Cafe Hayek: Stiglitz Errs

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October 03, 2008

Stiglitz Errs

Don Boudreaux

Despite being a Nobel laureate in economics, Joseph Stiglitz needs a refresher course in basic trade theory. In his Vanity Fair article he asserts that greater purchases by Americans of foreign oil would put upward pressure on the U.S. trade deficit and thereby "force the U.S. to continue borrowing gargantuan sums from abroad, making us even more indebted." This claim is simply wrong, on two counts.

First, if Americans increase their imports of oil, this fact does not necessarily increase the size of the U.S. trade deficit. If the foreign suppliers of this oil spend all of their dollar earnings buying American exports, then there's no increase in the size of the U.S. trade deficit.

Second, even if we assume that foreigners who sell more oil to Americans will spend none of their resulting earnings on American exports during the current period, not a single dollar earned by these foreigners need be borrowed back from these foreigners by Americans. Americans can borrow these dollars from foreigners, of course. But John Doe in Denver or Jane Roe in Roanoke (or Uncle Sam in Washington) is no more "forced" to borrow back the dollars they spend buying oil from Sheikh Faisal in the middle east than they are "forced" to borrow back the dollars they spend buying mutton from shepherd Frank in the Midwest.

If foreign oil suppliers to the U.S. lend the dollars they earn to Uncle Sam or to the likes of General Electric, then greater Americans' oil imports do indeed make possible not only an increase in the U.S. trade deficit, but also an increase in Americans' indebtedness. But if these same foreign suppliers instead hold on to their dollars, or buy equity in General Electric or real-estate in Rhode Island, or if they use these dollars to fund foreign direct investments in the U.S., then even though the U.S. trade deficit rises, it does not increase Americans' indebtedness.

I'd give an "F" to any of my undergraduate students who would make such a fundamental mistake as the one made here by Stiglitz.

Posted by Don Boudreaux in Balance of Payments, Myths and Fallacies, Trade | Permalink

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But John Doe in Denver or Jane Roe in Roanoke (or Uncle Sam in Washington) is no more "forced" to borrow back the dollars they spend buying oil from Sheik Faisal in the middle east than they are "forced" to borrow back the dollars they spend buying mutton from shepherd Frank in the Midwest.

What? I'm not forced to pay taxes providing principal and interest on Treasury Securities? Because a collectivist fiction you label "Uncle Sam" somehow is not "forced" to sell Treasury notes (it being the chief enforcer itself), I'm not forced to participate in the buyer's entitlement to tax revenue?

What?

Huh?

We should buy the cheapest oil we can find, regardless of the nationality of the seller. That goes without saying.

I'm forced to borrow when Uncle Sam borrows. That should go without saying too. In fact, let's stop calling Treasury securities "investments" and start calling them what they are, "entitlement to tax revenue".

Posted by: Martin Brock | Oct 3, 2008 6:10:37 PM

Interestingly, a bunch of the accumulated trade deficit (most of which was reinvested in the US) was invested in CDOs, MBSs and so on. If things are truly as bad as the politicians think, then the financial "meltdown" just undid the purported "damage" caused by a number of years of trade deficit.

Posted by: Chris | Oct 3, 2008 6:23:00 PM

Excellent point, Don. Cannot be said too often that foreigners with dollars, and not wanting to buy U.S. goods or U.S. debt securities, can always buy up equity securities. However, the point about FDI, which many tend to think about as something that always goes outbound from Americans to the rest of the world, does sometimes work this way. There's many foreign companies that employ Americans in their foreign owned facilities...it's probably the smarter thing for foreigners to do considering the economic climate.

Posted by: lowcountryjoe | Oct 3, 2008 8:09:55 PM

Martin - how about we cut spending to balance the budget. Then once we get surpluses we can start to pay down the national debt in about 30 years!

Posted by: Crusader | Oct 3, 2008 8:09:59 PM

Cutting Federal spending suits me. We can inflate away the national debt anyway.

Posted by: Martin Brock | Oct 3, 2008 10:23:38 PM

Remember...

In 2002, Joseph Stiglitz conduct a study on the behalf of Fannie Mae.

