The debate over Larry Summers’ potential appointment to Fed chair provides an excellent opportunity to explain the logic behind one of his biggest policy missteps. During the East Asian financial crisis he worked alongside Robert Rubin and Alan Greenspan to impose a solution that required the countries of the region to repay their debts in full. The quid pro quo was that they would have the opportunity to hugely increase their exports to the United States in order to get the dollars needed to make their payments.
This bailout put muscle behind Robert Rubin’s strong dollar policy. Robert Rubin’s predecessor as Treasury Secretary, Lloyd Bentsen, was happy to have the dollar fall. This was part of the textbook story of the deficit reduction being pursued by the Clinton administration. Lower deficits were supposed to mean lower interest rates.
One of the dividends of lower interest rates was supposed to be that investors would hold fewer dollars, causing its value to fall relative to other currencies. This would make U.S. exports cheaper to people in other countries, leading them to buy more of our exports. A lower valued dollar would also make imports more expensive for people in the United States, leading them to buy fewer imports.
More exports and less imports means an improved trade balance which would increase demand and growth. And to some extent this is the story we saw in the first years of the Clinton administration with the trade deficit falling to its lowest non-recession levels as a share of GDP since the Carter years.
However Robert Rubin’s high dollar policy reversed this story. The rise in the dollar led a predictable rise in the trade deficit. Because of the harsh terms imposed in the bailout from East Asian financial crisis developing countries began to accumulate foreign exchange (i.e. dollars) on a massive basis in order to avoid ever being in the same situation. This caused a huge run-up in the dollar, which pushed the trade deficit ever higher.
The deficit reached 4 percent of GDP ($640 billion a year in today’s economy) in 2000 before falling back somewhat in the 2001 recession. It eventually peaked at almost 6 percent of GDP in 2006.
The trade deficit creates a huge gap in demand that must be filled by some other source. This is income that people are spending overseas rather than in the United States. In the late 1990s this gap was filled by the stock bubble. The $10 trillion in wealth generated by the bubble led to a huge surge in consumption as the saving rate was pushed to then record lows. The bubble also led to an increase of investment, although much of it was in hare-brained start-ups like Pets.com.
After the stock bubble burst the economy needed some other source of demand to replace the money lost through the trade deficit. Contrary to conventional wisdom, the economy was very slow to emerge from the 2001 recession. It did not regain the jobs lost in the recession until 2005. At the time this was the longest period without job growth since the Great Depression.
When the economy did emerge from the 2001 downturn it was on the back of the housing bubble. The bubble generated huge amounts of demand both by pushing construction to record levels and through the wealth effect on consumption. Of course it was predictable that this bubble would also end badly, as it did.
While Summers did not hold the levers of power through the housing bubble years, he did set the process in motion in the 1990s with his high dollar policy. He was also a major cheerleader at the time, denouncing those who raised questions about the exotic financing that was supporting the run-up in house prices as “luddites.”
Furthermore, we still have the basic math problem that he left us from his years in the Clinton administration, how do we fill the gap in demand that resulted from his high dollar policy. While a subsequent fall in the dollar has reduced the trade deficit, it is still close to 4.0 percent of GDP ($640 billion). This can be filled by the government’s deficit spending, but Summers has repeatedly warned that this is only a short-term strategy.
So how does Summer want to solve the math problem? Is he going to push for another bubble to juice the economy again or perhaps he has changed his mind and decided that a strong dollar really wasn’t such a good idea after all.
Anyhow, there is no way around this math. You either want a lower dollar, you want to sustain high budget deficits, you want another bubble, or you want high unemployment. That is the math, what is Summers’ answer? We should know this before he gets appointed to the country’s most important economic post.
Note: Correction made on imports becoming more expensive when the dollar falls. Thanks to the people who called it to my attention.