Gita Gopinath on Trade, Currencies, and Economic Transformation

Tyler Cowen (0:04)

Conversations with Tyler is produced by the Mercatus Center at George Mason University, bridging the gap between academic ideas and real world problems. Learn more at mercatus.org. For a full transcript of every conversation enhanced with helpful links, visit conversationswithtyler.com.

Hello everyone and welcome back to Conversations with Tyler. Today I'm honored to be speaking with Gita Gopinath, who is Professor of Economics at Harvard, formerly First Deputy Director at the International Monetary Fund, which is number two in that institution, formerly Chief Economist at the International Monetary Fund, and one of the leading figures in international trade and finance and economics more generally. Gita, welcome.

Gita Gopinath (0:54)

Thank you, Tyler. Thanks so much for having me on your show.

Tyler Cowen (0:57)

Today, I have only easy questions.

So we're economists, right? Relative prices matter, but it seems that trade balances are fairly weakly correlated with real exchange rates. How could you explain that?

Gita Gopinath (1:11)

Yes. So if you look at what goes into a trade balance equation, it depends upon the relative price of your goods in international markets, but it also depends upon the relative level of demand in the two different countries for just overall consumption. So for example, if in the US, consumption is strong, while in China, consumption is weak.

Even if relative prices were to favor, for example, US goods, just the overall level of demand being lower in China would reduce the overall level of exports from the US to China. So both those variables matter to not just the relative price, but also the relative levels of demand in countries.

Tyler Cowen (2:00)

But why doesn't at some point the real exchange rate keep on adjusting so that the substitution effect finally has some importance relative to the income effect?

Gita Gopinath (2:09)

There is this notion that if you were to write an economic model, that our models would predict necessarily that a country that's running a current account deficit, for instance, that would experience a depreciation of their real exchange rate, and a country that's running a current account surplus would experience an appreciation of their real exchange rate. I think that's an incorrect statement. This is the formal statement. It's partly correct, but here's the accurate statement. The only thing our models tell you is, as you know, we have what is a no-ponsy condition, which is some sort of an intertemporal budget constraint. What it tells you is that a country that is, for example, running deficits and therefore accumulating a lot of liabilities to the rest of the world will have to repay those liabilities, because we have a condition or either way is your default, one of the two. So how do you repay those liabilities? You repay those liabilities in the equation will tell you that at some point, you have to start running trade supplices to repay those liabilities.

Assuming you don't have an exorbitant privilege in the sense that what you owe to the rest of the world in terms of interest payments is not always that much cheaper than what the rest of the world owns from you. There are periods in US history when that's been true, that's less true now and I don't think we can assume that's going forward. So a country that's accumulating a lot of debt to the rest of the world, or liabilities to the rest of the world, for instance, will say at some point have to run trade balance supplices. Now, there are two ways that those trade balance supplices can come about. One is through a real exchange rate depreciation. So that is true. That could be one channel. But the other channel is if the country's overall level of demand were to collapse, then that would also mean that they would import less relative to the rest of the world whose demand is higher, and they would import more. So either of those channels or both of those can be in play.

If you look at the evidence in the data and you try to do some kind of a decomposition of how much of it is real exchange rate versus demand, I mean, there is no clear mapping from the fact that if you're a country that's running current account deficits or running trade deficits for a long period of time, that you necessarily should see a weakening currency.

Tyler Cowen (4:30)

That puzzles me all the more. So if we think of Australia, which does not have exorbitant privilege, as you know, they ran trade deficits for decades steadily. There was no reason to think Australian demand would suddenly collapse, right? Australia's done fine, has strong fundamentals.

Yet the intertemporal constraint on that process, it never seems pushed into the present. Why is the intertemporal constraint so weak? And how should that shape how we think about how economies actually work? Is everything just flash period by period in like the very simple Keynesian models, or is it something else?