The 1993 Turnaround

1. SavingsDeficitsLinks between the Domestic and the International SectorsEcon 102Winter 2001Mr. Smitka

2. The 1993 Turnaround

3. Structural Balances up, tooThe Government is Saving

4. Interest as a share of the budget

5. Wealth & Consumption

6. Consumption is up sharply

7. Investment & Saving

8. Govt, Personal & Corp Saving

9. Domestic & Foreign Savings

10. If everyone is consuming ... • Then where do we get the goods? • (T-G) was negative • (S-I) is negative • So C is high • But I is also high • AS - real GDP - can’t expand overnight • Can all of this happen simultaneously? • What gives?? … inflation?

11. S-I arithmetic • Y = C + I + G + X - M • C = Y - T - S (“S” is private savings) (“T” taxes net of transfers) • Substituting: Y = Y - T - S + I + G + X - M • Rearranging: 0 = (I + G + X) - (T + S + M) • leakages equal injections • Or: (T-G) + (S-I) + (M-X) = 0

12. (T-G) + (S-I) + (M-X) = 0 • Govt savings (T-G)plus • Private savings (S-I) plus • Foreign savings (M-X) total to zero • all money goes somewhere! • But these also represent the flows of real goods and services • If the government raises taxes it forces us to cut C and frees resources for G

13. Case Study: 1980s US • Initial change: Reagonomics • Lower taxes • Increase G (“Star Wars”), don’t cut elsewhere • Let transfers continue their increasing trend (rising health care costs & an aging population) • Despite “voodoo economics” claims during the primaries, this did increase budget deficits • the initial deficits were due to recession, not Reagan & the Democratic Congress that passed his budget • remember “structural” vs “cyclical” deficits

14. Federal Deficits & Surpluses

15. DIGRESSIONFood for thought • Today is different, but partly for cyclical reasons • Will “W” push the “voodoo economics” against which his father campaigned in 1979-80? • Missile defense • Big tax cuts • Hands-off social security, other budget items

16. The 1993 Turnaround

17. So we borrowed a bit ... • Well, $5.6 trillion, mostly under Reagan and Bush Sr. • So what? • Selling lots of bonds drives down prices • That’s the same as driving up interest rates • Or ... (the textbook’s version) • A tax cut stimulates the economy, driving up Y and hence MD and hence “r”

18. Nominal Interest Rates

19. Short-term interest rates (pink)-- as deviation from average --

20. Real Interest Rates-- deviation from trend (black line) --

21. Now what might happen? • We started out the 1980s in balance(T-G) + (S-I) + (M-X) = 0 0 0 0 • Bit deficits (T-G) threw us out of balance ==> how adjust? • Economists expected “crowding out” (T-G) + (S-I) + (M-X) = 0 -- ++ 0 • Impossible to “buy” growth absent AS shifts • No “flex” anticipated on the intl side

22. But in fact ... • Real interest rates rose • Attracting foreign capital • And if everyone buys US$ their price rises • We ended up with a very strong dollar

23. Forex Rates“real” is adjusted for movements against many currencies and for inflation rates

24. Reflecting ... • Large capital inflows • The US went from being the world’s banker ===> • To the biggest customer of the world’s banks • All during a period of just 8 years

25. Capital Flowsfrom creditor to debtor

26. Money flows … and goods? • The strong dollar made imports cheap • US trade moved to big deficits • These deficits however let us keep growing • If used for investment, future growth will let us keep our creditors happy without tightening our belts • If used for consumption….. • Which do you think is the case? (check data!)

27. US Trade, 1900-2000Historically - until the 1980s - we ran trade surpluses

28. But others must adjust, too! • If we “want” to run a deficit and borrow from abroad • Others must “want” to run surpluses and lend overseas • In fact, Japan and Germany both suffered from surplus savings • They avoided the paradox of thrift • We could have our cake (I) and eat it too (C)

29. International Savings (CA) Balances-- Europe and Japan offset the US -- Current Account Balance (Percent of GDP ) 1977- 1980- 1983- 1986- 1989- 1979 1982 1985 1988 1991 1992 1993 1994 -------------------------------------------------------------- U.S. -0.7 0.0 -2.3 -3.2 -1.2 -1.1 -1.6 -2.3 Japan 0.8 0.0 2.8 3.5 1.8 3.2 3.1 2.8 Germany 0.5 -0.5 1.7 4.3 2.2 -1.2 -0.8 -1.1 France 0.8 -1.2 -0.6 -0.2 -0.8 0.3 0.8 0.7 Italy 1.6 -2.2 -0.5 -0.2 -1.7 -2.3 1.2 1.3 U.K. 0.2 1.9 0.7 -1.6 -3.0 -1.7 -1.9 -0.1 Canada -1.9 -0.7 0.1 -2.3 -3.9 -4.0 -4.3 -3.3 k G10 average -0.2 -0.8 0.5 0.5 -0.3 -0.5 0.5 0.8

30. Shifts in Japanese Savings Flows

31. Swings in Japan were v. large- one source of savings for the US - • Investment plummeted with the transition from high growth (postwar reconstruction, convergence with the US) to “normal” growth c. 1971-73 • But the Japanese were still poor and kept saving • So a potential “paradox of thrift” developed • Keynesian budget deficits bailed them out 1975-81 • Exports to the US bailed them out from 1982-1986 • And a “bubble” during 1987-91 • But slow growth since then

32. So where do we get the goods?

33. Macro, not micro! • As the previous chart shows, we import everything!! • Aggregate trade is a “macro” issue,not a micro one • Indeed, developing countries’ experience suggests protectionism exacerbates deficits • Intermediate goods imports dominate, and a small “burp” in trade thus kills all production

34. Freer tradeand enhanced incomes & welfare

35. Trade Rises as Share of Output

36. Freer trade leads to more trade • But it also raises incomes through enhanced long-run productivity growth!! • Remember, tariffs and quotas are taxes, and hurt real incomes while shifting production to sectors where we’re inefficient

37. Trade deficits • Trade deficits accumulate • But we’ve got lots of trade in lots of sectors • There will be no sudden crisis, but: • a gradual loss in maneuvering room if we must keep real interest rates high to attract capital • lower “I” and slower long-run growth

38. Sectoral composition of trade

39. The End Economics 102 Prof. Smitka Winter 2001

40. Convergence

41. Innovations & Consumption