I think the following is a sensible statement:
It would also be more constructive if the United States took responsibility for its part in international imbalances. An undervalued yuan is only one aspect, allowing China to sell its goods cheaply and amass huge savings in the process. Another is the United States’ federal budget deficits – which result in large part from serial tax cuts – requiring America to borrow from China and other foreign lenders.
Dean Baker does not:
While this argument can be a convenient weapon against the Bush administration deficits, it doesn’t make a great deal of sense. First, the numbers don’t add up. We’re looking at budget deficits of around $250 billion and trade deficits of close to $800 billion. There is no economic theory that will explain how a $250 billion budget deficit can cause an $800 billion trade deficit. (You’re welcome to add in the $200 billion borrowed from Social Security, and it still does not come close to adding up.) Then we need a mechanism. High budget deficits are supposed to cause high interest rates. But U.S. interest rates are low by historical standards. With inflation around 3.0 percent, we should expect to see an interest rate on the ten-year treasury bill of close to 6.0 percent. Instead, it is just over 5.0 percent. Of course, the high interest rate is supposed to be what attracts foreign investors to put money in the U.S., which in turn drives up the value of the dollar. This is always the immediate cause of the trade deficit. People buy foreign produced goods at Wal-Mart because they are cheap, not because the U.S. is running a budget deficit. Anyhow, the NYT should find more legitimate grounds for bashing Bush’s budget policy. The trade deficit is a first and foremost a dollar problem, requiring a dollar solution (which will not be pretty). It is not a budget deficit problem.
Where do I and Dean disagree? I would have started with his use of the unified deficit rather than the general fund deficit – but Dean already notes the Social Security surplus. But I see this more of a comparative static exercise rather than an accounting exercise. If the move to fiscal irresponsibility lowered national savings, it would tend to lead to higher real interest rates. But that does not mean that real interest rates would necessarily be double digit or whatever. After all, we endured a global inward shift of investment demand a few years back.
Is Dean saying that exchange rates are exogenous? I would hope he would concede that an increase in our national savings rate would tend to devalue the dollar. OK, certain foreign nations (including China) are basically pegging their currencies to the dollar. Maybe we would prefer that these nations return to a floating exchange rate policy. But as long as these nations save more than they investment and we save virtually nothing – we will be running current account deficits with real exchange rate adjusting to insure as much.
Update: Dean Baker comments, which is always appreciated. His comment reminded me of something that Kash said:
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.
On this one – I agree with Kash.