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When forecasts don’t pan out

Summary:
There’s no shame in making forecasts that prove inaccurate; I’ve done so many times. Nonetheless, it is useful to try to figure out why a particular forecast didn’t pan out. Stephen Rose has a paper on the effects of trade on the US economy, which contained this observation: [T]he notion that the United States can continue to run trade deficits is incomprehensible for many people. In 1988, Harvard finance professor Benjamin Friedman in his book Day of Reckoning wrote that the United States would have serious negative economic consequences because it had five years of trade deficits that averaged a bit less than 2 percent of GDP. He argued that the United States would have to pay off the principle and the interest in the 1990s, which would lead to a negative capital

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There’s no shame in making forecasts that prove inaccurate; I’ve done so many times. Nonetheless, it is useful to try to figure out why a particular forecast didn’t pan out. Stephen Rose has a paper on the effects of trade on the US economy, which contained this observation:

[T]he notion that the United States can continue to run trade deficits is incomprehensible for many people. In 1988, Harvard finance professor Benjamin Friedman in his book Day of Reckoning wrote that the United States would have serious negative economic consequences because it had five years of trade deficits that averaged a bit less than 2 percent of GDP. He argued that the United States would have to pay off the principle and the interest in the 1990s, which would lead to a negative capital balance. This would require the value of the dollar to decline so that exports would increase, and imports would decrease to maintain the United States’ balance of all payments.

None of these things happened. Instead of negative consequences, U.S. GDP growth in the 1990s was higher than GDP growth in the 1970s, 1980s, and 2000s. Furthermore, between 1994 and 2019, the trade deficit was never less than 2 percent of GDP.

This continued imbalance was offset by massive inflows of foreign capital. As of the fourth quarter of 2020, foreigners held $41 trillion of U.S. assets versus the $27 trillion of foreign assets held by the United States. One would think that a $14 trillion net international debt would lead yearly investment balances to be negative as well, yet, this has not played out. The United States gets a higher rate of return on its foreign assets than foreigners get on their U.S. assets. The difference is so large that the United States has had positive investment income in every quarter during these years.

It seems logical that if a current account deficit represents net borrowing by a country, then these deficits will lead to a future negative capital balance, as interest is paid on the loans.  The problem is that current account deficits do not represent net borrowing; rather they reflect the net flow of capital.  And capital assets include not just loans, but also equity.

Suppose that each year someone borrows $1,000,000 at 2% interest.  They invest $500,000 in the stock market, where their return averages 5%.  The other $500,000 is spent on luxury goods.  How long can they keep doing this?

Forever.

The 5% return on their stock portfolio is more than enough to pay the 2% interest on their loan, with some left over to add to their capital.  This can go on for as long as the investment income exceeds the interest payments on the loan.

This example is a good way of visualizing why Milton Friedman was wrong back in 1988.  He started with the common sense idea that people and countries cannot live beyond their means forever.  If they spend more than they earn, then at some point there will be a bill to pay.  But he forgot that investments in real capital goods can be highly productive.  America is not actually living beyond its means; it’s using its intellectual capital to produce highly valuable investments throughout the global economy.

Here’s another common sense notion that proved incorrect.  During the decades after WWII, many manufacturing jobs moved from high cost northeastern states like Massachusetts to lower cost southern states like Alabama.  Common sense suggests that this would cause the two economies to converge over time.  And for a period they did seem to be converging, as per capita income grew faster in the south than the northeast.  But over the past 40 years this process has gone into reverse, with incomes in Massachusetts rising rapidly as it shifted to higher value added products.    Here’s Rose:

In 1960, the New England and Mid-Atlantic states had the highest and third-highest concentration of manufacturing employment—42 and 37 percent, respectively. In contrast, by 2019, these two regions had a lower-than-average proportion of manufacturing workers.

The East South Central (Alabama, Kentucky, Mississippi, and Tennessee) and the West North Central (Iowa, Kansas, Minnesota, Missouri, Nebraska, North Dakota, and South Dakota) regions had an above-average manufacturing share in 2019, but below-average manufacturing shares in 1960. The East South Central region benefited from two waves of manufacturing employment—the movement of firms from New England and the Mid-Atlantic in the 1970s and 1980s and the arrival of many foreign automotive firms opening factories in the United States after 1980.

The movement of manufacturing employment across states does not support the primacy of manufacturing industries as the key to a strong economy. Indeed, the two regions with the largest manufacturing share loss—New England and Mid-Atlantic—had 6 of the top 10 states in terms of GDP per capita (and this does not include Washington, D.C., which has the highest GDP per capita).

Despite the high cost of living, the population of places like Massachusetts, New York City, and Washington DC grew much more rapidly during the 2010s that the population of low cost East South Central states like Alabama, Mississippi, Arkansas, Kentucky and Louisiana.  (Tennessee is an exception, due to booming Nashville.  It also has no state income tax.)

Rose’s entire paper is well worth reading.  It shows that very little of the job loss in America is due to trade, most is due to automation.

HT:  David Levey

Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment". In May 2012, Chicago Fed President Charles L. Evans became the first sitting member of the Federal Open Market Committee (FOMC) to endorse the idea.

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