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1 {-U}fr HuMsolor IrusrrrurroN ontrrrusrrlantrc Issurs The Twin Deficits in the United States and the Weak Dollar Adjustment in the World Economy and Policy Recommendations for Germany and the European Union February 2005 Development of the Dollar-Euro exchange rate since April 2001 Sponsored by Deutsches Programm filr transatlantische Begegnung of the German Federal Ministry of Economics and Labor

2 The Humboldt Institution on Transatlantlc Issues is a network for young professionals in the fields of academia, politics, culture and economics at the Humboldt-Univer6itiit zu Berlin. We bring experts together for workshops of one or two days to discuss problems in the transatlantic relationship and to formulate solutions to address them. Our goal is to utilize existing expertise in German Universities to strengthen transatlantic dialog, and to build bridges between academiand policy. Die Humboldt Institution on Transatlantic Issues is sponsored by the German Federal Ministry of Economics and Labor, ERP-Sonderverm6gen. For more information: Dr. Tim Stuchtey Humboldt Institution on Transatlantic Issues Humboldt-Universitdt zu Berlin Unter den Linden Berlin Tel: +49 (030) Fax: +49 (030)

3 The Twin Deficits in the United States and the Weak Dollar Adjustment in the World Economy and Policy Recommendations for Germany and the European Union On the 12th of December 2004, the HuMBoLDT INSTrrurroN TMNSATLANTTc IssuES held a workshop on the twin deficits in the United States, the recent weakness of the dollar and implications for policy in Germany and the European Union. The term "twin deficits" refers to a simultaneous occurrence of a deficit in the government budget and a deficit in the current account of a country. This paper: (1) summarizes the facts regarding the recentwin deficits in the U.S.; (2) describes possible scenarios for the adjustment of the world economy to the current account deficits in the U,S.; (3) presents policy recommendations for Germany and the European Union. Summary The United States now runs the largest current account deficit in the country's history. The deficit in the current account coincides with a large decrease in government saving in the United States, The current account deficit in the U.S. has recently been financed mainly by sales of U.S. government debt to foreign central banks, especially in East Asia. Most economists agree that the current account deficit in the U.S. of the present size is unsustainable. The world economy will have to adjust. Adjustment will involve a change in relative prices of goods: products made in the U.S, will become cheaperelative to products made in the rest of the world. Adjustment will also involve a change in relative prices of goods within each country. In the U.S., products internationally traded will become more expensive relative to non-traded goods; the opposite will happen in the rest of the world. This means the following for Germany and the European Union. Consumers there will enjoy cheaper-impofts, workers and owners of capital employed in the traded goods sector (say, the automobile industry) will lose, workers and owners of capital employed in the non-traded goods sector (say, retailing) will gain. There will be a need to reallocate resources from the traded goods sector to the non-traded goods sector, This reallocation of resources will be costly but is inevitable. Letting the Euro float freely helps keep the costs of adjustment low. Product market deregulation, the continuation of labor market reform and the elimination of policy measures that encourage Germans to save "too much" will also help keep adjustment costs down. While Europe has already been adjusting, East Asian policymakers have thus far attempted to prevent adjustment there from taking place. East Asian policymakershould be encouraged to accept the idea that this policy is flawed.

4 The Twin Deficits in the United States and the Weak Dollar Adjustment in the World Economy, Policy Recommendations for Germany and the European Union Resufts of the Workshop on December LZthr 2OO4 Prof. Bartosz Ma6kowiak, Ph.D.1 Economic Theory (Macroeconomics), Humboldt-UniversitHt zu Berlin The twin deficits in the United States: the facts Economists estimate that the United Sfafes ran a current account deficit equal to about 5.5o/o of its gross domestic product (GDP) in In the past, the U.S. had run substantial current account deficits in the second half of the 19th century, when it was a developing country, but these deficits never exceeded 4o/o of GDP. The U,S. also ran substantial current account deficits in the 1980s, but again they never rose above 4o/o of GDP, The size of the U.S. current account deficit is therefore u n precedented, The current account deficit in the U.S, in 2OO4 is approximately equal to the country's trade deficit: the U.S. imports more goods and services than it expofts. The difference amounts to about 600 billion U.S. Dollars, or roughly 5.5olo of GDP, Someone has to finance the excess of imports over exports in the United States, Foreign individuals and governments do so, by accumulating financial claims on the United States. The current account deficit in the U.S. implies that the U.S. is a net exporter of financial assefs. In the last five years, U.S.- owned assets abroad have remained roughly constant (at about 600lo of GDP of the U.S.). In the same period, foreign-owned assets in the U.S. have increased from about 600/o to about 90o/ of GDP. Thus the net international investment oosition of the United States (how much the country owes to foreigners) amounts now to approximately 3Oo/of its GDP, or over 3,000 billion Dollars. This magnitude is also without a precedent in the history of the United States. A current account deficit is equal to the difference between a nation's investment and saving, The current account deficit in the U.S. means that private individuals and the government in the U.S. invest more than they save. Following a small surplus around 1990, in the first half of the 1990s the current account of the U.S. recorded a deficit of about L-2o/o of GDP. The deficit deteriorated sharply in the second half of the 1990s, and this event was associated with a boom in private investment in the U.S, As the private investment boom ended, government saving in the U.S. decreased sharply from about 3o/o of GDP in 1999 to about -4o/o of GDP in 2003 and Thus the large current account deficits at present coincide with large government budget deficits hence the "twin deficits". (Had private individuals in the U.S. reacted to government budget deficits by saving substantially more, the current account would not have deteriorated, but in fact private saving in the U,S. has remained low.) Of course, the world as a whole cannot run a deficit in the current account! Large deficits in an economy of enormous size like the U.S. have to be I Humboldt-Universitiit zu Berlin, Wirtschaftswissenschaftliche Fakultiit, Institut fur Wirtschaftstheorie, Spandauer StraBe 1, D Berlin - Phone: +49-(0) , bartosz@wiwi.hu-berlin.de

