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Monday, October 25, 2010

Comeptitive devaluations - Krugman, Sumner and Yglesias

Scott Sumner remarks on Paul Krugman's post "Worst economist in the world". Krugman is not impressed with the logic, neither is Sumner. Sumner also points to Matt Yglesias who dissects the argument. But the journalist's argument has merit. It is slightly different but I would give it a benefit of doubt. Let me explain:

In normal circumstances, "competitive devaluation"results in inflation. Inflation is OK if income distribution mechanisms are working. So if employment is robust, economic engines are operating, then the transmission of higher oil prices into higher incomes creates a balancing effect by creating higher ability to spend. 

Currently, those mechanisms are not working. So "other things being equal" does not apply today. Thus, higher oil prices will impair the household balance sheets further. At the same time, the increase in input costs will either weigh in on corporate performance or get transmitted to households again. Thus, the rise in oil prices is ominous for households.

However, they have no bearing on international trade. It cancels out.

Meanwhile, there is an argument about commodities being store of value. We need to understand the argument carefully. Store of value has to be independent. Commodities are co-dependent on the economy. Commodities carry value because of the demand. At higher prices, elasticities tend to affect demand and hence the value. The commodity prices may reach higher but will have to come back to demand-supply equilibrium. 

Thus, commodity prices contain two intersecting variables. A measure of value and price as indicated by demand supply balance. Since these two variables are finely mixed up we cannot separate one from other. Thus it is inappropriate to draw conclusions from the prices of commodities.