There’s no shame in making forecasts that prove inaccurate; I’ve done so many times. Nonetheless, it is useful to try to figure out why a particular forecast didn’t pan out. Stephen Rose has a paper on the effects of trade on the US economy, which contained this observation:
[T]he notion that the United States can continue to run trade deficits is incomprehensible for many people. In 1988, Harvard finance professor Benjamin Friedman in his book Day of Reckoning wrote that the United States would have serious negative economic consequences because it had five years of trade deficits that averaged a bit less than 2 percent of GDP. He argued that the United States would have to pay off the principle and the interest in the 1990s, which would lead to a negative capital balance. This would require the value of the dollar to decline so that exports would increase, and imports would decrease to maintain the United States’ balance of all payments.
None of these things happened. Instead of negative consequences, U.S. GDP growth in the 1990s was higher than GDP growth in the 1970s, 1980s, and 2000s. Furthermore, between 1994 and 2019, the trade deficit was never less than 2 percent of GDP.
This continued imbalance was offset by massive inflows of foreign capital. As of the fourth quarter of 2020, foreigners held $41 trillion of U.S. assets versus the $27 trillion of foreign assets held by the United States. One would think that a $14 trillion net international debt would lead yearly investment balances to be negative as well, yet, this has not played out. The United States gets a higher rate of return on its foreign assets than foreigners get on their U.S. assets. The difference is so large that the United States has had positive investment income in every quarter during these years.
It seems logical that if a current account deficit represents net borrowing by a country, then these deficits will lead to a future negative capital balance, as interest is paid on the loans. The problem is that current account deficits do not represent net borrowing; rather they reflect the net flow of capital. And capital assets include not just loans, but also equity.
Suppose that each year someone borrows $1,000,000 at 2% interest. They invest $500,000 in the stock market, where their return averages 5%. The other $500,000 is spent on luxury goods. How long can they keep doing this?
Forever.
The 5% return on their stock portfolio is more than enough to pay the 2% interest on their loan, with some left over to add to their capital. This can go on for as long as the investment income exceeds the interest payments on the loan.
This example is a good way of visualizing why Milton Benjamin Friedman was wrong back in 1988. He started with the common sense idea that people and countries cannot live beyond their means forever. If they spend more than they earn, then at some point there will be a bill to pay. But he forgot that investments in real capital goods can be highly productive. America is not actually living beyond its means; it’s using its intellectual capital to produce highly valuable investments throughout the global economy.
Here’s another common sense notion that proved incorrect. During the decades after WWII, many manufacturing jobs moved from high cost northeastern states like Massachusetts to lower cost southern states like Alabama. Common sense suggests that this would cause the two economies to converge over time. And for a period they did seem to be converging, as per capita income grew faster in the south than the northeast. But over the past 40 years this process has gone into reverse, with incomes in Massachusetts rising rapidly as it shifted to higher value added products. Here’s Rose:
In 1960, the New England and Mid-Atlantic states had the highest and third-highest concentration of manufacturing employment—42 and 37 percent, respectively. In contrast, by 2019, these two regions had a lower-than-average proportion of manufacturing workers.
The East South Central (Alabama, Kentucky, Mississippi, and Tennessee) and the West North Central (Iowa, Kansas, Minnesota, Missouri, Nebraska, North Dakota, and South Dakota) regions had an above-average manufacturing share in 2019, but below-average manufacturing shares in 1960. The East South Central region benefited from two waves of manufacturing employment—the movement of firms from New England and the Mid-Atlantic in the 1970s and 1980s and the arrival of many foreign automotive firms opening factories in the United States after 1980.
The movement of manufacturing employment across states does not support the primacy of manufacturing industries as the key to a strong economy. Indeed, the two regions with the largest manufacturing share loss—New England and Mid-Atlantic—had 6 of the top 10 states in terms of GDP per capita (and this does not include Washington, D.C., which has the highest GDP per capita).
Despite the high cost of living, the population of places like Massachusetts, New York City, and Washington DC grew much more rapidly during the 2010s that the population of low cost East South Central states like Alabama, Mississippi, Arkansas, Kentucky and Louisiana. (Tennessee is an exception, due to booming Nashville. It also has no state income tax.)
Rose’s entire paper is well worth reading. It shows that very little of the job loss in America is due to trade, most is due to automation.
HT: David Levey
READER COMMENTS
Kevin Dick
Oct 9 2021 at 4:21pm
That’s a good article, but unfortunately ends badly.
“Furthermore, the easiest way to help low-paid workers is to increase the minimum wage.”
Why would you make a very careful, data driven case on trade and then simply assert that a minimum wage is desirable?
Scott Sumner
Oct 9 2021 at 7:54pm
Yes, people are moving from California to Texas, where the minimum wage is only half the level of California. Minimum wage laws don’t solve the problem of poverty.
Winslow Kelpfroth
Oct 10 2021 at 1:46pm
re: Texas lower minimum wage than California.
