Shrink-proof
Sep 18th 2003
From The Economist print edition
Why America's deficit is hard to turn around
IF FOREIGNERS lose enthusiasm for American assets,they simply click on a mouse,Capital
markets are the most liquid and efficient markets in the world; billions of dollars can shift at the
touch of a button,The problem is that the other side of America's balance-of-payments
ledger—the world of imports and exports—is much more sluggish,
According to economics textbooks,shrinking an external deficit should be straightforward
enough,For the current-account deficit to shrink,the trade deficit must fall,which means that
America must import less and export more,That,in turn,means raising foreigners' appetite for
American goods and services relative to Americans' own demand for them,
There are two main routes,Either overall spending by foreigners rises relative to American
spending as other economies perk up,or (more painfully) America's economy slows down,To
help things along,Americans should shift their spending towards goods produced at home,A
cheaper dollar will encourage them to do that while boosting American exports at the same
time,
The most effective engine of adjustment would be an autonomous increase in demand abroad
for American goods,perhaps through faster growth in customer countries,In practice,though,
it tends not to happen that way,The typical current-account adjustment,according to the IMF
study cited earlier,is associated both with a sizeable fall in the exchange rate and with a drop
in output in the adjusting economy,Ms Freund's study for the Federal Reserve reached the
same conclusion,suggesting that a sustained export surge is the most important factor in
turning round a deficit,
Although America finds it easier than most countries to fund its external deficit by sucking in
foreign capital,its economy has a number of characteristics that make it much tougher than
elsewhere to shrink that deficit,The first problem is the sheer size of it,and the huge gap
between imports and exports (see chart 7),At just under $1.4 trillion in 2002,America's
imports are worth almost 50% more than its exports ($974 billion),Closing the gap means
exports have to grow much faster than imports,If imports were to increase by,say,4% (about
half their average growth rate since the mid-1990s,and consistent with modest economic
growth in America),exports would have to rise by 11%,more than 1.5 times the average of
the booming late 1990s,to reduce the trade deficit to $300 billion over two years,
Moreover,Americans have a particular penchant for imports,Back in 1969,two economists,
Hendrik Houthakker and Stephen Magee,noticed an odd phenomenon,for any given rate of
economic growth,America's imports tended to grow faster than those of other countries (and
faster than America's exports),So if all countries were growing at the same speed,and
exchange rates remained stable,America's trade deficit would worsen inexorably,To stop the
deterioration,the American economy would have to grow more slowly than others,or the dollar
would have to fall,
This phenomenon has long perplexed economists,Why
should America be more addicted to imports than other
countries? For a long time,economists thought it must
have something to do with trade barriers abroad that
prevented American exports from flourishing,But trade
barriers,at least in the rich world,have been lowered
substantially since the 1960s,
Another theory,pioneered by Paul Krugman in the late
1980s,is that Americans' apparent love of imports
reflects the growing array of products made by countries
that export to America,For any given rise in income,
America's import demand is not abnormally high,he
argued,Rather,it is the supply of exports from fast-
growing supplier regions,such as East Asia,that has
been rising,
Another explanation points to the high levels of immigration into America,Immigrants,goes
the argument,have a particular penchant for goods from their own country,Thus imports in a
country with lots of immigrants will be relatively higher than elsewhere,
Lastly,there is the possibility that the relationship between growth and imports shifts as
economies develop,Catherine Mann,from the Institute for International Economics,finds that
the predilection for imports is much less pronounced in services than in goods,That suggests
America's import bias will become less marked as the share of services in the global economy
becomes ever larger,
For the moment,however,the import bias remains,In a detailed re-estimation of the statistics
in 2000,three economists at the Federal Reserve,Peter Hooper (now at Deutsche Bank),Karen
Johnson and Jaime Marquez,found that America's imports rose 1.8% for every 1% increase in
overall spending,A 1% rise in foreign demand,in contrast,produced a less than proportional
(0.8%) rise in American exports,
This lopsidedness,together with the sheer scale of America's current-account deficit,means
that tackling it will be tricky,Unless other countries grow substantially faster,relative to
America,than they do now,the bulk of any adjustment will depend on a depreciation of the
dollar,
Down with the dollar
