In the event that lower labor and regulatory costs* abroad cause domestic companies to relocate their operations and this results in lower expected and realized economic activity, what would we expect to see domestically?
*This does not delve into the destructive outcomes associated with labor, regulatory, and tax races to the bottom where nations attempt to lure global firms by allowing for the violation of human rights, household income repression, environmental degradation, financial speculation, and low tax rates (tax havens) on the very wealthy. Obviously all these practices are covered in the disclaimer as they clearly favor private interests at the cost to the global community. In this sense, struggling Western citizens and families should band together with the poor slave-like workers in the third world as both have been exploited to varying degrees. The policies, politicians, private sector executives, and institutions that seek to exploit those that are most vulnerable are the ones that impose costs onto society. Attacking immigrants or poor third world workers amounts to blaming groups that have also been victimized by the same public and private sector elites who have endangered the livelihoods of the western middle class and poor.
- A lower neutral rate
- An underutilization of labor and capital
- Deficient aggregate investment and demand
- Subdued inflation as firms lack pricing power due to weak NGDP
- Expectations of a more gradual path for monetary policy
- Fiscal space as the private sector does not fully make use of all the national economy's available resources
To simplify imagine that only one foreign economy (country B) exists that interacts with the home country (country A-USA). If the domestic economy has a larger output gap compared to the foreign economy where it experiences the symptoms listed above, under a flexible exchange rate regime the foreign currency would be expected to appreciate. The faster growth experienced in country B relative to country A should see their interest rate spread widen which incentivises capital inflows into B. As a result, market participants can issue lower interest paying liabilities denominated in currency A to fund the purchase of higher interest bearing financial assets denominated in the foreign currency (carry trade). The upward pressure on the currency should equalize conditions in both countries until market participants are indifferent between holding assets in either currency.
Moreover, once the foreign economy's spare capacity is more fully absorbed, their labor costs should rise in response. This creates the incentives to invest in productive capacity. Rising wages improves household creditworthiness which may promote an expansion of household credit issuance. Both of these conditions should put upward pressure on global aggregate demand which in turn boosts demand for country A's exports. Moreover, as the exchange rate and labor costs adjust global firms will have less of a reason to relocate to the foreign economy. From the domestic economy's (country A) perspective, a stronger global economy increases employment, aggregate demand, and interest rates at home all of which reinforces domestic growth.
What if the foreign economy fixes their exchange rate to country A's currency? They must do so by purchasing financial assets issued by agents which are domiciled in country A. US treasury securities play a critical role in this process. As foreign economies attempt to stockpile US treasury securities in order to manage FX rate volatility amid capital inflows, the symptoms listed above should still remain relevant unless country A's private sector responds by engaging in a credit expansion. The private sector does so by issuing a greater volume of financial assets which global market participants seek to willingly absorb. In doing so, this funds greater domestic activity resulting in a lower output gap, falling unemployment, and rising interest rates due to elevated credit demand. This can be dangerous and eventually destabilizing when the expansion of private credit is undertaken to an excessive degree. The private sector issues such securities in part because of their beliefs pertaining to their future expected income flow (growth) that will be used to meet the future stream of debt payments. Once reality fails to meet such expectations, debt servicing costs become more burdensome than previously anticipated. As the private credit expansion devolves into a credit contraction consistent with private sector deleveraging (debt repayment, "money" hoarding, increased desire to accumulate safe financial claims to restore net worth), aggregate income/spending growth will slow, interest rates fall, and labor and capital resources will again be underutilized.
Although a depressed domestic interest rate environment is consistent with deficient domestic investment (whether a result of terms of trade shock, the end of a domestic credit expansion/financial crisis, or something else... technological aka robot shock), the fiscal authority still retains the capacity to maintaining a path of nominal GDP that is consistent with full employment in an economy producing at its full capacity. This can be done by issuing highly sought after securities to fund domestic investment, tax-cuts, and social (insurance) programs etc. In such an environment where foreign central banks/governments, global financial intermediaries, and the foreign private sector all demand dollar denominated securities**, the only limit to the government's ability to issue safe dollar denominated treasuries is the availability of spare resources in the domestic economy. As long as the private sector is unable or unwilling to profitably hire all those that want to work full time or cannot make use of the available excess capital, this fiscal space exists. Therefore, trade and globalization need not be a problem and have shown to produce a broad social benefit. However, what is required is a fiscal and monetary regime that enables the economy to produce to its full potential while also managing local issues associated with economic disruptions that citizens simply can't insure against individually.
