Yesterday my dentist asked me if there was a short and sweet book I could recommend to him that would help him establish a framework for his thinking on matters economic. He thought he had good instincts about the major topics of the day—which I can confirm—but he needed a theory or theme for structure to organize his thinking. I said I would think about it.

Actually, I’ve given a lot of thought to such questions, but I still don’t have a short and sweet answer. I once took a stab at discussing what high school economics teachers should teach, one version of which I posted here in December 2008. Maybe I can update that some day.

The question made me think first of Henry Hazlett’s classic, Economics in One Lesson. That, in turn, reminded me of Frederic Bastiat, on which some of Hazlett’s book was based. But Bastiat’s nuggets of wisdom are spread out over more than one book. My dentist had current events and issues in mind; so that places his request in the macro rather than micro realm, which takes much of the fun out of it.

Wednesday morning, Arlen Specter handed me an example of economic illiteracy to chew on in this context. President Obama’s meeting with democrats was carried on TV and the first question came from the party-switching Senator Specter. Paraphrasing, he said his question had to do with jobs, jobs, jobs. He said we had lost over two million jobs because of our trade deficit with China. He pleaded for some protectionist relief and noted that he had been opposed to China’s membership in the WTO in the first place.That got my attention because I had written an op ed favoring China’s membership. To his credit, President Obama didn’t give him much relief, although he, himself, has been taking small steps toward that slippery protectionist slope.

Free trade, or freer trade, is one of those battles we have to win over and over. One huge problem is that we see the jobs lost to free trade but not the jobs gained. And, of course, the benefits of free trade have little to do with jobs anyway. The benefit of free or freer trade is a higher standard of living in trading nations. The impact on jobs is virtually neutral: maybe a small gain in jobs, or maybe a small loss of jobs depending on various circumstances. The benefits come from needing fewer jobs for a given level of consumption rather than more. Freer trade in that regard is similar to labor-saving technology. You get more output with fewer workers, and the excess workers are available for the new things.

Satire, and carrying faulty but appealing arguments to their logical conclusions, may be the best ways to discuss trade and other issues that are not intuitively obvious. That was Bastiat’s specialty, and his tongue-in-cheek petition to the French Parliament on behalf of the French candle makers is the most famous example of that approach. The candle makers, you see, were suffering from competition from an unfair competitor—the sun. Bastiat’s petition sought relief for the candle makers through a law that would mandate the closing of all windows, shutters, blinds, etc. through which the sunlight entered. This would not only create more jobs in the candle industry, but it would have spillover or multiplier effects—but this was before Keynes—throughout the economy. General prosperity would result from shutting out the sun.

A shorter, and perhaps sweeter, satiric argument was given by Henry George, who pointed out that protectionists want to do to their own country during peacetime what the countries’ enemies would want to do to it during wartime—close its ports to imports.

Back to Senator Specter and his assertion that over two million jobs have been lost to our trade deficit with China. The thing is this: when we import more, it leads to more exports; when we export more, it leads to more imports. The net result is a zero, or close to zero, change in the domestic (and foreign) job count. The benefits of trade have nothing to do with the job count.

Our imports, taken by themselves, result in more dollars in the bank accounts of foreign exporters. Our exports, taken by themselves, result in fewer dollars in the hands of foreign importers. If we import more than we export, as we are wont to do, dollar balances will build up abroad and be available for more exports from the United States. Other things equal, those excess dollar balances will put downward pressure on the dollar relative to foreign currencies and stimulate those additional foreign imports and U.S. exports.

If the trade imbalance is sterilized and not allowed to affect the exchange rate, then there will be upward pressure on foreign prices and nominal incomes and downward pressure on U.S. prices and nominal incomes. This will, at the margin, trigger trade adjustments similar to the effect of a dollar decline. Again, more imports result in more exports.

The balance of payments always balances when all transactions are taken into account. Since rising imports lead to rising exports and rising exports lead to rising imports, most of the adjustment or balancing takes place within the trade accounts—trade in goods and services. However, precise balance to the penny and to the job is unlikely. Nevertheless, the balancing adjustments will continue. A net import balance will result in an equal inflow of foreign capital; a net export balance will result in an equal outflow of capital. These capital flows that finance and offset residual trade imbalances will tend to affect jobs in the same direction as would be the case if trade were precisely balanced.

