In my previous post on Peter Schiff and the Austrians a commenter pointed out that I might be misrepresenting Schiff’s position and that it could be salvaged if we allowed for some of Schiff’s own nonsense assumptions. The conversation got a little weedy and veered off course somewhat. Here I would like to take the commenter’s argument at face value, not debate the accounting and see if Schiff’s position remains consistent with very basic macroeconomics.
Okay, so let’s start with our sectoral balances framework,
(S – I) = (G – T) + (X – M)
Now, let’s substitute in some numbers that are fairly consistent with the current US numbers (all numbers are expressed as a percentage of GDP),
(8% – 4%) = (14% – 6%) + (4% – 8%)
These are approximations, of course. I did not look up the real numbers. But they are not far off and using them will not harm our argument in any way.
Now, recall that Peter Schiff argued that the US should do three things: first, it should increase savings; second, it should decrease the government deficit; third, it should increase the interest rate and strengthen the dollar.
In order to examine the first of these the commenter suggested that we reorganise the equation as such,
(S) = (I) + (G – T) + (X – M)
Again, we can give those expressions numerical values,
(8%) = (4%) + (8%) + (4% – 8%)
I’m not altogether comfortable with this approach for reasons I laid out in the comments section. But let us proceed to examine Schiff’s argument in this light anyway to see if it is possible.
Now, the interest rate should rise according to Schiff. This has the effect, according to him, of increasing private savings — which it would. But it would also have the effect of increasing the trade deficit as imports, M, became cheaper and exports, X, more expensive. Let’s plug some numbers into those parts of the equation then,
(10%) = (?%) + (?%) + (2% – 10%)
In order for this to balance, as I pointed out in the piece (while providing empirical evidence of just this) the government deficit, (G – T), would have to increase. The commenter said that this was not the case. Instead, private investment could increase.
There are two assumptions that need to be examined here. (1) That private investment would increase in a high interest rate environment and (2) That an increase in private investment in the face of a rise in the value of the dollar would not increase imports, M, and further worsen the trade balance.
Both assumptions are false. Private investment tends to fall, not rise, in the face of high interest rates — that is basic macroeconomics. Also, with a high value dollar imports would obviously rise if investment increased.
Let’s suppress the first assumption though. Let’s imagine that investment, for some bizarre reason, did rise in the face of increased interest rates. But let’s be realistic and assume that this also led to an increase in imports because of the increased investment together with the higher valued dollar. So,
(10%) = (8%) + (?%) + (2% – 11%)
Well, now we have to balance the equation by adding in a value for the government balance, (G – T), right? So, let’s do that,
(10%) = (8%) + (11%) + (2% – 11%)
What has happened? Even assuming that private investment increases in the face of high interest rates — a highly unlikely, if not impossible assumption — if we allow that such investment would further deteriorate the trade balance in the face of a high valued dollar, the government deficit still increases from 8% of GDP in our first equation to 11% of GDP when we try to implement Schiff-o-nomics.
This is, of course, perfectly consistent with the empirical example I laid out in the original post.
We could, of course, tell some different stories. We could have wages fall and this might offset the fall in exports from the higher valued dollar. Let’s try that then. Let’s say that the wage decreases totally offset the fall in exports,
(10%) = (8%) + (9%) + (4% – 11%)
Well, the government deficit still rises from 8% of GDP to 9% of GDP.
The lesson should be clear: Schiff’s story is totally inconsistent. It makes no sense. When examined in any detail it simply does not add up. Even if we give him the benefit of the doubt on certain issues — like the fact that investment will increase in the face of high interest rates — the argument doesn’t add up. Schiff and the Austrians are talking swill that is totally at odds with very basic macroeconomics. And that is the end of the story.
You are wrong. The trade deficit would fall, and in fact turn into a surplus. Higher interest rates would make it very expensive for Americans to buy imports as they would not be able to borrow the money to pay for them. Big cuts in government spending would also reduce the demand for imports. Plus lower taxes, fewer regulations, and more capital investment, which would result from higher saving, would increase domestic production. Therefor we would not have to import as much. Plus I believe that the U.S. dollar is overvalued due to foreign support, which I believe will be withdrawn under my scenario. This will increase the costs of imports, thereby reducing demand for those products. However the dollar’s value will be diminished regardless of what is done. However, if my advice is followed the dollar’s value will be reduce much less than it will be if we remain on our current course.
