Dollar Disorientation

In my latest column "Dollar Disorientation" I threatened to continue pursuing the muddled issues of twin deficits and dollar devaluation on this blog. Bruce Bartlett, who I criticzed rather sternly, e-mailed a suggestion that he could advise me of other topics to write about. Yet Bruce and I worked together at Polyconomics back in April 1989, when I was invited to present the following testimony at the Federal Reserve. My views have not changed much, but I gather his have.

The last section alluded to my "A Baedeker to Better Living" The Wall Street Journal, February 23, 1989.

I condensed this and took out refrences, but it's still complex. The main point is to show that these arguments have been going on for a long time. My next blog will be simpler, I promise.

Excerpts from
“International Economic Policy: Choices, Problems and Opportunities for the Bush Administration”

Testimony before the System Committee on International Economic Analysis
Board of Governors, Federal Reserve System

Alan Reynolds April 14, 1989

Policies that threaten recession or inflation are to be avoided, regardless of their promised effects on budget or trade deficits. Although a recession might reduce the trade deficit, it would surely increase the budget deficit. And although a weaker dollar might conceivably reduce the trade deficit, it would surely increase inflation.

So long as the U.S. is operating at high employment, a slowdown in the growth of government purchases and government-financed consumption would help free-up real resources, such as energy and labor, to expand private production. An increase in taxation, on the other hand, does not free-up resources for private production, but instead permanently transfers private resources toward government services (which are quite difficult to export).

The United Kingdom and Australia moved from budget deficit to surplus in the past few years, yet nonetheless have sizable current account deficits, high inflation and extremely high interest rates. Clearly, there is no automatic link between budget and trade deficits, or between budget deficits and inflation. The "policy mix" idea -- the theory that higher taxes are a substitute for prudent monetary policy -- is a proven recipe for stagflation. Easy money simply stimulates nominal GNP (demand), while higher tax rates suffocate real GNP (supply).

Many economists who did not anticipate the U.S. current account deficit nonetheless confidently "project" that it will continue indefinitely. The usual policy conclusion is that the dollar should be repeatedly devalued.

By accounting convention, the current account deficit equals investment minus private savings and government deficits. Many economists have emphasized "net" figures for investment and savings, often expressed in nominal terms and divided by gross national product. Regardless of the legitimacy of such statistical creativity, it is gross investment outlays that have to be financed from domestic or foreign wealth, not simply the net portion. Measured in 1982 dollars, gross private investment increased by 42% from 1980 to 1988, from $509 billion to $721 billion. Since it is highly unlikely that real savings could have increased that rapidly, particularly if marginal tax rates had been higher, the 1984-88 surge in investment was partly financed by reduced U.S. investment abroad (notably, fewer loans to LDCs) and by increased foreign investment in the United States.

Since the current account deficit is mainly a real phenomenon -- an increase of real investment that exceeded the increase in real savings -- it follows that depreciating the dollar could only help by reducing real investment or (less likely) increasing real savings. Another big drop in the dollar could indeed cut real capital investment, and thus narrow the gap between investment and savings. It would do so because taxes on real profits and capital gains increase with inflation, reducing the incentive to invest. Moreover, the Federal Reserve would be likely to respond to the inflation by temporarily raising interest rates, thus causing households and firms to postpone purchases of durable goods and structures.

A familiar academic point is that a one-time depreciation of the dollar merely results in a one-time increase in the level of prices, not an ongoing increase in the rate of inflation. Yet a one-time increase in the price level certainly looks just like inflation to the public and the politicians, so the Fed feels compelled to react to past depreciation of the dollar by a subsequent freeze on bank reserves. The resulting lucrative real return on cash makes it impossible for producers of, say, houses and cars, to recover past costs that had been inflated by the previous devaluation. This results in squeezed profit margins, and cutbacks in investment and employment. In this way, a lower dollar may indeed reduce the trade deficit, but it does so by provoking contraction.

Commodities priced in dollars can normally be expected to increase with a lower dollar -- including the price of oil -- since such commodities become cheaper to foreign countries which therefore purchase more. The increased cost of imported commodities, as well as reduced competitive pressure from imports, can be expected to increase prices of U.S. exports. Once dollar prices of imported commodities and exported finished goods have been inflated by the lower dollar, the net effect on the volume or value of imports and exports is ambiguous. Since there is little spare capacity to quickly expand the volume of exports, devaluing the dollar for that purpose mainly boosts prices. On the import side, there is no certainty that reduced quantities of imports will ever outweigh the increased price, particularly for essential imports such as oil or nickel. Since a drop in the dollar strengthens foreign demand for oil and other commodities that the U.S. imports, bidding-up their prices, that effect alone can make dollar depreciation counterproductive.

On the other hand, efforts to deliberately slow the U.S. economy, through monetary stringency or surtaxes, could likewise prove dangerous, particularly for foreign countries dependent on net exports for employment. One immediate effect would be to reduce output more rapidly than employment, causing falling productivity, rising unit labor costs and falling profit margins. Another effect would be cancellation of contracts and orders for plant and equipment, needed to expand capacity for export and for import-substitution. The resulting reduction of potential supply and productivity are harmful to the longer-run inflation outlook, even though prices might be temporarily depressed by going-out-of-business sales.

There are also practical difficulties with the using dollar devaluation as a trade weapon. Toyota has not been able to raise prices enough to compensate for the stronger yen, because of competition from Korea, Mexico, Brazil, Canada, and U.S. plants making Japanese cars. The weaker dollar reduced the cost of commodities to Japan, making price restraint feasible for finished goods. Japanese and European producers of autos, electronics and chemicals also responded by moving more production inside the United States, but that means more imported machinery and materials which increase the U.S. trade deficit in the short run. Indeed, the U.S. has virtually imported entire factories.

Another reason such capital surpluses and trade deficits are self-correcting is that the relative improvement in U.S investment opportunities must eventually face diminishing returns. As plant and equipment becomes more abundant in the U.S., and relatively scarcer in capital-exporting countries, the relative return on additional investment will begin to look more attractive elsewhere.

So long as capital is free to move between countries, the old idea that current accounts "should" be balanced is literally impossible -- it implies zero capital flows. Chronic current account surpluses are a symptom of relatively poor after-tax real returns on capital. The best solution to so-called "imbalances" of trade and investment flows is to improve investment opportunities elsewhere -- particularly in Continental Europe, Latin America and Africa.

In short, the main challenge to the new Administration, and to the Federal Reserve, is to continue to lead the world toward expanding opportunities for investment, employment and trade. That requires secure property rights, including money that is expected to hold its value over time, predictable regulations, reasonable taxation and free trade. The more countries that follow such policies, including Marxist economies, the less burden on the United States and Japan to serve as locomotives for the cabooses. This is no time to make a fetish of mere instruments and symptoms, such as budget or trade gaps, at the expense of the broader picture.