21 January 2011

Balancing the Budget

With record-level deficits, balancing the federal budget is once again being debated in Washington. There seems to be a consensus that balancing the budget would be a good thing but how to go about it is such a contentious issue that I have little hope of progress this year.

The seeming consensus on this issue is curious to me. After all, John Maynard Keynes advocated deficit spending especially in recession times and Keynsian economics seems to be the philosophy of the day. But I'll save the reasons for balancing the budget for another post. Today, I'm writing about some of the unexpected side effects of balancing the budget.

Last April I wrote about a lecture by my former Business Finance professor where he explained some of the unprecedented features of the current recession. Among other things, he pointed out the unusual nature of our trade deficit with China. Normally, when a large trade deficit occurs, the currency of the importer nation (the US in this case) weakens relative to the currency of the exporter nation. That's because the exporter nation has an excess of the other nation's currency. That weakening of the currency causes imported goods to increase in price until domestic manufacturing becomes competitive or exports balance out he imports.

However, much of the fuel in China's current economic growth comes from exports and the Chinese government wants to keep feeding that fire. Therefore, the Chinese government buys dollars from exporters in exchange for Yuan. But to balance the trade deficit, they have to get those dollars back into the US. They do so by buying US Treasuries. In other words, we export debt to balance our importing of goods.

So, what would happen if, by some miracle, we balanced the federal budget in 2011? Chinese institutions wouldn't have a place to put their dollars, the trade deficit would weaken the dollar relative to the Yuan, imports would become more expensive to us just as our exports became less expensive to Chinese consumers. Domestic manufacturing would increase, unemployment would decrease.

Of course, domestic economic stability would occur at the expense of reduced growth in the Chinese economy. Whether they would accept that without taking some action we may never know..

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