In that study Joseph Stiglitz have said:

This analysis shows that, based on historical data, the probability of a shock as severe as embodied in the riskbased capital standard is substantially less than one in 500,000 – and may be smaller than one in three million. Given the low probability of the stress test shock occurring, and assuming that Fannie Mae and Freddie Mac hold sufficient capital to withstand that shock, the exposure of the government to the risk that the GSEs will become insolvent appears quite low.

http://www.sbgo.com/Papers/fmp-v1i2.pdf

Posted by: David Gagnon | Oct 3, 2008 11:05:06 PM

David, what a great paper. Hindsight is 20/20, but it's still great to read old predictions,

"the implication is that the expected cost to the government of providing an explicit government guarantee on $1 trillion in GSE debt is just $2 million." Turns out that not just greedy CEOs make colossal mistakes about costs.

Although one of his assumptions was dead on, "the government would almost surely be forced to intervene in a variety of markets." Be forced to? By the invisible hand of politics?

Posted by: Jason | Oct 4, 2008 12:22:42 AM

"If the foreign suppliers of this oil spend all of their dollar earnings buying American exports, then there's no increase in the size of the U.S. trade deficit."

Yes, I see your point. Every bit of empirical evidence says that at the margin foreign suppliers spend far from 100% of their earnings on US exports, in fact, showing substantial home bias, but you think the theory should be noted regardless of the fact.

Isn't the evidence that you would fail a nobel prize winner more proof that you are a bad teacher than anything else? I mean after all, you haven't even sniffed the presitge, acclaim, and publications that Stiglitz has.

Posted by: Charlie | Oct 4, 2008 3:20:34 AM

Good point, Charlie. Other people think Stiglitz is great, so Don must, too, or else he's a bad teacher. How dare Don have an opinion that differs from other people's opinions!

But wait... Don's opinion differs from yours, & he has more prestige, acclaim, & publications than you do. Hmm. My head is spinning. Who's right? Don or Charlie? Certainly using my own brain is wrong, as I lack the credentials Charlie values. So whose opinions should I unquestioningly glom on to? What's an intellectually parasitical follower to do?

Any advice, Charlie?

Posted by: Hans Luftner | Oct 4, 2008 4:05:14 AM

Charlie asks:

"Isn't the evidence that you would fail a nobel prize winner more proof that you are a bad teacher than anything else? I mean after all, you haven't even sniffed the presitge, acclaim, and publications that Stiglitz has."

I see... So...

Walter Duranty knew of the Soviet famine but ignored the atrocities to preserve his access to Stalin. The famine came in 1933, a year after Duranty won his Pulitzer Prize.

Every Nobel Prize, or any other "highly" cherished award winner, is to be above professional scrutiny and of exceptional moral character?

I think not...

Posted by: Babinich | Oct 4, 2008 6:15:38 AM

Charlie,

I agree with you that foreigners, in fact, invest heavily in dollar-denominated assets -- and, by the way, in doing they overcome much home bias in investing. But I disagree that it is inappropriate for me, or for anyone else, to point out that greater imports do not necessarily mean a larger trade deficit. The meaning conveyed by Stiglitz was mistaken on this count -- mistaken not only on the point that more U.S. imports do not necessarily mean a higher U.S. trade deficit, but mistaken in his words and tone that convey the popular, but false, impression that a higher U.S. trade deficit is necessarily bad for Americans.

But Stiglitz's more important error is his claim that a higher U.S. trade deficit requires -- "forces" -- more U.S. borrowing from abroad. That's simply wrong.

Given the widespread lack of understanding of trade in general, and of the balance of payments in particular, it's a shame that a prominent economist such as Joseph Stiglitz fuels such misunderstanding with such a careless claim.

Posted by: Don Boudreaux | Oct 4, 2008 6:26:48 AM

I thought a more glaring error of Stiglitz was, "To curb inflation therefore means that the price of everything else needs to fall drastically to compensate, which means that unemployment would also have to rise drastically." That sounds like the Phillips Curve, which is vertical. Edmund Phelps won his Nobel Prize for showing that there is no trade-off of inflation and employment.

