by Edwin M. Truman, Peterson Institute for International Economics
Speech prepared for "The ECB and Its Watchers VI" Conference
July 2, 2004
© Peterson Institute for International Economics
It is a distinct pleasure to be back in Frankfurt. As a former central banker, I confess to a bit of discomfort in the role of an outsider looking in. However, conferences such as this one are part of the process of central bank transparency and accountability. I congratulate Volker Wieland and his colleagues on this conference, and I commend Otmar Issing and his colleagues for their participation.
I have organized my remarks around the five questions posed in the annotated program:
1. Is the US current account deficit sustainable? No, but the extent and timing of its adjustment are uncertain.
2. How will the adjustment take place? Through a combination of substantial changes in exchange rates; a modest, largely endogenous slowing of US growth; and, it is to be hoped, some acceleration of domestic demand in the rest of the world.
3. What are the implications for the euro area? It is likely to have to absorb more than its proportionate share of the adjustment.
4. What are the implications for US and euro area fiscal policies? It is urgent for the US to address its fiscal imbalance. The case for compensating fiscal action in the euro area is less compelling. In any case, the European Central Bank (ECB) will bear a major responsibility for sustaining European growth and stimulating domestic demand.
5. Is there a role for policy coordination to help manage the adjustment process? Yes, starting with information exchange and shared analyses.
You have heard my short answers to the five questions. After that fine lunch, you may all go to sleep while I elaborate.
Is the US current account deficit sustainable?
When I left the Federal Reserve in 1998, when the US current account deficit was 2.3 percent of US GDP, the staff had concluded that deficits on that scale were not sustainable indefinitely. Six years later, the deficit is twice that size and not likely to narrow significantly over the next two years. This history should give us pause, but it does not undermine the basic conclusion that sooner or later the US current account deficit will narrow substantially, a view found in Kohn (2004).
The adjustment is uncertain not only with respect to timing but also with respect to size. It is useful in this context to think in terms of the US net international investment position (NIIP). It was estimated (on a market value basis) at 24.4 percent of GDP in 2002 and is estimated to have actually declined slightly to 24.1 percent of GDP in 2003. The ratio declined because $546 billion in net financial flows in 2003—associated with the current account deficit—were largely offset by $448 billion in valuation adjustments principally due to the dollar’s depreciation; the resulting percentage increase in the NIIP was less than the percentage increase in US GDP.
It would be nice in this connection to employ elegant analyses involving primary surpluses, growth rates, and interest rates, but the data do not lend themselves to such a treatment. I prefer to use a back-of-the-envelope approach. In order to stabilize the ratio of the US NIIP to GDP, the ratio of the current account deficit to GDP must equal the growth rate of nominal GDP times the NIIP ratio.
Using this framework, and assuming a normal growth rate of US nominal GDP of 6 percent, we can identify a range of possible pairs of US current account deficits and NIIPs.
1. NIIP status quo: Maintaining the US NIIP ratio at about 25 percent of GDP implies a reduction in the US current account deficit to 1.5 percent of GDP, which would be a substantial correction.
2. Current account status quo: Maintaining the current account deficit at about 5 percent of GDP implies that the NIIP would stabilize at 83 percent of GDP. In other words we have a long way to go.
3. Productivity view: Under this view, a continuation of the recent elevated growth of US productivity combined with the increased flexibility of financial markets identified by Greenspan (2004) suggests that the US current account deficit in the near term need only narrow to 4 percent of GDP, which would imply a NIIP of 67 percent.
4. Global wealth view: Mann (2003) suggests that we could think in terms of stabilizing the share of net claims on the United States as a share of global wealth. Her approach yields a current account deficit narrowing to about 3 percent of GDP and an NIIP at about 50 percent of GDP.
5. Issing view: I (Truman 2004a) have interpreted Otmar Issing (2003) as endorsing the view, which he attributed to the IMF staff, that the US current account deficit has to shrink to 2 percent of GDP, implying an NIIP of 33 percent.
