Thursday, December 23, 2004

Brad DeLong today gives a tepid endorsement of a "soft-landing" scenario for the US current account deficit.
To restate: (1) the dollar falls, (2) as a result net exports rise, (3) export and importing-competing industries hire workers, (4) unemployment falls, (5) wages start rising and bring rising inflation with them, (6) the Federal Reserve raises interest rates to stop any inflationary spiral, (7) the economy cools off as higher interest rates reduce construction and investment spending and raise unemployment back to its natural rate.

It could happen--if exports react rapidly and substantially to the falling dollar, and if the rising long-term interest rates that diminish employment in construction and investment-goods production are somewhat delayed...
But well before we get to step [7], it would be nice to see some actual evidence that we can even get to step [2].

Thus far we have had nearly three years of [1] ("the dollar falls") and not a bit of [2] ("net exports rise"). From February 2002 to December 2004 the dollar has fallen 16% in real terms (per the broad dollar index) while the trade deficit has grown in real terms about 60%. I keep hearing the "delayed effects" mantra, but it's beginning to wear really thin for me.

What if there is no necessary connection at all between [1] and [2]? What if the US is the global price-setting market, and thus rather than importing inflation via a falling dollar which would cut into import consumption, the US exports deflation instead and maintains import consumption at current or even rising levels?

The key mechanism to correct the CA deficit is not a falling dollar, but -- as I discussed early last week -- rising savings. A little targeted protectionism wouldn't hurt, either.


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