive? Under current law, the answer is no. Jeff, who has a libertarian prespective, thinks the ban is unjustifiable.

But the free-market perspective does not yield an easy answer here. Free-market economists believe the government should enforce private contracts. Imagine that drug companies sold inexpensive drugs to Canada with the contract provision that they not be resold to the United States. One could then argue that the government should help the drug companies enforce that contract. But isn't that in effect what the ban on reimportation does? So perhaps one can justify it as a part of the governmental job of enforcing private contracts. (That is the essentially the argument made by legal scholar Richard Epstein.)

Suppose we weren't talking about Canada (which has low drug prices largely because of price controls) but instead we were talking about Africa. Suppose a drug company offered an AIDS drug to a poor African country at slightly above marginal cost. (This is much below the US price, which includes a markup due to the monopoly power granted by the patent). Should American AIDS patients be allowed to buy the drug in Africa and bring it back to the United States? Jeff would say yes. But if policymakers followed this advice, arbitrage would prevent the drug company from price discriminating. A single price (or approximately so) would have to prevail worldwide. The result: The drug company wouldn't offer the low-cost drug to the poor African country.

Remember what we learned in the fall in ec 10: Price discrimination can sometimes make goods available to more consumers and increase the efficiency of market allocations. Nonetheless, those consumers who end up paying more than average can easily see the situation as unfair, which is what is happening with the issue of drug reimportation.

Question to think about: Should the U.S. government set up legal institutions that facilitate or impede international price discrimination?

Conflict-of-interest alert: Like drugs, textbooks are sold for different prices in different countries, and publishers make great effort to avoid the natural arbitrage. So, perhaps, I am not completely objective about this issue.

Federal Reserve Communication

Monetary policy under the new Fed Chairman Ben Bernanke will probably not be very different than it was under Alan Greenspan, but the way the Fed communicates about its policy may change substantially over time. The Washington Post has a good article today on the topic by Nell Henderson. Here is an excerpt:

The Fed's Bright Idea

Federal Reserve officials will conclude their policymaking meeting today by carrying on a practice that former chairman Alan Greenspan began as a radical innovation 12 years ago. They will tell the world what they have decided to do with short-term interest rates.

And if the Fed's new chairman, Ben S. Bernanke, has his way, central bank officials also will agree today to explore several possible ways to publicly communicate much more in the future about how they view the economy, the inflationary risks and the likely path of interest rates.

"Under Chairman Greenspan, [Fed] policy has become increasingly transparent to the public and the financial markets, a trend that I strongly support," Bernanke told Congress at his confirmation hearing in November. "I expect going forward to look for other opportunities to increase the transparency of the Federal Reserve."...

"Being opaque came naturally to [Greenspan], that's just the way he is," [economist Alan] Blinder said in a recent interview. "Being more open and clear comes naturally to Ben, and I expect we'll see that continue."

To Blinder, for example, the FOMC's last statement reflected Greenspan's style -- cryptic, coded and generally impenetrable to a normal person. In contrast, he predicted one of the first acts of the Bernanke Fed will be to "adopt English as its official language. That itself would be a positive step."

Question for ec 10 students: What is the right amount of openness for policymakers, such as those at the Fed? Neither extreme (complete secrecy or webcams at every meeting) seems desirable. How do you strike the right balance?

Monday, March 27, 2006

The Welfare State and Immigration

Economist Paul Krugman takes on the difficult question of immigration in his NY Times column today. One of the hardest issues is highlighted by the contrast between these two passages:

1. "[M]odern America is a welfare state, even if our social safety net has more holes in it than it should -- and low-skill immigrants threaten to unravel that safety net. Basic decency requires that we provide immigrants, once they're here, with essential health care, education for their children, and more."

2. "What are we going to do about it? Realistically, we'll need to reduce the inflow of low-skill immigrants. "

Krugman seems to be saying that basic decency requires being generous to poor immigrants, but that moral imperative in turn requires that we force them to stay in their home country, where they are even poorer. Yossarian would appreciate that logic.

Here is how economist Gary Becker resolves the dilemma: "I am attracted by a policy that allows illegal immigrants to come, but denies them eligibility for any government assistance."

Question for ec 10 students: How should American policymakers take into account the welfare of unskilled workers abroad? Does "basic decency" require us to do more once they cross the border into our country? Do the requirements of "basic decency" stop at the border, so we can wash 0ur hands of their suffering by keeping them out? Political philosopher Michael Sandel might know the answer to these questions, but economists are struggling with them.

Update: Economist David Friedman offers his thoughts on this topic.

Does the Stock Market Prefer Democrats or Republicans?

Economist Jeremy Siegel reports:

On the afternoon of Election Day, November 2, 2004, exit poll numbers were released from both Florida and Ohio that suggested Kerry was doing much better than expected. If the Democrats took Ohio or Florida, electoral math made it very difficult for Bush to win.

Immediately upon the release of Kerry's supposed success, there was a sell-off in stocks. The Dow Industrials, which were up strongly early in the day, plunged about 100 points when the polls were released. But in the evening, the exit polls proved wrong, and Bush was the clear victor. The following day stocks made up all the lost ground and then some.

