Macroeconomic imbalances have been an important topic for years. Already in the
late 1990s the Federal Reserve concluded that the U.S. current account deficit
was on an unsustainable trajectory. And yet the deficit has continued to grow
to the point at which it is now more than six percent of Gross Domestic Product.
At a conference at the Institute for International Economics in February 2004,
I identified external adjustment as the number one challenge facing the United
States and the European Union. But virtually nothing has been done.
Why not? The fundamental reason is that there is no consensus on either side
of the Atlantic, or of the Pacific, about how the adjustment process should move
forward. The basic explanation is that we, the citizens and policy makers, are
the problem, because we have no real desire to see things change. But the clock
is ticking.
A substantial reduction in the U.S. current account deficit to something like
three percent of GDP over the next three to five years is the best assumption
on which policy makers should base their policies. In the process, the euro will
probably rise to at least $1.55 and could easily reach $2.00. The adjustment
of the U.S. deficit could be more, and it could be less. But if the process is
not well managed, it could be messy. Indeed, on the messy side, former Federal
Reserve Chairman Paul Volcker recently warned against complacency over global
imbalances, including the U.S. fiscal deficit.
One reason why so little has been done is what my colleague Catherine Mann calls “codependency,” or
as Martin Wolf of the
Financial Times remarked in early April, “the United
States has in essence become the world’s borrower of last resort.” Americans
like it, the rest of the world likes it, and we have a situation of unsustainable
vendor finance. A
more complex answer is that the U.S. current account deficit is not just about
exchange rates, whether market determined or not; it is also about savings and
investment balances and the balance
between domestic demand and supply, both in the United States and in the rest
of the world.
In order to bring about change, therefore, one needs to change policies. The
G7 in mid-April pronounced
again about the need for exchange rates to reflect fundamentals. Those communiqués
used to include policies
among the fundamentals. Policies are unchanged, and so fundamentals are
unchanged. And the reason why there
is no change in the United States or in
the rest of the world, particularly
Europe, is quite clear. Change is politically and economically painful.
A reduction in the U.S. current
account deficit of three percent of GDP ($375 billion) would require a cut in
domestic demand of something close to $400 billion, or $1,350 per capita in the
United States. Everybody is going to have to reduce consumption or physical
investment by that much as part of the adjustment process.
Much of the adjustment will be
facilitated through dollar depreciation. If the dollar falls by 30 percent, and
half of that is passed on to import prices, there will also be an adverse terms
of trade
effect of about $1,000 per capita. If you add these two figures together, they
come to about $2,300 per capita in the United States. It is no surprise that
U.S. politicians are not anxious to inflict such painful change on Americans.
The rest of the world will also experience pain. The stimulus that the U.S. current
account has provided will not only stop; it will be reversed. If the
adjustment amounts to about three
percent of U.S. GDP, about one percent of global GDP on average will have to
be found elsewhere.
According to European trade statistics, the dollar’s decline has not affected
the euro area over the last three years. Exports to the United States are still
growing at a double-digit rate. The share of euro area exports to the United
States has fallen slightly, while the U.S. share in euro area imports has risen
slightly. So far, however, there has basically been no adjustment, and no pain
associated with exchange rate changes. The reason is
that demand in the U.S. economy, over-stimulated by loose fiscal and monetary
policies, has been growing at an annual rate of 4.5 percent and is sucking in
imports.
“It is no surprise that U.S. politicians are not anxious to inflict such
painful
change on Americans”
Over the last three years the dollar has depreciated by 15 percent on average,
meaning that exchange rates in the rest of the world have risen by an average
of 18 percent. The euro had risen by just over 50 percent against the dollar
by April 2005, but only by 24 percent in
real effective terms. (The real effective exchange rate is an indicator of competitiveness
that takes into account both
export and import competitiveness.) As part of the adjustment process, I assume
that the dollar will decline on an effective basis by a further 20 percent; other
currencies will have to appreciate by 25 percent on average. This figure is a
little more than the total depreciation of 30 percent mentioned above, because
there is likely to be some overshooting.
We might consider three different scenarios for exchange rate movements, using
the Federal Reserve staff’s index for the dollar and the weights of the
currencies of the countries that are
included. As a first scenario, one could assume that the currencies of the rest
of the industrial countries, excluding the euro area, appreciate by 25 percent,
and the currencies of the rest of the world
do not appreciate at all. To produce an average appreciation of 25 percent, the
euro would have to rise by 85 percent, to about $2.40 from $1.30. The effective
appreciation would be somewhat less, but, at about 70 percent, it would still
be large.
“The United States and the European Union have made two mistakes in dealing
with
the Chinese exchange rate”
The second scenario would involve getting some help from the rest of the world.
