December 13, 2006; Page A18
Since the beginning of 2006, depreciations of the dollar -- about 12.5% against the euro, 14.9% against the pound sterling, and about 2.1% against the yen, all more or less floating exchange rates -- have occasioned intense speculation in the financial press as to whether these currency moves should be welcomed as the beginning of the great "correction" to America's current account and trade deficits. After all, the U.S. has been running such deficits since the early 1980s -- and over the last year, the current account deficit ballooned to about 7% of its GNP. Shouldn't the market now discipline the world's biggest debtor and bid the dollar down to help reduce the trade deficit?
Essentially, the answer is no.
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Take the euro. The chart nearby shows the dollar's fluctuations against the German mark, which was transformed on Jan. 1, 1999 into the euro, from 1970 to the present. In the last decade and a half, the many ups and downs of the dollar value of the floating euro-mark were quite comparable, and sometimes greater, than what we have observed this year. Indeed, the dollar strengthened against euro in 2005 about as much as it fell in 2006. Only if the change in the dollar's current exchange rate is measured from January 2002, at the peak of the U.S. high-tech bubble, would the fall seem to be portentous -- and of the order of 30% to 40%. But this would be grossly misleading. High-tech bubble aside, the value of the dollar in euros is about the same now as in the mid-1990s.
Putting aside countries such as Zimbabwe with chronic inflation and ever-depreciating currencies, economists have learned that a floating rate between two financially stable countries moves close to a "random walk." Over the next few days, weeks, months or even years, the dollar value of the euro is just as likely to move up as down. Although such moves can be quite disconcerting, they cannot be forecast. Consequently, the best guess of the future exchange rate is just today's spot value. (Tip for astute corporate executives: Don't bother hiring highly paid consultants, including this one, to forecast how a floating exchange rate will move!)
The one big exception to this essential randomness is when governments force (or "talk") an exchange rate into changing, and then sustain it by altering the future course of monetary policy. The first great depreciation of the dollar started in August 1971, when Richard Nixon undermined the old Bretton Woods system of fixed exchange rates. He imposed a tariff on all imported manufactures, and refused to remove it until other industrial countries appreciated by changing their dollar pegs -- which they had done by December 1971. The fixed-rate system broke down altogether in early 1973.
But the story doesn't end here. To help insulate the American economy from the inflation ensuing from the dollar's devaluation, Nixon also imposed wage and price controls from 1971 into 1973 -- and leaned heavily on then Fed Chairman Arthur Burns to gun the money supply to make the economy boom and ensure Nixon's overwhelming re-election in 1972. But it soon became clear that the wage and price controls for repressing inflation were untenable and doing great damage to the economy -- so they were abolished by the end of 1973. Unsurprisingly inflation shot up in 1973 and hit almost 12% in 1974.
Unfortunately, the Carter administration in 1977 resumed the policy of trying to talk the dollar down -- and Treasury Secretary Michael Blumenthal stated that the yen in particular should appreciate against the dollar. With increasing inflation and great uncertainty about Fed policy, there was another run on the "Carter" dollar in 1978 requiring an international rescue operation.
Of course, these shenanigans drove the dollar down and led to the great inflationary turmoil of the 1970s. Not until 1979, when Paul Volcker became Fed chairman and imposed very tight money with extremely high interest rates in the early 1980s, was inflation painfully squeezed out of the American economy. But an incidental side-effect was that the dollar shot upward in the foreign exchanges by more than 50%, because foreign capital inflows were attracted by the high U.S. interest rates. Thus, the shock of disinflation fell disproportionately on American companies producing internationally tradeable goods: The decline in manufacturing created the infamous "rust bowl" in the Midwest.
To correct the overshoot, the leading industrial countries in 1985 got together in New York's Plaza Hotel to "talk" the dollar down. And, sustained by somewhat easier money in the U.S. but also by relatively deflationary (tight) monetary policies abroad, the dollar did fall very sharply against the mark and other major currencies such as the yen. (Indeed, it "overshot" downward and had to be supported by the so-called Louvre Accord in 1987.) In Europe, the sharp appreciations slowed economic growth causing what was then called "eurosclerosis." The Japanese yen had appreciated the most, with additional American pressure creating the expectation of further appreciations. This thoroughly destabilized Japan's financial system with gigantic stock and land markets bubbles in the late 1980s that crashed in 1991 -- and severe deflation from the overvalued yen throughout its "lost decade" of the 1990s.
Given the unfortunate macroeconomic consequences of large changes in nominal exchange-rate-cum-monetary policies, why is it that so many economists today advocate dollar depreciation? On the one hand, they are transfixed by continuing large U.S. trade deficits that they see to be unsustainable. They also are enamored with a popular but incorrect theory, sometimes called the elasticities model of the balance of trade, that seems to point to a straightforward solution. If a deficit country such as the U.S. can somehow depreciate its "real" exchange rate -- i.e., its nominal exchange rate depreciates without causing either inflation at home or deflation abroad -- then its trade balance should improve. Its exports become less expensive in foreign monies so that foreigners buy more, while its imports will look more expensive in dollar terms so that Americans buy less. Et voilà!