But, Siegel points out, this reaction may be historically atypical:

Despite the behavior of the market during the last Presidential election, over longer periods of time, the stock market has done significantly better under Democratic administrations....Since 1948, Republican Administrations have controlled the White House 57.2 percent of the time. But during the period that the GOP was in office, stock returns have averaged only 9.53 percent per year, while under Democratic administrations, stocks returned 15.25 percent per year, more than five percentage points higher.

You can read more here:

Wages, Productivity, and Inequality

Greg Ip reports on recent trends in wages, productivity, and inequality in today's Wall Street Journal:

Wages Fail to Keep Pace With Productivity Increases, Aggravating Income Inequality

Since the end of 2000, gross domestic product per person in the U.S. has expanded 8.4%, adjusted for inflation, but the average weekly wage has edged down 0.3%.

That contrast goes a long way in explaining why many Americans tell pollsters they don't believe the Bush administration when it trumpets the economy's strength. What is behind the divergence? And what will change it?

Some factors aren't in dispute. Since the end of the recession of 2001, a lot of the growth in GDP per person -- that is, productivity -- has gone to profits, not wages. This reflects workers' lack of bargaining power in the face of high unemployment and companies' use of cost-cutting technology. Since 2000, labor's share of GDP, or the total value of goods and services produced in the nation, has fallen to 57% from 58% while profits' share has risen to almost 9% from 6%. (The remainder goes to interest, rent and other items.)

The Bush administration's defenders, and many private economists, say wages are bound to catch up. "Everything we know about economics and historical experience is that when productivity goes up, real wages go up, too," says Phillip Swagel, a scholar at the conservative American Enterprise Institute who worked in the Bush White House. It took a couple of years for wages to catch up with accelerating productivity in the late 1990s, he says. "This time, it's taking three, maybe four or five."

Another factor holding down wages is that employer-paid health benefits, pensions and payroll taxes have risen almost 16% since 2000, making employers less generous with wages.

In addition, it appears that the highest-salaried workers -- executives, managers and professionals -- are widening their lead on the typical worker....

Many economists predict that with the U.S. unemployment rate below 5% now, workers will regain their leverage. Indeed, wages have picked up recently.

Still, wage inequality may continue to rise. Lawrence Katz, an economist at Harvard University who worked in the Clinton administration, says the wage gap has been growing for the past 25 years, particularly between the top and the middle. He believes the biggest factor is technology, which has complemented the skills of the well-educated while rendering redundant routine skills of many in the middle.

Question for Ec 10 students: According to the neoclassical theory of distribution, real wages depend on productivity. What is the relevant measure of wages for this theory--cash wages or total compensation (cash wages plus fringe benefits)? Which is the better measure of economic well-being? According to neoclassical theory, if the cost of fringe benefits rises, holding other things constant, what happens to compensation and cash wages?

Sunday, March 26, 2006

SNL economics

One of my students writes me:

Hi Professor Mankiw,
During Saturday Night Live tonight this highly Ec10 relevant sketch appeared:
I thought it was pretty funny.

Yes, I thought it was funny, too.

Update: Sorry, the video is gone.

Bus Drivers Respond to Incentives

People respond to incentives--a basic principle of economics. Austan Goolsbee provides a good example here:

An excerpt:

Companies in Chile pay bus drivers one of two ways: either by the hour or by the passenger. Paying by the passenger leads to significantly shorter delays. Give them incentives, and drivers start acting like regular people do. They take shortcuts when the traffic is bad. They take shorter meal breaks and bathroom breaks. They want to get on the road and pick up more passengers as quickly as they can. In short, their productivity increases.

Artificial Intelligence

My colleague Ken Rogoff says that chess-playing computers may tell us something about the economy of the 21st century:

Artificial Intelligence and Globalization
Kenneth Rogoff

Today’s conventional wisdom is that the rise of India and China will be the single biggest factor driving global jobs and wages over the twenty-first century. High-wage workers in rich countries can expect to see their competitive advantage steadily eroded by competition from capable and fiercely hard-working competitors in Asia, Latin America, and maybe even some day Africa.

This is a good story, full of human drama and power politics. But I wonder whether, even within the next few decades, another factor will influence our work lives even more: the exponential rise of applications of artificial intelligence.

My portal to the world of artificial intelligence is a narrow one: the more than 500-year-old game of chess. You may not care a whit about chess, long regarded as the ultimate intellectual sport. But the stunning developments coming out of the chess world during the past decade should still command your attention.

Continue reading here:

Opinion vs Pedagogy

The goal of this blog is primarily pedagogical. As a result, I will spend less time offering my personal opinions than do other bloggers. I do, however, write opinion pieces from time to time, and I usually post these on my Harvard website. My most recent piece, from the Wall Street Journal, can be found here:,filter.all/pub_detail.asp

Although this blog will sometimes lapse into self-promotion (as I just did), I will try to keep it to a minimum. I will, however, often link to other economists' opinion pieces, if they have pedagogical value.


This blog is an experiment, primarily aimed at interacting with students in Ec 10, the large introductory economics class that I teach at Harvard. Other students and teachers using my textbooks may find it of interest as well. Its main role will be to direct students to interesting articles with the goal of enhancing their study of economics. I had previously been doing this for my students via email, but I thought that a blog would be more convenient for them, and it would allow others to access it as well.