Imagine a miracle occurs and this Congress cuts government purchases by $110 billion and does not further erode net taxes. This would shave 17.8% off the General Fund deficit ($618 billion for the fiscal year ending 10/31/2004). Would it also reduce the $618 billion trade deficit by $100 billion? Not according to the simulation of the DGE model (SIGMA) from Chris Erceg, Luca Guerrieri, and Chris Gust:
Our salient finding is that a fiscal deficit has a relatively small effect on the U.S. trade balance, irrespective of whether the source is a spending increase or tax cut. In our benchmark calibration, we find that a rise in the fiscal deficit of one percentage point of GDP induces the trade balance to deteriorate by less than 0.2 percentage point of GDP. Noticeably larger effects are only likely to be elicited under implausibly high values of the short-run trade price elasticity.
Given that their model seems to absolve responsibility for the large current account deficit away from Bush’s fiscal stimulus, the authors suggest other factors for the enormous deficit may be at work, which not unexpectedly was noticed by Daniel Drezner last weekend. Also noticing this paper were Brad DeLong and David Altig.
Any reduced form coefficient such as this notion that a $110 billion rise in government purchases only lowers net exports by $22 billion is as much a product of the structural form itself as it is the parameters of the structural form, such as price elasticity. Those of us who grew up on Mundell’s IS-LM modeling some 40 years ago might have suggested to our students that regardless of whether price elasticity is very high or not – that two propositions follow from his Keynesian model with flexible exchange rates: (1) foreign demand shocks so impact exchange rates that there are no net impacts on the trade balance; and (2) fiscal stimulus completely crowds-out net exports if capital mobility is perfect.
So how do Erceg, Guerrieri, and Gust arrive at what they note “may appear surprising”? We must remember that Mundell’s results appeared surprising at first until economists understand the implications of how he modeled asset markets. In Mundell’s model, the Central Bank maintained a fixed money supply in the face of an IS shock, the economy was small relative to a large world financial market, and capital was internationally mobile. While the Erceg, Guerrieri, and Gust model does not have these Mundellian features, the model implicit in Glenn Hubbard’s writings for the Bush CEA on why fiscal stimulus does not raise interest rates were premised on Mundellian thinking.
It is interesting that the public policy debate is centered on whether the tax cuts can be made permanent and not on short-run Keynesian thinking. To the degree that fiscal stimulus raises the sum of government purchases and consumption – it must completely crowd-out the sum of net exports and investment. Hubbard was suggesting that little of this crowding-out would be in the form of investment, which implies most of it would be in the form of net exports. If John Taylor wants to dismiss extensive net export crowding-out, he is implicitly saying that most of it will be in the form of investment crowding-out.