RESEARCH & IDEAS

A Macroeconomic View of theCurrent EconomyQ&A with: David A. MossPublished: January 25, 2010Author: Sean Silverthorne

Concerned or confused by the economicenvironment? Take some lessons from historyand concepts from macroeconomics to get abetter understanding of how the economyworks. A Q&A with HBS professor David A.Moss, author of A Concise Guide toMacroeconomics: What Managers, Executives,and Students Need to Know. Key conceptsinclude: Macroeconomics involves thinking about

the economy as a whole, rather than theactions of individual actors.

The three pillars of macroeconomics:output, money, and expectations.

A good grasp of macroeconomics will helpreaders make better sense of the businessnews and trends.

We can use the long history of financialmarkets and institutions in figuring out howto prevent another financial crisis.

If they didn't understand it already,executives and corporate managers have learnedone huge lesson over the past couple of years:macroeconomics matters.

Interest rates. Exchange rates. Tradedeficits. The Gross Domestic Product. Inflation.All of these can affect a company's bottom lineby influencing the cost and availability ofmoney, goods, and services. Macroeconomicforces can conspire to make business moredifficult, but they can also present opportunitiesto executives who know how to, for example,read a country's national income accounts andbalance of payments.

For explanations on how the economicsystem works and what history teaches us,business readers might turn to A Concise Guideto Macroeconomics: What Managers,Executives, and Students Need to Know, byHarvard Business School professor David A.Moss, who holds graduate degrees from Yale ineconomics and history. The book, which grewout of background notes Moss wrote for hisMBA students, is a nontechnical, accessibleexplanation of broad concepts such as "output,""money," and "expectations"as well as morespecific ones ranging from real exchange ratesto total factor productivity. Moss also includes

numerous tools for interpreting big-pictureeconomic developments.

We asked Moss to talk about the book andsome of the events now taking place on themacroeconomic horizon.

Sean Silverthorne: What's the definitionof macroeconomics?

David Moss: It involves thinking about theeconomy as a whole. Micro is about firms andindividual actors and how they behave; macro isabout aggregate performance of the economy:overall GDP, trade surplus or deficit, inflation.

In principle, we should be able to get rid ofthe (macro/micro) distinction because all microbehaviorall the firms and individualsaddup to the aggregate economy. But it turns outthat we're not there yet. There's still a great dealwe don't fully understand. We see patterns atthe macro level that are sometimes hard todisaggregate and pinpoint exactly where theycame from at the micro level. So as a result, weseparate macro and micro. Someday, if we everfigured everything out, these things would cometogether. That's true in many areas of study.

Q: What will executives and otherbusiness readers learn from the book?

A: One of the most important things isthey're going to be able to read the FinancialTimes, the Wall Street Journal, and TheEconomist much more effectively than theycould before. Those publications integratemacroeconomics with what we know aboutbusiness and markets, often in the very samearticles. Without some background inmacroeconomics, much of that goes past thereader.

What exactly does it mean that the realinterest rate has moved, or the real exchangerate has moved this way or that? There aredifferent types of productivitylaborproductivity, capital productivity, and totalfactor productivity. Which is the right one tolook at in a particular context?

There's a lot of information outthereparticularly in the business press. Ifthese aren't familiar terms, and if one doesn'thave a way of putting it all together, then youcan't process all of this information as

effectively as possible.I think another thing readers will learn is

that they can look at big developments at themacro level and start to think about what theymeanhow these developments might comeback and affect their bottom line.

Let's take exchange rates. Exchange ratesfluctuate widely, and anybody who tells youthey know what the exchange rate is going to betomorrow either has godlike powers or isputting you on. But there are patterns over time.For example, countries that are running largeand ongoing current account deficits tend to seetheir currencies depreciate over time. Thisdoesn't mean that the currency of a countryrunning consistent current account deficits isgoing to depreciate tomorrow or next week oreven next month. But over time, you expect it todepreciate. So if you're a business manager, youprobably want to be fairly well hedged againstthis possibility, either by making use of certainfinancial instruments or by carefully spreadingout your real investments across variouscountries.