5 balanced by large surpluses elsewhere. This is indeed what has happened. For example, Japan's current account surplus amounted to as much as 3.5olo of its GDP in 2004, Germany's to 3.3olo of its GDP, and many emerging market economies have been running surpluses in their current accounts or at least smaller deficits than they used to. A nation can finance a deficit in its current account by selling a variety of financial assets to foreigners, such as private equity, private debt and government debt, It is remarkable that the United States is now a net importer of private equity securities, despite its large current account deficit. It is equally striking that fhe current account deficit in the U.S. is now financed mainly by sales of U,S, government debt to foreign central banks, especially in East Asia. The accumulation of reserves by foreign central banks paid for about 80o/o of the current account deficit in the U,S. in Most recent estimatesuggesthat the accumulation of reserves was equally important in 2O04t Dollar reserves increased by 150 billion in China and Japan each, and by billion in the rest of the world. (Compare to the size of the current account deficit of the U.S., roughly 600 billion Dollars.) The process of adjustment to the current account deficits in the United States Recently, a number of leading academic economists have argued that the current account deficit in the U.S. of the present magnitude is unsustainable. Most notably, this point of view has been expressed by Maurice Obstfeld of the University of California at Berkeley, Kenneth Rogoff of Harvard University and Nouriel Roubini of New York University. That the deficit is unsustainable means that, sooner or later, the current account of the U.S. will need to move toward a surplus. Roubini, in a paper written together with Brad Setser who attended the HITI workshop, predict the future of the current account balance in the United States, According to one scenario, the trade balance (the main component of the current account) will evolve slowly over time. However, according to another scenario, the trade balance of the U.S. will radically improve in a short period of time. The researchers observe that, if a rapid change were to occur, it would most likely result mainly from a decrease in imports by the U.S (as opposed to an increase in exports of the u.s,), It is impossible to predict the speed with which adjustment will in fact take place. However, irrespective of the speed of adjustment, it is possible to predict what will happen in the United States as its current account balance moves toward a surplus, Likewise, it is possible to predict what will happen in the rest of the world as its current account balance moves toward a deficit, To understand what will happen, consider a national income identity for any economy. The identity says that national income (known as gross national product or GNP) is equal to the sum of four components: private consumption, government consumption, investment and current account, The sum of the first three components indicates the amount of resources that a country absorbs relative to its income. Hence the sum of the first three components is known as absorption. The nationa income identity states that, for any country, income equals absorption plus current account, Let us now suppose that adjustment is taking place; hence, the current account of the U.S. is moving toward a surplus, By the national income identity, this implies that absorption will decrease relative to income in the United States Conversely, absorption will increase relative to income in the rest of the world, as the current account balance there deteriorates. Adjustment will involve a relative shift in absorption of output produced in the world economy: the U.S. will absorb less and the rest of

