Friday, March 7, 2008

Blowing my own horn

Here's a paper I wrote in May 2007 called "A Careful Depreciation of America". It doesn't have all the cool pictures and such, but it also was when the dollar was at a "shocking" $1.36. It's depreciated 14 percent since then.
Anyway, maybe this'll get me on "Google". :)

As the United States’ economy has expanded since 2001, one statistic that has expanded along with it is the country’s current account deficit, which reached $856.66 billion for 2006. Many of the Democrats elected to Congress in November 2006 pointed to the current account deficit amid concerns about globalization and the changes this has forced in the American economy, and coupled this criticism with the fiscal deficits that re-appeared starting in 2001. Others have countered this argument by saying the high current accounts and trade deficits are offshoots of strong economic growth, and are paying themselves off with higher living standards both in the U.S. and around the world. Federal Reserve Chairman Ben Bernanke recently said despite the U.S.’s trade deficits, protectionism was not the proper way to fix the problem, telling a crowd in Butte, Montana, “In the long run, economic isolationism and retreat from international competition would inexorably lead to lower productivity for U.S. firms and lower living standards for U.S. consumers.” (Associated Press, May 1, 2007)

But Bernanke also has to evaluate economic growth and the value of the American dollar as part of his job as Fed chairman, and both of those figures have dropped over the last year compared to many of the U.S.’s competitors. If the United States is willing to accept some fiscal and consumption changes that result in slower growth over the course of a few years, it appears that it can withstand a depreciation of the dollar. Foreign countries are driving ahead economically, and while their strong growth will be hampered, their strong internal consumption and investment means they will not be stopped by a U.S. slowdown. The United States could withstand a steady depreciation if it coincides with a larger effort to gets its current and fiscal deficits in order. Fiscal discipline in particular could prevent a more rapid depreciation that could cause crippling adjustments and maladies that would spread beyond the American borders.

1. The U.S. current account deficit and depreciation
The United States has seen its current account become blow up over the last decade, with its deficit going from just over $100 billion in 1996 to annual rates that threaten $900 million today. Its deficit has more than doubled since the U.S. dollar hits its peak in 2002, and reached 7 percent of GDP in the fourth quarter of 2005 before settling at 6.5 percent for all of 2006.

Many have become concerned with the current account deficit and dollar’s drop, especially over the level of capital inflows that are required to maintain the deficit. An economist told the Senate budget committee earlier this year that “the United States must attract capital inflows of almost $4 billion from the rest of the world every working day to finance our current account balance,” and warned that if countries were to pull back on the amount of money flowing to the U.S., that the dollar would drop very quickly and possibly trigger a recession (Bergsten, 2007). These deficits seem to have had an effect on the U.S. currency, as the euro’s value has gone up 53 percent against the dollar in the last five years, reaching rates over $1.36 per euro in April 2007.

Others have countered by calling the current account deficits an externality of strong U.S. growth that is not a concern, and instead something that should be welcomed. The United States’ increased appetite for imports over the last fifteen years matches theories espoused in Mundell-Fleming and other models, where increased incomes translate to more purchases from all sources, including foreign ones. And much like how the United States is credited with helping China and other economies by importing those countries’ goods during its robust expansion, the U.S. can have their economy pulled up by other countries that grow faster over time, as they become fertile markets for U.S. products. This is often related to claims that a dollar drop can turn into a good thing, as it can make U.S. exports cheaper overseas, and drive up income through an improved trade balance.

The U.S had a $232.5 billion trade deficit with China in 2006, and the yuan has appreciated nearly 7 percent in the last two years versus the dollar, as the Chinese agreed to allow more fluctuation in the yuan’s value. Officially, U.S. Treasury Secretary Henry Paulson has said a strong dollar and current trade policy is in the country’s interest, and a driver of a thriving economy (Reuters, April 20, 2007). But Paulson has also called on China to increase the flexibility of its currency, and the surplus of American dollars going to China combined with China’s 11 percent annual growth and signals that Chinese officials will put in monetary controls to cool their economy means the yuan would stand to appreciate more against the dollar in a freer-floating system.