Stiglitz seems like the anti-Hayek. He believes that markets are never efficient because they lack necessary information. Yet, somehow the government has this information is able to make Pareto-efficient improvements. I don't have a Nobel Prize so I can't dispute him on the math, but everything I've observed shows me the opposite. Perhaps it is a problem with incentives, but the government seems to be the last to know.

Posted by: Jason | Oct 4, 2008 8:13:42 AM

I would not give Stiglitz an F for saying that “greater purchases by Americans of foreign oil would put upward pressure on the U.S. trade deficit” but I sure would give him, and so many others, including many tenured professors who hold opposite views, for not denouncing the inexistence of free financial markets, when these markets are forced or so much induced to follow the opinions of some few credit rating agencies.

In the Financial Times October2, in “Brussels stiffens bank capital requirements" they report that there is legislation coming that will "require credit rating agencies to register and meet standards if they wish to operate in Europe."

Hallelujah! Now, at long last, we will be able to fully trust the credit rating agencies and so be able to follow them anywhere?

Are the regulators incapable of learning? Are the PhDs incapable of seeing further than their regressions?

Posted by: Per Kurowski | Oct 4, 2008 8:55:02 AM

Chris says “Interestingly, a bunch of the accumulated trade deficit (most of which was reinvested in the US) was invested in CDOs, MBSs and so on. If things are truly as bad as the politicians think, then the financial "meltdown" just undid the purported "damage" caused by a number of years of trade deficit.”

We should perhaps reclassify CDOs, MBSs and so on as “feel good” consumption goods on which case there never was a trade deficit.

Posted by: Per Kurowski | Oct 4, 2008 8:58:01 AM

I would give Stiglitz an "F" not for predicting that greater U.S. imports of oil would increase the U.S. trade deficit. I would give him an "F" for his mistaken assertion that a higher trade deficit "forces" Americans to borrow more.

Posted by: Don Boudreaux | Oct 4, 2008 9:01:23 AM

Perhaps it is a problem with incentives, but the government seems to be the last to know.

No. It's just that the people we call "the government" are few in number, and these people aren't omnipresent, omniscient or omnipotent, regardless of their delusional regard for their own incredibly vague, self-serving propositions.

Posted by: Martin Brock | Oct 4, 2008 9:07:08 AM

I would give him an "F" for his mistaken assertion that a higher trade deficit "forces" Americans to borrow more.

The forced borrowing is certainly real.

A higher trade deficit might encourage statesmen to force me to borrow, if the flow of money back into the U.S. lowers the statesmen's cost of forcing me to borrow vs. forcing me to pay taxes.

I suppose the forced borrowing might contribute to the higher trade deficit. If Chinese central bankers fixing exchange rates couldn't buy U.S. Treasury securities, would they necessarily buy U.S. mortgage backed securities instead? If they could't buy entitlement to the productivity of U.S. citizens from our Federal government, maybe they'd just let their currency strengthen instead.

I don't exactly what the link is, but the two processes are not independent.

Posted by: Martin Brock | Oct 4, 2008 9:18:48 AM

Martin,

When Uncle Sam borrows (from foreigners or from Americans), he certainly does, as you say, "force" American taxpayers to borrow.

But greater imports by Americans in no way forces Uncle Sam to borrow. Uncle Sam's fiscal affairs are solidly in the hands of Congress. If that body, with or without the acquiescence of the White House, engages in deficit financing of its expenditures, the responsibility is exclusively that of the Congress. It is not forced to spend what it spends or, hence, to borrow.

Posted by: Don Boudreaux | Oct 4, 2008 9:29:31 AM

I'm responsible whether I like it or not.

I couldn't care less whose team occupies the Congress vs. the White House, but the White House has veto authority, even if this one rarely exercises it, so it shares accountability for forcing me to sell entitlement to my productivity to Chinese central bankers fixing exchange rates, just as it shares accountability for forcing me to buy mortgage backed securities at above market prices, possibly from Chinese central bankers.

Would our trade deficit be so high without all of this forced borrowing? I don't know, but I doubt it.