When we import more, most of the balancing will take place from more exports over time. The jobs lost from imports will be almost offset or just more than offset by jobs gained from exports. However, the net inflow of capital will put downward pressure on interest rates and will also stimulate job growth. The problem is that the jobs lost to imports are more visible and more easily associated with imports than the jobs created by more exports and larger capital inflows. That’s why good economics is often bad politics. Our leaders not only need to understand how trade works; they need to have the courage to explain it to their disgruntled constituents rather than pandering to them.

Good luck with that.

Exports or goods and services increased by $3.7 billion to $132.0 billion while imports increased by $9.3 billion to $168.4 billion. The deficit for September increased from $30.8 billion to $36.5 billion, an increase of 18 percent.

The cause of the deterioration is not obvious. Normally faster growing imports than exports would reflect faster U.S. growth than our trading partners. That isn’t the case with our Asian trading partners, especially China. They have been growing faster.

The answer may lie in capital flows that mirror trade flows and can be the driving force rather than just the passive financing of trade. In other words, the trade deficit may be “financing” an increase in net capital inflows rather than the other way around.

This explanation is consistent with what I’ve suggested before–that more net capital inflows (and thus larger trade deficits) may be necessary to make up for the shortfall of domestic saving in financing domestic investment. With huge increases in government dissaving in the form of larger and larger budget deficits, national saving is shrinking. That means either domestic investment has to fall to match lower saving, or more foreign saving will be necessary to supplement domestic saving.

This explanation is plausible, but nonintuitive. Among  other things, it suggests that we have to have a larger external deficit because of our larger budget deficit. The positive side of that is that a shrinkage of the budget deficit would help on two fronts: it would help finance and sustain domestic investment and would also help reduce the external deficit and accumulation of U.S. debt by our trading partners.

The second paragraph acknowledges this implicitly when it says “Thailand, South Korea, Russia, and the Philippines have been snapping up dollars this week in order to hold down the value of their currencies.” It goes on to say that Brazil’s finance minister said the country’s currency remained too strong even after Brazil adopted some capital controls to weaken it.

While a majority of pundits on financial TV argue for a strong dollar to boost—or should I say “buck up” the U.S. economy, the rest of the world seems to understand that a weaker domestic currency would help them get out of recession, unless, of course, all or most countries do it and cancel each other out. Such confusion is an important reason countries should adapt domestic policies to domestic needs and let their exchange rate adjust to reconcile those with the outside world. 

Yesterday, rumors were going around that China might soon restore the gradual appreciation of its yuan, which implies a weaker dollar relative to the yuan. That would be helpful both to China and the U.S. since the U.S. trade deficit is largely China’s trade surplus. But wasn’t it just the day before yesterday that China was urging the United States to strengthen the dollar, which would imply a weaker yuan. Consistency is difficult to maintain as blog writers will tell you.

I visited China in 2003 and 2006 and made several speeches and gave several TV interviews. I kept making the point that China’s exchange rate was China’s business, but then I pointed out that holding the yuan down was subsidizing U.S. consumers at the expense of their own. The first part of my message was not really correct since every exchange rate has two sides and affects both parties, but I thought it best to be diplomatic about it. During both periods the U.S. was trying to pressure China to appreciate the yuan, and I was convinced that China would do so only if we quit urging them to publicly.

One of the huge mistakes made early in the Great Depression was the severe Smoot-Hawley trade law, which led to competitive devaluations all over the world and triggered a sharp shrinkage in world trade. We haven’t gone that far yet in our Great Recession, but we are on a slippery slope. Exchange rate manipulation can do harm similar to tariffs and non-tariff barriers to trade. Once we start the game of competitive exchange rate changes it can easily get out of control. Instead, let’s follow Milton Friedman’s advice and keep the float clean.

I have always kept track of the U.S./Canadian dollars by comparing the two prices inside new book dust covers. I wrote about this here on October 4, 2007 in a post titled McTeer on Dollars and Books.

Chairman Greenspan’s book, The Age of Turbulence, was released on September 17, 2007, priced at U.S. $35.00 and Canada $43.50. That was a 24 percent difference despite the parity in the exchange markets that month. His publisher obviously didn’t think the parity would hold.

