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Dollars, Debt and the Trade Gap
Thoughts on the Dropping Dollar
December 19, 2006
Too fast? Too slow? A welcome adjustment? An ominous indicator?
In early December, the dollar scraped a 20-month low against the euro and 14-year low against the pound. Though the dollar has strengthened slightly since then, questions about the currency remain a focus for economic policy makers. Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke traveled to Beijing for meetings last week and afterward top U.S. and Chinese officials said they agree that increased currency flexibility in China will be a key to reducing global trade imbalances. China's alleged practice of keeping the yuan artificially weak against the dollar is often cited as an important issue for U.S. trade. But the value of the venerable greenback has other important implications as well.
The Online Journal asked economists Menzie Chinn, of the University of Wisconsin-Madison, and Kash Mansori, of Salem College, to discuss the dollar's recent drop, their long-term outlooks for the currency and how the dollar's value could affect everything from interest rates to the bloated U.S. current account deficit, which rose to of $225.6 billion -- or 6.8% of gross domestic product -- during the third quarter.
What do you think? Share your comments on our discussion board.
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Menzie Chinn writes: I've written in other places why a slide in the dollar might be troubling. But to begin with, it might be useful to discuss why the dollar is declining now. In my view, the key reason is a plain-vanilla interest differential story. With the U.S. economy softening considerably in the fourth quarter, money and currency market participants -- rightly or wrongly -- expect the Fed to reduce the target federal-funds rate in the coming year. With the European Central Bank perceived as hawkish on inflation, the stage is set for a widening real interest differential in favor of the euro. Over the short horizon, interest rates are an important factor in the attractiveness of a currency, since investor returns expressed in common-currency terms typically rise with rates.
About four weeks ago, in the space of a few days, the dollar lost 1.6% of its value against other major currencies. Even now, the dollar is roughly at the same value as it was after the drop. Against a broader basket of currencies, the drop was about half that, but the market volatility is suggestive of how sensitive the dollar is to revisions in expectations. And I think observers are nervous because they are wondering if a dollar decline will trigger a more fundamental set of moves on the part of central banks and other quasi-state entities -- in terms of holdings -- and on the part of private actors like hedge funds. The importance of hedge funds, combined with the rapid expansion of derivatives markets injects a heightened degree of uncertainty into the current situation.
In other words, while investment bank and professional forecasters are predicting a slow and steady depreciation of the dollar over the next year, a sharp move in the dollar might push the system over a tipping point so that a much more discontinuous decline occurs. If market participants are myopic, that provides yet another scenario for a big drop. On the other hand, this precarious balancing act of the dollar has proven far more durable than many observers had believed possible, and so may survive this challenge.
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Kash Mansori writes: Thanks for starting things off, Menzie. I think you've put your finger on two crucial points. Many observers are very nervous about the dollar, and much of that nervousness stems from the possibility that exchange rates are susceptible to rapid and severe movements.
Why is that the case? First of all, almost everyone agrees that the dollar will be a lot weaker in the future. Here's why: If you believe that the U.S. current account deficit of almost 7% of GDP will not continue forever -- i.e., if a current account deficit this big is not indefinitely sustainable -- then you must think that it will fall. But for the current account deficit to fall, we'll need a weaker dollar, which will make U.S. exports more competitive and imports more expensive. Since the deficit is simply so very big, the eventual fall in the dollar seems likely to be big too.
So how might this happen? There's a well-developed economics literature that explains why exchange rates that move by a large amount tend to do so abruptly. In a nutshell, the idea is that as soon as people start feeling that a substantial currency drop is imminent, everyone tries to dump it at the same time, ensuring that the fall becomes precipitous. (Paul Krugman provides a nice summary of the classic economic literature on the subject.)
Putting this all together, it's easy to understand the jitters of many exchange rate observers. Perhaps we could turn your initial question around, Menzie. Instead of wondering "why now?" maybe we should be asking, "Why hasn't the dollar declined by more than it already has?"