Posted by: Martin Brock | Oct 4, 2008 9:47:55 AM

I have nothing against the Chinese by the way. They're just the standard example these days.

Posted by: Martin Brock | Oct 4, 2008 9:55:57 AM

Here's my simple in the shower attempt to explain this.

First we , since Reagan, have went from the worlds largest exporter to the worlds largest importer. It seems to me there is one way in which that might be good and one way in which it might be bad.

It seems to me that if we have a huge trade deficit it might be because we are making less things and buying more things on credit. As I understand it reading the papers sometimes extending too much credit can be a problem. At some point you have to make something or provide a service to cover your debt. I'm thinking we haven't done that.

I'm guessing a big chunk of our "growth" over the last 25 years and especially the last 10 was on paper.

So would I rather my country, my economy buy its next chunk of energy from a Middle East country on credit OR would I rather my country home grow (produce it's own unit of energy) and actually sell it for an equal exchange of cash.

I think I'd rather have paid for windmills in the plains states then debt owed oil from terrorist harboring nations.

I think my understanding is rudimentary and I'd love to see Stiglitz defense of his claim.

Posted by: muirgeo | Oct 4, 2008 11:13:59 AM

It seems to me that if we have a huge trade deficit it might be because we are making less things and buying more things on credit.
Posted by: muirgeo | Oct 4, 2008 11:13:59 AM

It seems to me you failed the same econ courses as Stiglitz.

It also seems to me that a Nobel in Economics is somewhat similar to the Heismann.

I think my understanding is rudimentary...
Posted by: muirgeo | Oct 4, 2008 11:13:59 AM

I'd say a little less than that....

Posted by: Mesa Econoguy | Oct 4, 2008 11:59:41 AM

Is foreign investment in the U.S. part of the trade deficit accounting?

Posted by: Sam Grove | Oct 4, 2008 12:22:09 PM

Muirgeo,

If you're serious about improving your understanding of these matters, you can do no better than to read one or more (and preferably all) of these three books:

Douglas A. Irwin, Free Trade Under Fire, 2nd ed., (Princeton University Press, 2005). [A third edition will be out within the next few months.]

Martin Wolf, Why Globalization Works (Yale University Press, 2004).

Johan Norberg, In Defense of Global Capitalism (Cato Institute, 2003).

Posted by: Don Boudreaux | Oct 4, 2008 12:26:27 PM

Sam,

The term "trade deficit" is poorly defined. What most people mean -- at least those who truly mean something meaningful when they use this term -- is the current-account deficit.

In a world of flexible exchange rates (which is our world today), any country's current-account deficit is exactly offset by a corresponding capital-account surplus for that country. For a country like the U.S. (that is, a country not heavily dependent upon direct foreign aid or remittances from emigrants), this fact means that every dollar of the current-account deficit is a dollar of foreign investment in dollar-denominated assets. Such investment is surely beneficial, at least on an ex ante reckoning, not only to foreigners who invest here but also to Americans.

Posted by: Don Boudreaux | Oct 4, 2008 12:32:30 PM

Martin - our forced borrowing due to out of control spending. Also I agree that we spend way too much on the military. We could easily cut 50% there, and still only cut the deficit in half. Other programs need to be actually cut, not just rate of growth stifled. People have to tighten their belts for a few years for the good of the country.

Posted by: Crusader | Oct 4, 2008 1:40:35 PM

Why do not those who are exercised about 'trade deficits' not more excited about foreign aid?

Posted by: Sam Grove | Oct 4, 2008 1:49:13 PM

I'll get excited about foreign aid, if you want, but it's a rounding era in the Federal budget and trade deficits.

If the Chinese want to buy foreclosed real estate, that's fine with me. If they want to buy farm land in Iowa, let 'em at it. That's what they really need anyway.

If they want to buy the Pentagon, let's sell it to 'em cheap. In fact, let's sell 'em our entire nuclear arsenal along with every lease on every military base we have worldwide. They can have Blackwater too.

Posted by: Martin Brock | Oct 4, 2008 2:05:46 PM

How do trade deficits compare to foreign aid?

In the case of trade deficits, we are getting something for our money, in the case of foreign aid we get, maaaybe, some strategic influence.

