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Tuesday, March 28, 2006

Deficit Dilemmas

Well there's some good news and some bad news for Brad Setser in today's FT. First the bad news.

"many economists say that even dramatic gestures by China would do surprisingly little to reverse the (current account) imbalance. The impact of currency movements on trade flows, they say, has been dwindling because of “local cost” pricing, where companies adjust price tags to keep in line with competitors, rather than according to fluctuations in the exchange rate."

Well here's one economist who agrees with this. The FT offers some evidence for its argument:

The US experience with Europe is instructive. Since its peak in July 2001 the euro has risen 44 per cent against the dollar. In spite of this boost to US competitiveness, the US bilateral deficit with the eurozone has grown by 75 per cent, from $53bn in the 12 months to July 2001 to $93bn in the past year.

“If an appreciation of the euro didn’t help that much, it makes you question why a revaluation of the renminbi would hold the key to reducing the US deficit,” says Paul Meggyesi, currency strategist at JPMorgan.

Well quite. So the lesson would seem to be that while - as Brad constantly reminds us - currency values matter, for international trade purposes it seems that, in a globalised world, they don't matter as much as they used to. Now for the 'good' news (if you can call it that):

Paul Donovan, global economist at UBS, says a revaluation of the renminbi would be ineffective in reducing the US deficit since most of the goods China sells to the US are not widely produced in America. About half of Chinese exports to the US fall into three categories – office machines, clothing and footware, and toys and other plastic goods – that represent just 4 per cent of US manufacturing production.

“If the US did not buy these goods from China it would have to buy them from abroad anyway,” says Mr Donovan. “As a result, the impact on the deficit would be very small

Now I call this good news for Brad, since this does form part of the case he has been making. The US export base is now so comparatively small compared to the scale of its imports that even significant growth elsewhere is only going to make a relatively small dent in the problem:

some economists argue that even a dramatic surge in demand in Europe and Japan might have a surprisingly modest impact on the deficit. US exports are now just 60 per cent as large as imports, which means the rest of the world would need not only to catch up with US growth rates but significantly outpace the US in order to start narrowing the deficit.

According to the Institute for International Economics, every 1 percentage point rise in real growth in the rest of the world reduces the deficit by a mere $15bn. Fred Bergsten, director of the IIE, says even if growth rates doubled in Europe and Japan, “this would only mean a $30bn reduction in the deficit. This would be good news and would be great if it happened but it is not the solution to the deficit”.

Moreover, the US has a much greater appetite for imports relative to domestic demand than does the rest of the world. Even if the US and European economies grow by the same rate, then imports will rise by more in the US.

So the only viable solution would seem to lie in slowing growth in the US itself, and Bernanke is, of course, set on this path. But this would be no 'free lunch' since any significant slowdown in US growth would be bound to hit growth elsewhere, expecially in export dependent economies like Germany, Japan and China.

Meantime the US legislative system trundles on with its attempts to define and act against the 'currency manipulators. The latest development is a bill in the Senate from Charles Grassley, chairman of the Senate Finance Committee, and Max Baucus, the committee’s leading Democrat, although as the FT points out this rather toothless measure seems largely "intended .... to draw away support from more draconian legislation that would impose 27.5 per cent tariffs on all Chinese imports to the US".