As you mentioned, the dollar has not really fallen by that much, other than against the euro. The chart of the dollar's exchange rate shows that the dollar's recent fall still leaves it dollar only 3% below its trade-weighted value of two years ago. In recent months, the dollar has actually strengthened against the Canadian dollar and Japanese yen (two of the four largest U.S. trading partners). This surprising strength of the dollar -- particularly against the yen, which may be "the world's most mispriced currency" -- is the real exchange rate puzzle that we face today, I would suggest.
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Menzie Chinn writes: Kash you make some excellent points. I agree the question could easily be recast to ask why the dollar has levitated so long in the face of large current account deficits. Part of the answer is asynchronized business cycle and the fact that central banks react to those business cycle effects. Another is the tax holiday on repatriation of profits incorporated into the Homeland Investment Act. Finally, there's the fact that the dollar is the world's key reserve and invoicing currency, so that booming East Asian and oil exporting country reserves are placed into dollars. A number of these hypotheses and others were examined in a conference on the subject of current account sustainability held at UW-Madison last April.
The smooth, slow dollar value decline can be a good thing, helping to switch expenditures away from foreign to domestic goods and thus reducing the trade deficit. This is how exchange rates are supposed to work as an adjustment mechanism.
Of course, all might not proceed smoothly. If the dollar decline is precipitous, it might spark inflationary pressures. I don't place too much weight on this possibility, because there is some research (see here and here) indicating exchange rate pass-through has been somewhat lower than it was during the 1980s. However, if incipient inflows of capital fall sharply, U.S. interest rates will have to rise in order to induce more inflows, thereby reducing economic growth. This scenario is examined here.
Kash Mansori is visiting assistant professor of economics at Salem College. He writes the economics blog The Street Light, providing commentary and analysis on news, politics, and the economy, with a focus on macroeconomic policy. His research interests are in the areas of international macroeconomics and public finance and frequently emphasize the domestic policy implications of international economic integration. Mr. Mansori received his doctorate in economics from Princeton University in 1998.Menzie D. Chinn is professor of public affairs and economics at the University of Wisconsin's Robert M. La Follette School of Public Affairs. His research is in the area of international finance and open economy macroeconomics. Recently his work has examined Yuan misalignment, the determinants of U.S. imports and exports, and the future of the euro as a reserve currency. He has also written on how fiscal policy affects interest rates, the interaction between capital controls and financial development, and the determinants of exchange rates. He also co-authors the blog Econbrowser. In 2000-2001, Mr. Chinn served as Senior Economist for International Finance on the President's Council of Economic Advisors. He received his doctorate in economics from the University of California, Berkeley.* * *
Kash Mansori writes: I think you're exactly right, Menzie. What is really worrying is the size -- in absolute terms -- of the adjustment needed to the U.S. current account balance. Still, it's important to remember that the consequences of a rapid dollar decline could also be severe for the rest of the world, especially in emerging markets.
This may particularly be the case for the 800-pound gorilla in the room: China. If the dollar plummets rapidly, the Chinese central bank (PBOC) would suffer massive capital losses on its more than $1 trillion in reserves. In addition, the real Chinese economy would suffer a dramatic to its massive export sector.
That's why I'm actually relatively sanguine about the possibility that foreign central banks could trigger a sudden dollar decline simply out of a desire to diversify their porfolios; I think that the PBOC and other central banks around the world, such as the Persian Gulf countries, have too much depending on a stable dollar. Instead, what worries me is the possibility that private investors around the world would decide to dump dollars, presumably because they foresee capital losses due to an incipient decline in the dollar. Perhaps myopically, international investors don't act like they expect those capital losses right now. But at some point they might.