Posted by: Sam Grove | Oct 4, 2008 4:09:38 PM

Foreign aid given by Uncle Sam is a minuscule portion of the federal budget (and, of course, an even more minuscule portion of annual U.S. GDP). It's also a tiny fraction of the U.S. trade deficit. Americans have far more important things to worry about. Indeed, the greatest harm done by American foreign aid is not to Americans but to citizens ruled by governments that receive this aid.

Posted by: Don Boudreaux | Oct 4, 2008 4:34:25 PM

Indeed, the greatest harm done by American foreign aid is not to Americans but to citizens ruled by governments that receive this aid.

I know, and how much has THAT cost us?

Instead of people in other countries emulating our "freedom", we have to export "democracy" to them with armies.

Cannot the cost of our interventions be seen as indirect foreign aid?

Actually, most foreign aid is not held as a benefit to other governments, but in our own strategic interest, hence foreign aid isn't so much "aid" as it is strategic bribery. "Aid" is just a selling point.

Posted by: Sam Grove | Oct 4, 2008 5:38:58 PM

Roanoke

Woohoo! Hometown gets a mention!

This is a great observation though.

What really bothers me is that people think a trade deficit is actually a bad thing. I have a trade deficit with Papa John's for Pizza ... I can't say I really mind.

Posted by: The_Chef | Oct 5, 2008 12:01:39 AM

Martin - you lefties obsession with Blackwater is pretty sad. You only don't like Blackwater because their CEO is buddies with Bush. Whoever is used next by the Obama administration will have just as much corruption, but you will not say anything because your preferred political class will be in charge. You don't have a problem with rent-seeking, you have a problem with Republicans who rent-seek.

Posted by: Crusader | Oct 5, 2008 12:09:48 AM

Crusader - I couldn't care less about your partisan loyalties, and you don't have a clue about mine.

Posted by: Martin Brock | Oct 5, 2008 12:37:02 AM

I'm no leftie, but I'll dislike Blackwater, or anyone else in a similar role, no matter who the president is.

Posted by: Hans Luftner | Oct 5, 2008 12:39:49 AM

Hans - we'll see how you hold Obama's feet to the fire when the time comes. We shall see indeed.

Posted by: Crusader | Oct 5, 2008 12:51:19 AM

Clearly you assume, incorrectly, that I don't despise Obama for the warmongering socialist he is.

Posted by: Hans Luftner | Oct 5, 2008 1:11:17 AM

Hans - how is Obama a warmonger?

Posted by: Crusader | Oct 5, 2008 2:30:22 AM

What really bothers me is that people think a trade deficit is actually a bad thing. I have a trade deficit with Papa John's for Pizza ... I can't say I really mind.

Posted by: The_Chef

Now do an experiment and always pay for your Papa Johns via a credit card and never pay off the credit cards. I think that's what we are doing with foreign oil trading.

Posted by: muirgeo | Oct 5, 2008 3:06:38 AM

Hans - how is Obama a warmonger?

He wants to escalate the Afghan war, & his "tough stance" on Pakistan & Iran amounts to not-so veiled threats. Also, he hedges his "opposition" to Iraq so much that I sincerely doubt he has any intention of leaving. I see no significant difference in either his or McCain's foreign or economic policy. Only their rhetoric.

Democrats oppose war in the same way Republicans favor the free market - they don't. They say they do because they're liars & their voters believe them. The "base" of either party is too emotionally invested in their party being the good guys that they'll make up the most laughable excuses to justify any deviation from their left/right mythology.

The only "change" I see if Obama wins is that the left will suddenly love the status quo, & the right will suddenly oppose it. Some of the rationales & rhetoric will change, while the reality on the ground will stay the same. "Left" & "right" is mostly party affiliation, anyway.

The Mets & the Red Sox are both playing baseball. Each team has the same goal & pretty much the same methods. The difference is that when they play against each other, the fans cheer if their team does something well & boo if the other team does the exact same thing.