6. Zero trade deficit: The logic of the primary-deficit/-surplus approach implies that the United States will eventually have to reduce its deficit on goods and services to zero. Net lending to the United States would be limited to the amount sufficient to cover net income payments (currently approximately zero) and net transfer payments (currently approximately half a percent of GDP). With a current account deficit 0.5 percent of GDP, the implied NIIP would shrink to 8 percent of GDP. Note that this would require not only (a) the elimination of our trade deficit of 4½ percent of GDP but also (b) a period of trade surpluses to pay off some of the net debt that has been accumulated in recent years.
It is important to acknowledge two qualifications to this type of analysis. First, although US net income payments on its substantial NIIP are currently negligible, the financial cost of carrying that position, which on the liability side is increasingly interest bearing, is understated. At nominal US short-term interest rates closer to 4 percent than the recent 1 percent, my rough estimate (Truman 2004b) is that the net cost of financing our position would increase by at least 0.7 percent of GDP. Everything else equal, this type of calculation suggests that for a given sustainable US NIIP, the eventual adjustment of the US trade deficit will be larger rather than smaller.
However, second, everything else will not be equal. To the extent that the adjustment of the US external position takes place via substantial changes in exchange rates against other major currencies, one consequence will be that the NIIP in dollar terms will contract. (In 2003, this effect contributed an improvement of 3½ percentage points to the ratio of the NIIP to GDP.) The reason is that US liabilities are predominantly dollar-denominated and roughly half our assets are denominated in other currencies. The IMF (2004) has estimated that a 25 percent depreciation of the dollar reduces the US NIIP ratio by 7 percentage points.
All this suggests a great deal of uncertainty about the size, as well as the timing, of US current account adjustment. However, my advice to policymakers at the ECB as well as the Federal Reserve is that they should assume that the eventual adjustment is likely to be associated with a deficit, at its narrowest, that is closer to 1 percent of GDP than to 4 percent of GDP. In other words, the adjustment will be at least 3 percentage points of US GDP. The principal reason is that the adjustment process is likely to overshoot, which is particularly relevant for near-term economic policy considerations.
How will the adjustment take place?
Let us now consider how the eventual adjustment will occur. First it is important to remember that current account deficits are endogenous and are not susceptible to direct policy influences. Attempts to do so via trade restrictions are not likely to be effective along with their other undesirable characteristics.
That said, the adjustment of the US current account deficit is likely to involve a combination of (1) substantial exchange rate adjustment, (2) slower US growth of US output and of domestic demand in particular, plus, one would hope, (3) faster growth of domestic demand in the rest of the world.
Of course as a first approximation, exchange rates are also endogenous variables, at least for the major currencies like the dollar and the euro, maybe less so for the Japanese yen, to say nothing of the Chinese renminbi. Therefore, estimates of how large an adjustment in the dollar will be associated with a given adjustment in the US current account deficit are likely to be misleading because they are based on calculations that implicitly assume that exchange rates can be treated as exogenous.
Nevertheless, I suspect that if the US current account deficit is to narrow to close to 1 percent of GDP, it will be associated with additional dollar depreciation of at least twice what we have seen on average since the dollar’s peak in early 2002; we have seen a net 10 percent adjustment from the dollar’s peak on the basis of the Federal Reserve Board staff’s broad index of the price-adjusted dollar. Thus, I would not be surprised to see a euro-dollar rate above 1.50.
In Europe one often hears the view that the adjustment of the US current account deficit should occur on the income side rather than on the price side. With respect to the rest of the world, the euro area included, a higher level and rate of growth, in particular of domestic demand, would certainly ease the adjustment process as well as be desirable for other reasons. A permanent boost in the level of foreign GDP (US export weighted) by 3 percent would raise US exports of goods and services by $36 billion (0.3 percent of US GDP) on a base of about $1.2 trillion, assuming an income elasticity of 1.0. This would help, but not a great deal.
On the US side, in order to reduce US imports of goods and services by, say, 2 percent of GDP, the level of US GDP would have to be reduced by 6 to 7 percent, assuming an income elasticity of 2.0 on a base of about $1.7 trillion. Such a scenario would be unacceptable in the United States and have a considerable knock-on impact on the rest of the world in addition to the negative first-round effects.
