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Friday, September 19, 2003

Worries About the US Trade Deficit and a Falling Dollar: A Reply to A Visitor's Comment

A visitor, Steve Shea, left a thoughtful comment at the end of the previous article that looked at the worries being expressed about the growing size of the US current account deficit . . . and the likelihood, consequently, that there will soon be a rapid sell-off of US financial assets by foreigners, fearful that the US couldn't sustain such high levels of debt to them. In the upshot, it's argued, the exchange rate of the dollar would fall sharply, and all sorts of harm would ensue to the health of the US economy and the manufacturing sectors of foreign countries dependent on exports to the US. That's one scenario, the doomsday one. The other, a soft-landing for the US economy, still seemed to the buggy prof to exaggerate harm: either to us or to others. The evidence? The buggy prof looked at a comparable period in recent US economic history --- 1985 - 1995 --- when, like now, there were record US federal deficits, alleged low-levels of savings a dependence therefore on imported foreign capital to invest in our financial assets, and then a sharp fall in the value of the dollar against major currencies at the time, especially the Yen and the German Mark.

A brief sidebar clarification about "alleged low savings" in the US. There's frequently confusion here. By definition, savings and investment have to equal one another over the year. By definition, too, the current account deficit each year is equal to the gap between net savings and net investment by Americans ---including, observe, American investments abroad --- generated out of US savings, with the gap then closed by importing the capital from abroad. (The imported capital from abroad --- foreigners investing in American financial assets like bonds and equity --- then raises the exchange rate of the dollar and leads to an equivalent size deficit in current account: the trade in goods and services.) But wait! To note a gap between net American savings and net American investment isn't the same as saying we're low savers as a country. As it happens, some fairly recent studies find that we are just behind Japan in our savings (and hence investment) levels if we look at gross investment and expand the meaning of the term in entirely persuasive ways. For a particularly good readable article of high quality on this count, see See Milka S. Kirova and Robert E. Lipsey, Measuring Real Investment: Trends in the United States and International Comparisons (National Bureau of Economic Research: Cambridge, Ma. February 1998), Working Paper 6404.



Steve's Comment

What about the time period 1970-75 when it was more the strong DM than the weak US dollar that caused economic discomfort here in the USA? Most of the member countries of the European Community --- 9 in those days --- tied their currencies to the DM after 1971; and --- it was alleged --- liquidity [in the US? Prof Bug] was tight. The result showed up poor accumulation of capital stock and real estate growth.

The answer to professor DeLong's question may be the result of how quickly China matures as a developed country.If and when and how China allows its currency to float, will they become an alternative to the US as a finacial trading vehicle ? Will money be diverted from the US to Asia slowing growth and prosperity here. The US dollar would not devalue; the New Chinese Dollar would appreciate resulting in lower stock and real estate values in the US. SWS

THE BUGGY RESPONSE

Steve:

Two good questions. Very briefly

1. The 1970s and Dollar Depreciation?

Yes, the 1970s --- specifically 1972 on --- were another period when the dollar fell in value brusquely . . . its first post-WWII adjustment compared to the major West European currencies. (By contrast Japan's currency --- which was about 350 Yen to the dollar in the 1970s and then 260/$ during the first six years of the next decade --- remained markedly undervalued until 1986: ever since, it has fallen and stayed in a range of about 115 - 150 Yen/$ . . . with a sharp, brief-lived surge in 1995 to 83 Yen/$. And since then? The Yen exchange rate has been in the 115 - 130 range, roughly speaking, with multiple pressures to rise toward 100 or so. Right now, thanks to massive buying of dollars the last two or three years, the Japanese government has managed to keep the exchange rate of the Yen from firming against the dollar to lower than about 114 Yen/dollar, essentially its exchange rate as of today. Already, as the G-7 group of big industrial countries gather to meet this coming weekend, some of the finance ministers who will be there have openly talked about pressuring the Japanese government to stop its currency interventions and let the Yen rise. For the EU ministers, their hope is that a Japanese lead here would persuade other Asian countries to emulate the example. Otherwise, they fear, a decline of the dollar's exchange rate in the future will be mainly against the euro, further constraining eurozone exports and hence its already paltry GDP growth the last two years . . . and apparently, according to the IMF's Projections, next year too. )

