Real linkage

One of the international finance puzzles is about the missing international consumption smoothing. Standard consumption theory predicts countries will trade with each other to drive out the problems associated with production fluctuations. A country with high output this year would want to have a trade surplus, which is effectively saving of the country, and reverse the course when the crop is not so good in other years. In reality, that is not the case observed by economists. A seminal paper by Backus, Kehoe, and Kydland is the standard literature in this regard.

To exacerbate the fluctuations, the world is now more linked together than before. Flood in the Midwest might just as well starves people in the South East Asia. With food riots all over the world, the real linkage is more evident than ever. Both Ken Rogoff and Joe Stiglitz argue that rising prices are not going to be tamed and that countries should start to allocate more resources to help the poor and the deprived.

I don't envy Bernanke's job at all. The cure for high inflation is written in macroeconomics textbook: just increase the interest rate. Yet, he doesn't have the luxury to do it. The linkage is real: if the U.S. economy is tanking, the world suffers. If the world suffers, it is bad for the U.S. Just imagine what would happen if food riots are spreading in China like the wildfire in California. The world cannot afford a breaking-down China.

Here is one little idea for research: the correlation among approval rates of politicians across countries might be a better indication of the real linkage than the output numbers can reveal.

(Picture: Washingtonpost.com)