Let the dollar fall or risk global economic disorder
Let the dollar fall or risk global economic disorder
By Martin Wolf
Published: May 10 2006 03:00 | Last updated: May 10 2006 03:00. Copyright by The Financial Times
Last week, I had the pleasure of moderating a governors' seminar on global payments imbalances at the annual meeting of the Asian Development Bank in Hyderabad. The discussion made even clearer than before how far the irresistible force of US desire for exchange-rate movement - well expressed by US Treasury undersecretary Timothy Adams - meets the immoveable object of Asian resistance. As a result, I fear, the chances of a row even worse than the one accompanying the end of the Bretton Woods exchange-rate system in the early 1970s grow ever bigger.
In Hyderabad, Yong Li, China's vice-minister of finance, referred to "rumours that the US dollar might depreciate by 25 per cent" as shocking. Similarly, Sadakazu Tanigaki, the Japanese finance minister, warned the ADB seminar that "overemphasising realignments of exchange rates could invite market speculation and deal a blow to the global financial markets".
If the US Treasury now labels China a currency manipulator in its semi-annual foreign exchange report due today, the tension will increase still further. Even if the US does not issue such a judgment, the day of reckoning will only be postponed.
After all, China's foreign currency reserves grew by $680bn (£364bn) between January 2001 and January 2006, in a successful attempt to keep the value of the renminbi down. Yet April's communiqué from the finance ministers of the Group of Seven leading high-income countries stated explicitly that "in emerging Asia, particularly China, greater flexibility in exchange rates is critical to allow necessary appreciations, as is strengthening domestic demand, easing reliance on export-led growth strategies and actions to strengthen financial sectors".
Singling out China in this way was a bold move. Judged by the rhetoric of its policymakers and the scale of its interventions, China is not about to concede to such pressure. Consequently, the dollar is weakening largely against the floating currencies. Since the middle of April, the Federal Reserve's broad trade-weighted dollar exchange rate has lost 3 per cent of its value, while the currency has fallen by 5 per cent against the euro.
The big question, however, is whether the Chinese, Japanese and others are right to believe that a large fall in the dollar can be avoided. In addressing this question, I put to one side two other questions; whether, properly measured, the US has a large current account deficit and whether, if it does, it is sustainable. The question here is a different one, namely, whether it is possible to reduce the US deficit substantially without exchange-rate changes. The answer is that it would be possible, but catastrophic for all participants, because it would demand a deep US recession, which would almost certainly end the US commitment to liberal trade.
The point emerges in a simple way from examination of the trends in exports and imports as a share of US gross domestic product (see chart). It has been made more rigorously by Maurice Obstfeld of the University of California at Berkeley and Kenneth Rogoff of Harvard.*
A very simple description of the current state of the US economy would be as follows: total demand is 107 per cent of gross domestic product; total output of tradeable goods and services is about 25 per cent of GDP; total demand for tradeable goods and services is 32 per cent of GDP; and total demand and supply of non-tradeables is 75 per cent of GDP. The difference between supply and demand for tradeables, by definition, equals the trade deficit.
Now assume a reduction of only 3 percentage points in the ratio of the trade deficit to GDP. This is just under 10 per cent of total demand for tradeables. Assume, for simplicity's sake, that the incremental demand for tradeable goods and services is proportionate to that for non-tradeables. Without any shift in relative prices, overall demand in the economy needs also to fall by just under 10 per cent to deliver the desired reduction in the trade deficit. This would generate a fall of about 7 per cent in GDP, all of which would fall on industries producing non-tradeables. But such a deep recession would create misery, while contributing nothing to the desired improvement in the external deficit.
To avoid the massive recession that expenditure reduction alone would generate, the price of non-tradeables has to fall substantially relative to that of tradeables. Such a shift is a decline in the real exchange rate. This should move spending towards non-tradeables and potential supply towards tradeables. Under plausible assumptions the real exchange rate changes needed to shift the economy in the desired direction are large. The quicker the adjustment, the bigger they must be. That is a good reason for making those adjustments slowly, which is also a reason for avoiding postponing them indefinitely.
Could these changes in real exchange rates be achieved without moves in nominal exchange rates? The logical answer, again, is yes. But that would require a fall in the nominal price of non-tradeables in the US - in other words, outright deflation in that country - and a rise in the price of non-tradeables in the exporting countries - in other words, rapid inflation there. The former is inconceivable, while the latter is apparently unacceptable. So nominal exchange rates must move.
If surplus countries resist this, there will be no adjustment. They are then gambling the wealth of their citizens on rapidly growing holdings of US liabilities. They are also gambling that US protectionist pressure can be contained as the deficit soars.
Economists working for Deutsche Bank have called the present informal exchange-rate arrangement "Bretton Woods 2". Remember that the US destroyed Bretton Woods 1 in 1971 by imposing an import surcharge and forcing currency appreciation. This led to a decade of monetary disorder. This disastrous outcome was the result of resisting adjustment too long.
The surplus countries must not assume that the present course is benign. On the contrary, it is very dangerous, politically and economically. It poses a great threat to a trading system, already imperilled by the looming failure of the Doha round of trade negotiations. Nothing is more understandable than the wish to stop currency adjustment. But it is a big mistake, all the same.
