Friday, March 12, 2010

Whenever FLG Hears True Economic Arguments That He Disagrees With

...he immediately looks at the time horizon under consideration. Most of the time, the analysis is true in the short-term, but not the long-run. Today, Dean Baker makes a variety of true statements about the Deficit (fiscal and trade) and the Dollar. I want to highlight this point though:
At a given level of GDP, the main determinant of the trade deficit is the value of the dollar. Politicians and even many economists like to hyperventilate about "competitiveness" and talk about how we're going to improve our trade situation by getting a better trained and educated work force, rebuilding the infrastructure, or fixing the tax code. But even if you gave any of these characters everything they wanted in whichever direction, there is no plausible story where their policy of choice would have even half the impact on competitiveness and trade as a 10 percent reduction in the value of the dollar -- and even then we would only see the impact after many years.

Notice the following phrase "at a given level of GDP." For laypeople, you can think of this as, at any point in time, which as you can imagine constrains the analysis to the short-term. So, at any point in time, the value of the dollar is the biggest determinant of the trade flows.

He then criticizes "getting a better trained and educated work force, rebuilding the infrastructure, or fixing the tax code" on the basis that we would only see an "impact after many years." I'll focus on why economists believe the first one, a better trained and educated work force, will help our economy.

The trade model that best reflects the long-term effects of free trade*, Heckscher–Ohlin model, results in the creatively named Heckscher–Ohlin theorem. The Heckscer-Ohlin theorem says, basically, that over the long run you will export what you have a lot of and import what you don't. So, a country like the US will export goods that take a lot of capital to produce and import goods that take a lot of labor to produce.

Well, a guy named Leontief tested whether this was true in real-life and found that the US in fact exports labor-intensive goods. Economists, confounded by a result in complete contradiction to the predictions of the model, looked for an explanation, and settled on human capital as the solution. The US exports human capital intensive goods. That is to say good produced by skilled and educated workers. Ergo, it would seem that the US, in a world of free trade, would, according to the Heckscher–Ohlin theorem, export ever more human capital intensive goods. Consequently, if that's where the jobs of the future would be, then we need to encourage people to get more education and skills. Voila, the policy recommendation of "getting a better trained and educated work force." It's a far more long run view of the situation.

Dean Baker's point is correct. The value of the dollar is the biggest determinant at any point in time, i.e. the short run, and many countries have used devaluation to goose their exports expeditiously. That's all true, but there are two problems with looking at it like this. First, it's a beggar-thy-neighbor policy that could result in retaliatory devaluation elsewhere. Second, it's not sustainable as a long-term policy solution. You can't devalue forever.

Now, in fairness, Baker's point was about an identity that net exports has to equal the sum of a nation's public and private savings, again, at any given time. Therefore, this presents difficulty for deficit hawks, but I think he's taking short-term analysis and extrapolating to the long run in a deceptive way.
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* It best represents the long-term because both capital and labor are perfectly mobile within countries.

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