About five months ago, I posed myself a few questions, relating to such matters as currency exchange rates, trade deficits, and public debts, in an effort to enhance my understanding of economics. I currently live in Argentina, a country where periodic financial crises have repeatedly thrown the country into disarray and economic depression. Much of what’s behind my desire for a firmer grasp of the so-called dismal science has to do with wanting to understand the forces that have shaped this country. After reading some basic economic texts (including Paul Krugman and Maurice Obstfeld’s standard text on International Economics) and taking a course on international finance, I’m hoping the effort I invest in answering the questions here will furnish that understanding.

In this post, I aim to outline a few basic concepts I think are important to understand before I can move on to the specific questions.

The first order of business is to ask why GDP, the bluntest measure of the health of an economy, goes up and down. GDP has nothing to say about the fairness of wealth distribution or whether productive activity in an economy actually improves the quality of life, but in general when GDP goes up, so does employment, so we can assume that an increase in GDP usually means an increase in the welfare of a country’s inhabitants. So why does it go up and down? Because the demand for it does. An economy is healthy when there’s constant demand for goods and services.

What happens when that demand flags? It’s important to point out the difference between the liberal and the conservative positions on this matter. Conservatives believe that if aggregate demand is in decline, it’s because the market has dictated such a decline. Government intervention, they argue, will not only potentially cause inflation, but is also inherently prone to inefficiency and corruption. It is thus wisest to allow market imbalances to work themselves out spontaneously (in the manner of Adam Smith’s benevolent "invisible hand"), even if it means unemployment in the short term.

Liberals, on the other hand, maintain with John Maynard Keynes that in order to keep demand (and therefore employment) at an optimal level, government can and should act as a "demand manager," intervening with government spending or tax policy. For example, when businesses in the private sector are not productively investing household savings, (thus running the risk of causing a recession–more on saving and investment in a later post), perhaps because they don’t judge such investment to be profitable under current circumstances, government can transfer those savings to the public sector and spend them, thus adding to GDP. (Whether this kind of spending generates sufficient confidence in an economy to reignite productive investment from the private sector is another matter, and will vary according to circumstance.)

My own inclination is to agree with Joseph Stiglitz’s observation that "the reason that Adam Smith’s invisible hand is invisible is that it does not exist." It’s a seductive notion because it involves no intellectual effort in determining which economic policy provides for the greatest welfare. Moreover, even if it were true, it wouldn’t be necessarily useful for our purposes here because the reality is that governments intervene in markets all the time. The sort of intervention that interests us here is called macroeconomic policy.

Departing a bit from the simplicity of the above analysis, we can summarize the fundamental goal of macroeconomic policy as equilibrium, both internal (domestic) and external (foreign trade).

Internal balance consists in maintaining full employment of an economy’s resources (human and otherwise) without the kind of "overheating" that can cause prices to rise. With this balance comes stability and predictability, which makes it easier for the private business sector to identify and invest in profitable opportunities, and which in turn spurs the kind of activity that keeps an economy’s resources productively employed.

External balance is a bit more difficult to define, and requires a basic understanding of what is called the "balance of payments" (BOP). The BOP involves tracking two types of transactions in two different accounts:

1. Transactions involving the export and import of goods and services are entered into the "current account."
2. Transactions involving the purchase or sale of assets are entered into the "capital account." That sort of activity can involve "direct investment" like buying plants and equipment in another country, or "portfolio investment" like buying stocks or bonds (including government debt like US Treasury bonds, widely held throughout the world).

(Note that I’m primarily trying to provide a layman’s summary here and want to avoid too much economic jargon, but because the idea of a "current account deficit" or surplus frequently appears in the news media, I think it’s important to flesh out a little.)

