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Sunday, November 11, 2007

Do I Dare Debate Paul Krugman on International Macro ?

Why not. Does help that I am defending Robert Rubin.

Rubin said

“You could have had surpluses that affected the savings rate and would have helped the trade balance. I think you would have had more confidence in the policy framework and you would have had a better dollar,” he says regretfully. He pauses to reflect. “But we are where we are.”

Krugman assumes, correctly I guess, that Rubin was not wishing for a huge major recession in the US and uses the standard international macro model to argue that, otherwise, the only way to improve the trade balance is to weaken the dollar.

The problem is that the standard model is a short term model in which the US net financial position is treated as a constant. I think I can reinterpret Rubin so that his claims make sense provided that the timing of "would have" and "would have" is just right.

OK Lower trade deficit means slack demand in the US, the fed thus sets lower interest rates and the dollar is less valuable compared to other currencies (the exchange rate is high) the US balance of trade is less negative and US net debt is lower so US net capital income is higher .

This means that now, with less debt, the current account can be in balance with a more valuable dollar.

So tighter fiscal policy first implies a "better" trade deficit (with a dollar worth less) and then a "better dollar" (with a more negative trade deficit).

I think this is all possible and technically (barely) consistent with Rubin's words.

However, I honestly think Krugman is right about what Rubin meant.

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