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December 23, 2004


More On The Dollar, The Current Account, And Soft Landings

General Glut's Globblog (great name) indirectly takes on my argument -- made here and here -- that the reversal of the U.S. current account need not be as gut-wrenching as some fear.   Actually he takes on what he refers to as Brad DeLong's "tepid endorsement" of my "soft landing" scenario.  (In truth, I didn't really interpret  DeLong's post as an endorsement, tepid or otherwise, but as a fair attempt to characterize an alternative view.)  Here's the core of the General's complaint:

Thus far we have had nearly three years of [1] ("the dollar falls") and not a bit of [2] ("net exports rise"). From February 2002 to December 2004 the dollar has fallen 16% in real terms (per the broad dollar index) while the trade deficit has grown in real terms about 60%. I keep hearing the "delayed effects" mantra, but it's beginning to wear really thin for me.

The "delayed effects" mantra, of course, refers to what is sometimes called the "J-curve" effect -- the tendency for the current account to deteriorate upon a sustained depreciation of the currency, before it gets better.  The idea is that export and import demand are relatively price-inelastic in the short run, so the main impact of a falling dollar is a rise in the exchange-adjusted price of imports.

I confess that I don't know the empirical literature well enough to speak to the issue of whether we are at the point where the J-curve explanation strains credulity.  (Maybe someone can fill me in on this.)   But I'm not inclined to lean on the "delayed effects" explanation in any event, not least because I suspect that the conditions that would yield significant J-curve dynamics would also work against the soft landing story.

Let me instead turn to the language I used in my previous post.

...the story I was telling was all about reversing the big capital inflows and trade deficits, one that starts with the presumption that foreigner's taste for absorbing ever more dollar-denominated assets has come to an end.

I've added the emphasis to make clear that I do not assume this process started three years ago when the dollar began to depreciate.   In fact, I have interpreted some of the fall in the exchange rate in much more conventional terms: Because the U.S. economy had been expanding faster than its major trading partners, import demand has grown faster than export demand.  In simple supply and demand terms, the greater desire for foreign goods by U.S. consumers and businesses means a greater supply of dollars, causing the dollar to fall in value relative to other currencies.

I realize that identifying a unique shock for every twist in the data can be the last refuge of a scoundrel.  Skepticism is entirely warranted. But we should be equally wary of starting history at some arbitrary time, and then interpreting all subsequent dynamics as the consequence of whatever shock we have chosen as our initial condition. As usual, we'll each tell our stories, keep our eye out for some compelling evidence in favor of one or the other, and hope we can sort it out in the end.   

December 23, 2004 in Exchange Rates and the Dollar, Trade Deficit | Permalink

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I'm not big on the J-curve literature, either, but the logic seems pretty clear. Three things, I think, need to be held in mind. One is that, as long as the dollar continues to fall, the short side of the J keeps working. The J-curve is in effect for the most recent decline in the dollar, just as it was for the initial decline from the high of 3 years ago. That would offset some of the current benefit from the long side of the J-curve. Another is that China is pegged to the dollar, so that we have received no benefit from relative price shifts vs China due to fx changes. Finally, oil demand tends to be rather inelastic in the short and medium term, and a good bit of the year-on-year rise in the trade deficit (46.7% as of the latest release in October) is due to petroleum. Now part of the rise in petroleum prices is obviously just a reflection of the falling value of the dollar, but limited opportunities for new domestic production in the short term means the J-curve for the oil account would be rather slow in turning around.

The benefit to the US trade balance from dollar weakness, in the end, has to do with prices and their impact on saving, spending and production decisions. We have been through a period in the US in which demand has been propped up by tax rebate and refund checks, as well as by the availability of funds through mortgage refinancing. Both have seemed to lower national savings, so working to offset the impact of fx changes on the trade balance. Those special factors encouraging spending have faded, so will no longer work to offset the impact of price changes across the border. That, however, seems to confirm you worry that adjustment won't be gentle. There is no current stimulus to household spending among US trading partners anything like the tax and refi cash we enjoyed, to take up the slack in demand.

Posted by: kharris | December 31, 2004 at 09:29 AM

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