Response to Comments on Blog #35: Thirlwall’s Law

Sorry for being late. There were really only two issuesraised (ignoring the comment about MMR vs MMT—which I’m not going to addresshere).

The first concerned the orthodox belief that trade dependson comparative advantage: Italy specializes in wine because of its climate andsoil. In the case of agriculture in the old days, there isn’t too much doubtabout that—it was hard to grow grapes at the North Pole, so Santa tradeddelivery services for products made in southern climes. But once we move beyondagriculture, and after we’ve invented greenhouses and the like, there is muchless truth in this. In manufacturing, a factory can be set up anywhere in theworld, often in a few weeks, and it takes a couple more weeks to train theworkers. And out in the real world what we find is that much of the trade infinished goods is actually between “equals”: Italy sends Fiats to Germany andGermany sends VWs to Italy. Tastes or preferences, styles, desire to be different,brand loyalty, and all that matters much more.

The second is more important and concerns the belief thateconomic growth is balance-of-payments constrained, as described by TonyThirwall’s “Law”. As Neil “Ramanan” Wilson Jargued: “There have been some suggestions that Thirlwall’s law stops thegovernment expanding domestic policy and will cause ‘twin deficits’ problems(increased government and external deficits). But why would that apply togovernment and not private expansion? Thirlwall’s law appears to have a fairamount of empirical data behind it, but is that curve fitting? In other wordsdoes the Law appear true because nobody dare do the domestic expansion in thecorrect fashion necessary to test the underlying assumptions on which it is based.”

To simplify and summarize: A country like the US that has ahigh propensity to import will tend to run a trade deficit if we grow fasterthan our neighbors who have low propensities to import. We will then run out offoreign reserves quickly so will be constrained to the extent that ourneighbors won’t take our currency in exchange. Thus, our growth will beconstrained—it needs to be slower than that of our neighbors.

To be sure, Thirlwall would throw in lots of caveats thatare usually ignored by those who wave his “Law” about. Not all growth has thesame implications for the trade balance. Income distribution matters forimports—so it depends on who benefits from the growth. We could target ourgrowth to areas that make us more competitive internationally—increasingexports. If we do grow faster than our neighbors, their demand for our currency(to invest in the US, for example, to share in the bounteous growth) might growas fast as our current account surplus. If we float the currency, theconstraint is softened since a trade deficit might cause the exchange rate tofall and thereby increase exports and reduce imports. And we can change policyto encourage exports and restrict imports, or to encourage “capital” inflows(demand for our currency to buy assets). So for all these reasons, there is nosimple “Law”.

Neil also raises an important point usually overlooked bythose who advocate the “Law”: the evidence in favor of a constraint probablyhas more to do with policy overreaction than to any real constraint.Governments react to a current account deficit by tightening the fiscal andmonetary policy screws, trying to raise unemployment and slow growth. That is apolicy choice. Except for those nations that choose to peg their currencies (oradopt foreign currencies—as Greece did), it is almost always going to be a badpolicy. Indeed, pegging the exchange rate is a bad policy because it usuallyforces government to give up policy space. Unemployment is the normal price ofpegging—and it is pegging and the reaction to a current account deficit that thenmakes Thirlwall’s Law “bite”.

Let us say that a country does not impose the “Law” onitself, refusing to adopt austerity when a trade deficit appears. What happens?At a constant (but not pegged—this is a little mental experiment) exchangerate, for its current account to increase, there must be a demand for itscurrency so that its capital account surplus rises by the same amount. In otherwords, there are two sides to the coin, and as foreigners demand the currency,a capital account surplus is created, and as the domestic population demandsthe imports, a current account deficit is created. We cannot split the coin inhalf to blame one side or the other.

Let us say that the rest of the world (ROW) will not allowthat to happen—the ROW will accept the currency only if it depreciates. OK,then, the currency falls in value to find holders of the currency given acurrent account deficit. And as the currency falls, exports might rise a bit,and imports fall a bit. But let us say that this will not restore trade“balance” (recall from my earlier blog however that “balance” is a misleadingword—the balances always balance!). As the currency depreciates, the terms oftrade turn against the country. In other words, it gives up more currency toget the same basket of imports.

(Yet in real terms as a current account deficit is created,the country gives fewer exports to get imports! How ironic: the real terms oftrade move in the favor of a trade deficit nation. Exports are the cost,imports are the benefit.)

If you are an OZ that imports oil and finished manufactures,a depreciating A$ raises the A$ cost of much of what you buy. And as BillMitchell argues, the swings of the A$ are historically large and do lead to verylarge fluctuations of the domestic purchasing power. But so long as Australiakept its commitment to full employment, it tolerated these swings withoutimposing austerity. Policymakers preferred to use their domestic policy spaceto maintain growth with (nearly) full employment. So Oz consumers would remainemployed and would substitute out of expensive imports as best they could. Andthey’d probably have to reduce overall consumption when the Oz Dollar fell. Thosewho follow MMT and Functional Finance believe that is the best policy.

Should a nation like Oz adopt other policy in response to atrade deficit? Bill often uses the example of auto manufacture. Oz might havetried to keep out Japanese autos in order to promote Oz auto production. Billhas argued this makes little sense, and would cost Australian consumersdearly—both in terms of loss of choice but also in terms of a policy ofdevoting substantial real resources to produce autos at what might be a scalefar too small to achieve economies of scale. I have no dog in this hunt and noparticular opinion on the issue of Oz auto production. But Bill’s argumentmakes sense to me as a general statement. It is also related to the comparativeadvantage argument briefly discussed above. If you can import high quality andlow cost products from abroad, it may not make sense to use government policyto block the imports and to subsidies domestic production. Remember: importsare a benefit, exports a cost, in real terms. Of course that is only true ifyou have a commitment to full employment. So if auto jobs are lost governmentmust ensure alternative employment.

The immediate response always is: “but auto jobs are good;nonmanufacturing jobs are bad”. Only one who has never worked in a factorycould literally believe this. (Full disclosure: I worked in a soup factory andwhile I liked the pay, I hated the work.) What most mean is that factory jobspay well, many service sector jobs don’t.

The solution—of course!—is to make the service sector paymore. I am always amazed at the lengths to which people will go to offer“crazily improbable” (in Keynes’s words) solutions rather than looking to theobvious.

To be clear, I have nothing against using domestic policy ina strategic manner—to target areas for expansion. All economies area alwaysplanned. The questions are: by whom and for whom. But responding to a tradedeficit by imposing austerity simply imposes a “Thirlwall’s Law” growthconstraint unnecessarily.

There are many other issues related to imports, exports, andexchange rates—we’ll return to some of them in the remainder of the Primer.