(1) Um… no. Look at the figures. The rise in interest rates and the strong dollar of the 1980s led to a massive opening of the trade deficit. We’ve seen this many times before. We know that an increase in interest rates will lead to a strong dollar. This will produce a bandwagon effect where foreign central banks try to even more accumulate dollars and foreign producers try to dump their exports on the US to accumulate dollars. We’ve seen this happen many times before. The facts don’t lie.
(2) The point of the sectoral balances framework is that you cannot simultaneously cut government spending, increase private saving and allow the trade deficit to open.
Your strong dollar policies would obviously lead to an increase in the trade deficit. That is basic macroeconomics taught in undergraduate courses and is shown to be true from the natural experiments that we have. If you understand slightly more complex macro — i.e. the sectoral balances accounting identity — it would be obvious to you that you cannot simultaneously increase private saving, decrease the government deficit and allow the trade deficit to widen.
Your argument violates two major and uncontested principles of macroeconomics. I’m sorry, but it just does. And it would not be taken seriously by anyone with a basic training in macroeconomics — regardless of what ‘school’ they come from or what their ideology is.
There’s also the small matter of the infinite capacity of foreign nations to buy dollars in exchange for their own currency.
A declining dollar would mean a rising Yen – which is nosebleed territory for the Japanese. It would mean a rising Yuan – nosebleed for China.
The response would be the same as it always is – intervention to bring the exchange rate down.
Unless the US is prepared to issue currency to buy the Yen the Japanese issue in their ‘liquidity operations’ then any US currency decline can be stopped any time the Japanese want. The same with any other export-led nation. And it only requires *one* of them to act.
I always find it interesting that US commentators cannot understand that foreign central banks don’t really care about paper losses on dollar assets.
Outside the US, the US dollar is just another asset – like Gold. It sits in a vault and gathers dust. Possibly if it is a Treasury bond, it accumulates more dollars to gather dust.
What foreign export-led nations care about is that there is enough of their own currency in circulation so that import-led nations can buy the real exports their economy actually depends upon.
Well, that’s the real heart of the issue. Schiff and other self-proclaimed ‘China experts’ simply do not know how these economies function and what their game is. I wanted to avoid this issue though because it just leads them to step up their ideological rhetoric so that the rubes are once more fooled. But it seems that even if you try to throw a curveball the rhetoric comes out (see above — that is actually Schiff by the way…). What these pundits sell is politics and ignorance — and some light relief for brain-dead MSNBC day-traders.
Peter Schiff is the only man that “predicted” the housing bubble but lost money on the rise up and the fall down. If he predicted anything like he says he did his investments wouldnt be losing half their value or going bankrupt. Also its kinda funny that his EuroPac precious metals firm suddenly popped up with the run up in precious metals. It just shows that Schiff is just a glorified gold salesman. Now he is interested in trading that “worthless fiat dollar” for “real money” gold when it is supposedly going to go to over $5000/oz. He does this out of the goodness of his heart, obviously, and at a premium.
“The same with any other export-led nation. And it only requires *one* of them to act.”
Why must they act to favour USA, they could support S,America instead or anything that helps them, Capitalism is self interest after all so this is a simple feasible possibility that dollars will not always be sought after.
China could keep bailing out USA even if their people object to resulting inflation from buying dollars as you say. They can continue indefinitely presumably. It seems improbable that they will always do this though.
Japan on the other hand I think cannot do whatever they like, their working population has been in decline for many years and the gov measures have already proved a failure to their great debt.
As a proper democracy its far more likely they choose not to continue to repeat that failure. Also they appear to be running trade deficits, so no excess dollars to waste.
“We know that an increase in interest rates will lead to a strong dollar.”
Higher interest rates dont have to mean a strong dollar. I think it depends on inflation (effective rate of return) and lots of other factors basically amounting to demand for dollars. Rates in theory should provoke greater interest in a currency but only if needs exceed supply, with so much debt its possible there are already too many dollars in existence .
In the 1980s high interest rates led to an increase in the value of the dollar despite the inflation. In 1981-1982 the CPI in the US was running at 10% which was pretty high. Meanwhile the dollar’s value climbed by 10%. See here.
Likewise, in the UK between 1978 and 1980 inflation was running between 10-20% and the sterling increased in value by nearly 25%. The cause? A substantial rise in the interest rate. It didn’t last, but it clearly shows that interest rates can be used to cause massive appreciation of the currency.
Anyway, the US has basically no inflation at the moment. If they raised interest rates it would lead to a high valued dollar. That’s just common sense macro. Schiff is talking complete rubbish and anyone who listens to his ramblings is a moron.