The Prince of Darkness by Robert Novak had come in with a little earlier with a 27 percent difference. Other books I bought around that time had a similar premium on the dollar, the lowest being 21 percent.

With dollar weakness again in the news, I’ve done a bit of empirical research on my recent purchases. A Colossal Failure of Common Sense, The Inside Story of the Collapse of Lehman Brothers by Lawrence G. McDonald and Patrick Robinson is priced at $27.00 U.S. and $33.00 Canadian. That’s a 22 percent premium for the U.S. dollar, in line with two years ago.

In Fed we Trust by David Wessel is priced at $26.99 U.S. and $33.99 Canadian. That’s a 26 percent premium, still in the middle of the range of two years ago. So was Glenn Beck’s, Arguing With Idiots, (a gift) at 23 percent–$29.99 U.S. and $36.99 Canadian.

This Time is Different, Eight Centuries of Financial Folly, by Carmen M. Reinhart & Kenneth S. Rogoff was a gift from my son who was vastly overestimating my scholarship and patience. Speaking of patience, Ken Rogoff and I once spent a week in London one afternoon visiting financial firms there. He was a delightful guy and great company for a professor at a school that doesn’t have a good football team. Anyway the publisher of Ken’s book apparently punted on the exchange rate question. The price was $35.00 U.S. with no Canadian price listed. I’d better not speculate, so that’s all I have to say about that.

Hold on. Stop the presses. I just bought Charles Gasparino’s The Sellout. Same thing: A USA price of $27.99 with no Canadian price.

Do I have to have a conclusion?  What about “The dollar hasn’t really lost any value in the last two years in terms of books, but some publishers are backing away.”

Then why is it that virtually all the commentary on the dollar on financial TV and in blogs fails to mention the balance of payments when discussing the dollar? The dollar is considered super-important these days while the balance of payments isn’t considered important enough to mention. That’s like saying the price is important, but supply and demand don’t matter.

Instead, a strong dollar is treated as both the evidence of U.S. economic strength and a major cause of it. A weak dollar reflects and causes economic weakness. This relationship is either taken as self evident or is based on historical periods when the economy and the dollar were strong together or weak together. Unfortunately, these conclusions are the opposite of what economy theory teaches.

Other things equal, a primary result of an exogenous weakening of the dollar is an increase in foreign demand for U.S. exports, since they are now cheaper in terms of foreign currencies. A weaker dollar also makes foreign exports (U.S. imports) more expensive in dollar terms. Therefore, the weaker dollar will stimulate U.S. exports and depress U.S. imports. This increase in net exports (U.S. exports minus imports) adds to total spending as measured by GDP. If GDP is at recession levels, a weaker dollar helps pull us out of recession.

I don’t deny that many other economic variables have an influence on these relationships. However, the relative price change brought about by changes in the exchange rate are considered dominant among economists who study the matter.

The positive jolt to domestic GDP caused by a depreciating home currency is well known all over the world. That is why during a global slump such as we are in today we have to guard against competitive devaluations where each country tries to boost its economy through depreciation or devaluation which has the opposite effect on its trading partners. The term of art is “beggar thy neighbor” policies, sometimes called “beggar my neighbor” policies.

While the competitive advantages of currency depreciation are widely understood around the world, most of the talking heads on financial TV seem to believe that the opposite is true for the United States. They imply that a stronger dollar will lead to a stronger economy and a stronger economy will lead to a stronger dollar.

Apparently forgotten is the pressure U.S. officials put on China in the not-too-distant past to let the yuan appreciate, which would effectively depreciate the dollar against the yuan. I wasn’t in favor of pressuring China on that point, but at least those who did understood that a more expensive yuan and less expensive dollar would help restore more balance to trade between those countries. Today’s proponents of dollar appreciation are pulling in the opposite direction. It is amazing to me that China has completely turned the tables on us by arguing that it is us with the weak currency while touting their own artificially weak currency (roughly pegged to the dollar and protected also by exchange controls) as a potential reserve currency.

I’m changing focus now. Pay attention.

