Wednesday, September 24, 2008

Borrowed prosperity

Megan McArdle is making sense:
A substantial minority of libertarians, and fellow-travelers on the right, view this crisis as just desserts. America has borrowed prosperity from the future, and now the bill has come due...

But I don't see how it is possible, over the long term, to have a bubble that consists of "borrowing from our future". We can't get money from the future--their financial system isn't integrated with ours. We can commit some people in the future to give others money, and in that sense our current political happiness with various old-age entitlements might be said to be borrowed from the future. But we cannot, ourselves, spend the actual cash that rightfully belongs to them.

Well, actually we can. We can borrow from foreigners. But America borrows in her own currency, and at pretty low interest rates. Our current account deficit is certainly worrisome, but not "the economy needs to contract by 1/3 to fix it" worrisome. Moreover, we still do most of our borrowing from good old US citizens.

Credit markets don't expand our wealth by borrowing from the future's precious prosperity reserves. They increase production by vastly increasing the efficiency of individual savings, funneling them into long term investments that require larger sums than most individuals can amass.
Yves Smith... not so much:
The sorry fact is the US has consumed at an unsustainable level. We need to reduce consumption and increase savings (and reducing debt is a form of savings). Reduced consumption means a fall in GDP. In Britain, which is going through its own credit crunch, the officialdom has said that the public will experience a fall in living standards. Why are we unwilling to accept the inevitable?
Smith doesn't present any theory of economic growth to accompany her confident assertion that we must experience a "fall in GDP," perhaps because there is no compelling theory to offer. The assumption that "reduced consumption means a fall in GDP" is embarrassingly undermotivated, especially when this reduced consumption comes as a result of increased savings. In fact, one key conclusion of almost every basic growth model is that a higher savings rate increases steady-state GDP.

As McArdle points out, it's impossible to have a bubble that "borrows from the future." The capacity of our economy is determined by capital, labor, and technology, none of which can be transported from the future to the present. (Yes, depletion of natural resources is an exception, but that's not the argument that Smith and most of her fellow-believers are making.) Once we acknowledge this simple fact, we're left with borrowing from foreigners. This is sizable -- our trade deficit is almost 6% of GDP -- but if our economy grows at 2 or 3 percent a year, we're adding the equivalent of our entire current account deficit in productive capacity to the economy every few years. This is hardly consistent with Smith's notion that if foreigners stop giving America a free ride, we're in for a sustained period of lower living standards.

In any case, it's certainly not clear that our current account deficit is inflating GDP, and confident statements on the matter reveal an obliviousness to what GDP actually is. Our consumption is higher because we can run deficits, although as I noted above the benefit isn't as overwhelming as one might think. But GDP doesn't measure consumption -- it measures what we produce. If the Voodoo God of Economics decided tomorrow to force the United States to have a neutral current account balance, there would be two opposing effects on GDP, whose comparative magnitudes are not at all clear:
  1. Americans, now that they could no longer achieve their former levels of consumption by running a trade deficit, would increase their labor effort to produce more at home, thus increasing GDP.
  2. With lower capital inflows (the natural concomittants of a trade deficit) coming in from abroad, and Americans eager to use their current production to maintain consumption, total capital investment in the US would fall, causing a long-term decline in the GDP growth path.
What's the lesson here? A little intuition goes a long way. Yves Smith has a Harvard MBA and 25 years of experience in investment banking, but despite her apparent erudition in financial instruments, she doesn't have the basic mental model of concepts like GDP that is necessary to make informed statements about the future trajectory of the economy. Her seemingly mature declaration that we have to "accept the inevitable," which involves a "decline in GDP," is actually an allegorical vision of borrowed prosperity that doesn't match the facts.

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