Washington, DC—This year the US current account deficit (trade, services, and transfers) is headed toward $180 billion or higher, the highest dollar amount on record. The decline of the dollar against the yen, deutsche mark, and other currencies in early 1995 offered hope for some subsequent correction. However, the sharp recovery of the dollar since August, pushed by intervention by the central banks of the United States, Japan, and Germany, means instead that the external deficit is likely to continue widening to more than $200 billion by 1997. In contrast, an acceptable policy target should aim for a US current account deficit less than half as large. The G-7's intervention has thus been largely counterproductive and has gone too far.

Proper policy now should have two main components. First, Congress and the administration should implement the initial stage of their pledge to eliminate the fiscal deficit over the next several years. The fiscal deficit is a root cause of the external deficit, and external adjustment would be a major benefit of fiscal correction. Second, G-7 authorities should shift intervention policy to halt any further rise in the dollar and in fact partially reverse the dollar's recent rise. The two policies would be complementary. Fiscal adjustment would reduce pressure on credit markets, reduce interest rates, and eventually reduce the strength of the dollar, making US goods more competitive internationally. A shift in intervention policy would provide the proper signal for this direction of the dollar.

These conclusions are developed by senior fellow William R. Cline using an economic model presented in his new study Predicting External Imbalances for the United States and Japan. The model provides a streamlined but accurate mechanism for explaining the path of the current account balance in response to changes in the exchange rate and in rates of domestic economic growth. A key feature of the model is that it shows about a two-year average lag between the exchange rate signal and the consequential change in trade, reflecting response time for orders and delivery. Figures 1 and 2 show this phenomenon for the United States and Japan.

For Japan, the model predicts that the current account surplus would have fallen from about $130 billion in 1994 to under $90 billion by 1997 if the yen had stayed at its mid-April level of 85 to the dollar. This would have amounted to 1-1/2 percent of GDP, consistent with the range of 1 to 2 percent that US negotiators sought in US-Japan trade talks.

However, the recent rebound of the dollar to over 100 yen means that Japan's surplus is likely to remain above $115 billion, or more than 2 percent of GDP. The scope for lessening US-Japan trade tensions that was present in the April exchange rate has now been lost, as has a golden opportunity for US firms to penetrate the Japanese market. The exchange rate reversal almost certainly swamps any trade gains negotiated by the Clinton administration in trade talks with Japan over the past two years. Intervention to reverse the dollar's decline has thus sewn the seeds for future US-Japan trade conflict, which already in 1995 nearly exploded into trade war.

The only plausible case for recent G-7 intervention is that it was worth aggravating future trade imbalances in order to avoid a proximate collapse in Japan's banking system, by boosting yen valuation of bank dollar assets. This argument would of course only justify intervention against the yen, yet the G-7 intervened against the DM as well. For the yen, Cline estimates that the April level of 85 per dollar was appropriate for the objective of achieving correction of Japan's excessive external surplus. Arguably, the fundamental equilibrium rate for the yen could be modestly weaker—in the low 90s—if considerable allowance is made for the increase in imports that would accompany recovery of the Japanese economy. Yet by September 18 the yen had moved to 104 to the dollar, a serious overshooting of even a generously estimated equilibrium rate.

The case for attempting to bolster Japan's financial system by yen depreciation is questionable. The most severe banking weakness is among credit union and trust banks hit by low real estate prices. Because real estate is nontradable, its price is unlikely to rise as a consequence of exchange rate depreciation, and might even fall. More generally, sustainable asset price recovery is not likely to result from exchange rate moves viewed by the market as transitory and artificial. A weaker yen also removes pressure from Japanese policy makers to adopt policy reforms that could shift Japan's engine of growth from exports to domestic demand. As for induced effects on trade, Cline shows that it would require improbably large increases in Japan's growth spurred by renewed weakness of the yen for the currency's reversal actually to reduce rather than increase Japan's trade surplus, as some seem to believe.

The study contains several additional findings:

• It is important to distinguish between industrial and developing country trading partners when analyzing US trade. Thus, whereas the dollar fell by 7 percent in real terms against industrial country currencies from 1994 to the second quarter of 1995, it remained unchanged against LDC currencies (as the collapse of the Mexican peso offset some dollar weakening against currencies of some East Asian NICs). Indeed, as of April, the principal remaining overvaluation of the dollar was against LDC currencies.
• Similarly, the new estimates shed light on the question of whether US trade is "asymmetric" because imports are more responsive to US growth than are exports to foreign growth—a frequent finding in past studies. Separate treatment of industrial and developing countries makes this supposed asymmetry disappear, an encouraging result for long-term prospects of US trade.
• The public perception of a collapse of the dollar in the second quarter of 1995 was exaggerated, because the fall against the yen and DM far exceeded the decline against other European currencies, and the dollar had actually risen against the Canadian dollar and Italian lira. On a trade-weighted basis including LDCs, the dollar had fallen only 4 percent from the 1994 average to the second quarter 1995. This explains why there was only limited adjustment of the deficit in the pipeline even at that time—to an estimated deficit of $160 billion by 1997—despite the perception of massive dollar decline.
• The rise in the 1995 deficit from about $155 billion last year to some $180 billion is being driven by the collapse of the trade balance with Mexico, the lagged impact of a stronger dollar in 1993, and erosion in the balance on capital income as the US has become the world's largest debtor nation.
• One reason for the seemingly chronic, large US deficit is that there is an annual deterioration of about $10 billion to $20 billion from what the study calls the "GAF" influences: G for the initial gap between imports and exports, which means proportionate growth widens the absolute difference; A for asymmetry of trade response to income growth (a possibility just discussed); and F for factor services. For the latter, net US capital income is falling by about $8 billion annually as the US goes deeper into international debt.

The principal policy conclusions of the study include the following.

• US fiscal adjustment is crucial to external adjustment. If the current political commitment to eliminating the budget deficit is achieved, the US external deficit is likely to fall to an acceptable range of about 1 percent of GDP. Typically, each dollar of fiscal adjustment reduces the external deficit by about 50 cents.
• As of mid-April, the dollar had declined far enough against the yen, but was still overvalued on a trade-weighted basis. At that time, further depreciation against NIC currencies (for example, that of China) and currencies of several European countries and Canada, was appropriate. By September, some rollback of the dollar's rise against the yen and DM was also appropriate. To cut the 1997 deficit from over $200 billion to a range of about $100 billion (arguably a sufficient adjustment if allowance is made for international statistical discrepancies), the dollar would need to decline by about 8 to 10 percent on a trade-weighted basis.
• In addition to US fiscal adjustment and a shift in G-7 intervention policy to halt or reverse the dollar's recent rise, Japanese authorities should adopt measures to stimulate the domestic economy, primarily to restore domestic growth but also to help reduce the large external surplus. The expected fiscal package to be announced on September 20 will be crucial in this regard.