The Current Account, the Savings Rate, and One-Equation Economics

Greg Mankiw points us to something Michael Spence said:

it would be useful if we stopped pretending or alleging that China’s exchange-rate policies are the root cause of our trade deficit. If our savings rate is stubbornly stuck below our investment rate, and if China does allow its currency to revalue over time, then we will simply run a deficit with another collection of countries, and from a domestic point of view, nothing much will have changed. Except that we won’t have this subject to discuss with China anymore.

While this sounds like a few comments from certain Angrybears, Brad DeLong has an objection:

One-equation economics assumes that certain economic quantities are fixed in stone, examines one equation – usually an accounting identity – and concludes that somebody else’s preferred policies will be ineffective and counterproductive. It does so by ignoring the fact that one of the aims or effects of the somebody else’s policies will be to change the values of the economic quantities that are–by assumption and only by assumption – claimed to be fixed in stone.

This reminds me of a debate that fellow Angrybear, Steve Kyle, and I were having with Dean Baker. The real insight came for Kash where he kindly credits the following to me:

one can really think of this is a question of cause and effect (otherwise known as a chicken-or-the-egg debate). Would a cheaper dollar induce higher savings, thus bringing about the needed change to the US’s savings/investment balance that would reduce the CA deficit? Or would an improvement in US savings cause the dollar to lose value, thus inducing US exports to rise and imports to fall and thereby improving the CA deficit? Obviously, exchange rates and domestic consumption/savings behavior are both jointly and simultaneously determined. But if I had to pick one to be more exogenous, I would vote for savings behavior. I think that the US’s underlying savings/investment balance has a lot more influence over the dollar exchange rate than the other way around. Dean suggests the opposite, and specifically argues that because the weak yuan has entailed the Chinese central bank buying lots of dollars, the Chinese exchange rate policy has effectively kept interest rates low in the US, which in turn has depressed savings.

One can read the rest of Kash’s excellent discussion, which links back to where Dean takes on a couple of Angrybears.

Update: Brad Setser weighs in on this debate with a detailed review of the data as well as suggestions that the U.S. savings rate is not as exogenous as Spence, Kash, and yours truly may have argued.