Sunday, August 21, 2005

Bad macroeconomics

Cursory scanning of the Op-Ed page of nearly any daily will typically net you a golden example of bad economics. Here's one:

Belinda Olivares' column

Citing the main howler:
THE ENTIRE citizenry has to cooperate in efforts to save on fuel, as it's a matter of national survival. With the price of oil predicted to shoot up to $70 per barrel from just over $30 a year ago, it's no longer a question of whether we can use up as much fuel as we want, so long as we can pay for it. The nation has to cut down on fuel consumption as it's going to drain our international reserves and could widen our budget deficit.

I won't talk about the price angle - yet. Let's just look at some basic national income accounting, shall we? Olivares claims there's a connection between oil price hikes, draining international reserves and widening the budget deficit. Is there?

At the national level, let Y = income (=spending), S = saving, C = consumption, T = tax revenue, G = government spending, X = imports, M = imports.

Based on total spending, we have:

Y = C + I + G + X - M.

Based on uses of income, we have:

Y = C + S + T

These two are basic accounting identities - they are true by definition. Equating income with spending, we have:

C + S + T = C + I + G + X - M.

Cancelling out C and with a little rearrangement:

S - I = (G - T) + (X -M)

What does this mean? National savings (net of what is lent to investors) is lent either to the government (G - T is simply the fiscal deficit) or to the rest of the world (X - M is borrowing by foreigners). Again, accounting identity - true by definition.

Now it follows that if there is a trade deficit, then net national savings equals what is lent to the government, net of what is borrowed from foreigners. Note that if the trade deficit widens, and net national savings is constant, it must be the case that the fiscal deficit increases. So on the surface, there does appear to be a link.

That's several ifs. On the other hand, if government holds steady on its fiscal policy, then G - T is constant (yes, that is perfectly possible), and therefore an increased trade deficit must drive net private saving down.

What about international reserves? It only enters the picture when we look at how a trade deficit is financed. There is another basic identity here:

M - X = capital inflows + change in international reserves.

(Here I am ignoring international transfers, like foreign grants.) Net borrowing from the rest of the world must be financed either by capital inflows from foreigners (foreign direct investment, and net investments in domestic financial assets), or by drawing down Central Bank reserves (of foreign currency and gold). If the trade deficit widens and capital inflows are constant, then international reserves must fall. Note that drawing down international reserves is independent of the government decisions on its budget deficit.

Where did the confusion come from? I think it is a common layperson's idea that the Central Bank somehow holds foreign reserves, which is used for imports - and that more lending for imports increases the debt of the government. Wrong. In the first place, the Central Bank is not the only (not even the main) source of dollars to finance purchases from foreigners. Second, government debt is not a liability of the Central Bank. If it decides to assume that liability, we are in for a terrific financial disaster!

Paying attention to the standard definitions can clear up a lot of nonsense about basic macroeconomics.

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