To help understand what could trigger such a change, let's think about the exchange rate from another point of view. The current account deficit is fundamentally determined by a country's national savings/investment balance. Countries (like Japan or China) that consume and invest less than they produce run current account surpluses. Countries that consume and invest more than they produce (like the U.S.) run current account deficits. From that perspective, only when the U.S. eventually starts consuming less -- perhaps due to a slowing U.S. economy -- can we expect the U.S. current account deficit to fall, and the dollar to start weakening to help make that happen. Of course, once the dollar starts falling, that's when we have to start watching out for the behavior of international investors who may decide the time has come to dump dollars.
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Menzie Chinn writes: China clearly doesn't have an interest in seeing the dollar decline quickly. So I'm certain that -- in part -- explains why the PBOC is tightly managing the yuan's appreciation against the dollar. But even if PBOC and other holders of large dollar reserves don't want the dollar to depreciate rapidly, they also don't want to be the last one out the door. That's why I view the current equilibrium as balanced on a knife's edge. Any decline in the dollar might be enough to prompt some central banks to try to diversify their holdings. The big question will be how China will respond once the dollar decline takes off.
So, while I used to worry a lot about China, now I worry a lot about China and the oil exporting countries. As Brad Setser points out, the oil exporters of the Persian Gulf maintain a much more rigid peg against the dollar than does China. The pace of reserve accumulation is certainly of a comparable magnitude, and when one adds in Russia, the oil exporters probably weigh more heavily in this dimension.
Changing the direction of the conversation somewhat, I'd like to spend a minute on the more likely "what-if" scenario wherein the central banks and private investors do not radically diversify out of dollar assets. In my view, this will result in a long-term secular depreciation of the dollar; after all, in the coming years, we will paying more in interest and dividends to the rest of the world than we will be receiving, and in order to keep the current account at current levels, the U.S. will need to export (on net) more. In other words, the "exorbitant privilege" that Gourinchas and Rey highlight (we get higher returns on our assets abroad than foreigners get on American assets) won't be sufficient to offset the massive debt we have taken on in the past decade. This will be true, despite the fact that our foreign-currency denominated assets abroad will rise in value when the dollar depreciates, limiting the deterioration in our net debt position (see Klitgaard and Tille). That's not a calamitous outcome -- merely a slow descent into genteel indebtedness, what Martin Wolf called the "comfortable path to ruin."
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Kash Mansori writes: The implications of the growing U.S. net international debt are indeed profound. As the interest payments on that foreign debt grow (much of it U.S. government debt, as this graph from the EPI nicely illustrates), more and more of the income and output of the U.S. will go toward simply servicing its international debts.
But what can a good policy maker to do about it? Treasury Secretary Paulson, along with four other cabinet secretaries and Fed Chairman Ben Bernanke, just returned from Beijing where he was trying to talk the Chinese into allowing the dollar to weaken against the Chinese yuan. Would a policy-induced fall in the value of the dollar be helpful?
That's not entirely clear. Suppose China agreed to let the yuan rise substantially against the dollar. As I've argued elsewhere, I don't think that the overall U.S. current account deficit would fall -- not until the savings/investment balance changes (but see Dean Baker for another perspective). However, China's contribution to that deficit would. That would have the side-effect of muting the calls of some China critics in Washington who have been arguing that the U.S. should put tariffs on Chinese imports. And maybe that's the desired outcome.
But on the other hand, foreign purchases of dollars have pushed interest rates in the U.S. down by as much as a full percentage point. If the PBOC were to stop defending the strong dollar, interest rates in the U.S. would surely rise, slowing the U.S. economy even further. While that would be good for the current account deficit -- and will probably have to happen sooner or later -- I'm not sure that's what Mr. Paulson would really like to see right now.
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Menzie Chinn writes: Kash, you put your finger on the key question. I agree that pushing down the dollar against the yuan isn't nearly enough to remedy the overall U.S. current account deficit. After all, China's deficit is only about one-fourth of the total trade deficit. So what can a good policymaker do? I think there are few policies that might reduce the likelihood of a "disorderly adjustment" of the sort we've been talking about.