As I read recently on the Department of Labor website, the federal minimum wage (same as Texas) applies to between 1-2% of the workforce. As I see mostly tech workers moving into Texas, it probably isn’t the lower minimum wage drawing them here.
Scott Sumner
Oct 10 2021 at 6:48pm
Many low wage workers are also moving to Texas, probably more than the number of tech workers. People are voting with their feet.
Matthias
Oct 9 2021 at 9:43pm
Well, a high enough minimum wage does ‘solve’ the problem of low paid workers:
At sufficient levels it turns them into unpaid non-workers.
(At more realistic levels, the employment effects seem more modest in aggregate. Perhaps because employers shift expenditure from non-wage benefits to wages. And people on the margin already have employment effects.)
Thomas Lee Hutcheson
Oct 10 2021 at 8:21am
Maybe he means that it is easier than making the EITC equivalently more generous.
MikeP
Oct 9 2021 at 5:29pm
But he forgot that investments in real capital goods can be highly productive. America is not actually living beyond its means; it’s using its intellectual capital to produce highly valuable investments throughout the global economy.
This notion is reminiscent of something I noted 14 years ago.
Scott Sumner
Oct 9 2021 at 7:55pm
Well put.
Phil H
Oct 10 2021 at 5:30am
This sounds right to me, but it also sounds quite Schiller-ish, as in the choice to buy American securities is an expression of the market’s animal spirits. If at some point the markets decided that investment in the USA was not so sensible, it could very quickly become a self-fulfilling prophecy.
Jose Pablo
Oct 12 2021 at 9:17pm
“If at some point the markets decided that investment in the USA was not so sensible,”
Then, at this very same point, the trade deficit would cease to exist since these two things (the foreigner’s willingness to invest in “made in USA” securities and the trade deficit these investments finance) are the very same thing.
The ability to produce “securities” foreigners are willing to buy can finance your consumption of goods and services that you don’t produce, forever. Particularly so if:
a) you can sell these securities for much more than the “cost” (in goods and services) of “producing” them,
and/or
b) these securities have limited “future liabilities” (meaning the quantity of future goods and services that you should give back to the “buyers”)
and/or
c) you “trade” these securities for “made in out of USA” securities with higher “future liabilities” attached to them.
Frank
Oct 11 2021 at 3:56pm
For clarity, net returns on foreign assets are part of the Current Account. The US has a sizable Current Account deficit. This is balanced by a US Capital Account surplus. So, the real exchange rate is cool as long as foreigners continue to invest in the US in spite of the posited lower rate of return.
When that should stop, we get a real devaluation and a Current Account surplus. This would happen automatically. No need for policy.
marcus nunes
Oct 9 2021 at 9:57pm
In 2014, 26 years after BF`s “Day of Reckoning”, Ceccheti and Schoenholtz ask “How big can the U.S. current account stay?” Also according to them, a “day of reckoning” was not too far away.
At the time, I wondered what sort of “exorbitant privilege” Australia, which has run almost continuous current account deficits for close to 150 years enjoyed!
https://thefaintofheart.wordpress.com/2014/07/25/a-useless-endeavor/
BC
Oct 10 2021 at 4:51am
“In 1988, Harvard finance professor Benjamin Friedman in his book Day of Reckoning wrote…This example is a good way of visualizing why Milton Friedman was wrong back in 1988.”
Benjamin Friedman or Milton Friedman?
Scott Sumner
Oct 10 2021 at 12:18pm
Yikes, I fixed it.
Thomas Lee Hutcheson
Oct 10 2021 at 6:33am
But imagine if we had run consistentlty lower deficits and the additional saving had gone into greater domestic and foreign investment combined with massive recruitment of talented immigrants.
What opportunities the US is passing up because of left-right gridlock.
Jon Murphy
Oct 10 2021 at 7:56am
This reminds me of something Garett Jones once said to me: “A model is useful even when it breaks.”
David Seltzer
Oct 10 2021 at 3:38pm
I suspect it’s because new information changes expectations. A forecast is based on historical data. Many researchers use Bayesian analysis to update forecasts.
Jon Murphy
Oct 10 2021 at 6:05pm
Even for the forecaster. Garett’s point was that understanding why a model broke (what its limitations are, etc) are important bits of information, too.
David Seltzer
Oct 10 2021 at 6:18pm
Good point.
Sven
Oct 10 2021 at 3:28pm
Forecast is made based on the hypothesis which are formed by a set of assumptions. Thus, if the hypothesis is already wrong the forecast will not be correct either.
So, what we see here is a a set of flawed assumptions.
Flawed assumption 1. “He argued that the United States would have to pay off the principle and the interest in the 1990s, which would lead to a negative capital balance. This would require the value of the dollar to decline so that exports would increase, and imports would decrease to maintain the United States’ balance of all payments.”
