Question

Please make at least 100 words comment on the discussion below.

When people say budget deficit causes current account deficit, what is the process there? Discuss all the possible channels.

According to the article there are at least three main channels by which budget deficit causes the trade deficit. All channels begin with expansionary fiscal policy, mostly tax cuts in this situation. The first and most direct is to pump up domestic expenditures, which leads to a rapid growth of imports. This leads to an increase in the trade deficit, as long as foreign demand for U.S. exports remains unchanged. There are more indirect channels as well. The next involves changes in value to the U.S. dollar. As the U.S. borrows to finance its deficit spending, this puts upward pressure on U.S. interest rates. As these rates rise in comparison to foreign interest rates, foreign money flows into U.S. financial assets. This increased demand for U.S. dollars leads to an appreciation of the dollar. With the increased value of the dollar, U.S. goods become less competitive, leading to an increased trade deficit. The other channel mentioned here shows how tax cuts raise the after-tax return on investments for U.S. investments, while also raising before-tax interest rates. This also leads to an appreciation of the dollar, which as show earlier will lead to an increase in the trade deficit.

For Robert Blecker, why he thinks the channels above are not the main cause of current account deficit at least during 1980s? Discuss the role of saving-investment nexus, budget and trade balances in US , Japan and Germany, exchange rate and monetary policy.

Blecker notes that these channels are plausible and do contain elements of the truth, but they do not tell the whole story. There are other macroeconomic policies that influence both the value of the dollar and the trade balance. These include foreign fiscal policies and both domestic and foreign monetary policies. He notes that conventional wisdom says that government deficits are strictly subtracting from national savings, when in reality an increase in government spending can have a positive effect on private saving. He explains how deficit spending can increase output and employment, which will lead to higher incomes for workers, firms, and investors. A portion of this higher national income will be spent on imported goods and services. This stimulates output and demand in foreign countries, leading to an increase in income abroad. A portion of those higher incomes abroad will then flow back to the home country in the form of capital inflows, equal to the size of the rise in the trade deficit. Blecker states this is a generalization of the Keynesian principle that deficit spending pays for itself by increasing saving. In this case it is foreign saving instead of domestic saving.

Blecker also notes that these channels do not account for the fiscal policies of other countries. Specifically he notes that two of the biggest surplus trading partners of the U.S., Germany and Japan implemented contractionary fiscal policies at the same time the U.S. was expanding. It was this opposite movement in fiscal policies that lead to massive trade imbalances. Thus it was not the “twin deficits” that led to a U.S. trade deficit, but rather a major decrease in foreign demand. He also talks about monetary policy in the U.S. He notes that a move toward a tighter monetary policy took place before there was a fiscal expansion implemented. This led to a stabilizing and then an appreciation of the dollar before most of Reagan’s tax cuts took effect.

In Blecker's view, what other factors that play dominant roles causing current account deficit? Discuss.

He notes that there have been at least several studies that have attempted to quantify how much the increased budget deficit led to an increased trade deficit in the early 80’s. Even the models which showed the largest impact fiscal expansion had on the trade deficit still only led to roughly half of the total amount. Thus, fiscal policy plays a significant role, but in no way tells the complete story. Blecker notes that there is an overlooked issue here: income distribution. The fiscal policies that took place in the early 80’s benefited almost exclusively the wealthiest 10% of households, with a large portion benefitting the wealthiest 1%. In fact, some of what looked like the effects of expansionary fiscal policies were actually effects of a regressive tax structure that was implemented prior to these cuts. The fiscal policies of the 1980’s led to a change in income distribution not only for future generations but to the present as well. This led to a negative effect on private saving propensity, especially among corporations, stockholders, and bondholders. Blecker advises that some possible solutions to the trade deficit problem is to restore progressivity to the income tax system and limit financial speculation.

Lastly, how this issue is related to current talks about US trade policy ? what should the US reform or maintain regarding international trade issues? Feel free to discuss your opinion.

I think there is a pretty strong argument that although the budget deficit and trade deficit may be correlated, one is not entirely to blame for the cause for the other. There is a pretty interesting section in the textbook that talks about the current account deficit and its implications. It talks about whether the U.S. should take measures to reduce the current account deficit. It mentions that even before the financial crisis it made sense that the U.S. should do this. Both households and the government have had insufficient savings in the recent years. It argues that the crisis has only made the need to address these issues more urgent. Consumption and investment have decreased, so in order to maintain demand the government has used monetary and fiscal policy to solve this problem. But this has led to some negative outcomes as well. Fiscal expansion has led to large deficits, which the government must now reduce. According to the textbook the only way remaining to increase demand is through net exports. What needs to happen is a depreciation of the dollar. This will increase exports and decrease imports. Although this may seem like a simple solution, there has been little downward pressure on the dollar due to the high demand for U.S. assets by foreign investors. I am not extremely knowledgeable about ins and outs of current trade policies, but I think this makes a lot of sense. I also agree with the article we read about restoring a more progressive income tax system as a potential solution to some of the macro policies that have taken place. I think that issue has only gotten worse since that article was written.