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Dear Philip,

Yes, there is a general shortage of aggregate demand.

However, if any one nation uses a fiscal adjustment to restore demand it will be that much better off if the rest of the world does not increase its aggregate demand.

Fiscal adjustments, much like imports, provide benefits and not costs.

Any unilateral fiscal response will restore both domestic output and employment as well as increase imports from nations who continue to suffer from a lack of aggregate demand.

The idea that there is a need for international coordination is continued evidence of a lack of understanding of the world’s monetary systems.

All the best,


>   On Thu, Nov 13, 2008 at 4:27 AM, Prof. P. wrote:
>   Dear Warren,
>   Many thanks.
>   What you suggest is very true. But not just in the US. Here in the UK
>   and practically everywhere else in the world this is very urgent and a bit
>   overdue. Do you not agree? Would anything along these lines come out
>   from the meeting of the G20 over the weekend, I wonder.
>   Best wishes, Philip


17 Responses

  1. Yes, Paulson’s statement that, “We cannot get out of this alone,” displays his lack of understanding on this issue. The constraints are in his mind. That’s why I’ve often said government should not employ people with private sector business backgrounds. The public sector and business are two entirely different things.

  2. The problem with unilateral fiscal policy is that we either have to pay the debt off in the future or we repudiate it. The first case means that the present citizens of the United States are borrowing from the future citizens of the United States. It’s like a parent squandering an inheritance so that the children get nothing. This doesn’t seem right. Repudiation is the other possibility, but that is a legitimate justification for war. Chinese workers whose parents allowed American to consume the fruit of labor in exchange for IOU’s, would be plenty mad, and rightfully so, if the next generation of Americans repudiated those IOUs.

    This is the same problem with deficit spending within a single economy. It is okay if the system is rigged right, so that the misers are told in advance that their accumulations of government IOUs will be whittled away by inflation and taxes. Otherwise there is a problem. Either we allow the misers and their heirs to eventually own everything, so that the masses are reduced to poverty. Or else we change the rules of the game midstream, by imposing taxes and inflation that the misers didn’t expect, which is a form of repudiation. The misers then get very angry, and rightfully so, that they are being cheated.

    Incidentally, a payroll tax holiday is certainly the fairest way of stimulating the domestic economy, since those who benefit are those who produce. But we also need to somehow rig the system so that accumulations of wealth tend to be quickly eroded, unless the wealth is actively invested. That is, the after tax real rate of return for passive stock and bond investors needs to be close to zero.

    One way to accomplish this with foreign debt is to restrict ownership of treasury debt to American citizens (and perhaps only $5 million per citizen). Foreigners and wealthy americans could own an unlimited amount of fed funds, but they would receive no interest. With inflation at 2%, that would provide a powerful incentive against building up huge accumulations of claims on future American worker output.

  3. Fred, start with ‘soft currency economics’ under ‘mandatory readings on this website (right margin) and let me know if you have any questions.

  4. Warren, I understand perfectly what you are saying. What you don’t seem to understand is that when other countries pile up a huge supply of dollars, they will eventually want to spend those dollars and that’s when the problem occurs. Now sure, if you plan on repudiation (either explicit or implicit via some tax scheme), then no problem. We just pile up a big debt now, enjoy the things the net exporters send us in exchange for dollar IOUs, and then when the exporters try to exchange these IOUs for something valuable that we have, we tell them to get lost. The Latin Americans used to try that, and the way we dealt with it was to send in the Marines. It’s called gunboat diplomacy. Now probably the United States will never be in the weak military position of the Latin Americans and repudiation will always be possible. Still, I’m a little queasy about going down a path with debt repudiation as the final result.

    Now, since I’ve read your very long article on soft currency, please go back and read MY very short posts more carefully and then let me know if you have any questions. 🙂

  5. Followup. One of the reasons the Latin Americans have always been weak and subject to gunboat diplomacy is precisely because they have allowed themselves to be lured down the easy path of “buy and enjoy now, pay and suffer later”. Don’t bother with all the hard work necessary to build an industrial economy. Just import whatever you want from the United States. Don’t have money to pay for these imports? No problem. We take credit! Then what happens when Uncle Sam comes knocking and wants the debt repaid? Ain’t got the dollars to pay? Fine, we’ll take possession of your natural resources and you can work in the fields until that debt is repaid, with interest, down to the last penny.

