Tyler Cowen: belief

Transcript context

…There is this notion that, if you were to write an economic model, that our models would predict necessarily that a country that’s running a current account deficit, for instance, would experience a depreciation of their real exchange rate, and a country that’s running a current account surplus would experience an appreciation of their real exchange rate. I think that’s an incorrect statement. This is the formal statement. It’s partly correct, but here’s the accurate statement: The only thing the models tell you is, as you know, we have what is a no-Ponzi condition, which is some sort of an intertemporal budget constraint. What it tells you is that a country that is, for example, running deficits and therefore accumulating a lot of liabilities to the rest of the world will have to repay those liabilities because we have a condition, or either way, you default; one of the two. How do you repay those liabilities? You repay those liabilities in the model, and the equation will tell you that, at some point, you have to start running trade surpluses to repay those liabilities. You’re assuming you don’t have an exorbitant privilege in the sense that the debt you’re showing to the world is always not much cheaper than what you owe to the rest of the world in terms of interest payments, is not always that much cheaper than what the rest of the world owes from you. There are periods in US history when that’s been true, that’s less true now, and I don’t think we can assume that’s going forward. A country that’s accumulating a lot of debt to the rest of the world, or liabilities to the rest of the world, for instance, our model will say, at some point, have to run trade balance surpluses. Now, there are two ways that those trade balance surpluses can come about. One is through a real exchange rate depreciation, so that is true; that could be one channel. The other channel is if the country’s overall level of demand were to collapse, then that would also mean that they would import less, relative to the rest of the world, whose demand is higher, and they would import more. Either of those channels, or both of those, can be in play, and if you look at the evidence in the data and you try to do some kind of a decomposition of how much of it is real exchange rate versus demand, there is no clear mapping from the fact that if you’re a country that’s running current account deficits or running trade deficits for a long period of time, that you necessarily should see a weakening currency. That puzzles me all the more. If we think of Australia, which does not have exorbitant privilege, as you know, they ran trade deficits for decades steadily. There was no reason to think Australian demand would suddenly collapse. Australia’s done fine, has strong fundamentals, yet the intertemporal constraint on that process, it never seems pushed into the present. Why is the inter-temporal constraint so weak, and how should that shape how we think about how economies actually work? Is everything just flashed period by period, like in the very simple Keynesian models, or is it something else? Well, it is a constraint that says that if you have net foreign liabilities to the rest of the world, then in a present discounted sense, at some point you have to be running surpluses to be able to pay that off. That’s the only thing that that constraint says, and that can happen through a combination of things. It can happen either because you have a discovery of a resource that you then export to the rest of the world and therefore your exports start booming because of that, or you have a recession in your country, and imports collapse. The real exchange rate does play a role. To be clear, I am not saying that the real exchange rate never comes into play; it does. You have seen countries whose incomes have grown over time, have had their real exchange rates appreciate; it just takes a long period of time. To assume that on a year-to-year basis that if a country is running a trade balance deficit, it should necessarily have a weaker real exchange rate, I think making that tight link would be problematic not just from the theory, but from the theory side and from the empirical side.…

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