September 20, 1995
|Contact:||William R. Cline||(202) 328-9000|
Washington, DCThis 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 weakerin the low 90sif 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:
The principal policy conclusions of the study include the following.