Note though. There are too many problems with using the 1970s as a reference point for probing the immediate future of the US economy, always assuming DeLong and others are right and the dollar's exchange rate will soon fall on the order of 25-50%. Above all, there were serious dislocations to the global economy in those days without parallel, before or since: the big oil price hikes of 1973-74 and 1979; new inflationary surges; the breakdown of the main Keynesian policy guide --- the Phillips curve, which postulated a stable tradeoff at the margins of unemployment and inflation; and a brusque, pronounced slowdown in the rates of GDP- and productivity growth in the industrial world. (Observe in passing that Japan's economy slowed down the most, by around 75% since then; Germany's by almost 2/3; only the US and the other English-speaking countries, Britain, Canada, Ireland, Australia, and New Zealand, have restored or even surpassed the pre-1975 growth rates here; a couple of the poorer EU Mediterranean countries have also done fairly well, Greece and Spain, despite high levels of unemployment. And the East Asian dynamos of Hong Kong, Taiwan, Singapore, and Taiwan continued to grow vigorously until the early, mid-1990s . . .with China leaping ahead too in the 1980s and early 1990s, only to slow down noticeably since.)

Nor is that all. Another problem with using the 1970s as a comparative era with today is that there weren't any US federal deficits to drive any alleged sell-off of US securities as the US dollar plunged in value against the European currencies that DeLong worries might happen now or in the immediate future.

On all these counts, then, the period between 1980 and roughly the end of 1994 --- when there were surging federal deficits and the dollar lost more than 50% of its exchange rate against the Yen and DM in nominal terms --- is much more relevant for trying to probe what might happen to the US in the future if the dollar fell rapidly in value again.

 

2) China and the Dollar.

I. I've treated this at length in some articles here: see above all these two:

China's Economy, Problem or Promise for the US

and more to the point still,

China's Surging Trade Surplus with the US: What To Do?

 

II. Yesterday evening, recall, Steve, I sent you a direct email in response to a comment that you left on the site. No harm in repeating it here now, with a few elaborations:

Steve:

1) Many thanks: a good question --- your asking whether we couldn't seek to persuade or pressure the Chinese government to open up the national economy to more US exports (running about $16 billion a year there, as opposed to about $121 billion of Chinese exports sold in the US this year). In particular, you see this as an alternative, or maybe supplement, to a variety of measures that the buggy articles just mentioned set out for dealing with the short-run problems for the US economy that are being caused by a flood of Chinese imports, especially since they're concentrated in a limited number of industries and are causing powerful protectionist backlashes . . . all a time, remember, when the entire US employment situation has been generally gloomy the last three years.

2) One of those proposed buggy measures was to invoke WTO safeguard measures against a surge of imports, which allow for temporary protection as long as it's coupled to a reasonable policy for making the affected industries more competitive within two or three years. Another was to accelerate the introduction of new trade adjustment assistance to displaced workers, which is based on paying the difference between their previous incomes and new ones in other jobs if the new incomes are lower (for up to 18 - 24 months). A third, which is more general, would be to improve the GDP growth rate of the US economy. As long as we have a new, much higher potential output --- our long-term growth trend, upped to about 3.5 - 4.0% a year (thanks to big productivity improvements the last several years) --- we need to find ways to increase considerably aggregate demand and hence raised current GDP to levels at or above 4.0% a year to increase the number of jobs.

A fourth buggy measure, focused directly on China, was to induce it one way or another to let the Yuan appreciate . . . probably on the order of 25 - 40% or so (depending on market forces buying and selling the Yuan). Right now, the Yuan is artificially pegged to the dollar at 8.3.

