November 30, 2003

Note: Is America's Trade Deficit Sustainable?

Dooley, Folkerts-Landau, and Garber argue that the U.S. trade deficit is sustainable:

Economist.com | Economics focus: ...Michael Dooley... David Folkerts-Landau and Peter Garber... come to the same sanguine conclusion... the deficit is manageable... because it replicates the post-war Bretton Woods era. America is once again at the centre of an international monetary system. On the periphery, where post-war Europe once stood, now stands East Asia, with its cosseted capital markets and fear of floating against the dollar. The players have changed, but the rules of the game are much the same.

Under Bretton Woods, the Europeans, as they regained their exporting strength, amassed ever greater dollar claims on America. Similarly, under today's "revived" Bretton Woods system, the East Asians hoard their export earnings in low-yielding dollar assets, such as Treasury bills. What East Asia hoards, America happily spends: the inflow of Asian capital keeps American interest rates low and demand high. Moreover, America tends to spend its cheap East Asian loans on cheap East Asian goods. America and Europe used to enjoy a similar relationship. As Jacques Rueff, a French economist, put it in 1965: "If I had an agreement with my tailor that whatever money I pay him returns to me the very same day as a loan, I would have no objection at all to ordering more suits from him."

America gets more suits, but what do the East Asian tailors get out of it? Yields on safe, dollar assets are low and the opportunity cost is high, given better returns at home or elsewhere. Messrs Dooley, Folkerts-Landau and Garber argue that East Asia's governments are accumulating dollar assets as a by-product of a strategy of export-led growth. East Asia is prepared to forgo better returns in order to keep its exchange rates down and export demand up. This allows the region's industries to compete on world markets and attract foreign investment. To stretch Mr Rogoff's metaphor, the rope East Asia extends to America is not a noose but a tow-line, which will gradually pull Asian economies towards greater prosperity...

I don't believe it. The magnitudes are just too large. A 1% of GDP U.S. current-account deficit led to the demise of the Bretton Woods system after 15 years. How many years can the current deficits--five times as large relative to the size of the U.S. economy--last? I give it three years at the most before the yuan and other Asian currencies get substantially revalued.

Posted by DeLong at November 30, 2003 05:44 PM | TrackBack

Comments

My economics underpinning is somewhat weak but can someone explain this: Why is the Euro appreciating so much vs the dollar when their economies are in even worse shape than the US?

Posted by: Prashant P Kothari on November 30, 2003 05:54 PM

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I don't think the Bretton Woods system would have lasted as long as it did if today's markets had existed then. Even the US had various forms of currency control (gold ownership ban, interest equalization tax). I realize that China is controlling the official RMB-USD rate, but

1) China may have other economic policy goals than fixing the RMB, and as it gets harder, I would guess eventually they will have to stop.
In particular, I don't see how China can control its internal money supply when it has to soak up all those excess dollar balances with yuan.

2) Eventually, even Americans are going to have a hard time ignoring an impending dollar crisis, and there is a lot of professionally-run money in America that is unlikely to ignore a one-way bet.
It is surprising that there hasn't been more speculation against the dollar already, but now that we hear the both Soros and Buffett are betting against the dollar perhaps this will gain momentum.

If everyone prints money to avoid revaluing, I assume we will get some significant inflation, followed by something bad depending upon what governments do next.

Anyway, I'm guessing this prediction will not be greatly superior to Irving Fisher's "permanent high plateau" for stock prices in 1929.

Posted by: Matthew Wilbert on November 30, 2003 06:22 PM

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>>Why is the Euro appreciating so much vs the dollar when their economies are in even worse shape than the US?

I imagine the main reason is the difference in interest rates between the US and euroland: 1% vs 3.5% (I think). If the US maintains its present roaring recovery, things could change, but that remains to be seen.

There's another rebuttal to the Bretton Woods argument: there wasn't a massive reduction in American savings during that era. In the long run, it makes it harder for consumers to keep sucking in unending volumes of Asian goods.

Posted by: Harrow on November 30, 2003 08:53 PM

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P Kothari asks, "Why is the Euro appreciating so much vs the dollar when their economies are in even worse shape than the US?"

Worse as defined by what criteria?

Many of the statistics coming out of the US are questionable, by the way. There has been systematic underfunding of many data gathering ventures. Others, like productivity, are notoriously difficult to measure.