*The Unsustainable US Current Account Position Revisited,November 30 2005; http://post. economics.harvard.edu/faculty/rogoff/rogoff.html
By Martin Wolf
Published: May 10 2006 03:00 | Last updated: May 10 2006 03:00. Copyright by The Financial Times
Last week, I had the pleasure of moderating a governors' seminar on global payments imbalances at the annual meeting of the Asian Development Bank in Hyderabad. The discussion made even clearer than before how far the irresistible force of US desire for exchange-rate movement - well expressed by US Treasury undersecretary Timothy Adams - meets the immoveable object of Asian resistance. As a result, I fear, the chances of a row even worse than the one accompanying the end of the Bretton Woods exchange-rate system in the early 1970s grow ever bigger.
In Hyderabad, Yong Li, China's vice-minister of finance, referred to "rumours that the US dollar might depreciate by 25 per cent" as shocking. Similarly, Sadakazu Tanigaki, the Japanese finance minister, warned the ADB seminar that "overemphasising realignments of exchange rates could invite market speculation and deal a blow to the global financial markets".
If the US Treasury now labels China a currency manipulator in its semi-annual foreign exchange report due today, the tension will increase still further. Even if the US does not issue such a judgment, the day of reckoning will only be postponed.
After all, China's foreign currency reserves grew by $680bn (£364bn) between January 2001 and January 2006, in a successful attempt to keep the value of the renminbi down. Yet April's communiqué from the finance ministers of the Group of Seven leading high-income countries stated explicitly that "in emerging Asia, particularly China, greater flexibility in exchange rates is critical to allow necessary appreciations, as is strengthening domestic demand, easing reliance on export-led growth strategies and actions to strengthen financial sectors".
Singling out China in this way was a bold move. Judged by the rhetoric of its policymakers and the scale of its interventions, China is not about to concede to such pressure. Consequently, the dollar is weakening largely against the floating currencies. Since the middle of April, the Federal Reserve's broad trade-weighted dollar exchange rate has lost 3 per cent of its value, while the currency has fallen by 5 per cent against the euro.
The big question, however, is whether the Chinese, Japanese and others are right to believe that a large fall in the dollar can be avoided. In addressing this question, I put to one side two other questions; whether, properly measured, the US has a large current account deficit and whether, if it does, it is sustainable. The question here is a different one, namely, whether it is possible to reduce the US deficit substantially without exchange-rate changes. The answer is that it would be possible, but catastrophic for all participants, because it would demand a deep US recession, which would almost certainly end the US commitment to liberal trade.
The point emerges in a simple way from examination of the trends in exports and imports as a share of US gross domestic product (see chart). It has been made more rigorously by Maurice Obstfeld of the University of California at Berkeley and Kenneth Rogoff of Harvard.*
A very simple description of the current state of the US economy would be as follows: total demand is 107 per cent of gross domestic product; total output of tradeable goods and services is about 25 per cent of GDP; total demand for tradeable goods and services is 32 per cent of GDP; and total demand and supply of non-tradeables is 75 per cent of GDP. The difference between supply and demand for tradeables, by definition, equals the trade deficit.
Now assume a reduction of only 3 percentage points in the ratio of the trade deficit to GDP. This is just under 10 per cent of total demand for tradeables. Assume, for simplicity's sake, that the incremental demand for tradeable goods and services is proportionate to that for non-tradeables. Without any shift in relative prices, overall demand in the economy needs also to fall by just under 10 per cent to deliver the desired reduction in the trade deficit. This would generate a fall of about 7 per cent in GDP, all of which would fall on industries producing non-tradeables. But such a deep recession would create misery, while contributing nothing to the desired improvement in the external deficit.
To avoid the massive recession that expenditure reduction alone would generate, the price of non-tradeables has to fall substantially relative to that of tradeables. Such a shift is a decline in the real exchange rate. This should move spending towards non-tradeables and potential supply towards tradeables. Under plausible assumptions the real exchange rate changes needed to shift the economy in the desired direction are large. The quicker the adjustment, the bigger they must be. That is a good reason for making those adjustments slowly, which is also a reason for avoiding postponing them indefinitely.
Could these changes in real exchange rates be achieved without moves in nominal exchange rates? The logical answer, again, is yes. But that would require a fall in the nominal price of non-tradeables in the US - in other words, outright deflation in that country - and a rise in the price of non-tradeables in the exporting countries - in other words, rapid inflation there. The former is inconceivable, while the latter is apparently unacceptable. So nominal exchange rates must move.
If surplus countries resist this, there will be no adjustment. They are then gambling the wealth of their citizens on rapidly growing holdings of US liabilities. They are also gambling that US protectionist pressure can be contained as the deficit soars.
Economists working for Deutsche Bank have called the present informal exchange-rate arrangement "Bretton Woods 2". Remember that the US destroyed Bretton Woods 1 in 1971 by imposing an import surcharge and forcing currency appreciation. This led to a decade of monetary disorder. This disastrous outcome was the result of resisting adjustment too long.
The surplus countries must not assume that the present course is benign. On the contrary, it is very dangerous, politically and economically. It poses a great threat to a trading system, already imperilled by the looming failure of the Doha round of trade negotiations. Nothing is more understandable than the wish to stop currency adjustment. But it is a big mistake, all the same.
*The Unsustainable US Current Account Position Revisited,November 30 2005; http://post. economics.harvard.edu/faculty/rogoff/rogoff.html
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