Likewise if the Republicans propose some economic measure then they're privatizing & letting the free market work, while if the Democrats propose the same measure they're protecting us from the greedy free market corporations. The public buys it, & votes them each back in, to protect us from the other, but both teams are still playing the same game. I only wish it were baseball.

I get the impression you're a Republican. Right? My apologies if I presumed incorrectly.

Posted by: Hans Luftner | Oct 5, 2008 3:08:10 AM

Crusader,

Anyone who doesn't have a problem with their tax dollars going to fund a private mercenary army is a nut job with a complete disregard for liberty.

Posted by: muirgeo | Oct 5, 2008 3:09:18 AM

Now do an experiment and always pay for your Papa Johns via a credit card and never pay off the credit cards. I think that's what we are doing with foreign oil trading.

The problem with this analogy is that Papa John's (or foreign countries) still get their money, but now The_Chef (or the U.S.) will have a harder time getting anyone to lend him more money. It seems only incidentally related to him actually trading with anyone, as he would have the same problem if he borrowed the money & hid it in his fridge & then refused to pay it back.

I agree that one should pay back what one borrows, but I still don't see what's wrong with "trade deficits." If Papa John's values The_Chef's money more than their food, & vice-versa, then everybody wins.

I guess I've never been clear on what's "deficient" about trade deficits. It seems so arbitrary. It almost seems like if anyone should object it should be the foreigners who wind up with mere dollars while we get actual tangible goods. But as long as they the dollars enough to trade for them, what's the problem?

Posted by: Hans Luftner | Oct 5, 2008 3:31:00 AM

Anyone who doesn't have a problem with their tax dollars going to fund a private mercenary army is a nut job with a complete disregard for liberty.

George, I agree with you. Scary, isn't it?

Posted by: Hans Luftner | Oct 5, 2008 3:42:32 AM

Without logic to guide him, muirgeo twists in the wind. He is bound to point in the right direction once in a while. Don't expect the same inputs to get you the same output the next time, though.

Posted by: Russell Nelson | Oct 5, 2008 9:42:41 AM

Anyone who doesn't have a problem with their tax dollars going to fund a private mercenary army is a nut job with a complete disregard for liberty.

I don't have an instinctual aversion to mercenaries. They are highly motivated and usually get the job done. Your attempt to assign morality to such a thing is childish.

Posted by: Crusader | Oct 5, 2008 1:40:57 PM

I think I'd rather have paid for windmills in the plains states then debt owed oil from terrorist harboring nations.

False generalization, muirgeo. You talk about what "my country" does as if our federal government buys all the energy and then rations it out to us.

If you'd rather pay for something do so. Don't like paying for foreign oil, convert your car to biodiesel and go get some spent grease from your local fast food restaurants. Don't like paying for natural-gas-generated electricity? Put some solar panels on your roof, and either find a way to store the energy for nighttime, or do what most do and sell excess capacity back into the grid to reduce your need to burn the fuels.

True, the government spends a lot of money buying oil for its own fleet of vehicles, its military, and the SPR. But none of that stops YOU from using YOUR money to get energy in any way you see fit.

Let's get straight to what you're really after. You want the government to use MY money to buy windmills and "renewable" power for YOUR benefit, because you don't want the hassle of having to take care of it yourself.

Posted by: Brad Warbiany | Oct 5, 2008 1:51:19 PM

Anyone who doesn't have a problem with their tax dollars going to fund a private mercenary army is a nut job with a complete disregard for liberty.

George objects to the "mercenary" while Hans objects to the "tax dollars".

Posted by: Sam Grove | Oct 5, 2008 3:11:52 PM

In fairness, I also object to privately funded killing.

Posted by: Hans Luftner | Oct 5, 2008 11:20:29 PM

Well, he didn't mention the killing part, but I suppose that's OK with him as long as the killers aren't mercenaries.

Posted by: Sam Grove | Oct 5, 2008 11:39:48 PM

I was originally convinced by this article's argument, but countries like Saudi Arabia can easily spend dollars in countries other than the United States because people in other countries know the rough value of a U.S. dollar. A Saudi could easily pay any foreign company in dollars because they would know the dollar is valuable.

Posted by: Greg | Oct 6, 2008 1:49:08 AM