If the currencies of the other
industrial countries rise by 25 percent, and those of the rest of the world by
15 percent to 20 percent, the euro has to
appreciate by only 42 percent to $1.85, along with a 21 percent increase in its
effective rate. As a third scenario, one can reasonably argue that Asia has
generally not been playing its proper role in letting its currencies appreciate.
In this scenario, the currencies of the other industrial countries and the euro
all
appreciate by 20 percent, and the currencies of the rest of the world outside
Asia (excluding Japan) rise by 15 percent. The Asian currencies will have to
appreciate by an average of 40 percent. That would put the Chinese renminbi at
5.90 to the dollar (compared to the peg of 8.28 to the dollar that was abandoned
in July), which is as difficult to imagine as the euro at $2.40. Importantly,
however, this scenario puts the euro at $1.56, with
essentially no effective appreciation.
These scenarios are just arithmetic, not proposals. The third scenario is
unlikely, but it underscores the importance of Asia as a whole. Asia is not just
China it also includes India, Taiwan, Malaysia, Hong Kong and other economies.
The United States and the European Union have made two mistakes in dealing with
the Chinese
exchange rate. One is to have focused until recently on floating the renminbi,
rather than on an interim adjustment of its peg to the dollar; the other is to
have concentrated on the renminbi, forgetting the other Asian currencies.
Big movements in exchange rates, of course, will be only part of the adjustment
process. Saving and investment have to shift in the United States, which will
either have to save more or invest less, and the reverse abroad. Demand and supply
will also have to shift in the United States, with less demand relative to supply,
and abroad.
Two European myths are poisoning discussions with the United States. One is that
the whole answer to global macroeconomic imbalances lies in the U.S. budget deficit.
According to this theory, cuts in the U.S. budget deficit would solve the external
adjustment problem. Of course, it is appropriate for the United States to cut
its budget deficit in its own interests, which include boosting confidence, but
increasing domestic savings is not the whole story. We also need to switch expenditure,
which is where exchange rate changes play a role.
The second myth is that the United States only needs to slow the growth of the
economy. Of course, it is necessary to slow the growth of domestic demand relative
to the growth of output. The level of domestic demand, however, would have to
fall by nine percent to achieve a two percent improvement in the external deficit.
That is not going to happen. Moreover, the macroeconomic impact on the rest of
the world would be the same as if the adjustment was achieved by exchange rate
changes alone, except that the rest of the world would not have the compensating
terms of trade improvement.
The U.S. version of this myth is the “growth gap.” Certainly it is
desirable for the rest of the world to boost the growth of its domestic demand,
or else the dollar will have to drop even further. The arithmetic, however, shows
that more foreign growth will not contribute much to overall adjustment; a three
percent increase in economic activity
in the rest of the world will generate an improvement in U.S. exports equivalent
to about 0.3 percent of GDP.
The conclusion is that we need more than exchange rate adjustments. We must boost
U.S. savings through fiscal policy. We need to boost consumption or investment
in the rest of the world through fiscal or structural policies. Most importantly,
however, we need to slow the growth of demand in the United States and accelerate
it in the rest of the world. Monetary policy is relevant. But the Federal Reserve
has failed to act, or even to acknowledge that it has a role to play in balancing
domestic demand and domestic supply. The same is true for the European Central
Bank, but in the opposite direction.
“European political setbacks suggest that the adjustment process is likely
to
be more rather than less messy”
By the end of June, the dollar had appreciated about six percent against
the euro since mid-April, rather than continuing its decline. The French and
Dutch rejection of the European constitutional treaty adversely affected sentiment
about the euro. But this does not alter the basic story. If the U.S. current
account deficit is to shrink to three
percent of GDP over the next three to five years, which remains a reasonable
basic assumption, the euro will rise to at least $1.55 and, probably considerably
higher, as part of an adjustment process that also involves three other elements.
These are the appreciation of most other currencies, a shift in the saving-investment
balance in the United States and the rest of the world, and a shift in the balance
between domestic demand and domestic output in the United States and the rest
of the world. The European
political setbacks suggest only that this process is likely to be more rather
than less messy, because of the increased risk that Europe will turn further
inward in its policy orientation.
Edwin M. (Ted) Truman is a Senior Fellow at the Institute for International Economics
in
Washington. He served as Assistant Secretary for International Affairs at the
U.S. Department of the Treasury from December 1998 to January 2001. He was previously
Director and later Staff
Director of the Division of International Finance of the Board of Governors of
the Federal Reserve System. He was on the staff of the Federal Open Market Committee
from March 1977 until his
departure from the Federal Reserve in 1998.
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