Monday, August 29, 2005

Paul Krugman's confusion about Greenspan and the housing bubble

When I first saw the headline of today's Paul Krugman column, "Greenspan and the Bubble" I felt hopeful. Might Krugman again get a temporary lapse into economic sanity and pinpoint the blame for the housing bubble on the Fed's cheap money policies?

No, instead he blames the bubble on some comments by Greenspan. While those comments should indeed be criticiized it is ludicruos to blame the bubble on the comments rather than his policies.

Moreover, in the end Krugman criticizes a valid observation from Greenspan. Namely that the end of the housing bubble should reduce the trade and current account deficit. He writes:

"And here's where Mr. Greenspan is still saying foolish things. In his closing remarks he suggested that "an end to the housing boom could induce a significant rise in the personal saving rate, a decline in imports and a corresponding improvement in the current account deficit."Translation, I think: the end of the housing bubble will automatically cure the trade deficit, too.

Sorry, but no. A housing slowdown will lead to the loss of many jobs in construction and service industries but won't have much direct effect on the trade deficit. So those jobs won't be replaced by new jobs elsewhere until and unless something else, like a plunge in the value of the dollar, makes U.S. goods more competitive on world markets, leading to higher exports and lower imports."

Hu? First of all, who said anything about replacing jobs? Reducing the trade deficit isn't the same as replacing jobs. Secondly, it is surprising to see a leading trade theorist like Krugman assert that currency movements is the only thing determining trade balances. As he of all people should know, the end of the housing bubble would mean a reduction in domestic demand something which would partially translate into a lower trade deficit. Moreover, a end to the housing bubble is likely to lead to a weaker dollar is it would make it likely that the Fed would reverse course and start cutting instead of raising interest rates.


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