* Some observers have been critical of the Bush administration's apparent policy to let the dollar depreciate further. The criticism is that, by driving up import prices, this policy will make US households poorer. The critique also argues that the underlying problem is a shortfall of US saving and it is that problem that should be addressed.
* Although we agree that a chronic saving shortfall is the proximate cause of the large US current account imbalance, we have two difficulties with this line of argumentation. First, if US saving were boosted prematurely, the outcome would be a weak economy, with rising unemployment-not a pleasant way to curb a current account imbalance. Second, this line of argument implies that a weaker dollar can somehow be avoided. Instead, we judge the choice as being between an early, orderly dollar decline and a later, disorderly one.
* If we are right that a lower dollar is a necessary part of the trade adjustment process, then better to get on with it.
Is Dollar Depreciation Unavoidable?
Some observers (for example, see Jeffery E. Garten's editorial in today's Wall Street Journal) argue that a policy of allowing the dollar to fall sharply in order to correct the US current account deficit is wrong-headed; by driving up the cost of foreign goods and services, it will just make US households poorer over time. Instead, they argue that the real problem is a shortage of domestic saving. The solution is to raise domestic saving by cutting the budget deficit and/or increasing the incentives for private saving.
Although we have sympathy with this view that the root cause of the current account deficit is a shortage of domestic saving and a surplus of foreign saving, we have two difficulties with this line of argumentation. First, it is important to recognize that the end goal is not to shrink the current account deficit per se, but instead to keep the US economy at full employment and to maintain price stability. If US policies were changed in a way that raised domestic saving sharply at the current dollar exchange rate, the result would be economic weakness as the domestic demand shortfall was not fully offset by trade improvement. The trade deficit would shrink, but the cost would be higher unemployment. The current account deficit can conceivably be cured by a US recession, but this hardly seems like it should be the goal of economic policy.
Instead the trick is to pursue policies that coordinate the adjustment in trade and in domestic saving. The goal is that as domestic saving rises, this dampening factor is offset by trade improvement. This necessitates a weaker currency to set the trade improvement process in motion. Once this is in train, then the policymakers can take steps to tighten fiscal policy or take steps to encourage a rise in household saving. If they do not do this, then the monetary authorities will instead have to force down domestic demand by raising interest rates.
Second, this line of argumentation implies that dollar weakness can be avoided-that there is a choice. We disagree with this conclusion. If the goal is to keep the US economy at full employment, then the US current account deficit is likely to continue to rise at the current dollar exchange rate. Since this is clearly not feasible-foreign investors must eventually balk at holding an ever increasing stock of dollar-denominated assets, the choice is a different one-an orderly dollar decline that begins early versus a decline that is postponed, but is larger and more violent when it finally occurs. If that is the choice, then a policy that seeks to achieve an orderly dollar decline is an appropriate one. Although US consumers are inevitably hurt by a dollar decline, the damage is minimized because the decline is orderly and there are not disruptive spillover effects into US financial markets.
Of course, this does not mean that the adjustment process will be pleasant. Unfortunately, it simply is a fact of life that the dollar has to move a lot to facilitate trade improvement:
(1) The US economy is not very open, so the dollar has to decline sharply to generate the shifts in tradable goods output and consumption necessary to close the trade deficit. Although the US current account deficit is only a bit above 5% of GDP, this represents more than 20% of US tradable goods, according to a recent paper by Maurice Obstfeld and Ken Rogoff.
(2) As incomes in the US and elsewhere rise, the US trade deficit tends to widen. That is because the income elasticity of demand of US consumers for foreign goods exceeds the income elasticity of demand of foreign producers for US goods. Or put more colloquially, when US households get richer, they buy more French champagne. When French households get richer, they buy more French champagne. The net effect of comparable growth rates in foreign versus domestic income is persistent deterioration in the US trade balance.
(3) The wide trade gap means that exports have to grow much faster than imports just to keep the trade gap stable. The dollar has to fall sufficiently to push the growth rate of exports more than 50% above the growth rate of imports merely to stabilize the trade deficit.
- Bill Dudley