Finance and the ceteris paribus economy

While reading Kenneth Rogoff's VOX piece on the debt supercycle I noticed in the sidebar a link to A historical look at deflation with Claudio Borio's name attached. I've looked at Borio's work on financial cycles before, so I was interested. Finishing up my response to Rogoff, I dove into the deflation article.

Here are the opening paragraphs:

Concerns about deflation – falling prices of goods and services – have loomed large in recent policy discussions (see e.g. Cochrane 2014, Muellbauer 2014, The Economist 2015). The debate is shaped by the deep-seated view that deflation, regardless of context, is an economic pathology that stands in the way of any sustainable and strong expansion.

However, the almost reflexive association between deflation and economic weakness is not so obvious. Seen as a symptom, deflation need not only arise from an aggregate demand shortfall, but also from greater supply, which would boost output. And seen as a cause, while it may be damaging – by pushing up real wages and unemployment, raising the real value of debt (debt deflation), or inducing consumers to delay spending – it may also be beneficial, by raising real incomes and wealth and making export goods more competitive. The cost of deflation is ultimately an empirical question.

Five words went off in my brain like fireworks: making export goods more competitive. I don't know, really, how that works: If deflation makes the dollar stronger, that affects exchange rates and makes US exports more expensive. I'm sure there are trade-offs, but they use those five words as if there can be no question that deflation makes exports competitive.

But before I confused myself with the exchange-rate consequences of domestic deflation, before that unfinished thought diffused itself like a puff of smoke, there were those five words and the fireworks in my head. When costs are falling, Borio et al. say, that's good for exports. By extension then, when costs are rising that's bad for exports.

The mind goes to Adam Smith, to Of the Component Parts of the Price of Commodities, to Smith's look at factor costs and the principles that regulate them. The mind goes to the cost of finance, a cost that competes with Smith's wages and profits and rent.

Imagine a stable economy, a ceteris paribus economy where nothing changes other than the size and scope of finance. Consider a period of time during which the size and scope of finance begin at a low level, but grow persistently, so that by the end of the period finance has grown very large.

Ceteris paribus, it takes just as many hours after that time period, as many as it took before, to produce an apple, to produce an automobile, to produce a skyscraper. It takes just as much capital consumption, just as much raw material, just as much managerial oversight. The only thing that has changed is the cost of finance.

But because the cost of finance increased among producers, profits fell and prices rose. Because the cost of finance increased among consumers, there is a chronic shortfall of demand. These changes have consequences.

Chronic shortfall aside, when the cost of finance increases as a share of output cost, it drives up the price of output. It makes the "basket of goods" more expensive. It makes exports more expensive.

I make that argument: that the rising cost of finance in the US economy increased the prices of US exports, putting the US at a disadvantage and contributing much to our unfavorable balance of trade. I make that argument.

That was the fireworks in my head, when I read those five words.


The U.S. balance of trade was really pretty stable until after the 1974 recession.

Graph #1: U.S. Balance of Trade since 1950

Some people attribute our trade imbalance to Nixon breaking the link to gold. Could be. Nixon took us off gold in 1971.

But Milton Friedman says it was the economic policy of the 1960s -- "the Kennedy and Johnson administrations" -- that ultimately forced us off gold. Nixon had to do something because "the situation had become very critical in 1971", Friedman says.

According to Friedman, then, even if our trade imbalance was created by breaking the link to gold, the underlying causes go back a decade before the link was broken.

At least a decade, I should say.