    What is happening with our massive trade deficit is that we are systematically allowing our industrial economy to fall into decline. As anyone who has studied engineering or hard science knows, industry is hard work compared to working in the services economy. Why bother when the foreigners will do the hard work for us and then sell us the products of this hard work on credit? Now I know what you’ll say. That the United States is still the world’s leader is all sorts of high-tech industries and we still get the most nobel prizes, etc. But things are changing very fast. How many bright young people do you know who are going into hard science, engineering or manufacturing entrepreneurship? Maybe a few want to become computer jocks. But nano-technology or materials engineering or aerospace engineering or anything like this? Forget that. Much too much work for too little pay and too much deferred gratification. Let the foreigners do all that hard stuff. The brightest Americans want to be lawyers or money-managers. If we continue on this path, then a day will come when we will lack comletely the industrial economy that underpins our current armaments industry. And when that happens, we will no longer have the military powers which allows us to repudiate debt (or “imposing a tax on exports” as you suggest in your soft currency article) with impunity. We’ll be in the position of the Latin Americans, forced to pay off all the debt we’ve incurred, with interest, down to the last penny. Hell of a future we’re handing down to our children, don’t you think?

  6. First, Latin America got in trouble over external currency debt, not local currency debt. that never has happened with floating exchange rates, there or anywhere else.


    ‘What you don’t seem to understand is that when other countries pile up a huge supply of dollars, they will eventually want to spend those dollars and that’s when the problem occurs.’

    Japan, for example, has been building $ reserves for 3 generations who have lived and died sending us stuff, and never spending any of their pile, just growing it. no reason for the US not to milk this cow as long as possible, not work to kill it.

    And if they do try to spend it, good luck to them! The will mostly drive up prices and only get back a fraction (in real terms) of even the toyotas they sold us years ago for $2,000.

    They are taking the risk, not us.


  7. >3 generations who have lived and died sending us stuff, and never spending any of their pile, just growing it. no reason for the US to milk this cow as long as possible, not work to kill it.

    3 generations ago, we had just finished nuking the Japanese and the Soviets were threatening from the north and the Red Chinese from the West, so the Japanese had little choice but to slave for us in exchange for protection. But there’s a new order of things coming down the road, methinks…

    Then again, maybe we’ll be okay. Maybe the Chinese of the future will have no desire to put us into the current position of Mexican lettuce-pickers and Hmong meatpackers while they take the position of Wall street investment bankers and K Street lobbyists, our children doing all the hard work while the Chinese live high off the hog, our children unable to resist this new order of things because they no longer have an industrial economy with which to build weapons. Maybe robots will do all the work in the future and war and scarcity will no longer be problems. If so, it won’t matter that we are currently letting our industrial economy be moved to Asia at an ever-increasing rate. And if not? Well then, too bad for the next generation of Americans, eh?

  8. But its been our choice to allow the destruction of our industrial base. Just because we were importing from China didn’t mean we had to let everyone here loose their jobs. We could have employed them doing something else. We’ve chosen instead to switch them to service jobs, or long term unemployment.

  9. Vipul: I’m not going to take the stupid position that the Asians “stole” our industrial base. But I DO maintain that there is a close relation between mercantilism (piling up dollars rather than spending them) and the loss of our industrial base. There is a profound geopolitical basis for mercantilism. The major mercentilists (Japan, Taiwan, Germany) have high population densities, limited natural resources, and a justified fear of being dominated/colonized/invaded by bigger countries with lots of natural resources. They compensate for these fears by subsidizing their industrial base at the expense of their consumers. Under free trade, our consumers benefit from this arrangment, and our industrial base shrinks. Now back in the old days of the cold war, this was no problem, because Japan, Taiwan and Germany had no choice but to ally themselves with us. In a sense, their industrial base was an extension of our own. But things are changing in China and Russia and those mercantilist countries can no longer be thought of as an extension of the United States. A day may come when the Chinese apply the screws and the Japanese and Taiwanese (and Koreans and Singaporeans and everyone else in Asia) decide to abandon us and make a deal with the Chinese. They are a lot closer to China than to the US, after all, and modern technology makes it impossible to keep the sea lanes open in the face of a determined opponent.

