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In an October 12th post, Paul Krugman made the following comment.
”. . . we’d all agree that deficits make us poorer if they crowd out investment spending — which they would if the economy were near full employment, but won’t if we’re deeply depressed. All we have to do is realize that net foreign investment — purchases minus sales of assets from and to foreigners — is also a form of investment. Or to put it a bit more simply, sure, budget deficits can make us poorer as a nation if they lead to bigger trade deficits.”
I have to say I have a bit of a problem understanding this one. Let’s assume we’re in a depressed state as we are now and the Government decides to run an additional $1 Trillion deficit, without, for simplicity, any corresponding debt issuance. Then, assuming that the private sector saves at the rate of 6% of GDP and the trade deficit is 4%, and, neglecting any fiscal multiplier, the additional Government deficit adds $900 Billion in aggregate demand to the US economy, $60 Billion immediately to savings, and $40 Billion to the foreign sector. So, the Government deficit spending has certainly made both the domestic non-Government sector, and the foreign sector richer in USD nominal wealth, though the domestic government sector has been made 24 times more wealthy than the foreign sector.
Of course, if we take into account the fiscal multiplier on the $900 B deficit, and we assume that the Fed will add to the money supply as necessary during the ensuing economic expansion, then that 900B deficit might end up adding as much as $2.7 Trillion in GDP to the economy if it’s spent in the right way. So how has this made us poorer?
Maybe Paul K has real wealth in mind in the quote and not nominal wealth. So, would the $40 Billion in increased trade deficit decrease out real wealth? I don’t see how, since in a trade deficit we send USD to the foreign sellers in return for real wealth, thus increasing the real wealth held by Americans. But maybe I’m missing something about the logic of the IS-LM model?
So, how, again, can budget deficits that increase trade deficits make us poorer?
(Cross-posted from New Economic Perspectives.)
9 Comments
I think maybe he meant something other than what he said.
Maybe “deficit spending” is what he should have said. Government investment crowding out private investment.
But even then it makes no sense. Government spending on infrastructure projects and new tech would fund both public and private enterprises, and investment in private companies would increase because the risk would be lower.
Hell, I invested in a bunch of construction companies when Obama got elected because I figured he’d actually use the stimulus to spur infrastructure maintenance and fix those crumbling bridges — boy was I wrong on that one.
Right, he fooled me too. Who knew he was a stealth Reagan Republican?
An excellent post. Rec’d.
If you find a good explanation of IS-LM model, I’d be very interested.
Krugman on IS-LM:
http://krugman.blogs.nytimes.com/2011/10/09/is-lmentary/
I actually read those sentences a few days ago and my brain said “Huh?”
Paul K believes that right now we need deficit spending AKA stimulus. The key phrase in that sentence being “right now”. This has led him to a long series of posts covering on the one hand, but on the other hand type situations.
Deficit spending is good now .. no it won’t cause this, it does not have to cause that. In this particular post I think what it doesn’t have to cause is higher trade deficits, although intuitively one would suspect if you put more money into the system domestically, consumers and companies will spend some of that on foreign obtained items. So .. that would have to be balanced by even more domestic spending, or it WOULD cause …
ARRGGHHH, my brain, my brain hurts! I’m turning into an amateur economist. Mammmaaaa help ….
Thanks.
Hi wigwam, You mean you don’t find Paul Krugman’s presentation of it a model of clarity? -:) -:) -:)
Paul needs to consult the sectoral financial balances model. That model tells us that as long as there’s demand leakage to savings and trade deficits, we need government deficits corresponding to the sum of the absolute value of these to have full employment. See previous posts by myself and wigwam. Until we reach full employment there is no reason to expect generalized demand-pull inflation due to Government deficits. We might get supply-push inflation, as we have with oil, but that sort of inflation has nothing to do with deficit spending.
Don’t forget this on IS-LM