The falling US dollar and rebalancing of the US current account
In the ongoing debate over the fall in the US dollar, some economists have taken the stand that the currency's decline will have little impact on the US current account deficit because it does not affect the fundamental imbalances that cause the deficit in the first place. To these economists, the current account deficit can only be corrected by tackling the structural problems that give rise to the imbalances.
For example, in last week's issue of The Edge Singapore, Manu Bhaskaran of economics consultancy Centennial Group wrote:
Instead, he thinks that structural factors need to be addressed.
Similarly, in a recent article for The New York Times, Jeffrey Garten, dean of the Yale School of Management, wrote:
I endorse the view that structural factors have a part to play in the global imbalances. It certainly seems fair to argue that a fall in the US dollar alone may not be enough to correct these global imbalances. However, should that lead one to dismiss the significance of currency adjustment? Arguing against the decline in the US dollar on such grounds misses some important points.
First of all, in practice, a decline in the US dollar cannot be isolated from a rise in US interest rates. For all practical purposes, a sell-off of US dollars must be accompanied by a sell-off of US assets and a rise in interest rates. The rise in interest rates in the US will raise the savings rate, cut consumption and hence, imports. Combined with the change in the terms of trade, it would have a substantial impact on the current account deficit.
Secondly, even if the fall in the US dollar and its related effects are not enough to eliminate the current account deficit, that does not mean that the dollar should not fall. Simple demand and supply considerations of the US currency imply that in the face of a persistent current account deficit and inadequate investment opportunities in the US, the exchange rate of the currency should fall. Failure to allow the currency to fall -- and interest rates to rise -- would result in excessively loose monetary conditions in the US, with all its attendant market-distorting and bubble-inducing effects.
Indeed, one of the reasons that Federal Reserve chairman Alan Greenspan brought up the problem of the current account deficit in his 19 November speech must surely be that he wanted a weakening of the US dollar to help him raise long-term interest rates, which had stayed stubbornly low and had been undermining the Federal Reserve's tightening stance.
Finally, the point that a fall in the US dollar may cause dislocations around the world -- or pain, to put it bluntly -- is very probably correct. However, the more pertinent point is: Is the pain avoidable? How can global imbalances be eliminated without pain?
Consider the fact that the US current account deficit can be reduced either by increasing US exports or decreasing imports. Increasing exports require other countries to import and consume or invest more. Who are these countries?
Western Europe and Japan are developed economies. Their capacity for additional productive investment is limited. Increased consumption looks more viable. However, these are also ageing societies. Their relatively high savings rates are necessary to offset current and future liabilities. How much increase in consumption can they actually afford?
The emerging economies, especially China and India, are younger, but their capacity for consumption is still relatively limited by the size of their economies as well as the limited stock of accumulated wealth from which they can draw down for consumption. For these economies, increased investment may be the better option. However, even here, remember that China, the engine of growth in emerging Asia, is already in danger of overheating from over-investment, with its banking sector weighed down by bad debts.
So there is a limit to what the rest of the world can do to increase consumption and investment without hurting their own balance sheets and creating future problems for themselves.
That leaves a reduction in imports as the remaining means to reduce the US current account deficit. A reduction in imports with offsetting increase in US production would hurt other economies. More realistically, though, a reduction of imports is likely to require some winding down of US consumption and investment; such an eventuality would hurt everyone.
So there appears to me that there is little likelihood that the US current account deficit and global imbalances can be eliminated without pain. And little reason for the US dollar not to fall further.
For example, in last week's issue of The Edge Singapore, Manu Bhaskaran of economics consultancy Centennial Group wrote:
Why is it wrong to think that currency realignment alone can or will do the job? Take the recent analysis by two highly respected economists, Maurice Obstfeld and Kenneth Rogoff. They estimate the US dollar will need to depreciate 50% in trade-weighted terms from its peak in early 2002 to bring about a more acceptable current account balance. That means a further trade-weighted depreciation of about 40% from today's level. But can such a quantum of US dollar depreciation occur without causing significant dislocation in the US itself as well as in its major trading partners such as Europe, Japan and developing Asia?
Instead, he thinks that structural factors need to be addressed.
The only solution is to go to the root of the global imbalances... These include the weak savings rate in the US (large budget deficit and extremely low household savings rate), and structural obstacles in Europe, Japan and developing Asia which limit investment spending and growth.
Similarly, in a recent article for The New York Times, Jeffrey Garten, dean of the Yale School of Management, wrote:
America's trade imbalance can be corrected, the current reasoning goes, with a much cheaper dollar -- perhaps 30 per cent cheaper than it is today... The problem with the...devaluation...is that it does not treat the root causes of America's economic imbalances. The need to borrow so much from abroad is caused by enormous consumption and anaemic savings.
I endorse the view that structural factors have a part to play in the global imbalances. It certainly seems fair to argue that a fall in the US dollar alone may not be enough to correct these global imbalances. However, should that lead one to dismiss the significance of currency adjustment? Arguing against the decline in the US dollar on such grounds misses some important points.
First of all, in practice, a decline in the US dollar cannot be isolated from a rise in US interest rates. For all practical purposes, a sell-off of US dollars must be accompanied by a sell-off of US assets and a rise in interest rates. The rise in interest rates in the US will raise the savings rate, cut consumption and hence, imports. Combined with the change in the terms of trade, it would have a substantial impact on the current account deficit.
Secondly, even if the fall in the US dollar and its related effects are not enough to eliminate the current account deficit, that does not mean that the dollar should not fall. Simple demand and supply considerations of the US currency imply that in the face of a persistent current account deficit and inadequate investment opportunities in the US, the exchange rate of the currency should fall. Failure to allow the currency to fall -- and interest rates to rise -- would result in excessively loose monetary conditions in the US, with all its attendant market-distorting and bubble-inducing effects.
Indeed, one of the reasons that Federal Reserve chairman Alan Greenspan brought up the problem of the current account deficit in his 19 November speech must surely be that he wanted a weakening of the US dollar to help him raise long-term interest rates, which had stayed stubbornly low and had been undermining the Federal Reserve's tightening stance.
Finally, the point that a fall in the US dollar may cause dislocations around the world -- or pain, to put it bluntly -- is very probably correct. However, the more pertinent point is: Is the pain avoidable? How can global imbalances be eliminated without pain?
Consider the fact that the US current account deficit can be reduced either by increasing US exports or decreasing imports. Increasing exports require other countries to import and consume or invest more. Who are these countries?
Western Europe and Japan are developed economies. Their capacity for additional productive investment is limited. Increased consumption looks more viable. However, these are also ageing societies. Their relatively high savings rates are necessary to offset current and future liabilities. How much increase in consumption can they actually afford?
The emerging economies, especially China and India, are younger, but their capacity for consumption is still relatively limited by the size of their economies as well as the limited stock of accumulated wealth from which they can draw down for consumption. For these economies, increased investment may be the better option. However, even here, remember that China, the engine of growth in emerging Asia, is already in danger of overheating from over-investment, with its banking sector weighed down by bad debts.
So there is a limit to what the rest of the world can do to increase consumption and investment without hurting their own balance sheets and creating future problems for themselves.
That leaves a reduction in imports as the remaining means to reduce the US current account deficit. A reduction in imports with offsetting increase in US production would hurt other economies. More realistically, though, a reduction of imports is likely to require some winding down of US consumption and investment; such an eventuality would hurt everyone.
So there appears to me that there is little likelihood that the US current account deficit and global imbalances can be eliminated without pain. And little reason for the US dollar not to fall further.
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