from Follow the Money

How does the Fed imagine the US current account deficit will adjust?

June 23, 2005

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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, it is pretty clear that the Bush Administration’s preferred solution to the current account deficit -- faster growth abroad -- won’t do much either. A percentage point increase in foreign growth generates a smaller increase in US exports than a percentage point increase in US growth generates in US imports. According to Menzie Chinn, a one percentage point faster growth abroad increases exports by 1.7-2%; a one percentage increase in the US increases imports by 2.3-2.5%. 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. Growth in Europe lagged, but US exports to Europe did well nonetheless. Some exchange rate moves matter, I guess. But even if Europe were to grow faster, it is pretty easy to show that say a 1% increase in Europe’s growth rate would not produce a big enough increase in US exports to put a dent in the trade deficit.

Plus, wouldn’t faster growth abroad just push up oil prices and hte US oil import bill even more?

Taking all these points together, I cannot quite figure out how the Fed imagines the needed fall in the US current account defict -- which the Fed recognizes has to happen at some point -- will come about.

My own view? The US deficit is now so large in relation to the US export base that it is pretty easy to show that any individual action in isolation won’t have an enormous impact of the trade deficit. 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, at least for deficit country. For example, a recent study by Freund and Warnock found that exchange rate adjustment allows current account adjustment with smaller falls in income growth: "In countries where exchange rate movements are limited, either because of managed systems, fixed exchange rates, or key partners fix exchange rates, the current account will deteriorate more than if the exchange rate were flexible. Moreover, because of restricted exchange adjustment, growth will be forced to do much of the work of the adjustment."

That message sort of got lost in Greenspan’s testimony.

I agree that the revaluation of the RMB would have a bigger impact if it was combined with a broader move by all emerging Asian economies. And a tariff narrowly directed at China certainly would create strong incentives to avoid the tariff by shifting a few things around -- that’s one of many reasons why I prefer a revaluation, which would almost certainly be combined with market pressure on the rest of Asia to revalue as well, to a China-only tariff.

But I am not convinced by Greenspan’s argument that a Chinese move alone would just lead to a rearrangement of final assembly among different Asian economies, or Kash’s argument that Chinese wages are so much lower than US wages that even a major shift in the exchange rate would not matter.

China’s exports are not growing just because the final assembly of goods long made somewhere in Asia is shifting to China. That is part of the story, but not the whole story. China is also making goods that previously were produced in the US. Think appliances. Think furniture. Looking forward, think cars -- maybe that will just shift the source of US auto imports from Japan and Korea to China, but maybe not. More than a few cars are still made in the US, whether by the Big three or foreign owned "transplants."

Look at the data. Overall imports from the Asian Pacific region grew 18% in 04, far faster than the overall 14.5% increase in non-oil imports. They are on track to increase 14% in 2005, again far faster than the general rise in non-oil imports. Since imports from Asia as a whole are rising far faster than nominal US GDP, they are increasing rapidly as a share of US GDP. That is a difference between now and the 2000-03 period, where overall imports from the Asian-Pacific stayed constant or even fall as a share of GDP. (for a broader study of the impact of China on Asian trade, see this Eichengreen study)

It is pretty clear that 14% y/y import growth from Asia as a whole v 3% export growth is NOT a sustainable trend.

I don’t think it is a coincidence that Chinese exports to Europe started to boom just when the dollar (and renminbi) started to fall against the euro. That counts as "credible" evidence that the value of the RMB has an impact on Chinese exports in my book.

China is big enough that I suspect a Chinese move alone would have some impact, though not as big an impact as a broader move across all of Asia. Goldman Sachs (New York) thinks a 1% change in China’s real effective exchange rate would slow Chinese export growth by 1%. Goldman Sachs (Asia) thinks a revaluation would also reduce savings and encourage investment in China’s non-tradables sector. Both slower export growth and less savings would tend to reduce global imbalances.

And anything that reduces China’s reserve accumulation and thus the amount of subsidized financing it provides to the US would tend to slow the US economy, and thus bring about a reduction in the trade deficit -- though not necessarily an increase in employment or a happy, smooth, soft landing.

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