6 the world will absorb more, relative to their income levels. Put differently, the U,S. absorbs "too much" at present - and the rest of the world "too little" - relative to some long-run equilibrium (state of balance), Let us summarize the argument thus far. The current account deficit of the U.S. is unsustainable in its present magnitude. In the future, the current account balance of the U.S. will move toward a surplus. This will involve a decrease in absorption relative to income in the U.S, and an increase in absorption relative to income in the rest of the world. The crucial next step in the argument is to observe that adjustment will involve a change in relative international prices of goods and services, and therefore adjustment will involve an international redistribution of wealth. Americans consume (absorb) mostly U.S.-made goods and services, whereas private individuals and governments in the rest of the world consume predominantly products made outside of the United States. As absorption goes down in the U,S. and goes up in the rest of the world, products made in the U.S. will become cheaper relative to products made in the rest of the world. This is what economists refer to as a change in the "terms of trade": a cross-country redistribution of wealth, whereby citizens of the U,S. lose while citizens of the European Union, China, Japan and other trading partners of the U.S. gain. Fufthermore, adjustment will also involve a change in relative prices of products and a redistribution of wealth within each country. The reason is that private individuals and the government in any given country consume (absorb) predominantly non-traded products. (Economists refer as non-traded products to goods and services that are not traded internationally, perhaps because of prohibitively high transportation costs.) Let us continue supposing that there will be a decrease in absorption in the United States and an increase in absorption in the rest of the world. Ihe price of non-traded goods and qervices in the U.S. (such as retailing) will decrease relative to the price of internationally traded goods (such as computer software). The opposite will take place in the rest of the world: the price of non-traded goods there will go up relative to the price of traded goods. Consider Germany as an example. Workers and owners of capital employed in the traded goods sector in Germany (say, the automobile industry) will lose, while workers and owners of capital employed in the non-traded goods sector (say, retailing) will gain. As absorption declines relative to income in the United Statet there will be a risk of a recession in the non-traded goods sector there. Indeed, observers argue that the non-traded goods sector in the U.S. is currently "too big" relative to long-run equilibrium, The speed at which adjustment takes place will matter. If adjustment occurs fast, there will be a risk of sudden collapse of some American companies producing non-traded goods. If adjustment takes places smoothly, capital and labor will reallocate gradually to find employment in the traded goods sector. Clearly, smooth adjustment would be less costly for workers and owners of capital. As absorption increases relative to income in the rest of the world, including Germany and the European Union, there will be a risk of recession in the traded goods sector there. Again, it is preferable that adjustment be smooth and gradual rather than abrupt, because workers and capital will need time to find new productive activities. We have seen that adjustment to the current account deficit in the U.S. will involve a change in the absorptionincome mix in the world; adjustment will also involve changes in the relative prices of goods and services throughout the world economy. The changes in the relative prices will cause a redistribution of wealth across nations and also within each individual country. The process will

7 be costly, just like any reallocation of resources is costly. The changes in relative quantities and prices will take place even if exchange rates are held fixed by policy. For example, even if the exchange rate between the Dollar and the Chinese Yuan is held fixed, the prices of Chinese products will increase faster along the adjustment path than the prices of American products, Furthermore, the prices of non-traded products made in China will increase faster than the prices of traded goods made in China. Letting exchange rates float freely will act to decrease the costs of adjustment. Exchange rates, when they float freely, often change rapidly and by large amounts. For example, the Euro can appreciate relative to the Dollar in an instant and by several percent. A stronger Euro motivates consumers in the European currency area to absorb a greater quantity of imports. A stronger Euro also motivates investors in the European currency area to move resources toward the non-traded goods sector and away from the traded-goods sector. Simultaneously, a opposite process begins in the United States. Thus a change in the exchange rate quickly directs consumers and firms to begin adjusting their behavior, Thanks to the floating Euro-Dollar exchange rate, the adjustment can begin without delay and will likely be smooth and gradual. In contrast, consider a country like China that maintains a fixed exchange rate vis-i-vis the Dollar. In the absence of appreciation of the Yuan, consumers and firms in China do not receive a clear signal telling them to begin adjusting. But once we accept that the current account deficit of the U,S. is unsustainable, we know that adjustment is inevitable, including in China! China cannot avoid adjustment by fixing the exchange rate! If the Chinese government insists on fixing the exchange rate, adjustment will occur via other prices, not controlled by poliry. In particular, China will experience inflation - an increase in the general level of prices of goods and services, And inflation is much more costly to an average family than exchange rate appreciation. Fufthermore, China will face a risk of an extremely costly, sudden collapse of production in the traded goods sector (if, as seems likely, the Yuan will be forced to appreciate). There is another reason why having a freely floating exchange rate can help adjustment, We have seen that the net international investment position of the United States is currently negative and large in absolute size. It turns out that most claims of foreigners on the U.S. are denominated in Dollars, while a significant fraction of claims of Americans on the rest of the world are denominated in currencies other than the Dollar (such as the Euro). Once financial markets had realized that a decrease in the current account deficit of the U.S. is inevitable, the Dollar began depreciating vis-i-vis the Euro. When the Dollar depreciates, the net international investment position of the U,S. improves, Pierre-Olivier Gourinchas of the University of California at Berkeley and H6ldne Rey of Princeton University estimate that a 2Oo/o depreciation of the Dollar causes a transfer of wealth from the rest of the world to the U.S. worth as much as 7o/o of GDP of the United States. We now see why having a floating exchange rate helps keep the costs of adjustment low. As investors suffer capital losses, the required size of adjustment in output levels and relative prices diminishes. The amount of foreign debt that the U.S. has to pay back via exports of goods and services goes down. In practice this means that, for example, German investors owning American stocks and bonds suffer relatively more, and workers in the German automobile industry suffer relatively less. Aggregate welfare of Germans probably improves. International risk sharing via floating e4change rates likely reduces the costs of adjustment for the more vulnerable members of the German society.