Q: You mentioned that you can't predictexchange rates. But are there rules of thumbmanagers can practice when thinking aboutexchange rates and how to play them?

A: I'll mention several.First, as I just suggested, it makes sense to

look at a country's current account deficit orsurplus. For countries that are running largecurrent account surpluses, like China and Japan,you'd expect their currency to appreciate oversustained periods of time. I can't say for surethat Japan's currency is going to appreciate overtime, but in all likelihood, it will. I would bevery surprised if China's doesn't appreciate overtime.

Another thing you want to look at isinflation. If a country has a higher inflation ratethan its trading partners, you should expect thatits currency is likely to depreciate over time aswell.

Maybe I can put this in some perspective.Over the long term, a main driver of a country'sexchange rate is probably its current accountdeficit or surplus. In the medium term, youprobably want to look at inflation rates. But at

COPYRIGHT 2009 PRESIDENT AND FELLOWS OF HARVARD COLLEGE 1

the day-to-day level, changes in short-terminterest rates seem to be a key driver. Forexample, if the European Central Banksuddenly (and unexpectedly) raises its keyshort-term interest rate tomorrow, you'reprobably going to see the euro appreciate,almost immediately. If the central bank of theUnited Statesthe Fedunexpectedly lowersits interest rate, the dollar may well depreciate abit that same day. You tend to see these veryquick fluctuations associated with interest-ratechanges. But over the longer term, the currentaccount balance is probably far more important.

Q: What is the current account deficit,and why is it important?

A: The current account deficit just meansthat you (as a country) are consuming, orspending, more than you actually produce.Think about a household. If you earn $100,000a year and spend $106,000, you're going to haveto borrow $6,000 (or draw down your assets) tomake up the difference. The same is true for acountry.

Between business spending, governmentspending, and consumer spendingconsumerspending being the biggestthe United Statesconsistently spends more than 100 percent of itsGDP (as high as 106 percent in 2005 and 2006).But of course we produce only 100 percent ofGDP, so we need to borrow the difference. Howdo we do that? Well, we ask the Japanese, theChinese, and some others for their goods, andthey give them to us. And then they lend us themoney to buy them. We are bothborrowingliterally borrowing in financialterms from, particularly, the Asiansandgetting their goods (imports). Someday, they'regoing to want us to repay, which means they'regoing to have a claim on our output. Andsomeday, we're probably going to have to run acurrent account surplus, where we're producingmore than we spend, and we're shipping off therest (the surplus) to our current creditors.

Q: Your book centers on the three pillarsof macroeconomics: output, money, andexpectations. Can you talk generally whythese are important to understand?

A: When you think about these three things,output should be in big letters, and the otherones in smaller letters. Output is really thecenter of macroeconomics, and the key measureis the GDP, that is, total aggregate output, themarket value of all final goods and servicesproduced.

In a sense, all that you (as a country) have isthe total output that you produce in ayearyour GDP. Sometimes people think ifeveryone owned lots of stocks and bonds, wecould all retire happy, regardless of the GDP.But if the nation's total output in future years isnot sufficiently large, then all those stocks andbonds are going to end up being worth a lot lessthan expected. Total output is the key to howmuch we can consume, not little pieces of paper

called stocks and bonds.As a result, economists worry a lot about

how a country can increase its GDP growthrate, how higher growth of output can beachieved over the long term, and how we canmake sure that in the short term total outputisn't unduly volatile (with unsustainable boomsand busts).

Q: The second pillar of macroeconomicsis money.

A: In some sense money is just anotherasset, but it turns out to be a rather special asset.One of the reasons it is special is that thereseems to be a relationship between people'sholdings of that particular asset and theircurrent consumption or spending. And that'sbecause money is an asset that you can use tobuy things, right now. It's the ultimate form ofliquidity. But another thing that's importantabout money is that its supply is largelycontrolled by the government. Depending onwhich type of money supply you look at, thegovernment has either a complete monopoly ora partial one. By their control over the moneysupply, central bankers can essentially setinterest rates, especially short-term interestrates.

And that's the basis of monetary policy. It'sbecause of that control over the moneysupplyeither increasing or decreasing themoney supplythe government can setshort-term interest rates. And that short-terminterest rate is what central bankers use to try tocontrol inflation and moderate the businesscycle.