Posted by: Charles on November 30, 2003 11:40 PM

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Brad - I seriously doubt the 1% CA deficit led to the demise of the Bretton Woods system in 1971. Instead it was the 1965-71 US inflation acceleration which caused it, by generating a 45% appreciation of the US Real Effective Exchange rate in 1965-70 (OECD data). The 1971-74 dollar depreciation corrected this problem. Since 1974 the US has run FAR larger persistent CA deficits yet the Real Effective Exchange Rate is today at its 1974 level. CA deficits have no value as an exchange rate forecasting tool, NET of what teh forward price already indicates.

Posted by: Peter vM on December 1, 2003 02:00 AM

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If you can't get foreigners to finance your current a/c deficit at below-reasonable rates, what's the point of being a global hegemon?

Posted by: dsquared on December 1, 2003 02:03 AM

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Matthew:

"In particular, I don't see how China can control its internal money supply when it has to soak up all those excess dollar balances with yuan."

Very soon, China will be running a dollar deficit. Petroleum and iron ore imports are outstripping everyone's projections. The campaign against the RMB peg is already past its expiration date.

When the Chinese stop buying treasury debt because they're giving all their dollars to the Saudis, presumably the Saudis will have to pick up the slack.

http://news.xinhuanet.com/english/2003-11/13/content_1177460.htm

BEIJING, Nov. 13 (Xinhuanet) -- China's trade volume hit 682.3 billion US dollars in the first 10 months of this year, up 36.4 percent, while the import growth rate of 40.4 percent exceeded that of exports by 7.6 percentage points, official figures show.

Statistics from Chinese Customs show that both import and export volume surpassed that of 2002, and the trade surplus dropped by 40 percent year-on-year.

China enjoyed a trade surplus of 14.87 billion US dollars during the 10-month period and the figure for last year was 30.4 billion US dollars.

China bought 31 million tons of steel and 141,000 automobiles in the first 10 months, figures show.

Machinery accounted for half of Chinese total exports and imports of primary products or raw material witnessed a strong growth, figures show.

Spurred by the vigorous Chinese economy and huge domestic demand, imports of iron ore, crude oil and refined oil increased by 30 percent to 49 percent.

Posted by: Michael Robinson on December 1, 2003 03:02 AM

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Matthew W,

Your point 3) describes the standard source of currency instability in developing economies. For all that hedge funds and “speculators” get the blame (thank you, Mr Mahathir), it is typically domestic capital flight that has kicked off currency panics, with speculators jumping in when they notice domestic cash fleeing. Of course, the US is not a developing economy, which is why the 5% current-account-deficit/GDP ratio has been able to occur at all. No other modern country has ever been able to reach a level like this, much less sustain it for long. The fact that the US is behaving a bit like Argentina should not lead us to precipitous conclusions. Ignore that man behind the curtain….

Charles,

However bad US data gathering may have become due to underfunding, it is unlikely to be worse than that in Europe, where efforts similar to those in the US to gather and process data have never been attempted. That does not mean, of course, that Europe must necessarily underestimate its own growth, any more than we in the US must necessarily overestimate ours.

Peter vM,

Is there any evidence that forward rates have significant power to predict spot fx rates, outside of textbook models? Certainly, beyond the special case of the US, current account deficits of a certain magnitude have a strong link to subsequent declines in the value of the offending nation’s currency?

Posted by: K Harris on December 1, 2003 07:53 AM

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>>China's trade volume hit 682.3 billion US dollars in the first 10 months of this year, up 36.4 percent, while the import growth rate of 40.4 percent exceeded that of exports by 7.6 percentage points, official figures show.

Wow! Michael, if those figures are for real, by the end of the year China will have almost certainly overtaken Japan as the world's third biggest trader in both imports and exports. And that doesn't even take into account Hong Kong (minus those tricky re-exports).

Posted by: Harrow on December 1, 2003 09:04 AM

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>>Very soon, China will be running a dollar deficit. Petroleum and iron ore imports are outstripping everyone's projections

Give over Michael. These imports aren't for domestic consumption. They're for manufactured goods production, and thus next period's exports.

Posted by: dsquared on December 1, 2003 09:14 AM

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>>If you can't get foreigners to finance your current a/c deficit at below-reasonable rates, what's the point of being a global hegemon?