2. Policy of depreciation
There is evidence that trade patterns are reflective of exchange rates. The U.S. dollar reached its peak against other major currencies in 2002, and after a year of recognizing and adjusting to the currency changes, U.S. exports have increased by 52.5% in nominal dollars over the last four years, compared to a 50.0% nominal rise in imports. But imports of goods also continues to increase, as consumption grows along with the U.S. economy. This increased appetite for imports was especially noticeable when the dollar appreciated in 2005, with imports increasing in nominal dollars by $16.83 million when comparing December 2004 to November 2005 (a 12.9% rise), while exports only increased by $6.49 million over the same time (9.1%).

With that in mind, a dollar depreciation could have a positive effect on export growth in the United States, and at least stop the growth of the trade and current account deficits, if not narrow them. The International Monetary Fund charted the United States and other countries that have had current account deficits, then later turned to surpluses over time, and said that depreciation and an improvement in the current account often went hand-in-hand. In these reversals, the currency depreciated by an average of 12 percent, and the current account was significantly diminished within 5 years, indicating that home and foreign countries respond to cheaper exports and more expensive imports (IMF, 2007). However, there was also a reduction of GDP growth of 1.4 percent in that time period when compared to the time in deficit, so there is a question as to whether the adjustment period may hurt the U.S. economy (IMF, 2007).

With that in mind, it is instructive to look at which economies adjusted their current accounts with little economic damage, and compare it with the ones that suffered economic setbacks. The IMF notes that the economies that handled a current account reversal best had

a larger-than-average total real depreciation (median of about 18 percent), which corrected a somewhat more overvalued currency and spurred export growth, and a strong increase in saving rates, associated with a substantial fiscal consolidation, which allowed investment rates to be sustained much closer to their pre-reversal values (IMF, 2007).

In other words, to keep the economy moving in this time of adjustment, the U.S. should be willing to depreciate the currency (an event that is already happening), tighten up its fiscal deficits, continue to encourage investment, and increase private saving. The fact that the U.S. has a large and long-term deficit may not make things much worse. The IMF notes that in advanced countries with deficits over 2 percent for more than five years, “the correction of these deficits has not been characterized by a larger decline in GDP growth or by a greater real effective exchange rate.” (IMF, 2007) The IMF adds that the ultimate drivers in current account adjustment were macroeconomic adjustments such as slowdowns in the economy and better stock market prices (IMF, 2007).

Another factor that seem to help countries during current account reversals is having a growth rate less than its trading partners before the reversal begins, which can help the depreciation and export growth occur. This can be working in the U.S.’s favor, as its economy is slowing down, with a growth rate of 1.3 percent in the first quarter of 2007, while China zooms ahead at 11.1 percent. The Euro zone and Japan also have picked up to expand at rates that match or exceed the U.S.

GDP growth, year-over-year

2006 Q1 2006 Q2 2006 Q3 2006 Q4 2007 projected 2008 projected
U.S. 3.7 3.5 3.0 3.1 2.3 2.7
Euro zone 2.2 2.8 2.8 3.3 2.3 2.1
Japan 2.7 2.1 1.5 2.5 2.3 2.3
Sources: European Commission, The Economist (April 28, 2007)

These indications of a growing world economy means that U.S. exports could be pulled up by growth in other markets, while simultaneously depreciating the currency. As an article in the October 21, 2006 issue of The Economist pointed out, “Asia is the world’s fastest-growing consumer market. The IMF forecasts that total household spending there will rise by almost 7% in real terms in [2006]. In comparison, the 3% growth in American consumption looks almost parismonoius.” The same article notes that much of the recent European growth is also consumer and investment-driven. While Asian economic growth would be hurt by an American slowdown, given their large trade surpluses to the U.S. and other big markets, American fates matter less to countries such as China, which had a third of its exports go to the U.S. in 1999, but only have a quarter of their exports go there now (The Economist, October 21, 2006). Real consumer spending in China has grown by an average of 10 percent a year in the last decade, and Japanese manufacturers are reporting shortages and plans for major expansion (The Economist, October 21, 2006). These Asian and European consumers may want to take advantage of cheaper American goods and services, making a depreciation a welcome measure for some American businesses.