8 We have now completed our discussion of the main events that will take place as the world economy adjusts to the unsustainable current account deficits in the United States. In conclusion, let us note that the process of adjustment has already begun, pafticularly in the European Union, while East Asian policymakers have thus far attempted to prevent adjustment from taking place. From its peak value of about 0.85, the Dollar has depreciated to about 1,3 (that is, as much as 50o/o) vis-ir-vis the single European currency in the last three years. Slowly but surely, the strong Euro has been motivating consumers in the European Union to absorb a greater quantity of imports. The strong Euro has also been motivating firms to move resources toward the non-traded goods sector and away from the traded-goodsector. And the weak dollar has led to opposite movements in the United States. This reallocation will strengthen in the near future, since individuals and firms react with some delay to changes in the exchange rate, In contrast, the value of the Chinese Yuan vis-i-vis the Dollar has not changed at all in the last three years, the Dollar has depreciated vis-i-vis the Korean Won by only about 180/o and visir-vis the Japanese yen by about 25olo. As we would expect based on the discussion above, China has seen a surge in inflation to above 5o/o per annum, instead of exchange rate appreciation. It is a mistake to assume that the current policy in East Asia is welfare-improving for individuals in the region. Quite likely, the policy of preventing currency appreciation by accumulating Dollar reserves has distorted relative prices and patterns of production in China, and perhaps also in the neighboring countries. The current policy in East Asia also increases the likelihood that the adjustment in the region will have to be sudden and costly. Policy recommendations for Germany and the European Union Product market reform. Product market deregulation would help create jobs and encourage productivity growth. In particular, deregulation in the nontraded goods sector (for example, in retailing) would lead to an increase in production and absorption of non-traded goods. Since consumers like to buy traded and non-traded goods together, absorption of traded goods would also increase. In effect, European products no longer demanded by American consumers would be sold to Europeans. Labor market reform. Reform of labor market institutions, initiated in Germany with "Haftz IV", should continue. Flexible labor market institutions make it easier for the economy to adjust to changes in relative goods prices. Partial reform, for instance reform that targets only the supply side of the labor market, may increase unceftainty and saving without stimulating labor demand, job creation and investment. Deregulation of financial transactions. Adjustment will be less costly in Europe if absorption goes up smoothly and income does not fall. There are reasons to think that some policy measures have been holding absorption aftificially low in the European Union, and especially in Germany. By international standards, it is difficult for private individuals in Germany to borrow, for instance for home ownership, for purchase of durable goods and using credit cards. Policy measures that in effect encourage German families to save 'ttoo much" should be removed. Monetary policy. The European Central Bank should continue its policy of nonintervention in the foreign exchange market, Sterilized interventions - interventions that leave monetary policy unchanged - are unlikely to affect the value of the Euro for more than a very short period of time. Relaxing monetary policy in order to depreciate the Euro is a bad idea. First, relaxing monetary policy will increase inflation at the time when inflation has persistently been at or above the upper bound of 2o/o set by

9 the ECB. Second, any increase in bbsorption and output caused by expansionary policy by the ECB will be temporary, whereas he damage to the future of the European Monetary Union will be long-lasting and hard to repair. Third, a freely floating Euro helps maximize the likelihood that the inevitable adjustment in Europe will be smooth and gradual. Fourth, the ECB always retains the freedom to relax policy, should the strong Euro cause a significant decrease in inflation. Fiscal policy. European governments should improve their budgets. With budgets in good shape, it will be possible to relax fiscal policy without damage to the Stability and Growth Pact in the event that growth slows in the traded goods sector. Foreign policy, European politicians should argue to American politicians that it would be preferable - both to the U.S. and to the rest of the world - if adjustment in the U.S. took the form of an increase in government saving, rather than an increase in private saving (say, triggered by a correction in the valuation of real estate). European politicians should argue to Chinese politicians (and their counterparts throughout East Asia) that the current policy in China risks creating a sudden, deep recession in the traded goods sector there and that the current policy should be abandoned.