Our Net Book Value just RESEARCH TOOLS Economist.comsuRveYs 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 cheaper dollar will encourage them to do that while boosting American exports at the same 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 tudy 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, Americas imports are worth almost 50% more than its exports($974 billion ). Closing the gap me 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
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 should America be more addicted to imports than other countries? For a long time economists thought it must Opening too wide have something to do with trade barriers abroad that America s trade in goods and services, Strn prevented American exports from flourishing. But trade barriers at least in the rich world have been lowered Impor substantially since the 1960s TRADE Another theory, pioneered by Paul Krugman in the late 1980s, is that Americans'apparent love of imports Exports 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 1111 199394959697989920000102 growing supplier regions, such as East Asia, that has Source: US Bureau of EconomIc Analysis 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 Disney World, in contrast become relatively less expensive. Second, this shift in relative prices encourages Americans to spend less on imports while boosting American exports
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 fastgrowing 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 the effect of a drop in the dollar by cutting their profits rather than raising the price en absorb usually extremely keen to maintain their share in the world's biggest market, they often absorb 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%o, 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 Obstfeld, an economist at the university of California at Berkeley reckon it will take a fallon o return to Harvard University after a two-year stint as chief economist at the IMF, and mauric 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%o 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 Russias default in the summer of 1998. If the dollar suddenly plunged, similar problems could arise
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? Copyright 2004 The Economist Newspaper and The Economist Group. All rights reserved
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? Copyright © 2004 The Economist Newspaper and The Economist Group. All rights reserved