Back in the world of economics textbooks,a fall in the exchange rate improves the trade
balance in two stages,First,the cheaper dollar increases the relative price of Japanese cars,
French wines and Italian holidays,Cars from Detroit,chardonnay from California or trips to
DisneyWorld,in contrast,become relatively less expensive,Second,this shift in relative prices
encourages Americans to spend less on imports while boosting American exports,
In the real world,however,matters are more complicated,First,a drop in the exchange rate
does not necessarily lead to an equivalent rise in the price of imported goods,This is partly
because the final price of an imported good includes numerous costs,such as distribution and
marketing,that are not affected by the exchange rate,Second,many countries that export to
the United States (especially Asian ones) price their goods in dollars,Since these exporters are
usually extremely keen to maintain their share in the world's biggest market,they often absorb
the effect of a drop in the dollar by cutting their profits rather than raising the price,
Economists reckon that in the 1990s only about half of an exchange-rate change had worked its
way through to manufacturing import prices after a year,Over a shorter period the effect can
be even less,In the year to May,says Michael Rosenberg,chief currency strategist at Deutsche
Bank,import prices to America,excluding oil,rose only 0.9%,even though the trade-weighted
dollar fell by 6%,
But even if prices do move,spending patterns may remain much the same for a while,because
consumers tend to be slow to adjust their spending in response to price changes,It also takes
firms time to change orders and production levels,And even in the long run,the impact on
imports of a drop in the dollar is weaker than that of a drop in income,According to calculations
by Ms Johnson and Messrs Hooper and Marquez,a 1% drop in the dollar reduces Americans'
demand for imports by only 0.3% in the long term,A 1% drop in income,on the other hand,
reduces imports by 1.8%,So if a drop in the dollar is to make much of a dent in the trade
deficit,it will have to be really big,
But just how big? The exact estimates differ,depending on how economists construct their
models,but virtually all the numbers are startling,In perhaps the most optimistic analysis,Fred
Bergsten of the Institute for International Economics reckons that the dollar needs to fall by
another 15-20% on a trade-weighted basis to bring America's current-account deficit down to
3% of GDP,His calculation assumes some increase in relative demand from abroad,Failing
that,the necessary currency adjustment becomes much bigger,Ken Rogoff,who is about to
return to Harvard University after a two-year stint as chief economist at the IMF,and Maurice
Obstfeld,an economist at the University of California at Berkeley,reckon it will take a fall of
closer to 35% to get the current account back into balance,Mr O'Neill from Goldman Sachs is
even more pessimistic,estimating that a trade-weighted drop of 43% will be needed to reduce
the current-account deficit by 2% of GDP by 2007,And Mr Rosenberg of Deutsche Bank thinks
that if demand patterns stay as they are,a depreciation of 40-50% may be called for to get the
current-account deficit down to 3.5% of GDP,
These are enormous shifts,If the burden were spread equally across America's trading
partners,a 50% drop in the dollar would send the euro to well over $2 and the yen to less than
60 per dollar,With exchange-rate changes of this magnitude,the risk is that currencies may
move too fast and perhaps even too far,Historically,exchange rates have tended to overshoot,
In the 1980s the dollar soared,then plummeted,In Mexico in 1995,the peso plunged and then
recovered,In the 1997-98 Asian crisis,Indonesia's rupiah dropped by over 75% before
gradually creeping back,
Even big exchange-rate shifts can be absorbed if they occur slowly,(The 8% drop in the dollar
since early 2002,for instance,has not caused any problems.) But if they happen quickly,
financial markets are roiled,and at worst financial institutions are unable to cope with the
strain,LTCM,a hedge fund,collapsed when interest rates suddenly shifted after Russia's
default in the summer of 1998,If the dollar suddenly plunged,similar problems could arise,
The risk of a dollar crash and a subsequent financial meltdown are not negligible,Discussing
the coming fall in the dollar,Mr Rogoff recently commented:,The world is set to jump off the
top of a waterfall without knowing how deep the water is below.”
Nonsense,say the optimists; just look at history,In the early 1980s,America's current-account
deficit rose sharply,Policymakers,economists and journalists fretted about the prospect of a
dollar crash,A book published in 1985,“Deficits and the Dollar”,by Stephen Marris,epitomised
the mood.,On present policies a hard landing has become inevitable for the dollar and the
world economy,” Mr Marris argued.,The dollar will,over time,go down too far and there will be
an unpleasant world recession.”
The dollar did indeed go down,just as he had predicted,but there was no nasty recession,Can
history repeat that feat?
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