What could lower US Trade Deficit?

The usual suggestion to lower trade deficit is increase exports and lower imports and also depreciation of the currency.

Luciana Juvenal, Economist at St Louis Fed in this short research note says:

What other forces could drive the trade  balance? As the chart shows, pronounced cycles and booms in asset prices have usually accompanied widening trade deficits. For example, U.S. equity prices rose by almost 340 percent between 1990 and 2000 before losing about one-third of their value in the first two years after the dot-com crash. Similarly, housing prices increased by around 130 percent between 1990 and 2007 with a marked increase from the early 2000s until 2007. Moreover, after the subprime crisis that began in the summer of 2007, sharply declining asset prices have brought about an improved trade balance.

What links exist between asset prices and the trade balance? Rising asset prices are presumably linked to trade deficits because they increase household wealth and spending, they can finance it by issuing equity. Conversely, weakening  asset prices might be associated with lower spending, and hence, lower demand for imports.

Very interesting finding. I didn’t think of this channel before. So what are the suggestions? 

In conclusion, a large U.S. dollar depreciation could be a key driver of the trade balance adjustment, but recent analysis has questioned its effectiveness. Given the strong links between equity and housing prices and the trade balance, moderating U.S. asset prices could serve as an alternative mechanism to sizably adjust the trade deficit.

Hmmm. Her detailed paper on these findings is here.

Fiscal Deficit and Inflation

There is a lot of debate on this in Indian media. And I have been busy trying to find some empirical work on the same.

Here is a paper (oldish) by IMF economists, Luis Catao and Marco Terrones:

Macroeconomic theory postulates that fiscal deficits cause inflation. Yet empirical research has had limited success in uncovering this relationship. This paper reexamines the issue in light of broader data and a new modeling approach that incorporates two key features of the theory. Unlike previous studies, we model inflation as nonlinearly related to fiscal deficits through the inflation tax base and estimate this relationship as intrinsically dynamic, using panel techniques that explicitly distinguish between short- and long-run effects of fiscal deficits. Results spanning 107 countries over 1960-2001 show a strong positive association between deficits and inflation among high-inflation and developing country groups, but not among low-inflation advanced economies.

I tried reading this paper but was too technical for me. Hence, can’t comment much. Anyways, those more technically endowed can read it and explain it if possible.

Here is another paper on emerging markets from the same duo:

Empirical studies have had little success in finding a statistically significant relationship between fiscal deficits and inflation in broad cross-country panels. This paper provides new econometric estimates for a panel of 23 emerging market countries during 1970-2000. Unlike previous studies, we allow for a rich dynamic specification and focus on the long-run relationship between the two variables controlling for differences in the inflation tax base. We find that a 1 percentage point reduction in the ratio of fiscal deficit to GDP typically lowers long-run inflation by 1½ to 6 percentage points, depending on the size of the inflation tax base.

This again is pretty technical.

In all, there seems to be some effect. More so for emerging econs. Happy reading.

Hearing on Fed Independence

House Committee on Financial Services had a hearing on Fed Independence. Some big monetary economists like Mishkin, Taylor, Metzer has testified along with Don Kohn. I have not read the testimonies yet. Should be exciting stuff and give insights on various monetary economics matters.

India Policy Forum 2009

ASB points to NCAER’s  conference – Sixth Annual India Policy Forum. The papers are here and look quite promising. The one by Anusha Chari and Laura Alfaro has been reviewed by Sunil Jain of BS here. The one by Rajnish Mehra on Indian equity premium also looks good.

I will try and review the papers later.

Addressing the root cause of crises is most important

I had pointed about papers presented at ABCDE conference.

I was just reading one of the papers presented by Giovanni Zanalda, an economic history professor at Duke University. In this paper he narrates evidence from three previous recessions and says if we do not address the root cause of the crisis, the crisis will continue.

In this paper I focus on three historical cases which show how at time of major financial and economic crises it is important to focus on solving problems in the underlying structure of the economy. Failure to address the root causes of a crisis leaves the financial system exposed to catch another cold which eventually could become pneumonia – using a medical analogy which would have been much in vogue among eighteenth-century political economists. Often crises emerge because of countries’ failure to adapt their economies to new international competition or institutions become obsolete, they are out of sync with contemporary economic and political developments. To address these problems it requires large amount of political and economic capital than in the case of traditional monetary and fiscal policies.

I first examine the work of an Italian author, Antonio Serra, against the backdrop of a series of financial and economic crises that plagued the Kingdom of Naples during the first decades of the seventeenth century. In contrast to the mainstream interpretation of the time, that emphasized the monetary origins of these crises, Serra identified “real” factors –from an absence of manufacturing and “entrepreneurial spirit” to a lack of credit and good governance–, as the primary reasons for the kingdom’s economic problems. I then review the work of Geminiano Montanari, an Italian mathematician from the seventeenth century, who challenged the common practice of blaming financiers and financial innovations as the source of all evils at times of financial crises. While recognizing the negative impact of excessive financial speculation, Montanari identified other more important causes of crises such as lack of investments in manufacturing and commerce. The third example is from the Great Depression and shows how countries began to recover after abandoning the gold standard, a measure taken against the dominant view and orthodoxy of the time.

The Research continues to debate what are the root causes for this crisis. I found the paper interesting as it discusses crisis way back in times. What is even remarkable is speculation etc were even blamed then for the crisis. However, the real causes were structural issues. This is what we see even now. Now much of the research points to issues with Government, regulation, Corporate Governance etc. Again nothing changes much as we look into history.