You can still get that warm, fuzzy feeling knowing that you're making the world a better place to live.

Posted by: Harrow on December 1, 2003 09:18 AM

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Chinese domestic auto sales went from roughly 60k per month through 2001 to roughly 93k per month in 2002, to 184k in September of this year. At least some of that disputed rise in oil imports is going to domestic consumption, though certainly not all. Mustn’t forget that, in addition to fueling those vehicles, making cars for domestic consumption takes energy, too. Xinhuanet, as quoted by Michael, also seems to support Michael: “Spurred by the vigorous Chinese economy and huge domestic demand, imports of ….crude oil and refined oil increased…” Huge domestic demand. And the trade surplus narrowed, suggesting that a good chunk of whatever new increment of imports there is (much of which just might need energy to run), is not going back out as exports.

Posted by: K Harris on December 1, 2003 10:15 AM

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Large oil imports by China would not justify the level of the peg. At the current price of oil and at the current peg, it is probably cheaper for China to manufacture diesel from coal than it is to import it. I believe in the US it would cost approx $30 per barrel, so I believe in China it would be $25 or less. And they are pursuing this in not such a small way. China seems quite serious about energy efficiency as well.

"Infrastructure construction of the US$3.3 billion coal liquefaction project in North China's Inner Mongolia is almost complete, laying the foundation for commercial production in 2005."
http://english.peopledaily.com.cn/200311/28/eng20031128_129254.shtml

Posted by: snsterling on December 1, 2003 10:51 AM

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The Japanese have been willing to subsidize their exports for decades. The Koreans would have done so too were it not for the troublesome run on their currency.

Still I doubt that everybody can play this game without throwing a wrench in the works. As more countries play the game with more and more money what happens to U.S. savings, debt and exports?

At some point countries have to develop domestic demand to sustain their economies. For some the point will come much faster than for others. The Merchantilest problem remains.

Posted by: Stan on December 1, 2003 11:40 AM

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K Harris says, "However bad US data gathering may have become due to underfunding, it is unlikely to be worse than that in Europe, where efforts similar to those in the US to gather and process data have never been attempted."

I've always found OECD data to be reliable, if somewhat sparse, K.

I think it was about 15 years ago when I first read in the business pages of the NYT that a major measure of economic activity (I forget which) was unreliable because the Admin had gutted the research department. The Republicans have never been keen about collecting data on wealth concentration or anything else that might undermine their political agenda. They are also fully capable of changing methods or otherwise politically spinning data. And so we are left with a situation in which there is a lot of data and perhaps half of it is reliable. But which half?

This, I think, is worse than not having data at all. ButI take your point.

Posted by: Charles on December 1, 2003 11:45 AM

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http://www.nytimes.com/2003/12/01/business/worldbusiness/01chin.html

Consumerism Grows in China, With Beijing's Blessing
By KEITH BRADSHER

GUANGZHOU, China

THE cellphone market extends block after block in this commercial hub in the southeast corner of the country. The ground floors of a string of buildings are filled with hundreds of small, fluorescent-lighted stalls, many with as little as eight feet of counter space.

The vendors sell not only cellphones, which Chinese typically purchase separately from their wireless service contracts, but also every conceivable component: keypads, display screens, batteries, plastic coverings and a dizzying variety of electronic connectors, wires and computer chips. Local phone users browse with buyers from cellphone repair shops and factories from all over China, for this is the nation's cellphone manufacturing and trading center.

Consumer goods markets like this - concentrated experiments in capitalism - represent the next hope for China's economic development. While China's economy has grown swiftly in recent years, most of the growth has been in exports or domestic investment spending. In an economy that in many ways is the reverse of that of the United States, Chinese consumers have proved to be fairly cautious spenders, at least until recently.

But with its ever-rising exports producing trade frictions, with overcapacity emerging in several manufacturing industries and with investment sectors like construction showing signs of overheating, Beijing is slowly but pointedly trying to encourage consumer spending.

The People's Bank of China has urged banks to lend less to property developers, for example, while drafting regulations to make it easier for consumers to borrow, especially to buy or lease cars. And credit card companies are fanning out in the major cities to sign up new cardholders. While retail sales are still rising much more slowly than investment spending, economists say that government statistics may underestimate a surge in spending on cars and cellphones this year.

