What are the implications of the ongoing financial crisis for the so-called “global imbalances” and the global configuration of exchange rates?
These themes, while somewhat less prominent now than those relating to shoring up the world financial system, remain of central importance for policymakers and analysts when trying to look beyond the day-to-day turmoil in financial markets. The large US current account deficit and the surpluses in countries such as China and the oil exporters remain points of instability. To tackle this difficult question, it is useful to stand back and take a look at what we have learned from the debate on imbalances and from recent data.
In several very influential articles, Obstfeld and Rogoff (2005, 2007) highlighted that a reduction of the US current account balance to sustainable levels would need to be accompanied by a significant real effective depreciation of the dollar. However, several others had taken a more benign view of the US current account deficit, arguing that it reflected the attractiveness of US financial assets, enhanced by the depth, liquidity, and creativeness of US financial markets (Cooper, 2008).
At first blush, the evidence so far does not fully settle the debate.
On the one hand, the notion that the US current account deficit could continue indefinitely without a significant exchange rate adjustment has clearly been disproved by the data: the dollar has depreciated significantly in real effective terms since its 2002 peak (Chart 1), and as of the summer of 2008 was close to its historical minimum for the past 35 years. Of course, the dollar has staged a spectacular rebound during October and November, but still remains some 15% below its 2002 peak.
On the other hand, despite the significant depreciation of the dollar the correction in the US current account has so far been relatively modest. Why is a ‘weak” dollar associated with a large current account deficit? Does this suggest that the dollar would need to depreciate further—much beyond its historical lows—to ensure a reduction of the US current account deficit? Or is the current configuration proof of a “disconnect” between the value of the dollar and the US current account?
In a new CEPR Discussion Paper, I argue that the correlation between the dollar exchange rate and the US external accounts is alive and well, and that the configuration of a weak dollar and a large current account deficit is the result of a host of underlying factors.
A first key point is that there are long lags in the relation between US external accounts and the real effective exchange rate. Chart 2 plots the US balance of goods and services (excluding oil) and a 2-year lag of a real effective exchange rate measure corrected to account for the difference in price levels between the US and its main emerging market trading partners (see Thomas, Marquez, and Fahle, 2007). The correlation is striking, and continues well into the most recent period. Indeed, about half of the total US dollar depreciation since the dollar peak in 2002 has occurred in the past two years, and may therefore not be fully reflected in the US external accounts. This line of argument is buttressed by the buoyant growth of US exports until the summer of 2008; in more recent months the worldwide decline in activity has taken its toll on US exports as well.
A second key factor is the price of oil, which in recent years has reached historical highs. As shown in chart 3, the US “oil bill” increased on an annualised basis by 2% of US GDP between early 2002 and the third quarter of 2008. In contrast, the large current account deterioration accompanying the dollar appreciation in the early 1980s was cushioned by a very sharp decline in oil prices, which reduced the import bill by over 2% of GDP. Once oil prices and lags are taken into account, the adjustment episode in the 1980s looks much more similar to the adjustment process currently underway.
Other factors may help reduce somewhat the need for a US trade balance correction over the medium term. One such factor is the "return differential” between US holdings of assets overseas and foreign holdings of US assets. The US has traditionally earned a higher rate of return on its assets than the one it pays out on its liabilities, in part because its portfolio is more heavily skewed towards higher-earning equity instruments (FDI and portfolio equity investment), while its liabilities are primarily in the form of debt securities. In light of the much larger size of external assets and liabilities relative to the 1980s, even taking into account the growth in GDP, the same “return differential” implies more significant gains for the US than two decades ago.
Does this mean that a reduction of the US current account deficit to a much more modest and sustainable range (say between 2 and 3% of GDP) over the next few years could occur with no further dollar weakening? Definitive answers to this question in the current unsettled economic environment are clearly difficult to put forward, since predicting the evolution of several key variables over the next few years (such as commodity prices and economic growth in the US and elsewhere) remains a daunting endeavour. This notwithstanding, the paper’s findings suggest that the level reached by the dollar over the summer would have been consistent with a significant reduction in the US current account deficit over the next few years. If the recent appreciation of the dollar were to be sustained, the US current account deficit could still decline over the medium term, particularly if oil prices remain close to the current levels, but this correction may be insufficient to prevent a further accumulation of US external liabilities relative to GDP.
Cooper, Richard N., 2008, “Global Imbalances, Demography, and Sustainability,” Journal of Economic Perspectives, Vol. 22, No. 3, pp. 93–112.
Milesi-Ferretti, Gian Maria, 2008, “Fundamentals at Odds? The U.S. Current Account Deficit and The Dollar,” CEPR Discussion Paper 7046.
Obstfeld, Maurice and Kenneth Rogoff , 2005, “Global Current Account Imbalances and Exchange Rate Adjustments," Brookings Papers on Economic Activity, Vol. 1, pp. 67–123.
Obstfeld, Maurice and Kenneth Rogoff, 2007, “The Unsustainable U.S. Current Account Deficit Revisited,” in Richard H. Clarida, editor, G7 Current Account Imbalances: Sustainability and Adjustment, University of Chicago Press, pp. 339-66.
Thomas, Charles, Jaime Marquez, and Sean Fahle, 2008, “Measuring U.S. International Relative Prices: A WARP View of The World,” International Finance Discussion Paper no. 917, Federal Reserve Board.