The rule of double-entry bookkeeping applies here: Every international transaction enters the BOP twice, once as a credit and once as a debit. Krugman and Obstfeld provide a useful example which I condense here:

• A US resident buys an Olivetti (Italian) typewriter for $1,000 in US currency (i.e., purchases an import), therefore a $1,000 debit is entered into the US current account
• Olivetti deposits the check, say, in an American bank, which is in effect a purchase of a US asset, a bank deposit worth $1,000, therefore a $1,000 credit is entered into the US capital account

Adding the current account and capital account together always produce a sum of zero. If a country has a current account deficit (i.e., the sum of the current account is a negative number)–that is, if it imports more than it exports–then it must sell assets abroad to finance consumption of those exports. Those sales can be either public (e.g., in the form of government bonds) or private (e.g., in the sale of company stock or other assets), and they result in credits in the capital account (the sum is a positive number).

Now, very generally speaking, in order to maintain external balance, a country should avoid an excessive current account deficit. Depending on a country’s circumstances, investors may regard that deficit as unsustainable–investor disfavor could result in pressure for currency devaluation (for reasons that I hope will become clearer in a subsequent post) or eventual debt default and consequently, lack of access to credit. On the other hand, if a current account deficit is the result of borrowing to finance productive investment (as opposed to financing consumption), it might be sustained over long periods of time. (As I may return to in subsequent post, the United States currently appears to be an exception to this rule.) So the definition of what constitutes an "excessive" deficit will vary widely according to circumstances.

Ideally, of course, economic policy would achieve internal and external balance simultaneously. Trying to restore internal balance during an economic downturn by stimulating aggregate demand might involve fiscal expansion (increasing government spending or lowering taxes), which could worsen the current account and upset external balance. On the other hand, using exchange rate adjustment (i.e., devaluating the currency) can make domestic goods cheaper relative to those sold abroad, thus stimulating domestic demand, and also stimulate demand abroad for exports, thus improving the current account. Some mix of both of these kinds of measures is generally needed, at least for countries under floating exchange regimes.

Often the twin goals of internal and external balance come into conflict with one another, particularly in a system of fixed exchange rates. In the era of the gold standard in the fifty odd years prior to the First World War, for example, there was a consensus among nations that the most important economic goal was to limit global monetary growth and stabilize price levels. This restricted the application of expansionary policy, and sometimes countries tolerated high unemployment rates in an effort to maintain external balance. After the Great Depression, however, a new consensus emerged that governments were responsible for maintaining conditions of full employment, and internal balance became more important. In economic downturns, there was now more pressure to undertake expansionary measures that might upset external balance, but which was arguably needed to restore productivity to an economy.

An optimistic point of view would regard this shift as reflecting a greater responsiveness to the welfare of the people under increasingly democratic conditions. That may or may not be the case. In general, however, we can assume that the relative weight given to internal or external balance reflects the relative dominance of one set of interests over another. I’m currently not clear on to what extent external balance might be favored over internal balance in the United States, nor who might be the beneficiaries of that preference. But I do know that in the cases of Argentina and other countries who have depended on the guidance of the International Monetary Fund (of which the United States is the largest shareholder) during the emerging market crises of the last 10 or 15 years, expansionary policy was anathema. The prescription in those cases invariably involved restoring a favorable current account balance, often with extremely severe domestic consequences in terms of unemployment, etc. Clearly, the beneficiaries were not those who rely on worker’s wages to provide for their families.

One final aspect of contemporary economics that I think is important to note is the consensus among nearly all responsible economists regarding the benefits of free markets (keeping government intervention to a minimum) and free trade (lowering barriers like tariffs). Economists do, however, tend to disagree on the circumstances under which a country can harness those benefits. Market fundamentalists on the far end of the conservative side tend to deny in the face of all empirical evidence the legitimacy of such conditionality–free markets in themselves, they argue, provide the greatest possible benefits under any conceivable circumstances. Nevertheless both sides agree in line with classical economic theory that free markets for both goods and capital, lowering barriers to trade, etc., are fundamental goods. Dissenters are typically derided as "neomercantilist" fringe cases. ("Mercantilism" refers to an economic outlook which prevailed prior to the emergence of classical economic theory, and which regards international trade as a zero-sum game, as opposed to the win-win perspective of free market economics.)

Next time: Exchange rates: why a haircut costs me $2 in Buenos Aires and $11 in Holland, Michigan.