While a weaker currency helps a country pull out of a recession, a strong currency is beneficial if there is no recession, or shortage of aggregate demand. A strong currency relative to those of your trading partners helps consumers by making imported goods and services cheaper in the domestic currency. The added competition from imports also lowers the price of many domestically produced goods and services. A strong currency puts pressure on producers, exporters, and potential exporters to remain competitive, which isn’t always possible. Businesses may fail and jobs may be lost.

A strong currency generally harms producers and exporters. To repeat: a strong currency generally helps consumers and harms producers.

So, how do you choose which group to help?

The answer is you don’t. Under our system of market-determined exchange rates, the rules-of- the-game call for hands off. Keep the float clean, not dirty. Government tinkering with a floating currency opens it up to intense lobbying by pressure groups that is best avoided.

In the quandary of whether to favor consumers or producers, importers or exporters, a couple of points should help. One is no matter what we do for a living, we are all consumers. Even those harmed as producers will be helped as consumers. Another question to ponder is this: Who is an economy for, consumers or producers? I think the answer is consumers. This is similar to the question, do we work to eat or eat to work? Or, do we import to export or do we export to import. I think the unstated consensus in a democracy is we work to eat and we export to import. Consumption is the end; production is the means. A more totalitarian government, like China, is usually tempted toward mercantilism, which includes a higher priority on exports than imports.

So, my conclusion is there is a strong argument to be made for a strong currency. It just doesn’t apply in the midst of a deep recession when the main problem is inadequate aggregate demand. Many people who don’t acknowledge that are, in my opinion, trying to avoid sounding “Keynesian.”

I’ve said this many times before. My position on a strong dollar is similar to St.Augustine’s position on chastity in his famous prayer: “Lord, make me chaste, but not just yet.” My prayer is, “Lord give us a strong dollar, but not just yet.”

Our national saving—made up of personal, business and government saving—is being supplemented by the foreign capital inflow that finances our current account deficit and helps support domestic investment. The floating dollar adjusts to help maintain the necessary relationships.

China has absorbed fewer dollars lately because our trade deficit has shrunk as reduced domestic demand has reduced our demand for imports more than reduced foreign demand has reduced the demand for our exports. China’s dollar holdings are influenced by everything that affects our trade deficit and capital inflow, including our budget deficit, along with personal and business saving.  Those holdings aren’t independent of these complex relationships.

If any category of our national saving increased, other things equal, our current account deficit would tend to shrink. An appreciating dollar would likely be part of that adjustment process. So, more personal saving, more business saving, or more government saving (a smaller deficit) would all tend to strengthen the dollar. Conversely, a reduction in those categories by our trading partners would have a similar effect.

One caution: if the government increases its deficit to increase transfer payments, which get saved by the recipients, there is no increase in national saving. The greater government dissaving offsets the greater personal saving.

Everyone would be happier campers if we saved more domestically and China and other trading partners would consume more and save less domestically. This would indirectly reduce the trade imbalances and the comparable capital flows and ease the downward pressure on the dollar.

Of course, government saving is tax revenue minus government expenditure; so more government saving could occur either through less spending or more tax revenue. Note that I said tax revenue, not tax rates.

Under those circumstances the dollar would be strengthened by the fundamentals. Attempts to support the dollar without the underlying support of the fundamentals would be like moving the dial on a thermometer without changing the temperature.

 We hear monthly reports on our trade balance—on how our exports of goods and services match up with our imports of goods and services. What hasn’t seemed to sink in is the fact that both measures are pointed down. Both our exports and our imports have been shrinking, as have the exports and imports of most major trading currencies. World trade is shrinking because of falling aggregate demand. Do we really want to add tariffs to the mix?

 Competitive trade barriers are insidious. So are competitive currency devaluations, with both designed to stimulate domestic demand at the expense of our trading partners. It’s a negative- sum game. Nobody wins.

No one has thought to mention that those amounts depend almost entirely on the volume and balance of trade between the two countries. If the U.S. trade deficit (and Chinese surplus) grows, it will be necessary to borrow more to finance it. If trade shrinks, less borrowing will take place.

If the willingness to borrow changes independently of the financing needs of trade, then the trade will have to adjust. Either way, the two are linked, and it is foolish to talk about them as if there is no relationship at all.

