Here’s my attempt at Applied International Economics in a few pages. Please make sure you read Part one (my last post) first or this may not make sense to you. Also, please check out the recently added About the Author and About the Blog pages at the links on the right.

Lesson #1: The benefits of trade. Trade in general makes everyone better off. International trade does have some potential negative side effects, but the fact that two countries that freely trade will both benefit as a whole is basically undisputed. Here’s a quick scenario to make the point and keeps things simple. Imagine a world with only two countries and two products: the US and Brazil, producing only apples and bananas. Apples are naturally easier to produce in the US, and bananas easier in Brazil. In the US, we could devote all our resources to make 600 apples or 200 bananas. If we try to make both, we could only make 300 apples and 100 apples. Brazil is the exact opposite, meaning they can either make 600 bananas or 200 apples if they specialize, or 300 and 100 if they try to do both. So if the countries don’t trade and decide to make everything themselves, they will each have 300 of one fruit and 100 of the other. If, however, they both just specialize in what they do best and then trade, Brazil will make 600 bananas, the US will make 600 apples, and we can both have 300 of each – a major improvement.

This same rule applies even if the US is better than Brazil at producing both apples and bananas. This is easy to understand if you imagine a rich computer engineer that makes $1,000 an hour. Let’s say he wants to paint his house. It would take him one hour and $100 to do it himself or he could pay someone else $500 to do it, which should he choose? He’s actually better off paying someone else. Why? Even though it’d only cost him $100 to do it himself, he’d lose the $1,000 he could be making at his other job in that hour. He’s better off getting ripped off by the painter and sticking to what he does best. The same applies to international trade: we are all better off if we stick to whatever it is we do best, regardless of whether or not another country does it better or worse. So, as a country, it’s in our interest to specialize in what we do best, and trade that product for what other countries do best.

This is all pretty simple: trade makes the both countries richer. But what if you are a banana grower in the US and we start trading with Brazil? You’re going to lose your job. In the long run the country is better off because we will create a lot more apple growing jobs and all the banana growers can start growing apples instead, but what if it’s not as simple as bananas and apples. What if we start trading with China and they specialize in manufacturing and we specialize in high-tech? Everyone in the US manufacturing industry is going to get hurt, and the only way they can reap the benefits of trade is to get retrained in the high-tech industry – something that doesn’t happen overnight and you get a lot of unemployed factory workers with hungry families during election season that think international trade is a terrible idea. The bottom line is that trade creates a lot of benefits, but requires some difficult adjustments.

This simple fact leads to a few different options. We can 1) just trade freely knowing it will work out better in the long run, 2) limit trade and give up the benefits to protect those that might otherwise have to adjust, or 3) promote free trade while finding a way to cushion the difficult adjustments that many will have to make. I think option 3 makes a lot of sense. The developing countries of the world are inevitably going to specialize in labor intensive industries such as manufacturing and textiles. The US has a comparative advantage in high-tech industries and services, which means that it actually makes sense for us to give up labor intensive work while we transition to a higher-wage high-tech economy. People are rightfully worried because the low wage earners are losing their jobs to other countries, but in the long run we can trade those jobs for higher wage jobs. For that to happen though, we need active government involvement in the economy. Those people that lose their jobs need to be invested in and retrained to claim higher income jobs. So when a factory is shutdown in our heartland the best policy isn’t to blame China, raise tariffs, and subsidize the factory; we should instead spend the money to retrain the workers of that factory to enter a more competitive industry with higher wages – teach them to do what we do best so they can reap the benefits of the international economy.

Lesson #2: Current accounts. In part 1 I talked a lot about spending more than we make, but what does that mean and how do we measure it? Is it the government deficit or private spending that’s the problem? The current account balance gives us the answer to that question. The current account balance is also known as the trade deficit or surplus. Our trade deficit in 2008 (at its highest level) was about $840 billion. Economists will try to confuse you by talking about capital flows and foreign investments, but in simple terms that means we bought $840 billion more stuff than we sold, or very simply the entire country spent $840 billion more than we made. How did we get that money? We borrowed it from other countries – it’s that simple. From 2006-2008 that deficit was between 5-6% of GDP, it’s now back around 3%. So we spent 5-6% more than we made before the economy to a hit – you probably don’t need a Ph. D. in economics to know that’s not sustainable in the long term. Even if the GDP grew at the average of around 3%, we’d still be collecting an exponentially growing amount of debt.