However, those growing foreign economies may also put pressure on U.S. financial markets, since investors may decide to put their money in growing European, Asian, and emerging markets over the United States due to strong growth rates, and less return from depreciated American dollars. A cheaper dollar makes it easier for people to get into the U.S. market, but it also means that the recent run-up in U.S. stock prices does not translate into major profits for foreign investors, since those increased stock prices are muted by depreciated currency. And foreign companies which hold greenbacks could decide at some point to trade in what they have, as they would prefer to hold a currency in another market, which could accelerate the dollar’s drop, and cause a serious adjustment. With the U.S. still being a world economic leader, analysts say a dollar crash would “increase risk premiums and unnerve frothy financial markets around the world.” (The Economist, December 2, 2006)

Another potential drawback of a depreciation policy is that changing prices do not have the effect on the trade and current account balances as much as a difference in income does. The IMF estimates that a one percent change in income in the U.S. changes imports at a rate five times that of a one percent change in price, and other estimates put that figure at 7 to 10 times more (IMF, 2007, Chinn, 2005). Likewise, the income effect on exports is around triple that of relative prices, so the key to higher exports may lie with improved economic growth in other countries over a depreciating currency (IMF, 2007, Chinn 2005). So the desired reduction in the current account and trade balance would be more likely to be an offshoot of slower U.S. growth compared to the rest of the world over expenditure switching. And if the U.S. uses fiscal or monetary policy to jump-start its economy, all gains in the current account could quickly be wiped out due to the heavy tendency for the U.S. to spend its extra income on imports.

Recent U.S. trade patterns with China show that a currency depreciation can improve the U.S.’s trade situation, but in a limited capacity. China began to allow its currency to move against the dollar in June 2005, and the dollar has steadily dropped against the yuan since then.

In the 17 months after the yuan began to float against the dollar, U.S. exported goods to China rose by 33.6% to $4.858 billion, while U.S. imports of Chinese goods rose by 32.4% to $27.777 billion, so some of this could be credited to expenditure-switching. But the overall goods deficit increased by $5.372 billion in the same time period, because of the previously-higher amount of Chinese imports to the U.S (U.S. Census Bureau, 2007). The U.S. has seen an improvement in its deficit with China in the last three months, but some of that could be due to traditionally lower levels of Chinese imports in January and February, and the rocketing growth of the Chinese economy. It would take a much larger expenditure switch for the U.S. goods deficit with China to decline year-over-year, and could be more economic trouble than that would be worth.

The U.S. has relatively inelastic demands for imported consumer durables and non-durables, and actually spend more on petroleum products and automotive products as those prices go up (IMF, 2007). A depreciation could hurt consumers in that they would continue to buy these products even with the higher price tag, and limit their spending in other areas, causing a slowdown in certain industries. The U.S. should see a boost in tourism and IT capital goods with a depreciation, as those exported products have the highest elasticities, but IMF data indicates that sales non-durable consumer and industrial products are barely affected by a change in price, and food and durable industrial supplies actually could see their revenues drop with a depreciation (IMF, 2007).

The IMF notes that prices for foreign trade are somewhat sticky, as 64 percent of exchange rate changes are transferred to import prices worldwide one year after the currency changes. This figure lowers to a 42 percent transmittal rate in the United States due to competition for customers in the large U.S. market (IMF, 2007). The U.S. does benefit from an export pass-through rate that nears 80 percent, but the IMF adds that because the U.S. runs such a large trade deficit, depreciation “would lead only to a partial narrowing of the trade deficit in the absence of other changes, such as a decline in the domestic demand for imports or an increase in foreign demand for U.S. products.” (IMF, 2007) Given the IMF estimate that a 10 percent depreciation would improve the U.S. trade balance by 0.3 percent, the dollar may need to significantly drop more in order to make a significant dent in the 6.5 percent current account deficit the U.S. finds itself in. And a significant dollar drop would increase the chances of major financial and economic disruptions.