Q: And what about expectations? Whyare expectations the third pillar?

A: Expectations are extremely interestingbecause they represent a connection betweenthe present and the future. Current decisions areaffected by what people expect the future tobring. For example, business managers set theprices of their productsat least in partbasedon expectations. More broadly, if people expectthe price of a good (say, wheat) is going to behigher in the future, then the price is going tostart rising today.

Although expectations of all sorts areimportant, one particular set ofexpectationsabout the state of the overalleconomy and one's own future incomeisespecially important from a macroeconomicperspective. If people believe the economy isgoing to falter, even if their reasons are wrong,in the short term the economy may well falter.If consumers believe that they'll soon be ineconomic trouble, they will reduce theirconsumption and start scaling back onpurchases. And what are businesses going todo? If they see people reducing theirconsumption (or even just planning to reducetheir consumption), business managers maydecide to scale back on their own operations, soas not to produce a lot of output that no one's

going to buy. Firms will start laying offworkers. And then, of course, the negativeexpectation becomes self-fulfilling. You caneven get stuck there for a long timein arecession.

That's why in some cases you need either avery aggressive monetary policy or large-scaledeficit spending, which is what we've seen thispast year. Both aggressive monetary easing(lower interest rates) and large-scale deficitspending send the signal that demand willincrease, and thus both aim to break the cycle ofnegative expectations about the economy.

Q: What's a good way to think aboutforeign direct investment in the UnitedStates? Are we selling too much of our coreassets to foreign investors?

A: Look, this is a political decision, and it'sabove my pay grade. There may be somestrategic assets that we (as Americans) don'twant to sell to foreigners. Congress is going tohave to decide which ones those are. It may bethat we don't want to sell certain elements ofour media to foreigners, or perhaps certainstrategic assets that are important for buildingcritical military equipment.

One can be too cautious about reliance onforeigners. In the early 19th century, the Britishthought their grain supply was strategic, andthey protected it aggressively. Eventually,however, with the repeal of the Corn Laws, theBritish decided to move toward free trade inwheat. It was a controversial move. Skepticsfeared that other countries that supplied wheatto Britain could use it as a weapon, bythreatening to starve Britain. But it turned outthat nothing of the sort ever happened, andBritain was almost certainly better off after itrepealed its Corn Laws.

The broader thing to think about with regardto foreign investors buying assets in the UnitedStates is that if we as a country are going tospend more than we produceif we're going torun a current account deficityear after year,then there's in fact no alternative to foreignersbuying our assets, either debt or equity. As Isaid, if you're earning $100,000 and you'respending $106,000, you're going to have toborrow or draw down your assets to make upthe difference. So that's what we're doing as acountry. The problem is not fundamentally thatforeigners are buying too many Americanassets, but that Americans are spending toomuch.

The right way to fix this, of course, is byincreasing the American savings rate. Up untilthe economic crisis, household savings wereessentially zero, business was saving in thevicinity of 15 percent (through retainedearnings), and the government was dissaving(because of its budget deficit) by a few percentof GDP each year. Once the crisis struck,household savings rose, and governmentdissaving (deficits) rose by about the sameamount.

HARVARD BUSINESS SCHOOL | WORKING KNOWLEDGE | HBSWK.HBS.EDU

COPYRIGHT 2009 PRESIDENT AND FELLOWS OF HARVARD COLLEGE 2

Over the long term, we'll need to find a wayto save more across the board. We'll need toincrease our national savings rate quitesubstantially. That's ultimately the only waywe're going to turn around our current accountdeficit and ultimately stimulate the kind ofgrowth longer term that we'd all like to see.

So what does that mean? We need to figureout how to encourage households to increasetheir savings, especially once the recession isclearly behind us. I think that will have to befront and center. Also, once the recession isover, we'll definitely need to get our budgetdeficits under controlmost likely bycontrolling spending and raising taxes. We'llcertainly need to prepare for the retirement ofthe baby boomers.

Q: The Federal Reserve Board and itschairman, Ben Bernanke, have tremendousinfluence on the business environment,particularly on interest rates. If you're amanager and interest rates affect yourbusiness, how do you think about this?

