Wednesday, October 04, 2006

Interpreting Stiglitz

Mark Thoma points to a New York Times commentary by Joseph Stiglitz, in which he suggests a solution to the US trade deficit:
There is one way out of this seeming impasse: expenditure cuts combined with an increase in taxes on upper-income Americans and a reduction in taxes on lower-income Americans. The expenditure cuts would, of course, by themselves reduce spending, but because poor individuals consume a larger fraction of their income than the rich, the “switch” in taxes would, by itself, increase spending. If appropriately designed, such a combination could simultaneously sustain the American economy and reduce the deficit.
There is only one problem with this solution (as Greg Mankiw points out, a bit more politely than here): it doesn’t make any sense.

If the decrease in government spending is offset by an equal increase in consumption due to the change in tax policy, we end up just where we started. As a matter of basic national income accounting, output minus government spending minus consumption equals domestic investment minus the trade deficit. Shifting output from government spending to consumption can’t reduce the trade deficit unless it increases total output or reduces investment. The Fed won’t tolerate an increase in total output (except for normal growth), so that leaves investment as the only possible offset for the trade deficit. But reducing investment doesn’t, in principle, help matters: we end up borrowing less (a lower trade deficit) but also building less productive capacity to pay back what we do borrow.

However, judging by Prof. Stiglitz’ Nobel Prize (as well as by some papers I remember reading by him), he seems like a pretty smart guy. I have to believe there is some method in his madness. The missing piece of this puzzle must have to do with the composition of investment. Some investment (plant, equipment, software) clearly does increase our ability to pay back what we borrow, but other investment (residential housing) probably not so much (although you can try to make an argument that the pleasure of living in better houses will substitute for other material consumption in the future, enabling us to send abroad more of what we produce). Largely as a matter of arithmetic, therefore, I conclude that Prof. Stiglitz expects his proposal somehow to reduce residential investment.

But how, exactly? It would have been nice if he had spelled it out. It seems like a vaguely reasonable conjecture that richer people are more likely to use their marginal income to buy bigger houses, compared to poorer people. (Housing, above some minimum threshold, is a “superior good,” perhaps.) But it isn’t obvious that this would be the case. If Prof. Stiglitz wants to convince other economists, he’s going to have to fill in the rest of the argument here.

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Anonymous Anonymous said...

I think the "deficit" in the paragraph you quote is the budget deficit, not the trade deficit. At least that's how I read it.

In that case, it would be somewhat easier to construct a mathematical model that does the job. Of course, there's the matter of different MPCs and the Lucas Critique, but it seems like a tractable math problem. However, as I posted on my blog, his phrase "If appropriately designed...," is pretty heroic. I'm not sure I trust either party to "appropriately design" the policy--especially with all those aforementioned problems running around.

Sounds nice, but I'm not sure what's behind the curtain.

Wed Oct 04, 02:34:00 AM EDT  
Anonymous Anonymous said...

Most "investment in housing" is simply land speculation, which is an instance of unproductive rent seeking. Of course, the proper solution is to tax ground rent, but perhaps that's politically infeasible.

Wed Oct 04, 06:22:00 AM EDT  
Blogger Gabriel M said...

Yes. It's pretty weird indeed. My first reaction was to make a big deal out of it on my site but it's not worthy it, since everyone seems to be on the same page.

The proposal is pretty bonkers.

The weirdest part is that we've had, what?, 70 years of demand fine-tuning experience? -- I mean, dear Zeus, what's the big mystery? There is only so much mileage you can get out of a IS-LM-AS frame of mind and, as prof. Mankiw pointed out, this proposal doesn't fit into that framework although it's worded that way.

Wed Oct 04, 07:44:00 PM EDT  
Anonymous Anonymous said...


There is only so much mileage that you can get out of IS-LM, but it is still in the heads of a lot of policymakers. One of the results being a tendency to overestimate our ability to fine tune.

Mankiw (and Mark Thoma, though less forcefully) correctly points out that it is the difference in MPCs that matter, and Mankiw specifically points out that they are probably not all that different.

But giving Stiglitz the benefit of the doubt, even if there are differences that could be exploited I doubt that those differences are policy-invariant.

One way or another I don't have confidence in either party's ability to fine tune something like this.

Wed Oct 04, 11:21:00 PM EDT  
Anonymous Anonymous said...

The trade deficit exists because the Asian mercantilists have built far more production capacity than can be kept employed if they allowed exchange rates to adjust to the levels at which free-market trading would absorb the dollars they get for their exports. Therefore they have no choice but to either use taxpayer or central bank money directly to purchase the dollars, or manipulate their interest rates so as to force their savers, insurance companies and pension funds to buy US bonds for yield, and to induce carry traders to borrow their currency and sell it to buy dollars with which to buy US bonds.

The need for the Asian power elites to keep their factories humming will not be lessened by lower US government deficits, so to whatever degree those deficits are causal to the trade deficit, their reduction would just force the Asians to fund US borrowing in non-government markets so as to sustain their exports.

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