Note: I’m blogging through Tyler’s 2005 Macro final. I’m not really imagining that these answers are ‘right’ in the exam sense, but rather just an excuse to think about 2005 questions in 2011.
1. The pessimists commonly argue that the large U.S. trade and budget deficits eventually will require a big fall in the dollar, higher real interest rates, and a general loss of confidence in dollar-denominated assets. We all know that g > r would stop this problem in its tracks. But let us say that g is not big enough relative to r. What other non-pessimistic scenarios can you outline? How valid are they?
I think that g and r are growth interest rates.
I’ll take the question generally as asking for non-pessimistic scenarios on trade and budget deficits in the future.
Not sure if its non-pessimistic, but the twin deficits persist to this day, mostly because investors are terrified of any investment other than treasuries. Flight to safety preserves the purchasing power of the currency of account.
Less pessimistically, of course, trade deficits due to investment can persist for as long as there are investment booms elsewhere.
And let’s not forget that those trade deficits are nice while we have them. I like the way Russ Roberts thinks of the extremis scenario of exchange rate ‘over/under-valuation. He says that if some foreign country wants to give us a bunch of free cars (be it from exchange rate ‘misalignment’ or enormous foreign productivity matters not), they’re going to of course undermine our domestic auto industry. But (now think carefully about this for a sec) we’re getting free friggen cars!
But to the degree that these foreign investment booms prove illusory, we get a debt overhang and disinflationary recession. But there I go being pessimistic again. Michael Pettis has convinced me that the end-game in China is going to be an abrupt and far-too-late end to their government sponsored investment boom. Ew.
There are also some insights in Tyler’s question, which actually isn’t so pessimistic. What we wouldn’t give for a bit of inflation, depreciation and the ensuing loss of confidence today!