More dollar devaluation of as much of 34 percent is only realistic solution
- Why America is switching to a weak dollar policy
By Martin Wolf
Financial Times, London
Wednesday, December 1, 2004
How far might the dollar fall?
By as much as 50 percent from its peak, in trade-weighted
nominal terms, suggest two distinguished international
economists, Maurice Obstfeld of the University of California
at Berkeley and Kenneth Rogoff of Harvard. Up to now, the
fall has been just 17 percent, on a broad trade-weighted
basis. More, it seems, is on the way.
The work of these two economists assesses the real
exchange rate adjustments needed to reduce the US
current account deficit. A prior question is whether
such a reduction is needed. The honest answer is:
Nobody knows. But it is easy to accept that the present
path is unsustainable, since both the current account
deficit and external liabilities are on an explosive
upward trajectory. On current trends, the current account
deficit might even jump from 6 percent of gross domestic
product to as much as 10 percent by the next decade.
Already, strains are showing. Since 2001, there has been
a net outflow of foreign direct investment and portfolio
equity, but a huge inflow of money from foreign
governments. In 2002, 2003, and the first half of 2004,
foreign governments financed $564 billion (43 percent) of
a cumulative current account deficit of $1,318 billion
(£695 billion). Since the US fiscal deficit is the principal
domestic counterpart of the external deficit, the flow
from foreign governments is the biggest (albeit
unofficial) aid programme in history.
Some argue that Asian governments -- and, above all,
China's -- are wedded to the fixed exchange rate against
the dollar. Others argue that, once the floor to the dollar
is established, private flows will, once again, take up the
strain. All this is conceivable. But at least one good
reason why the private sector will not finance the US
deficit is the size of the exchange-rate risk. To assess
this risk, it is necessary to analyse how big a fall in the
dollar might be needed. The smaller the needed fall, the
smaller the exchange-rate risk and the more sustained
the capital inflow will be.
Total spending by US residents now exceeds GDP by
close to 6 percent. Suppose that the US was a small
country whose aggregate income was spent on perfectly
tradeable goods and services. All that would then be
needed, to eliminate the current account deficit, would
be to cut aggregate spending by this amount. The excess
demand currently satisfied by imports would disappear,
while GDP itself would be unaffected. No change in
relative prices would be needed and so no change in the
This is not how any economy, least of all the US, works.
Prof. Obstfeld and Prof. Rogoff introduce three
modifications: first, the tradeable goods and services made
by the US are different from those it imports; second, the
US accounts for at least a quarter of global output; and,
third, some three quarters of US output is made of things
it can trade only with difficulty, such as domestic transport,
health care, restaurant services, and so forth.
Think of a world with just two countries: the United States,
with an external deficit of 6 percent of GDP, and the rest
of the world, with a surplus of 2 percent. A reduction in the
US current account deficit and so of the rest of the world's
surplus must now generate changes in three relative prices
-- prices of US-made tradeables relative to its imports, prices
of US non-tradeables against its tradeables, and the prices
of foreign non-tradeables against foreign tradeables. What
then determines the change in the real exchange rate (or
home prices against foreign prices)?
The answer is the price changes needed to preserve full
If there were no changes in relative prices, a reduction in
US demand would not only improve the current account
deficit but also generate a recession. A reduction in
demand equal to the current account deficit would end
up reducing it only from 6 percent to 4.2 percent of GDP.
But it would also lower demand for non-tradeables and
so reduce GDP by 4.2 percent. To eliminate the external
deficit, GDP would need to fall by a sixth and output of
non-tradeables by a fifth.
This would be a depression.
Moreover, since the US is a large country, the reduction
in its demand for tradeables would affect the rest of the
world. To eliminate its current account deficit, the required
reduction in US demand must be still bigger.
Reducing a current account deficit unquestionably demands
a fall in demand relative to output. But to prevent a big
recession, there must also be a rise in the relative price
of tradeables in the country reducing its deficit, to switch
demand toward non-tradeables and so sustain output, with
the opposite happening in countries reducing their
surpluses. For a big country there will also need to be a
reduction in the terms of trade -- the price of its tradeables
against those of the rest of the world.
The size of the required price changes is determined by
"elasticities of substitution" -- a fancy name for the
changes in relative prices needed to bring about given changes
in demand. According to Prof. Obstfeld and Prof. Rogoff, the
real exchange rate depreciation needed in the US could be
as big as 34 percent. Moreover, in these calculations, the
internal price change exceeds the terms of trade adjustment
by a large margin: If the needed real depreciation is 34
percent, the deterioration in the US terms of trade is only 7
Finally, because the pass-through of changes in nominal
exchange rates to prices is low, the nominal exchange rate
change needed might be double the real one.
This is not an analysis of what will happen. It is an analysis
of what could happen if the US had to eliminate its current
account deficit. Provided the rest of the world is happy to
finance a substantial (albeit somewhat smaller) deficit
indefinitely or is relaxed about the speed of adjustment, the
required changes in relative prices can be smaller, slower
Yet the risks are also obvious. To bring about a substantial
reduction in the external deficit without a deep recession, the
US needs a huge change in internal relative prices. If the
financing of the deficit is indeed in doubt, a weak dollar is
a certainty. Hard currency enthusiasts may want the US to
choose a depression instead, or hope the deficit can grow
without limit. Neither position is sensible. Big adjustments
in the dollar's real value are a certainty. The only questions
are when, how, and how much.
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