This article appeared in NewDeal2.0
on July 1, 2010 and in AToL
on July 15.2010
In monetary economics, the trade deficit and the fiscal deficit
are referred to as the “Twin Deficits” as if they were genetically
related twins
merely because they both contribute to increases in the public debt.
Yet these
two deficits are genetically opposite and can act like fighting twins
to
neutralize each other in their adverse economic effects.
A fiscal deficit is created by government spending in excess
of revenue in the domestic economy. The external penalty of a
persistent fiscal
deficit is the devaluation of the exchange rate of the domestic
currency in
foreign trade.
A trade deficit is created by excess imports over exports in
foreign trade. One of the curative measures for a persistent trade
deficit has
been conventionally identified in trade economics as a devaluation of
the
domestic currency against those of its trading partners, or in
multilateral
trade, against a reserve currency. Currency devaluation is expected to
make
exports less costly and more competitive in price. It is also expected
to make
imports more costly in local currency terms.
Therefore, there is logic in viewing a fiscal deficit as a
solution to a trade deficit through its function in devaluing the
domestic currency.
Under the Bretton Woods regime of fixed exchange rate pegged
to a gold-backed dollar, it was considered normal that an economy that
ran
persistent trade deficits would see its foreign trade decline unless
the
currency was devalued officially, since at that time, foreign exchange
markets
were not allowed to operate beyond currency settlement at the central
bank of
the reserve currency – the US Federal Reserve.
A deficit in foreign trade for an open economy is equivalent
to a corporation running a loss in domestic market operation due to
imbalance
between cost of production and sales revenue derived from the market
price of
its products. The solution to operational losses in a corporation is to
either
lower the unit cost of its products without reducing quality, or to
increase
the unit price without affecting sale volume, or an optimum mixture of
both.
Increasing the volume of trade would cut operational losses
only if the greater sale volume reduces the unit cost of production,
and provided
that greater sale volume is not achieved through price discounts. If
the unit
cost in sales is fixed independent of production volume, increasing the
trade
volume will only exacerbate the losses.
This happened to General Motors at a time when its labor
cost per car remained independent of volume of production to result in
a
negative unit profit margin. Under such circumstances, the more cars GM
sold,
the higher its losses. The solution then was to shut down production
even if
that would lead to losing market share.
The monetary regime of an open economy allows the exchange
rate of its currency to be determined by market forces. The central
bank can still
and does intervene in open market operations to keep the exchange rate
of its
currency at the level targeted by monetary policy. This is done by
selling its
own currency in the open market for foreign reserves to keep the
currency from
rising in exchange value, or buying its own currency with foreign
reserves to
keep it from falling in exchange value.
Depreciating a currency in an open economy without capital
control and with full currency convertibility can be achieved by a
central bank
accumulating foreign reserves through selling its own currency. Or it
can be
achieved by government running a persistent fiscal deficit to signal
market
forces to push down the exchange rate of its currency. Thus a
controlled persistent
fiscal deficit is a form of soft intervention that can produce the same
result
as a hard intervention of conducting open market operations through
selling or
buying the currency to accumulate or drain foreign reserves.
Even for countries that have accumulated excessive foreign
reserves from trade surpluses, such as China
and Japan,
the option
of soft intervention with a persistent fiscal deficit serves as a way
to absorb
the excess accumulation of foreign reserves not usable in the domestic
economy,
through high domestic spending from a fiscal deficit.
For countries that have insufficient foreign reserves and
trade deficits, such as the Baltic states in recent years, the option
of soft
intervention with a persistent fiscal deficit serves as a relatively
less
painful way to reduce the trade deficit by lowering the exchange value
of its
currency to stimulate more export.
However, if the trade deficit failed to be reduced or
eliminated by currency depreciation alone, as frequently the case, the
trade
deficit then can only be reduced by lowering the trade volume or in
extreme
cases, stopped completely. In such a case, a fiscal deficit can still
act as a
stimulus on the domestic economy to create needed domestic production
to
replace the reliance on imports and to develop import substitutions.
Of course, the fiscal deficit must be used constructively
and not for wasteful indulgence. Furthermore, a perpetual fiscal
deficit is
unsustainable and will lead to hyperinflation independent of foreign
trade. But
a controlled fiscal deficit can be an effective measure to wean
economies from
excess dependence on foreign trade, both for those with trade deficits
or those
with trade surpluses. June 29, 2010