On the other hand, the historical experience of the United States, and of other industrial countries as well, has been that growth slows during periods of substantial external adjustment, in part, because of deliberate policy actions but in larger part via the endogenous process of adjustment. For example, during the 1987–90 period of US external adjustment, GDP per capita grew at an annual rate of 1.5 percent, compared with 3.0 percent during the previous four years. During the same period, gross domestic purchases expanded only 0.9 percent per year, compared with 4.6 percent over the previous period.
Such considerations support the view that the adjustment process can be either messy or smooth. Macroeconomic policies supporting faster growth of domestic demand in the euro area and facilitating slower growth of US domestic demand have roles to play. Without supportive macroeconomic policies, exchange rate adjustments will be larger and the risk of financial disruptions will increase. It is also important to remember that historically exchange rate crises have occurred well into the period of external adjustment rather than at their start. The increased flexibility of financial markets that Greenspan (2004) has identified may prove to be a double-edged sword.
What are the implications for the euro area?
The implications of this analysis for the euro area are that it is likely to bear more than its proportionate share of the US external adjustment.
If the adjustment is limited to, say, 3 percentage points of GDP, this translates into 1 percentage point of GDP for the rest of the world. (US GDP is roughly a quarter of global GDP.) Because many other areas of the world are even less well positioned to absorb this adjustment and because of the flexibility of euro exchange rates, the euro area’s share of the US external adjustment is likely to be more than 1 percentage point of its GDP.
Moreover, even if the US external deficit only ceases to expand, this would impart a negative impulse to growth in the euro area compared with the situation that has prevailed on average over the past decade when the US economy has imparted substantial net stimulus to global growth via its widening external deficits.
What are the implications for US and euro area fiscal policies?
It has again become fashionable to link the US external deficit and its adjustment with US fiscal policy. The twin deficits have reemerged. Although external and internal deficits are linked through the saving-investment identity in the national income accounts, an identity is not the same as a behavioral relationship. The two deficits are not analytical twins. When the supply of government saving declines (the fiscal deficit increases), the net inflow of foreign savings (the external or current account deficit) does not necessarily change either dollar for dollar or with the opposite sign.
Two important distinctions are relevant. First, current account deficits are essentially endogenous to the working of the economic and financial system. Budget deficits are affected by cyclical factors, but they are also directly influenced by fiscal policy. Second, a spontaneous increase in a country’s external deficit reallocates global saving while a policy-induced increase in a country’s internal or budget deficit subtracts from global saving.
In the current context, the implication for US fiscal policy is that the external deficit benefits the US economy in the sense that it adds to the supply of saving and, potentially, to investment. If financial market forces reduce the net inflow of saving from abroad and in the absence of a compensating increase in domestic saving, the result would be a substantial reduction in US investment and a lowering of the US potential growth rate.
As a consequence, if one believes that the US current account deficit is unsustainable and that a substantial adjustment is inevitable over the next three to five years, then the United States would be well advised to address its fiscal deficit sooner rather than later in order to sustain investment and potential growth. In the process, the United States would facilitate the adjustment process by reducing the expansion of gross domestic purchases relative to gross domestic production. In addition, the resulting lower interest rates might contribute to a somewhat weaker dollar.
In principle, compensatory fiscal policies—expansionary policies—would be desirable in the euro area and the rest of the world. This would help maintain global saving and investment as US national saving increases. In practice, the case for compensatory fiscal action in some other areas of the world such as East Asia may be stronger than is the case for the euro area itself. However, it is important that the fiscal authorities in the euro area keep their respective eyes on the ball of domestic demand.
In the absence of tighter fiscal policy in the United States, and in the context of market-driven external adjustment, the burden on US monetary policy to maintain full employment and, in particular, price stability is increased. Similarly for the euro area, if the scope to relax fiscal policy or to slow the process of fiscal consolidation is limited, the burden is increased on the ECB to stimulate and sustain domestic demand.
Is there a role for policy coordination to help manage the adjustment process?
Turning to the question of whether there is a role for policy coordination as part of the process of correction of the US current account deficit, the prima facie case is quite obvious. Policy coordination can help to provide a reality check for the authorities in the United States as well as in the euro area. It might also facilitate a degree of advance planning for the adjustment process once it gets seriously underway.
