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June 30, 2005

Does Financial Globalization Remove the Possibility of a Dollar Crisis? Obstfeld and Rogoff Say, "No!"

Maury Obstfeld and Ken Rogoff say that Greg Mankiw, Alan Greenspan, and others who point to increased financial globalization as a reason not to worry (much) about the U.S. current account deficit are simply wrong. Increased financial globalization has implications for the value of gross international asset positions, but has very little to do with the macroeconomics of how unsustainable trends in net international asset positions come to an end. The unwinding of unsustainable trends in net positions requires that countries' inhabitants change how much and what kinds of goods they consume. This has little to do with financial globalization, and a lot to do with exchange rates, relative goods prices, and demand elasticities:

Maurice Obstfeld and Kenneth Rogoff (2005), "Global Current Account Imbalances and Exchange Rate Adjustments" (Berkeley: University of California):

[T]he global equilibrium ramifications of an unwinding of the US current account deficit, currently running at nearly 6% of GDP [make] the potential collapse of the dollar... considerably larger (more than 50% larger) than our previous estimates [of five years ago].... [G]lobal capital market deepening... [has] accelerated over the past decade (a fact documented by Lane and Milesi-Ferreti).... Unfortunately, however, global capital market deepening turns out to be of only modest help in mitigating the dollar decline that will almost inevitably occur in the wake of global current account adjustment.... [A]djustments to large current account shifts depend mainly on the flexibility and global integration of goods and factor markets. Whereas the dollar’s decline may be benign as in the 1980s... the current conjuncture more closely parallels... when the Bretton Woods system collapsed....

[...]

Given our analysis, why then do some, such as Greenspan (2004), argue that a decline in the United States current account deficit is likely to be benign? Greenspan points to the fact that capital markets are becoming increasingly integrated, and cites reductions in home bias in equities, the secular waning of the Feldstein-Horioka puzzle, and other factors.... But our calibration here is totally consistent with the current degree of integration of capital markets.... What matters... is not the depth of international capital markets, but the costs of adjusting to lower tradables consumption in the goods markets.... [N]ontraded goods account for 75% of GDP... home bias in tradable goods consumption... US current account adjustment necessarily requires a significant exchange rate adjustment.... [E]ven a closing up of the US current account from 6% to 3% would require very substantial exchange rate adjustments, especially if one takes the likely effects of exchange rate overshooting into account....

The real question is not whether there needs to be a big exchange rate adjustment.... The real question is how drastic the economy-wide effects are likely to be. This is an open question.... [W]hereas US markets may have achieved an impressive degree of flexibility, Europe (and to a lesser extent Japan) certainly has not. The rest of the world is not going to have an easy time adjusting to a massive dollar depreciation.... With the increasing diversity of banks’ counterparty risk... a massive dollar movement could lead to significant financial problems that are going to be difficult to foresee before they unfold....

[T]he optimists can point to the dollar’s relatively benign fall in the late 1980s (though arguably it was a critical trigger in the events leading up to Japan’s collapse in the 1990s). But perhaps the greatest concern is that today’s environment has more parallels to the dollar collapse of the early 1970s than to the late 1980s....

Posted by DeLong at June 30, 2005 01:05 PM