It might do so by requiring a larger capital inflow (and thus a larger current account deficit) to make up for the shrinkage in domestic saving relative to investment caused by the growing budget deficit.

When domestic saving is inadequate to finance planned investment, investment must shrink to the savings available, or the saving must be imported from abroad via a larger capital inflow financing a larger current account deficit. The imbalances will affect and be affected by many economic variables, but the impact of the exchange rate on the current account balance is surely a principal one. Since a growing budget deficit seems inexorable, the needed saving will put upward pressure on domestic interest rates and upward pressure on the exchange rate.

Other things equal, a stronger dollar will weaken our current account balance by making imports cheaper and our exports more expensive. Bottom line: the budget deficit may strengthen the dollar. It doesn't seem right, does it?

If you are not convinced, lets start over and approach it as follows.

Without having to resort to numbers, I think we can all agree on the following:

*Consumers are stressed and will be hard pressed to increase personal saving substantially.

*The budget deficit is in the process of an historic explosion-increasing the negative saving coming from the government sector.

*National saving from those two sources is in a sharp decline.

*Other than pulling down investment drastically to match the shrunken saving, we need to borrow more saving from abroad to supplement domestic saving.

*We get more foreign saving by running larger current account deficits, which are financed by larger capital inflows. Those larger capital inflows are what we need.

*Greater capital inflows respond to many economic variables, but mainly they finance the current account deficit.

*To attract more foreign capital, we need to run a larger current account deficit.

*The main way to get an increase in the current account deficit is for the dollar to appreciate and become less competitive, i.e., stronger and for domestic interest rates to rise.

*The need for more saving, made much more acute by the budget deficit, will put upward pressure on the dollar.

*Therefore, the budget deficit will strengthen the dollar.

Protectionism is creeping insidiously into the rhetoric of financial TV.  "Taxpayer money should be spent to stimulate the domestic economy, not foreign economies."  "We should be creating domestic jobs, not foreign jobs."

This slippery slope to protectionism is undesirable. It won't work. It will invite retaliation.

However, it's not only undesirable, it's unnecessary.  Listen carefully.

When we import goods and services, we do generate income and employment abroad rather than at home. However, the exporter now has more dollars to use importing from us. When we export goods and services, we get the foreign currency to use on imports. The simple fact is that imports stimulate exports and exports stimulate imports. Imports and exports tend to move together, in the same direction and largely to the same degree. In all countries, including ours, imports and exports rise and fall together, not by coincidence, but through cause and effect. I'll elaborate on that more later.

If we attempt to keep income and jobs by importing less, we may seem to be successful in the first instance. However, with fewer dollars, our trading partners will import less from us. The income and jobs we gain or retain are more likely to be known to us. We probably won't know the resulting loss of income and jobs; or, at least, the cause and effect is likely to be lost. But the fact remains: when we protect jobs through protectionist trade measures, we lose other jobs. We delude ourselves.

Exports and imports and their consequences do tend to rise and fall together, but, in the short run, they aren't likely to move perfectly together. A small deficit or surplus may result and be sustained for a time. However, this does not destroy the conclusions above because the small deficit or surplus will tend to affect domestic income and jobs in a compensating manner.

For example, if our exports rise 10 percent and the resulting rise in imports is 12 percent, the two percent trade deficit will be matched by an equal increase in capital inflows. A surplus would reduce net capital inflows by a like amount. These capital flows will tend to affect the domestic economy in the same way as if trade had been perfectly balanced.

It's another example of the seen and the unseen. If protectionist measures help one part of the economy, and are seen; they will harm another part of the economy, likely unseen. They not only will lead to retaliation and bad consequences in the long run; they don't even work in the short run.

A footnote: the internal adjustment mechanism that keeps imports and exports in line with each other depend on many factors, but especially on the exchange rate regime. If exchange rates are free to adjust, the necessary price and income signals that motivate the necessary resource shifts will result primarily from incipient exchange rate changes and secondarily from nominal changes in prices, wages and interest rates. If exchange rates are fixed or rigid, nominal changes in home-country prices and incomes will be necessary. The real internal changes will be similar, but they are more likely to take place without frictions that might cause unemployment under flexible exchange rates.