First, get the budget deficit under control. That includes increasing tax receipts, cutting government spending, reining in entitlements -- these are all going to be necessary first steps to redressing the profligacy of the last six years. Doing so will reduce aggregate demand and hence imports. It'll also reduce the necessity for issuing so much federal debt, and at the same time make us less vulnerable to the whims of the PBOC and other state actors in the international economy.
I know there is a lot of skepticism about the importance of the budget deficit in this area. However, my empirical work with Hiro Ito indicates that there is a solid link between budget deficits and the current account deficit. Simply stated, we found a one-percentage-point decrease in the budget deficit results in between 0.2 percentage points to a half percentage point decrease in the current account deficit. For the unconvinced, note that between 2000 and 2005, one saw a roughly 4.3 percentage point of GDP swing in the federal budget balance. Let's take a high estimate of how that would affect the current account deficit by using the coefficient of 0.5. This implies a 2.2-percentage-point decline in the current account. Guess what the actual decline in the current account was between 2000 to 2005 … 2.2 percentage points. So In other words, I don't agree with Bernanke's saving glut hypothesis that asserts that the largest source of our current account deficit is located in East Asia. Overspending on our side plays a significant role as well.
Second, we still push for flexibility in the yuan. But not because it will necessarily -- in itself -- change the current account deficit. Still, it will help diminish the need for the PBOC to purchase so many Treasuries in order to keep the high value of the dollar. The decrease in demand for treasuries will result in higher interest rates (see Warnock and Warnock) and lower consumption spending including spending on imported goods.
Third, because I don't believe we have seen the end of high oil prices, we need a long-term plan to deal with energy use and reduce the growth rate of oil imports. The first best solution would be a tax on gasoline to encourage conservation. The second best -- if that is politically infeasible -- is an increase in the corporate average fuel economy (CAFE) standards. Both were viewed as non-starters in earlier times; now a consensus is apparently building for some sort of action on this front.
Clearly, any one of these options has its political challenges. It's no surprise that the easiest one -- pressuring China -- is the only one that has thus far been pursued. But taking action now will reduce the pain of adjustment later on.
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Kash Mansori writes: You've nailed all of my favorite possible policy actions to help keep the future current account adjustment -- and the dollar decline that will go with it -- from being too traumatic, Menzie. But these policy recommendations are a little like a cardiologist prescribing a low-fat diet and lots of exercise to a heart patient -- it's not fun medicine or easy for the patient to stick to. So I share your skepticism about whether they will actually happen.
So what do I think will happen? Here's my guess. I suspect that the rapidly weakening housing market will soon force households to reverse recent trends, and start saving more of their income. That, along with reduced investment spending, will help improve the U.S.'s underlying savings/investment imbalance. It will also cause a period of sluggish growth (perhaps outright recession), but that will have the effect of reducing the expected returns on dollar assets, finally driving the value of the dollar down in a serious way. That in turn will help make exports more competitive and imports more expensive, facilitating the badly-needed improvement in the U.S. trade balance. This doesn't have to be a disastrous series of events. But as I mentioned above, there is a real possibility that a significant dollar decline could turn into a rout, which could turn this slightly depressing but relatively benign scenario into a financial crisis.
And will our worst fears play out if that's the case? They might, but the truth is that we just don't know -- we're truly in uncharted territory. Never before has any country been able to run such a large current account deficit for so long. Never before has any country borrowed such a massive amount of money from the rest of the world in such a short period of time. Never before has the world changed its preference for international assets (particularly U.S. assets) so rapidly. Never before have global central banks accumulated such staggering quantities of foreign exchange reserves. Never before has our domestic financial system been so dependent on international capital for its low interest rates, and by extension, been so vulnerable to events in the foreign exchange markets. And never before has the country most at risk for a painful exchange rate adjustment -- been the owner of world's dominant reserve currency.
The U.S. current account balance will fall, and the dollar will fall along with it. But because this situation is so novel, the questions "how?" and "when?" just don't have any easy answers.
What do you think? Share your comments on our discussion board.
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