Friday, November 19, 2004

Stephen Roach is right -- the world needs a weaker dollar. That being said, our favorite Cassandra is putting the horse before the cart as well as expecting far too much from a weaker currency.

First the whole horse and cart thing.
America�s saving shortfall has major consequences for the rest of the world. Lacking in domestic saving, the US imports saving from abroad in order to fund the ongoing growth of its economy. And it must run massive current-account and trade deficits to attract such capital from overseas. The United States balance-of-payments deficit hit an annualized $665 billion in mid-2004, or a record 5.7% of GDP.
The US doesn't need to run massive current account deficits to attract capital. China, for example, is being flooded with foreign capital as it runs a moderate current account surplus around 2% of GDP. The current account deficit follows the capital inflows, not the other way around.

Now it could be said that the US federal government must run massive budget deficits to attract capital from overseas. If foreign capital loses interest in US stocks and bonds, capital (either private or official) can still be attracted by selling treasuries. This, of course, is the great irony of the budget deficit debate to the degree that we're even having one in the US. If the federal government cuts its deficit in half in four years, how will we attract the capital necessary to run such massive trade deficits? For the 12 months through September 2004, 42% of all capital inflows to the country are into treasury notes. If we won't sell them our debt any longer, they might not bring their money at all.

Thus we wind up raising taxes, cutting government spending and consuming fewer imports (and thus fewer goods overall) all at the same time. Nice pickle we've gotten ourselves into.

Second, how much different will a lower dollar really make? The general line goes, of course, that a lower dollar makes US imports more expensive and US exports less expensive, thus automatically adjusting the current account imbalance toward a long-term sustainable level. In respone, I offer this insight from Obstfeld's and Rogoff's recent paper "The Unsustainable US Current Account Position Revisited".
our framework should not be thought of as asking the question: "How much depreciation of the dollar is needed to rebalance the current account?" Thought wildly popular, this view is misguided. In fact, most empirical and theoretical models (including ours) suggest that even very large autonomous exchange rate movements will not go far toward closing a current account gap of the magnitude presently observed in the case of the United States. The lion's share of the adjustment has to come from saving and productivity shocks that help equilibrate global net saving levels, and that imply dollar change largely as a by-product . . . the relative price of imports and exports is only one element underlying the overall real exchange rate response, and not the dominant element from a quantitative viewpoint.
In short, simply selling more and buying less isn't going to cut the mustard. The US is going to have to start saving a hell of a lot more to get out from under this weight.

How high will interest rates have to go before Americans save rather than spend? Former Fed Governor McTeer is making noise indicating that a federal funds rate of 2.5% or so is high enough. The yield on the 10-year is stubbornly low and 30-year mortgage rates just won't go above 6% while one-year ARMs are, according to the Mortgage Bankers Association, back under 4%. Clearly dramatically higher interest rates are called for if the US current account is going to start shrinking, but all the signs from the markets are that ultra-low rates are here to stay.

US savings may have fallen to 0.0% in October, and there is always yet another lower-rate mortgage to take out to facilitate continuing consumption without income. Until US interest rates start rising, I don't think the falling dollar is going to do much of anything to address the current account deficit.

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