March 02, 2005
Notes on Blanchard, Giavazzi, and Sa, "The U.S. Current Account and the Dollar"
Olivier Blanchard, Francesco Giavazzi, and Filipa Sa (2005), "The U.S. Current Account and the Dollar" (NBER: Working Paper 11137).
Blanchard, Giavazzi, and Sa model the current behavior of Asian central banks in pegging their currencies to the dollar as a continuous outward shift in the Asian demand curve for dollar-denominated assets that keeps the exchange rate stable: as the U.S. current-account deficit increases the supply of dollar-denominated assets that must be held by foreigners, the outward shift in the Asian demand curve keeps the price of dollar-denominated assets--the exchange rate--from depreciating.
They then model the (future) collapse of the peg as a refusal to shift the Asian demand curve out any further. The (unexpected) collapse of the peg thus leads to:
- A sudden depreciation of the dollar, and large capital losses on foreigners' dollar-denominated assets.
- These leave foreigners well short of their (very large) desired saddle-point equilibrium dollar-denominated asset holdings, hence:
- The dollar does not fall far enough to erase the trade deficit and the capital inflow
- The dollar continues thereafter to gradually depreciate over time, until
- Foreigners hold the (very large) dollar-denominated asset holdings associated with their shifted-out demand curve, and trade balances.
- This means that the collapse of the peg is a problem--the U.S. trade deficit falls, but does not have to immediately swing into surplus; the dollar falls, but not by all that much immediately.
But isn't it more likely that when the peg collapses Asian central banks' desires to hold dollar assets will be severely diminished, and that the foreign demand curve for dollar-denominated assets will move back to its original un-shifted-out position? In that case we have:
- Foreigners look around, decide that they are holding many too many dollars, and decide to pull money out of the United States
- Not a decline but a collapse of the dollar to generate the U.S. trade surplus that is the flip side of the capital outflow.
- Over time, an appreciation of the dollar as foreign holdings drop, the desired capital outflow diminishes, and trade moves into balance.
- In short, the Roubini-Setser disaster scenario.
What principally distinguishes the Blanchard-Giavazzi-Sa model from the Roubini-Setser disaster scenario is not the interesting dynamics and modelling details added by the masters of imperfect substitutibility and the dynamic saddle path, but the implicit assumption that Asian central banks hold on to their current holdings of dollar-denominated assets even after the reason for acquiring those assets--maintaining social peace through high exports from Shanghai--is gone.
Is that a realistic and likely assumption?
(There is another difference as well: in BGS the collapse of the peg is unexpected. The decline in the value of the dollar carries with it a huge decline in the foreign-currency value of dollar-denominated assets with no compensating increase in contemporaneous returns or fall in desired dollar-denominated asset holdings valued in foreign currency. I need to wander down the hall and ask Pierre-Olivier Gourinchas how large these valuation effects are, both now and a year and a half from now.)
Details and Quotes
Abstract: There are two main forces behind the large U.S. current account deficits. First, an increase in U.S. demand for foreign goods. Second, an increase in the foreign demand for U.S. assets. Both forces have contributed to steadily-increasing current account deficits since the mid-1990s. This increase has been accompanied by a real dollar appreciation until late 2001, and a real depreciation since. The depreciation has accelerated recently, raising the questions of whether and how much more is to come, and if so, against which currencies: the euro, the yen, or the renminbi. Our purpose in this paper is to explore these issues. Our theoretical contribution is to develop a simple portfolio model of exchange rate and current account determination, and to use it to interpet the past and explore alternative scenarios for the future. Our practical conclusions are that substantially more depreciation is to come, surely against the yen and the renminbi, and probably against the euro.
"The model builds on two old (largely and unjustly forgotten) papers, by Henderson and Rogoff (1982), and, especially, Kouri (1983)..."
BGS: This may be the place to make a point sometimes overlooked.... To reduce the trade deficit while maintaining stable output, the depreciation must come with other measures that increase domestic saving, such as a decrease in budget deficits.... These other meausures, however, have to come in addition to the depreciation. The statement that a reduction in budget deficits reduces or eliminates the need for depreciation is obviously incorrect...
BGS: If the purpose is to limit the eventual dollar depreciation, then the right monetary policy is... to decrease interest rates... have a larger depreciation in the short run, and a smaller depreciation in the long run.... [S]uch a policy must be accompanied by a reduction of the budget deficit so as to maintain output at its natural level...
BGS: The longer the Chinese wait to abandon the peg, the larger the eventual appreciation of the renminbi
BGS: It is often asserted that the recent appreciation of the euro against the dollar is (at least in part) the side-effect of the Chinese peg.... We think this argument is simply wrong
(I agree with BGS here too)
And, last, it's our currency but their problem:
BGS: A large fall in the dollar is not by itself a catastrophe for the United States.... It offers the opportunity to reduce budget deficits without triggering a recession. The danger is much more serous for Japan and western Europe... [T]heir room for macroeconomic maneuver is very limited...
- D. Henderson and K. Rogoff (1982), "Negative Net Foreign Asset Positions and Stability in a World Portfolio Balance Model," Journal of International Economics 13: pp. 85-194.
- Pentti Kouri (1983), "Balance of Payments and the Foreign Exchange Market: A Dynamic Partial Equilibrium Model, in J. Bhandari and B. Putnam, eds. (1983), Economic Interdependence and Flexible Exchange Rates (Cambridge: MIT Press).
- P.-O. Gourinchas and H. Rey (2004), "International Financial Adjustment" (Berkeley: U.C. Berkeley xerox).
- M. Obstfeld and K. Rogoff (2004), "The Unsustainable U.S. Current Account Revisited" (Cambridge: NBER).
Posted by DeLong at March 2, 2005 12:09 PM