The reality is that coupled with freer capital movement, more and more competitive devaluation had become widespread around the world. This meant that many countries exported their surplus savings to the United States. So, in which case the value of the dollar did not have to decline. In other words, United States continued to have current account deficits. The writer’s flawed assumption was that trade imbalances would even out in the long run. However, in an expansionary monetary system with a free capital movement it doesn’t have to be that way as we observe in the current paradigm. The expansionary monetary system with a free capital movement allows us to have continuous deficit position. Since the writer was thinking with a gold standard logic his forecast proved to be wrong.
Flawed assumption 2.”This example is a good way of visualizing why Milton Friedman was wrong back in 1988. He started with the common sense idea that people and countries cannot live beyond their means forever. If they spend more than they earn, then at some point there will be a bill to pay. But he forgot that investments in real capital goods can be highly productive. America is not actually living beyond its means; it’s using its intellectual capital to produce highly valuable investments throughout the global economy.
This assumption is both right and wrong. Yes, America is more productive than foreigners. However, its investment abroad does not compensate its borrowing from abroad. America is certainly living beyond its means. Otherwise America’s international investment position would be zero.
Flawed assumption 3. “Here’s another common sense notion that proved incorrect. During the decades after WWII, many manufacturing jobs moved from high cost northeastern states like Massachusetts to lower cost southern states like Alabama. Common sense suggests that this would cause the two economies to converge over time. And for a period they did seem to be converging, as per capita income grew faster in the south than the northeast. But over the past 40 years this process has gone into reverse, with incomes in Massachusetts rising rapidly as it shifted to higher value added products.”
Of course, I know, you will not accept my claim that the expansionary monetary system changes relative values of goods and services in the long run. However, all of your logic here is only possible with the expansionary monetary system. And, you actually implicitly, without realising, acknowledge it. What you say is exactly admitting that the values instead of converging would diverge over time. This is the diverging pattern of relative values of goods and services. So, the common sense was also thinking that values would converge in the long run since the flawed neoclassical theory, which is actually a theory based on a constant money supply system, was claiming that. However, as you concede values do not converge, they diverge in the long run. This is exactly due to the expansionary monetary system.
“Despite the high cost of living, the population of places like Massachusetts, New York City, and Washington DC grew much more rapidly during the 2010s that the population of low cost East South Central states like Alabama, Mississippi, Arkansas, Kentucky and Louisiana. (Tennessee is an exception, due to booming Nashville. It also has no state income tax.)”
Your implicit acknowledgement continues above sentences.
In addition, this statement is also another way of saying that relative values change in the long run: it’s using its intellectual capital to produce highly valuable investments throughout the global economy. However, this is in international level instead of domestic.
Falling interest rate and rising capital return is clear indication of the pattern.
Jon Murphy
Oct 11 2021 at 10:51am
Not necessarily. Correlation does exist absent causation. For example, miasma theory actually does a pretty good job predicting spread of many kinds of diseases. The hypothesis that disease is caused by “bad air” is false, but the correlation between bad air (poor ventilation, bad smells, etc) and sickness is high.
Sven
Oct 11 2021 at 5:38pm
In which case it does not. This is because the hypothesis and predictions are like going two opposite ways in this example. So, there is no correlation.
Jon Murphy
Oct 11 2021 at 6:08pm
Sorry I don’t understand what you are saying. What is the “it” and the “this” in your comment to me referring to?
Sven
Oct 13 2021 at 7:24am
What I meant was there is no correlation in this case.
According to hypothesis there needed to be convergence. However, What we have been observing is divergence.
David S
Oct 11 2021 at 12:18pm
Scott, your example of the millionaire who borrows at a low rate and reinvests for higher returns is consistent with the financial practices of many wealthy people. Just about every millionaire I’ve ever met has mortgages on their multiple houses. Given that countries have an even longer lifespan than individuals, a diverse arbitrage regime can outlast several generations of doom-and-gloomers. I bet you could find pundits from the 1950’s railing against the dangerous profligacy of the Federal government and the millions of American who were taking out home loans and car loans during that period.
A small quibble about regional comparisons in the U.S.—state vs. state data can conceal broad disparities at the county level. Boston is rich, but Worcester, Fitchburg, and Holyoke are not. This is even more extreme (sort of) in California. Consider house prices in Kevin McCarthy’s district vs. L.A.
Scott Sumner
Oct 11 2021 at 5:04pm
That’s true, but keep in mind that most of Massachusetts’ population lives in the Boston metro area.
Mark Z
Oct 11 2021 at 3:12pm
Is the inter-regional comparison between the east south central states and New England really the right comparison? Especially when emphasizing automotive firms, haven’t Alabama and Tennessee have been gaining much more ‘at the expense’ of Michigan rather than Massachusetts?
Scott Sumner
Oct 11 2021 at 5:02pm
Lots of clothing and textile jobs moved from New England to the South during the decades after WWII.
Comments are closed.