    We could, of course, let the rest of the world subsidize us while we rebuild our industrial base. But that gets us into the nasty issues of government planning (and government corruption and waste). A simpler approach, in my opinion, is to simply call an end to mercantilism. No more trade deficits. Moreever, we expect those existing dollar piles to be spent. That will cause a free market rebuilding of our industrial base, as the dollar sinks and the prices of imports soars. So what if the consumer suffers a little? The consumer also suffered mightily in World War II. There are bigger issues at play here.

  10. How are we going to actually do that though? Are you going to bring back tariffs? What about all the oil we have to import?

    And how are you going to explain the sudden drop in standard of living?

    Instead of that, why not just spend more money here and rebuild our industrial base ourselves, while also enjoying the imports from the rest of the world. Like JCM says, have our cake and eat it too. If your worried about government waste, just use Warren’s idea of an employed labor pool. Eventually enough money will enter the system that those employed by the government will be hired away to work in the private sector, on whatever it is that consumers want.


    3 generations who have lived and died sending us stuff, and never spending any of their pile, just growing it. no reason for the US NOT to milk this cow as long as possible, not work to kill it.

    7. seems obvious japan simply has it backwards and runs a trade surplus because they think it’s a good thing to accumulate $. and we send trade negotiators to try to stop it so we must agree.

    8. for a while at least we did ’employ them somewhere else’
    as unemployment fell to 4.5%. it’s more recently that we have let domestic demand fall sufficiently to do some real damage as unemployment moves up through 6.5%.

    time for a payroll tax holiday!

    10/11 so if china ‘cuts us off’ and doesn’t export to us what happens in real terms? walmart shelves go bare, prices of that stuff rise as some do without and it gets allocated by price to the point where we build it ourselves. ironically our politicians think this is a good thing, which is why paulson went there and got them to stop buying dollars- our exports went up and he and bernanke bragged about it. of course our real terms of trade and our standard of living fell as we got priced out our ability to consume in real terms. and our leaders considered this success.

    it also caused a drop in demand overseas where they don’t fathom how to sustain domestic demand and don’t want to anyway, as they think it’s somehow inferior to exports. anyway this meant their economies contracted which further hurt our financial sector which finally was allowed to spill over to our domestic demand by our backwards leaders.

    and here we are, experiencing a drastic slowdown because no one in public policy understands how a spread sheet (our monetary system) works.

    a drop in demand is the easiest possible problem to address.

    when it’s finally understood years from now they will look back at what happened to human kind during this era of no understanding of the monetary system with total amazement.

  12. And you, Warren, still don’t understand how the real world works. The strong do as they wish, the weak suffer what they must. Might makes right. The Japanese and Germans got a taste of what losing a war feels like back in 1945, and THAT is why they are practicing mercantilism. It has nothing to do with failure to understand a spread sheet. They understand the value of a strong industrial base, and they are willing to forego immediate gratification in order to maintain a strong industrial base, and they understand that a trade surplus is the best way to force the building of an industrial base. The United States has never lost a war, nor have we ever had to fear invasions, due to our geographic position. We DID have a scare during the cold war of being attacked by intercontinental missles. Not uncoincidentally, that was the era of both American trade surpluses or at least even trade balances and industrial supremacy. These phenomena are always tightly correlated, for deep sociological reasons. For the past 2 decades, for all the bloat in our military budget and all the sound and fury about terrorism, we haven’t really seen ourselves as threatened by anyone, and that is why we have been allowing trade deficits and deindustrialization to take place.

    But like I said, maybe this is all irrelevant. Maybe robots will do all the work in the future and all 6 billion humans on this planet can have a life of infinite plenty and infinite leisure. There will be no scarcity, and hence no wars. Everyone will realize with amazement that the United States was right to run trade deficits, deindustrialize and otherwise live for the present with no concern for the future.

