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June 30, 2005

Brad Setser Has Lots to Say--All of It Interesting

Brad Setser is happy with Martin Wolf:

Brad Setser's Web Log: Martin Wolf makes sense (the Economist does not) : Martin Wolf's FT column makes a number of crucial points:

  1. Asia has let undervalued exchange rates (and reserve accumulation) substitute for policies to promote domestic demand. The (growing) backlash in the US toward these policies hardly should be a surprise: "So long as exports remain competitive and trade balances strong, the need to promote domestic demand, thereby reducing the surplus of savings over investment, is diminished. Net exports support demand instead. This is modern mercantilism. The adverse reaction now seen in the US congress is predictable and understandable."
  2. Continuing this system is risky: "They [the US deficit and emerging market surpluses] generate growing protectionist pressure in the US; they force the US into monetary and fiscal policies whose consequence is growing indebtedness, both domestic and externally, they are likely to end in a brutal correction, and that correction is likely to be more brutal the longer it is delayed."
  3. China's scale constrains its ability to continue to rely on exports to substitute for a lack of domestic demand: "A country with a population of 1.3 billion cannot grow at 10% a year and remain as dependent on trade as one with 50m without provoking a backlash from its trading partners."
  4. Adjustment ultimately hinges on China's willingness to adopt policies -- exchange rate adjustment, stimulus to domestic demand -- that will reduce its current account surplus significantly: "A world in which emerging market economies not only run vast current account surpluses but also recycle the capital investors want to place in their economies is unprecedented, undesirable and unsustainable." "China, for example, has foreign currency reserves almost as big as annual imports. With current policies, those reserves are likely to continue to grow rapidly for indefinite future. This is not a reasonable pattern of development in the medium term.

The IMF estimates China's 2005 current account surplus [at] $80 billion. That... is low... $120 billion this year (even with oil at $60). That current account surplus combines with net FDI inflows of $70 billion... to generate a basic [financial] balance of close to $200b, or above 10% of China's GDP. To quote Wolf, that "is enormous by any standards."

Brad Setser is unhappy with the Economist:

[It] manage[s] to argue that a country with a large and growing current account surplus even in the face of a massive investment surge is not really undervalued. The Economist article argues that... it makes sense to look at a country's behavioral equilibrium exchange rate... Using work from Stephen "Current account deficits do not matter" Jen, the Economist concludes that yuan is only modestly undervalued. Let's repeat that. The Economist looks at a country with a current account surplus of 6-8% of GDP in the midst of an investment boom, and says its currency is NOT undervalued.

I am not sure what the "behavioral" exchange rate measures in the context of a country whose government is spending more than 10% of its GDP to manage its exchange rate.... We all know that they have fixed their exchange rate to the dollar, and have spent huge sums -- over $150 b in 2003, over $200 b in 2004, and probably over $250 b in 2005 -- to keep that peg....

The other argument made by the Economist is that "internal balance" in China -- keeping China's workers employed -- requires an undervalued exchange rate.... It is hard to dispute the fact that China's undervalued exchange rate is stimulating employment in China's export sector.... Wolf... argues that it is neither politically or economically sustainable for a country as large as China to offset the absence of internal demand with a huge-- at least 5% of GDP and perhaps closer to 8% of GDP this year -- current account surplus. I agree....

[U]nprecedented deficits in one key part of the global economy, and unprecedented reserve accumulation and current account surpluses in another. But you would never know that there was a real problem in the world just from reading the Economist...

Brad Setser is puzzled by the Federal Reserve:

Brad Setser's Web Log: How does the Fed imagine the US current account deficit will adjust?: Greenspan does not think a revaluation of the RMB would have a major impact on the US trade balance. The Fed does not think that reducing the fiscal deficit would generate a major reduction in the current account deficit. Bernanke thinks a smaller fiscal deficit would just produce a bigger housing boom. Empirically, work from the Fed staff -- work summarized by Roger Ferguson in his current account deficit speech -- suggests that changes in private savings and investment offset a rising (or falling) budget deficit, so a $1 fall in the fiscal deficit only reduces the current account deficit by 20 cents.

If you take "Houthakker-Magee" seriously... the Bush Administration's preferred solution... faster growth abroad... won't do much either.... According to Menzie Chinn, one percentage point faster growth abroad increases exports by 1.7-2%.... Given that exports have to grow something like 60% faster than imports to keep the trade deficit from expanding, faster growth abroad only works if accompanied by slower growth in the US. Remember, the world as a whole grew extremely rapidly in 2004 -- and the US current account deficit still expanded significantly.... Plus, wouldn't faster growth abroad just push up oil prices and hte US oil import bill even more?...

My own view? The US deficit is now so large in relation to the US export base that... [no] individual action in isolation [will] have an enormous impact.... Get rid of China's current account surplus of $120b (projected 2005) through increased US exports to China and the US current account deficit would fall from an enormous $820b (projected 2005) to an only slightly less enormous $700b. The only thing guaranteed to bring about a big adjustment fast is just what no one wants. A hard landing.

Bringing down a 7% of GDP current account deficit (that is where we are heading, fast) and 7% of GDP trade and transfers deficit without a crash will take time, and a bit of everything. Exchange rate adjustment. Steps to stimulate domestic-demand led growth abroad. Fiscal adjustment in the US. Lower oil prices would be a nice bonus. Slower consumption growth in the US.

Exchange rate moves matter. Bringing down the trade deficit won't necessarily be a lot of fun -- living beyond your means usually is nicer than living within your means. But a fair amount of evidence suggests that a weak exchange rate can make the external adjustment process a bit more pleasant...

Posted by DeLong at June 30, 2005 11:31 AM