Economics and the mid-life crisis have much in common: Both dwell on foregone opportunities

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Thursday, January 06, 2005

U.S. Goods and Services Trade Deficits

Many of us take great delight in teaching students that so long as we can exchange coloured pieces of paper, which are really cheap to produce (even with the holograms), for other countries' goods and services, that's a pretty neat deal.

Unfortunately it is also a short-run confidence game, in more ways than one. If people in other countries, and especially their central banks, decide they no longer want to hold our pieces of paper or our IOUs, then the exchange value of these pieces of paper will drop, and we won't be able to get as much for them in the future.

I don't know if the U.S. has reached that stage, yet, but I'd be pretty nervous if I were a central banker in some other country, sitting on tonnes of U.S. t-bills. I'd want to start liquidating or at least diversifying that position. This seems to be the view, too, of John Quiggen in "The Unsustainability of U.S. Trade Deficits", which is in the latest roundup of articles in The Economists' Voice from Berkeley Electronic Press.
However it takes place, the consequences of a rapid loss of confidence will follow a pattern familiar from a broad range of recent financial crises in countries including Mexico, Thailand and Argentina. Interest rates will increase, and access to credit will be reduced. Heavily indebted households and businesses will face severe distress and will be forced to reduce consumption and employment, or perhaps face bankruptcy or liquidation.

These processes will reduce aggregate consumption, and therefore the demand for imports. In this way, the trade account will be returned to balance, but with a sharp reduction in aggregate activity and a corresponding increase in unemployment and business failure.

Concluding Comments
It is inevitable that the U.S. trade account will return to balance, and likely that most of this adjustment will take place within the next ten years. The only question for policy is whether the adjustment will be relatively smooth, like the process which resolved the first U.S. trade deficit blowout in the 1980s, or sharp and costly, as in the case of the many countries that experienced financial crises in the 1990s.

It isn't a pretty picture, and the role of U.S. gubmnt fiscal deficits in this is touched on only briefly. To read more about the current account and why the U.S. deficit is not indefinitely sustainable, check out the links provided here by The Marginal Revolution.
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