With multinationals still racing to build factories in China, economists say the country's growth in exports and investment may not slow markedly. But if it does, consumer spending could take up some of the slack....

Posted by: anne on December 1, 2003 01:36 PM

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Dsquared is on the right track. That is just precisely what the Nazis did to exploit Vichy France and (through that) North Africa - rig the exchange rates.

The process is long term sustainable if you don't just use the momentary advantage for current consumption, but instead you "invest" abroad. The scare quotes are there because, in proportion to the exchange rate rigging, what happens isn't just true capital transfer abroad to acquire wealth but also a wealth transfer from exporting inflation (the Dutch used this in the East Indies to set up their "culture system" of exploitation). Even a small proportion causes material harm because the wealth transfer is cumulative, like a slow leak.

Right now the process is being mediated - middlemen countries remain willing to accept US funny money because they can literally pass the buck and acquire revenue earning assets in third countries like Australia, but the USA isn't yet building up a portfolio of such assets. This is analogous to the British handing over one Indian state to another to get money from the second one (which is what happened to Rohilcund). That way, it doesn't look like acquisition but to a free co-operation between the exploiter and the second state. I presume that eventually the bucks being passed will be devalued out of significance, and that this process is beginning even now.

Posted by: P.M.Lawrence on December 1, 2003 04:10 PM

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K Harris - Over short horizons, forwards predict Spot(t+1) no better by Spot(t). Therefore, holding high interest rate currencies (unhedged) generates positive returns over time. HOWEVER, there is NO positive return earned from holding CA surplus currencies against shorting CA deficit currencies. The CA is NOT a predictor of future currency RETURNS (although it may have some weak predictive power over distant future spot rates).

Posted by: Peter vM on December 2, 2003 01:07 AM

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P.M. Lawrence,

"Dsquared is on the right track. That is just precisely what the Nazis did to exploit Vichy France and (through that) North Africa - rig the exchange rates."

Ah yes! Those evil Americuns! They are FORCING other countries to hold their debt! Dsquared couldn't further from the truth. The U.S. has been complaining to the Japanese for decades.

It is internal politics that is driving this process in the countries doing it. Partially doing so shields them from economically destabilizing currency runs. Mostly, it enriches export oriented businesses, protects markets from imports while the subsidy involved is not recognized by the large unfocused majority who pay it. Doesn't any of that sound familiar?

Posted by: Stan on December 2, 2003 07:26 AM

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Peter,

I'm getting the impression that we need to be very precise in defining terms - predicting spot rates vs predicting returns. My guess is that is because the outcomes have less to do with fx spot and futures rates than with interest rates, that price differentials between spot and futures are largely a reflection of interest rate differentials. In the case of the current account, on the other hand, there is not a one-way relationship between demand for currencies and the current account deficit. Up to a point, a point which cannot be known ahead of time, the widening of the current account is accompanied by demand for the currency of the deficit country, so that (assuming no peg), that country's currency appreciates. After that mysterious point is reached, a wide current account deficit is associated with a depreciation of the currency. It is the approach to this point that I take to be Brad's concern. The fact that there is no consistent relationship between the the size of a current account deficit and fx rates is not a surprise. Your assertion was that current account deficits have no value as an exchange rate forecasting tool. In fact, very few things do, if any. The issue Brad was raising (I think) is not one of forecasting incremental changes in fx rates, but rather of identifying circumstances in which change will not be incremental. What he sometimes casts as a question about investor behavior is, I would guess, really a question about policy. Isn't it a policy mistake for a policy maker to create a situation in which investors might, all at once, divest themselves of lots of the policy maker's currency?

Posted by: K Harris on December 2, 2003 12:13 PM

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I suppose the force of the balance of payments constraint is a controversial subject. When it comes to the weight of dollar assets in Asian and European portfolios, we don't really know how much is too much. So reasonable people disagree.

But the tone of the commentary from some of these dollar bulls seems innocent of the currency's steep decline during the past 18 months. They would be more credible if they first conceded that the dollar has fallen quite a bit already.

The dollar is by no means yet cheap, but it is acting as though there is some issue somewhere. America crushes the rest of the world in the growth and return contest, and the dollar goes down anyway. Why?

Posted by: Gerard MacDonell on December 2, 2003 01:00 PM

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