The first step would be for US and European authorities to exchange information about what they see as the outlook for the US current account deficit and its implications for monetary and fiscal policies. For example, the respective authorities should communicate whether they have factored into their forecasts or projections the potential for significant US external adjustment. I suspect that they have not.
Second, the authorities should share their analysis of such questions as: How large a current account adjustment is likely or necessary for the United States or the world? What is the best way to go about achieving it? What should be the respective roles of monetary, fiscal, and other policies in the process? What will be the likely implications for the global economy? What role can or should exchange market intervention play in managing the process?
I have no illusion that one would find similar answers to these questions on both sides of the Atlantic. I also have no illusion that the answers would be similar on the same sides of the Atlantic. These are challenging and difficult analytical issues. However, a process of mutual education would benefit the international economy as a whole.
To the extent that US and euro-area authorities share a common view on some of these issues, they would be positioned to share, and possibly to articulate, common objectives. I do not have in mind communiqué platitudes about smooth adjustment, noninflationary growth, or the avoidance of excessive exchange rate volatility. What one might envisage would be actual concrete commitments with respect to policies in pursuit of common objectives.
Joint or coordinated policy actions, in particular with respect to monetary policy, might be considered. With respect to exchange rate policy, the United States and the euro area have a common interest in persuading other countries to participate in this dimension of the adjustment process. Of course, I am thinking of China but also of other countries, including Japan.
Today, there is recognition of that common interest. I am less certain that US and euro-area views are informed by a shared analysis of the underlying issues. I am also less certain that US and European authorities are placing sufficient emphasis on the self-interests of the other countries in achieving their own objectives of sustained growth under conditions of reasonable price stability while at the same time facilitating the adjustment of international imbalances.
Finally, what about joint foreign exchange market intervention? I would not exclude the possibility of joint action in exchange markets at some point during the adjustment process once it is under way. Again, however, it should be informed by a shared analysis of the process of adjustment and its likely course. In the post-Louvre period in the late 1980s, the authorities tried to short-circuit that process. In my view, it was a feckless effort that set back international policy coordination rather than enhancing its credibility. However, that is a topic for another occasion.
In summary, let me recapitulate my answers to the five questions:
1. The US current account deficit is unsustainable, but the extent and timing of its adjustment are uncertain.
2. The eventual adjustment will take place through a combination of substantial changes in exchange rates; a modest, largely endogenous slowing of US growth; and, it is to be hoped, some acceleration of domestic demand in the rest of the world.
3. The euro area is likely to have to absorb more than its proportionate share of the adjustment.
4. In this context, it is urgent for the US to address its fiscal imbalance. It is desirable, in principle, that compensating fiscal measures be adopted in the rest of the world. Absent supportive fiscal adjustments, the burdens on ECB and Federal Reserve policy will be larger.
5. Policy coordination can assist the adjustment process. It should be grounded upon exchanges in information about forecasts and shared analyses about the adjustment process.
Greenspan, Alan. 2004. Remarks on the Current Account before the Economic Club of New York. Washington: Board of Governors of the Federal Reserve System. Photocopy (March 2).
IMF (International Monetary Fund). 2004. How Will the US Budget Deficit Affect the Rest of the World? World Economic Outlook. Washington: International Monetary Fund.
Issing, Otmar. 2003. Europe and the US: Partners and Competitors—New Paths for the Future, remarks at German British Forum, London, England. Frankfurt, Germany: European Central Bank. Photocopy (October 28).
Kohn, Donald L. 2004. Remarks on the United States in the World Economy at the Federal Reserve Bank of Atlanta. Washington, DC: Board of Governors of the Federal Reserve System. Photocopy (January 7).
Mann, Catherine L. 2003. How Long the Strong Dollar? In Dollar Overvaluation and the World Economy, ed. C. Fred Bergsten and John Williamson. Washington: Institute for International Economics.
Truman, Edwin M. 2004a. The Euro and Prospects for Policy Coordination. In The Euro at Five, ed. Adam Posen. Washington: Institute for International Economics (forthcoming).
Truman, Edwin M. 2004b. Budget and External Deficits: Not Twins but the Same Family. Paper prepared for the Federal Reserve Bank of Boston conference The Macroeconomics of Fiscal Policy (June 16).
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