To sustain it, Beijing buys huge quantities of dollars daily with Yuan --- to the tune of $250 300 million worth a day, about $80 billion last year alone --- a sure sign of an undervalued currency. It then further keeps the Yuan artificially low by maintaining rigid capital controls on outflows of capital movements from China. In the process, of course, the Chinese government --- which has come to depend on both very large inflows of multinational investment on export-led growth (plus huge pump-priming deficit spending since 1997, not least to stop price deflation) --- doesn't keep the resulting dollars under Chinese mattresses. It reinvests most of the dollars in the US economy . . . mainly in Treasury securities, no doubt also in corporate equity and bonds. One way or another, that increases the pool of savings in the US. And since our national savings aren't sufficient to cover our national investment at home (and abroad), interest rates, it's said, are lower than they would otherwise be.

Note that other countries --- not least, China's Asian neighbors --- have been concerned about the undervalued nature of the Yuan. They even appear willing at an APEC meeting --- Asian Pacific Economic Cooperation, just getting under way --- to criticize Beijing openly on this score. One problem for them? Aside from Beijing's showing no interest in acceding to their criticisms, they themselves generally have undervalued currencies and are hardly willing to allow them to float and let market forces determine the exchange rate.

3) Which brings us to your suggestion: that we seek to induce Beijing to open up its economy to more US exports.

On the face of it, that's clearly a desirable objective. It's also been the policy of the US government in the Clinton and Bush administrations ---- precisely a major reason for agreeing to admit China to the WTO, whose rules, including those governing intellectual and other property rights, are supposed to work to that end. Have they been very successful so far? Obviously not. To repeat, while the US buys about $121 billion worth of Chinese exports right now, we have been selling only about $16 billion worth of our exports there. They have, in fact, scarcely risen since the mid-1990s except at a turtle's pace.

What's the problem?

Well, for a start, we're dealing with a CP authoritarian government that still presides over a mixed economy with a huge, bankrupt state industrial sector and very finally shaky state banks that gobble up the big savings of the Chinese people and pour them back into the state-owned firms. Though the government has cut back the numbers of these firms and employment, they still are a big absorber of savings, with no profit in sight, and the banks remain rickety. On top of that, the economy depends largely on both export-led growth (about $75 billion last year on a global basis, the surplus with the US over $100 billion), and on the largest infusion of multinational investment in the world . . . larger now, at existing rate, than the inflow into the US economy. As long as it depends on export-led growth, and as long as unemployment continues to grow as the state-sector is reduced in size --- official figures show a ludicrous 2 or 3% unemployment rate: it's probably 10 times that --- there's really little we can do to pry open the economy there without leveling outright punitive tariffs or quotas that may be illegal under WTO rules. Then, too, if you recall how hard it was in the 1980s and early 1990s for the US to break into the Japanese market --- a far more rule-governed, open economy (compared to the Chinese anyway) --- you'll appreciate how difficult such opening could be in China's far more authoritarian economy. A largely sheltered economy would see, among other things, large numbers of outright bankruptcy on the part of uncompetitive firms as more imports flowed in.  

Yuan Appreciation?

Back to the Yuan exchange rate. Agreed: whether we can convince the Chinese to let the Yuan appreciate isn't an easy option either, but it seems more promising than trying to pry open an economy like China's . . . at any rate, in any foreseeable short- or mid-term: say, 3-10 years. Saying that it's promising, mind you, isn't to say that it would be easy. The trouble is, the economy there --- despite official figures about rapid GDP growth --- is so shaky, financially and otherwise (full too of social tensions and built-in conflicts as economic restructuring goes on), that the government and the CCP might dig in against any such appreciation, fearful of the domestic implications, as the Yuan rose in value . . . this, even if for other reasons (which I don't detect), they were willing to do so, perhaps worried that outright protection might be Congress's alternative.

In any case, as long as countries with huge domestic markets --- China, Japan, South Korea, never mind the EU --- prefer export-led growth, they will likely find ways to continue running undervalued currencies. After all, on this count, they need only buy dollars with their own currencies, something they can't run out of. The upshot? Even though the US, with its trade deficits for over 20 years continues to create far more jobs than they have, and simultaneously to experience far greater advances in GDP and productivity (aside from the very poor Chinese in per capita income), there is little prospect we can force them to switch growth on our own and reorient it in more balanced ways.

In turn, as long as this imbalance in their economic orientation persists, there will also persist -- as an article in today's Economist notes (with a very good graph) --- in the global economy, with the US virtually the only engine of growth.