The Sham of “Fiscal Responsibility” in Public Policy

The budgets of a government are different in nature than the budgets of a family, yet it seems that few media and political elites seem to understand this. A sovereign government can for example create more currency (which doesn’t necessarily lead to more inflation, per the quantity theory of money) for various initiatives, an option legally unavailable for personal families.

It’s official: New York Times columnist David Leonhardt pronounced the Democrats as the party of fiscal responsibility. In contrast to three of the last four Republican presidents who raised deficits with big tax cuts for the rich and increases in military spending, the last Democratic presidents sharply reduced the budget deficit during their term in office.

Leonhardt obviously intends the designation to be praise for the party, but it really shows his confusion about budget deficits and their impact on the economy. Unfortunately, this confusion is widely shared.

Contrary to what Leonhardt seems to think, the economy doesn’t get a gold star for a balanced budget or lower deficit. In fact, lower deficits can inflict devastating damage on the economy by reducing demand, leading to millions of workers needlessly unemployed.

This has a permanent cost as many of the long-term unemployed may lose their attachment to the labor market and never work again. Their children will also pay a big price as children of unemployed parent(s) tend to fare worse in life by a wide variety of measures, especially when unemployment is associated with family breakup, frequent moves and possible evictions. Also, lower levels of output will mean less investment, making the economy less productive in the future.

We actually have some basis for estimating the cost of long periods where the economy suffers from insufficient demand. If we compare the Congressional Budget Office’s (CBO) projections for potential GDP in 2018 made before the Great Recession, with their current projections, the gap is more than $2 trillion, or 10 percent of GDP.

That loss comes to more than $15,000 a year for every household in the country. In other words, the CBO’s projections imply that if we had managed to sustain high levels of demand in 2008 and subsequent years, rather than falling into a severe recession with a weak recovery, the annual income of the average household would be $15,000 a year higher.

A Lower Dollar Would Actually Reduce the Trade Deficit

It was unusual to see this issue come up as it did in the news recently.

A couple of days ago, Treasury Secretary Steven Mnuchin touched off a firestorm by saying something that is obviously true. He said that a lower-valued dollar would reduce the trade deficit.

As I pointed out yesterday, this is based on the radical concept of downward sloping demand curves. The idea is that when the dollar falls in value relative to other currencies, it makes goods and services produced in the United States cheaper for people living in other countries. This means that they will buy more of our exports.

On the other side, a lower-valued dollar means that we will pay more for imports. This means that we would buy fewer goods and services from other countries and instead buy domestically produced goods and services.

With fewer imports and more exports, we have a smaller trade deficit. It’s all pretty straightforward.

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We saw a massive increase in the trade deficit in the last decade which eventually peaked at almost 6.0 percent of GDP in 2005 and 2006. This led to the loss of millions of manufacturing jobs, decimating communities in places like Pennsylvania and Ohio.

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All of this is to say that a “strong dollar” is not just a stupid talking point. It is a really big deal with enormous economic consequences for the US and world economy. And those consequences have been very bad for large segments of the US population. Those responsible still have not owned up to this fact. (I’ll also add the little tidbit that the fact our manufacturing workers have to compete with labor in the developing world and our doctors don’t is by design, not a fact of nature. This is yet another reason why those harmed by the high dollar have reason to complain.)

China May Lessen Its Currency Manipulation Soon

The Chinese currency management done over the past several years is a significant issue because it raises the U.S. trade deficit, and a higher U.S. trade deficit — as seen in recent years — means a contribution to a shortfall in U.S. economic demand. A considerable shortfall in economic demand has hurt the majority of U.S. workers, as it means the U.S. is importing too much and exporting too little. This policy actually matters quite a bit, as its macroeconomic implications effect the voting trends in the U.S. that then have an effect on world affairs.

A NYT article told readers that investors are worried because China may stop buying and could even start selling US Treasury bonds:

“Bond markets appeared to be further spooked on Wednesday by a report that China’s central bank, which owns $1.2 trillion in United States Treasury bonds, may be poised to slow or even halt its buying of United States debt. China has total reserves of just over $3 trillion.”

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While China’s decision to stop buying, and possibly start selling US Treasury bonds, is presented as a bad thing in this piece, it is exactly what anyone who had complained about China’s currency “manipulation” (e.g. Donald Trump) would want to see. This “manipulation” (which should more accurately be called “management” since it is entirely open) involved China’s government buying US government bonds and other assets in order to prop up the dollar against the yuan.

By buying dollar-based assets, instead of selling its dollars in international currency markets, China was increasing the demand for dollars, thereby pushing up its price. If it stops and reverses this process, it will be lowering the value of the dollar relative to the yuan. This will make goods and services in the United States more competitive internationally, thereby reducing the US trade deficit.

Rather than being a hostile gesture toward the United States, this is exactly what Trump claimed he was going to make China do in his campaign. He said that he would a take a tough line with China and make it end its currency management.

It is also worth noting that if the dollar declines in the months ahead it would be the exact opposite of what most economists (including the Trump administration’s economists) had predicted as the outcome from the tax cut. They had predicted a flood of foreign investment, which would have the effect of increasing the value of the dollar and the trade deficit.