  13. you can buy a strong industrial base on ebay. it’s just a commodity.

    and if there is an aspect of it that is deemed a national security issue i’d require the military and maybe other govt depts to buy that stuff only domestically with no imported content allowed. that will keep suffient quantities of that stuff for our national security and let the rest of us enjoy the cheap imported stuff for our frivolous consumption.

  14. I see no reason why the government should ever buy anything that isn’t produced domestically, using domestic materials whenever possible. They can afford it, after all; and that would put more money into american pockets. Sure, we can build bombers and hummers, but China is getting rich off of paper clips and plastic cups.

    Someone once said that the practice of philosophy is akin to re-building a ship piece by piece while trying to keep it afloat. This simile is at least as relevant to economics. The question I always return to is whether or not it’s worthwhile trying to keep the ship afloat.

    This system is dependent on “frivolous consumption;” that is what keeps it afloat. That is what keeps the strong strong and the weak weak (at least in financial terms). The impulsive idealist in me would scuttle the ship: let the shelves go bare, let people live without cheap luxuries, let them starve without cheap pre-packaged food-substitutes. Many poor would die; many rich would be rich no longer. As a matter of philosophy it’s an easy exercise; as a practical matter, however, it would be a riotous mess.

    No matter what your philosophical position, it should be more productive to keep the ship afloat. The best option for dissenters, I think, is to jump ship and find a nice island somewhere; either make an example of some natives, and rule with an iron fist, or build a nice hut, raise some goats and chickens, and take up gardening. I’m already practicing my gardening.

  15. Fred, I understand where you are coming from with your military comments. But I have to say, I just disagree with you. First of all, for all practical purposes there is no way that the foreign holders of US$ reserves can ever force the united states to do anything with them. They cannot force us to sell them all of our gold / ships / cars / houses / women, etc… in exchange for the dollars they hold. They sold us real products in exchange for $ reserves, and they can “spend” those reserves to acquire real goods from us or from others selling denominated in dollars. That is the limit of what they can do. The military thing is just a free-floating anxiety based on the reality of tension in the world, but it’s not a very logical assumption as a consequence of net foreign dollar reserves.

    I guess I am curious as to what they imagine them doing. Do you imagine the rest of the world banding together and showing up on our shores with a flotilla and demanding our stuff in exchange for the dollars they hold? In point of fact, that particular method of wealth acquisition has been around much longer than the dollar, and anyone wishing to pursue it needs no pretext to do so, they only need the means. Do you get what I am saying? Foreign powers do not need massive US$ reserves that they cannot force us to “redeem”… as justification to make war against us. They have many other reasons for doing so, and indeed need no reason at all. So, to assume that net foreign reserves of US$ is somehow inevitably going to result in the rest of the world showing up to seize all our assets is just not very logical; it’s not a reasoned argument. As a matter of fact, it doesn’t even make sense – if they wanted to do that they don’t need to accumulate a bunch of dollars they can’t spend first.

    Perhaps I am woefully uneducated, here, but it seems pretty straight-forward to me. There is a simple transaction taking place: we buy goods and services from these nations. They sell us goods and services in exchange for payment denominated in dollars, pure and simple. If they don’t want to sell to us, and thus acquire dollar reserves in exchange for their goods, they don’t have to. If they don’t want to buy treasuries, they don’t have to. Nobody is forcing foreign entities to either sell goods to the US nor to acquire US treasuries. And by the way, what denomination do you think a treasury return is in? The “responsibility” of the US government is ONLY to pay the yield IN DOLLARS, and there is no functional limitation in our ability to do that. What do you imagine transpiring that could prevent the United States from honoring the need to dollars?

  16. ‘I see no reason why the government should ever buy anything that isn’t produced domestically, using domestic materials whenever possible. They can afford it, after all; and that would put more money into american pockets.’

    at the macroeconomic level it’s better to buy what’s ‘less expensive’ unless there are strategic/national security issues.

    fiscal policy can put whatever funds in whatever pockets it wants in any case

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