The crucial flaw in this reasoning is the missing link to monetary policies. Apart from random short-term fluctuations, any substantial nominal depreciation can only be sustained by future monetary adjustments permitting inflation at home or foreign central banks acquiescing to deflation abroad -- the trade-off between the two being somewhat arbitrary. True, following a devaluation there are lags before prices begin to rise at home or fall abroad. But even in this short run of price "stickiness," the balance of trade of the depreciating country is unlikely to improve.
Why? First, for imports already contracted for and invoiced in a foreign currency like the euro, the U.S. importer would have to pay more (depreciated) dollars for the European goods he had agreed to buy. Economists call this the "J curve" effect.
Second, with a temporarily real depreciation of the dollar, international investors would see a window of opportunity for a year or two to undertake physical investments at lower cost in the U.S. Conversely, they would see countries with appreciated currencies to be more expensive. As a consequence, an investment-led spending boom in the U.S. would increase imports and a slump abroad would reduce imports of American goods -- as in the aftermath of the Plaza Accord described above. The upshot is that the net effect on the U.S. trade balance in this intermediate term of two years or so would be ambiguous -- even though the foreign currency prices of American exports in world markets had been (temporarily) reduced.
In the long run, a general depreciation of the dollar's nominal exchange rate against other currencies can only be sustained by an increase in the U.S. price level relative to that in foreign countries such that any real depreciation washes out! Thus there would be no net price advantage left to U.S. exporters as domestic costs rose to offset the effect of the nominal depreciation. Of course, this is just the end result, which looks unduly clean. In the transition, however, financial turmoil associated with higher inflation in the U.S., coupled with deflation abroad, could well lead to major losses in output and declines in productivity growth characteristic of the 1970s and 1980s.
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Given these caveats, what can be done about the now-huge U.S. current account deficit? The "problem" is not new and there need be no crisis unless the never-ending Greek chorus of editorial writers in the Financial Times, The Economist, the New York Times, and so on, praising every (random) decline in the dollar as a welcome step in helping correct global imbalances, somehow foment a run on the dollar. However, this need not happen if Treasury Secretary Hank Paulson sticks firmly to the strong dollar policy bequeathed from former Secretary Robert Rubin -- and Fed Chairman Ben Bernanke continues to squeeze U.S. inflation downwards.
Unfortunately, Mr. Paulson, by continuing to pressure China to appreciate the renminbi against the dollar, somewhat undermines his professed strong dollar position. If China were coerced into really large appreciations of the renminbi, it could face the same deflationary fate as Japan in the 1980s and 1990s -- and all this without reducing its trade surplus.
The U.S. current account deficit simply reflects the excess of expenditures in the U.S. relative to income, or, equivalently, the amount by which America's moderate level of investment exceeds its very low saving rate -- both by households and the federal government. So the first order of business in correcting the trade deficit is to reduce the structural fiscal deficit of the U.S. and possibly run with surpluses. The second order of business is to provide incentives -- possibly tax incentives -- for American households to increase their saving. Both require major changes in U.S. public finances and should be phased in gradually but very deliberately.
However, this is not the end of the story. To work smoothly, adjustment has to be two-sided. The East Asian countries with large saving and trade surpluses, notably China and Japan (also Germany and various oil producing emirates) must move to increase consumption in parallel with American efforts to reduce consumption. Governor Ben Bernanke wrote an excellent paper in 2005 (just before he became chairman of the Fed) interpreting trade imbalances to be as much as or more of a saving glut in the rest of the world than a saving shortage in the U.S. The very low interest rates prevailing world-wide support Mr. Bernanke's hypothesis. If it were only a saving shortage in the U.S. we would face much higher interest rates and a possible credit crunch.
This two-sided approach to righting international trade imbalances has a further great advantage of better stabilizing the world economy overall. Some people worry that if the U.S. were to move unilaterally to raise taxes and reduce private consumption, aggregate demand would be insufficient. U.S. households would no longer be "consumers of last resort" for the world at large. Thus unilateral moves by the U.S. to contract consumption, unless done very gradually, could foment a world-wide slump. However, if contraction in the U.S. was offset by expansion elsewhere, such problems would be minimal -- and trade imbalances could be reduced more quickly. In neither case, however, would any substantial change in the dollar's exchange rate be necessary or desirable.
So we now have enough grist in the mill for Secretary Paulson's visit to China. To his great credit, Mr. Paulson has said that he very much wants to engage China constructively. Thus, in considering China's (and other Asian countries') trade surpluses, he should not reach for the wrong instrument -- particularly one that is based on faulty theorizing. A major reduction in the yuan value of the U.S. dollar will not correct the saving imbalance between the two countries. However, it could cause a major bout of monetary instability with deflationary consequences in China itself. And if China is the linchpin, such that other countries in Asia and even Europe follow with their own appreciations against the dollar (as many dollar devaluationists seem to want), the inflationary pigeons may well come home to roost in the U.S. -- as in the 1970s.
Mr. McKinnon, professor of economics at Stanford, is author of "Exchange Rates under the East Asian Dollar Standard: Living with Conflicted Virtue" (MIT Press, 2005).
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