Monetary and fiscal policy together can facilitate a level of nominal GDP growth that is consistent with full employment and capacity utilization without requiring a dramatic shift in global trade or trade policy. What is needed is a commitment to maintain a volume of domestic economic output that absorbs all those that are available to work full time as well as any excess capacity. By not doing so, the global system will be rightfully under attack by those that are most vulnerable to persistent joblessness, financial insecurity, low income growth, class conflicts, resentment, and hopelessness that all manifest from deficient economic activity. Thus, a lack of policy coordination, mainly on the a fiscal side, amid weak domestic NGDP growth has been the source of suffering among those that have been hit the hardest by the financial crisis and shifts in the composition of the economy. The household sector's increasing inability to adequately deal with the shifts in the domestic economy due to global competition and technological advancement was masked by an economy that was dependent on the expansion of household credit. Once the financial crisis brought this to an end, the underlying fragility in the household sector was exposed. Therefore in the absence of faster global spending or a domestic credit expansion, fiscal policy must work to fund aggregate activity. With that said, the monetary policy stance must communicate the willingness to allow the level of NGDP to return and then remain on the desired course.
Disclaimer: The above is not in any way in support of trade policies that knowingly favor private interests at the expense of the broader public. That is beyond my very small circle of competence. Despite that, any trade deal that produces joblessness and depressed domestic economic growth can be mitigated using a combination of fiscal and monetary policy. By doing so, high inclusive growth is well within reach as long as the political environment is supportive.
*This does not delve into the destructive outcomes associated with labor, regulatory, and tax races to the bottom where nations attempt to lure global firms by allowing for the violation of human rights, household income repression, environmental degradation, financial speculation, and low tax rates (tax havens) on the very wealthy. Obviously all these practices are covered in the disclaimer as they clearly favor private interests at the cost to the global community. In this sense, struggling Western citizens and families should band together with the poor slave-like workers in the third world as both have been exploited to varying degrees. The policies, politicians, private sector executives, and institutions that seek to exploit those that are most vulnerable are the ones that impose costs onto society. Attacking immigrants or poor third world workers amounts to blaming groups that have also been victimized by the same public and private sector elites who have endangered the livelihoods of the western middle class and poor.
**The trade and current account deficit (capital account surplus) is a consequence of the foreign sector's desire to accumulate dollar denominated financial assets. It has shown to be far more benign than advertised by alarmists.
**Although China is constantly threatened as a currency manipulator, the PBOC has steadily allowed the yuan to appreciate against the dollar for the past several years. As this may have partially contributing to slowing Chinese growth, the PBOC is now in the process of maintaining the FX rate (to a broader currency basket) in the face of capital flight. In essence, Chinese policymakers have been battling market forces that are putting downward pressure on the currency.
Furthermore as Michael Pettis has pointed out, protectionism is more likely to hurt current account surplus nations than it will help current account deficit countries in generating economic growth and full employment. Trade restrictions are more costly for current account surplus economies that achieve full employment through export sales and are therefore dependent on foreign demand. With that said, the benefits of protectionism are limited in closed developed current account deficit nations as their economic activity is more reliant on business investment and consumer demand. In this respect, Trump overstates the role of foreign demand for US tradable goods and services while undervaluing domestic demand as the largest driver of growth. Given the above, the US economy during the Great Depression more closely resembles the present Chinese economy than it does today's United States.
Furthermore as Michael Pettis has pointed out, protectionism is more likely to hurt current account surplus nations than it will help current account deficit countries in generating economic growth and full employment. Trade restrictions are more costly for current account surplus economies that achieve full employment through export sales and are therefore dependent on foreign demand. With that said, the benefits of protectionism are limited in closed developed current account deficit nations as their economic activity is more reliant on business investment and consumer demand. In this respect, Trump overstates the role of foreign demand for US tradable goods and services while undervaluing domestic demand as the largest driver of growth. Given the above, the US economy during the Great Depression more closely resembles the present Chinese economy than it does today's United States.
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