The speed at which capital can move is quicker than ever, and an economist points out that two-thirds of movements in current accounts come from a major change in parity of return between two countries (Bergin, 2004). A depreciated dollar and low rate of return could lead to a major shift out of U.S. assets could lead to an immediate worsening of the current account, and then make the resulting adjustment in import prices and inflation all the more jarring. Using fiscal discipline and reduced consumption of imports can lessen the need for a bigger depreciation and risk of capital flight, because with increased saving, the current account can stop its descent and reduce the surplus of dollars that require higher interest rates and a depreciating currency to allow the deficits to continue. Improvement of the fiscal and current accounts can also increase the chances of any depreciation being a smooth, orderly one, instead of having a brisk fall in the dollar that requires serious reactive action and economic pain.

3. Adjustments through monetary policy
Another method that could be used as part combating the U.S’s large current account deficit would be through monetary policy by the Federal Reserve. Part of the U.S.’s increase in its current account deficit can be credited to vigorously expansive monetary policy enacted by Fed Chairman Allan Greenspan starting in early 2001. As a result, U.S. consumption and housing investment boomed, which increased demand for imports. It also put downward pressure on the dollar for a second reason, as interest rates fell below the Euro Zone’s and neared Japan’s zero-level rates.

The cuts in rates started about a year before the dollar’s slide from its 2002 peak, and the Fed’s raising of rates from 1 to 5.25 percent coincided with the one time period of dollar strength against the euro in 2005. Monetary policy could have helpful effects on stemming a dollar drop, or could speed it up depending on what the U.S. decides to do. Strong European and Asian growth may allow the U.S. Fed to have its job done for them if the U.S. chooses to depreciate, as it can lead to a boost in U.S. exports that can result from a depreciation, and those growing economies may be tempted to raise rates above the United States. Foreign countries having higher rates would keep the U.S. from having to depreciate by lower its interest rates, and then deal with inflationary pressures that lowering American interest rates may cause. Europe’s growth also means that it may be prepared to adjust to a further depreciating dollar because it is less reliant on export growth to drive its economy. As an analyst notes, “the euro would have to rise to $1.43 to make the ECB raise rates by a quarter of a point less than it otherwise would have done,” and the dollar would have to go down another 5 percent from its record lows to reach that (The Economist, December 2, 2006).

However, there are concerns with using monetary policy as a tool to depreciate currency. A financial disruption due to dollar depreciation can cause Fed officials to try to stem the tide of drooping stocks and asset prices by loosening money, which can cause even more downward pressure on the dollar with lower interest rates and increased demand for imports through consumer spending. This could lead to a quicker-than-desired drop in the dollar, and can accentuate the financial instability while also leading to possible inflation due to higher import prices.

The increased holdings of U.S. debt by foreign investors has another potential pitfall, as the depreciating dollar may discourage U.S. investors from buying into more expensive investments overseas, and drop the value of those exchanges. With their domestic stocks and bonds dropping in value due to a lack of U.S. demand, foreign investors may lean toward cashing in some of their U.S. holdings due to the financial difficulties in their home country, which would cause a quicker dollar depreciation due to a surplus in funds, or cause the U.S. to raise interest rates further to try to encourage these foreign investors to stay in American funds. The raised rates can lead to slower growth or recession in the United States, and further discourage foreign investors from putting their money into America. Foreign holders have so far continued to increase their positions in U.S. treasury debt, as residents of the United Kingdom more than tripled their holdings to nearly a quarter-trillion dollars from July 2005 to November 2006 (Bengsten and Truman, 2007). In the same time period, people from oil-exporting countries rode the oil price rise to take on 50 percent more of the U.S. debt, and the Chinese also continued its purchasing of American debt, raising their holdings from $298.0 billion to $346.5 billion (Bengsten and Truman, 2007).