A: It's worth putting yourself in the shoes ofBen Bernanke and trying to imagine how hethinks about it. That's going to be helpful inassessing what he might do.

As a central banker, Mr. Bernanke has toworry about a number of different things:inflation, unemployment, GDP growth,exchange rates, the stability of the financialsystem, and so on.

In more normal economic times, he wouldlikely focus mainly on maintaining a low andstable rate of inflationperhaps around 2percent. He has written and spoken in the pastabout his belief in inflation-targeting. The basicidea is that if the central bank manages to keepinflation within the target range (again, around2 percent), then everything else will tend to fallinto place: low unemployment, relatively stableGDP growth, and so on.

So, once the financial crisis and therecession are well behind us, probably the bestway to predict how Bernanke will set interestrates is by looking at where inflation is headed.

If inflation is rising above the 2 percent level,he's likely to push the short-term interest rateupward, in order to contain inflation. If inflationis falling below the 2 percent level, he's likelyto push the short-term interest rate downward.That would be the best way to predict what he'sgoing to do in normal times.

Of course, these haven't been exactlynormal times. With the financial system inserious jeopardy and unemployment surging,Mr. Bernanke put aside inflation-targeting andused just about every weapon in his arsenal tosave the economy from collapse. He loweredthe federal funds rate to just about zerothelowest everand he developed and employedall sorts of unconventional tools to helpstabilize things, including asset purchaseprograms, large-scale financial guarantees, anddirect lending to nonbank financial institutions.My own view is that while he inevitably madeall sorts of mistakes (especially in the lead-up tothe crisis), his extraordinary actions in the heatof the crisis may well have saved us from acomplete financial collapse and a far worsemacroeconomic crisis.

Once the biggest dangers are behind us, Mr.Bernanke will have to figure out how to getthings back to normal. His aggressivestimulation of the economy could easily proveinflationary if he doesn't bring rates back up intime. But it will be a delicate balancing act ifunemployment remains unusually high.

Eventually, if all goes well, we'll get back tostandard inflation-targeting, and monetarypolicy will become far more predictable again.But for the time being at least, the FederalReserve remains in uncharted waters.

Q: As a field of academic study, where doyou think macroeconomists have made themost progress?

A: There's a lot that macroeconomists don'tknow. But I think in monetary policy they'vemade a good deal of progress. Had we had thesame level of knowledge today that we had inthe early 1930s, we might have faced a secondGreat Depression. Bernanke, of course, was a

careful student of the Great Depression; heunderstood it quite well, particularly from amonetary standpoint. The level of monetaryunderstanding is much better than it was in thepast. And that reduces our odds of falling intoanother Great Depression. Again, it doesn'teliminate those odds, but it reduces them.Macroeconomists deserve a lot of credit forthat.

That said, excessively low interest ratesduring the boom years may well have helped tocause the crisis. So monetary policy, whilemuch better than in the past, is still nowherenear perfect. For example, we still know verylittle about how to prevent a bubble frombecoming a problem in the first place.

Q: In your own field of research, whatare you working on these days?

A: Well, I'm working on a number ofthings. I've spent a great deal of time over thepast year thinking about financial regulationand what it should look like, and I've beentalking with lawmakers in Washington aboutthis quite a bit.

I've also launched a new second-year courseat Harvard Business School on financial history.I started creating the course long before thefinancial crisis hit, but it's definitely beenfascinating to teach about past financial boomsand bustsabout the history of financialinnovation, financial growth and excess, andfinancial regulationat this particular moment.

Financial history has truly come alive overthe past couple of years. My hope is that we canuse that historythe long history of financialmarkets and institutionsin figuring out how toprevent another financial crisis going forward.That's where much of my work has beenfocused these days.

About the authorSean Silverthorne is editor-in-chief of HBS

Working Knowledge.

HARVARD BUSINESS SCHOOL | WORKING KNOWLEDGE | HBSWK.HBS.EDU

COPYRIGHT 2009 PRESIDENT AND FELLOWS OF HARVARD COLLEGE 3

A Macroeconomic View of the Current EconomyAbout the author