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More dollar devaluation of as much of 34 percent is only realistic solution

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  • GATAComm@aol.com
    Why America is switching to a weak dollar policy By Martin Wolf Financial Times, London Wednesday, December 1, 2004
    Message 1 of 1 , Dec 1, 2004
      Why America is switching to a weak dollar policy

      By Martin Wolf
      Financial Times, London
      Wednesday, December 1, 2004

      http://news.ft.com/cms/s/69dceca6-433f-11d9-bea1-00000e2511c8.html

      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
      exchange rate.

      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
      employment.

      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
      percent.

      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
      or both.

      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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