So why are we spending too much and who’s doing the spending? Is it the government’s fault, individuals’, or corporations’ – can we blame it on China? That’s where things get a little confusing, try to stick with me for a few tough paragraphs and we’ll get through some discussion of monetary policy and exchange rates. Much of this is based on diminishing returns and investment. Basically, some investment is good because it will increase our future income, but too much is bad because the economy can’t grow fast enough to make it worth it. If interest rates are low people are likely to borrow money to invest. If interest is high we’re likely to save rather than spend (investment is a kind of spending). The government and the Federal Reserve try to keep investment at an optimal level by using a bunch of tools to raise or lower the interest rate. When the economy is slow they lower the interest rate to speed things up; and when they’re worried about over-investment they raise interest and slow things down. (Also realize the government doesn’t control the rate, they just interact in the market to adjust it; private interactions have a lot to do with interest as well.) That’s called monetary policy – so what does this have to do with spending? Let’s look at a simple example.

Let’s say we all make $100 and give $30 to the government in taxes. We expect the government will spend the $30, but what happens if they spend $40? The government has to borrow money; and that causes the interest rate to go up. We all had $70 left that we would have either spent or invested in the private sector, but since interest is high and the government needs money we save more money than usual by buying a government bond at a good interest rate. Now instead of spending or investing $70 on the private economy, we save $10 and spend $60 on the economy. This is not a bad thing because supposedly the extra money the government spent is just like spending it ourselves; it brings us products like national defense and new roads. But now we have less to spend on private goods and invest in private companies. This not only causes stock prices to decrease; you’ll also remember from part 1 that this reduction in demand causes layoffs and unemployment. This should be okay because those people should be able to find jobs working on all the new government projects – but people don’t like having to find new jobs so they write their congressman. Your congressman is worried about his reelection in 6 months and not about the debt 30 years from now so the government decides to make sure we can get our big army and new roads, and no one in the private sector has to lose jobs. They use their monetary policy tools to bring the interest rates back down and encourage more borrowing and less saving. The government still has to raise money for their deficit, but places in Asia are more than happy to give us the loan because they believe in spending less than they make and want to save some money in reliable US government bonds.

We’ll get right back to that story, but have one last concept to understand before I continue: exchange rates. Exchange rates are a byproduct of current accounts and monetary policy. If we buy more stuff from China than they buy from us, then they have more dollars than we have Yuan (Chinese currency). Because of supply and demand this means that dollars would become less valuable to them since they have so many – all other things being equal. The dollar becomes weaker (the exchange rate lowers) and next year we can’t buy as much stuff from China with our weak dollar and the current account balance will become more even. That’s how it’s supposed to happen. But what if our interest rate goes up? That makes dollars harder to come by and thus more valuable, meaning we can keep on buying lots of stuff from China. And what makes the interest rate go up? The government needing to borrow money makes interest go up…and now back to the story.

So now the government has spent extra money on its people and loosened up monetary policy so everyone can have their cake (government spending) and eat it too (private spending). To pay for their extra spending they start borrowing money from China who likes to save lots of money because they don’t give their people any cake. China loaning our government all that money has the side effect of strengthening the dollar and making it easy for us to buy all their stuff – giving them more dollars that they turn around and loan right back to us. So now we have a huge government debt to pay, the trade deficit is getting worse, and we’re spending more than we make, all while we were in the midst of perfectly prosperous economic times – then the sub-prime mortgage crisis hits…whoops. We can’t stimulate the economy and smooth the bumps by spending a little borrowed money because we’ve already been doing that when we didn’t need to. Since we ate our cake on borrowed money last year I guess we’re stuck with ramen noodles for a while until we dig ourselves out of the hole.

So back to the question, whose fault is this? China could probably save a little less money and let their people have a little more cake – but that’s their choice not ours, they can save as much as they want. Are America’s corporations to blame? If they invest or spend too much they immediately pay the price on the market, so they couldn’t cause the problem if they tried. What about the average American, especially those in the habit of spending more than they make? They aren’t helping, but sooner or later they have to come good on their loans or they won’t get to borrow any more money. Then there’s our government who can borrow and spend as much as they want to make the economy look good and get reelected a few times, but aren’t responsible for paying it back – that’s next generation’s problem. But really that means it’s my fault, the government answers to ME, right? Am I looking the other way while they pass off problems to my children so I can have my cake and eat it too?

Here’s the simple solution. Once the recession is over we must slowly reduce the federal deficit until it is balanced and keep our hands off the monetary policy games, letting the market set the natural interest rate. Then we must keep it that way unless there is a major shock to the system that requires temporary intervention and borrowing. It’s that simple. Meanwhile we could also pass some free trade agreements (which Democrats are hesitant to do) and use our new found wealth to offer retraining to our factory workers (which Republicans are hesitant to do) so they can make $40 an hour building robots that do my laundry and solar panels that keep energy costs down and let China have the $10 an hour jobs making T-shirts. That kind of talk about making hard adjustments and using ideas that come from both sides of the aisle doesn’t get people elected though.