Canadians and Brazilians more than doubled their holdings in the same time, Brazil increasing to $51.0 billion, and Canada to $47.8 billion (Bengsten and Truman, 2007). The increased holdings of American debt allow it to continue to run these deficits and not suffer a major economic disruption in recent years, but a depreciation increases the danger of capital flight in the future, as foreign investors see the value of their holdings go down. The huge level of foreign holdings means the Fed has to be careful not to be overly expansive in its policy, as lower rates could lead to a flood of American securities on the market and lower prices. Perhaps a harbinger of the possible problems with foreign investors cashing out is the moves by Japanese investors over the same period. Japan is the largest holder of U.S. treasury securities, and unlike many other currencies, the yen has depreciated against the dollar in this time period, and has also lost value against other major currencies like the euro. While appreciating countries like China and the U.K. were increasing their holdings in 2005 and 2006, Japan dropped its holdings from $669.4 billion to $637.4 billion (Bengsten and Truman, 2007).

Conversely, the Fed may decide that dollar weakness and inflation are the bigger concerns and decide to raise rates, which increases the possibility of disenchantment with investing in the United States, and increasing the chances of an American recession. While exporters to the U.S. are more insulated from American economic problems, it still would have a severe short-term impact as a large market dries up, and cause rattling instability that could slow further economic development.

4. Recommendations and ramifications
The world economy can be comfortable with a gradual decline in the U.S. dollar, as an orderly shift could improve the United States’ yawning current account deficit, and put it and other countries on firmer footing for further growth down the road. The United States should not actively intervene to have the currency depreciate, because the U.S.’s slower growth and large current account deficit should continue a natural depreciation against the currencies of many other developed economies. The United States should also encourage China to continue to move toward a more flexible exchange. That, combined with the signaled efforts of Chinese officials to tighten money and capital controls to cool its hot economy, should put pressure on the yuan to appreciate against the dollar.

However, the dollar’s decline needs to be without major, sudden drops in order to maintain stability in the financial markets and lessen the need of central bank intervention. One of the ways that depreciation can be controlled is to make the dollar’s drop part of a bigger initiative to control the United States’ free-spending habits. The United States continues to run a negative savings rate where the amount that is consumed is more than the income of its citizens, and much of that consumption is in the form of imports, which drives down the current account balance.

One of the ways is to reduce the U.S. fiscal deficit, perhaps by using fiscal policy to remove the desire to consume at high levels. Expenditure reduction, either through increased taxes or reduced government spending, would have a cooling effect on the economy, and combined with the depreciation would result in a shift to exports as a source of growth over consumer spending. This also could stem some of the inflation effects from raised prices on imports due to a depreciation, as the United States would reply less on imports. Foreign countries which rely on a strong American market may suffer some disruption, but their increasing economies also could look to cheaper American goods to consume, satisfying needs in both countries, and lowering the large surpluses that appear in many emerging economies.

If the United States does not make attempts to improve saving and reduce this reliance on import consumption as a key component of its economy, a dollar depreciation could lead to serious consequences. The foremost concern with depreciation is that such a move could mean a pattern of stagflation. This would happen if a rapidly dropping dollar led to significantly higher prices in the U.S., and foreign investors pulling out of American markets as any dollar profits are eaten up by the lower currency. The Federal Reserve may have to respond to the financial instability by raising interest rates to slow down price increases and encourage foreign investors with a higher rate of return. Raising rates when economic growth is not high has plenty of dangers economically, as the higher rates can cut off U.S. investment in domestic industries and discourage borrowing in financial markets. This can result in recession in the United States, with some spread to overseas trading partners, and expansionary policies to get out of the recession can drive up demand and prices, which could depreciate the currency further, and start the cycle all over.

The key question is whether U.S. politicians and citizens are willing to take the short-term hit that could improve the chances of long-term financial serenity. Pandering to voters with tax cuts and refusals to limit spending has helped to put the U.S. in their current hole, and the lack of leadership from Congress and the President leaves the country in a precarious position. If the voters and their representatives limit themselves now with fiscal discipline and a steady depreciation, it may keep the U.S. economy from reaching the rapid levels of growth that exist in other countries around the world, but it will also allow needed adjustments to take place. If these small adjustments do not happen now, they will be much bigger and painful to deal with later, and it is in the U.S. and the rest of the world’s interest to tackle these problems as quickly as possible.