Does exchange-rate management have a role in the U.S. macro-policy tool kit? Stabilization is not wise policy if the current account continues to deteriorate

Business Economics,  July, 2004  by Michael R. Rosenberg

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Figure 3 also provides alternative projections for the U.S. current-account deficit, assuming both a slowdown in U.S. GDP growth (to two percent per annum on average over the next five years) and a sharp drop in the dollar's value. In one, we assume that the dollar's trade-weighted value falls by ten percent in 2004 and another ten percent in 2005. In the other, we assume that the dollar's trade-weighted value falls by ten percent in 2004, another ten percent in 2005, and still another ten percent in 2006. In the first simulation, the cumulative 20 percent depreciation of the dollar over 2004-05, in conjunction with slower U.S. GDP growth, is estimated to bring the U.S. current-account deficit/GDP ratio down to around four percent of GDP by 2008. In the second simulation, the cumulative 30 percent depreciation of the dollar over 2004-06 is estimated to help narrow the U.S. current-account deficit to around three percent of GDP by 2008.

Whether the dollar will need to fall by 20 percent or 30 percent will ultimately depend on what current-account-deficit/GDP ratio is deemed to be sustainable in the long run. While many analysts place the U.S. sustainable current-account deficit close to 2.5-3.0 percent of GDP or possibly even lower, a more optimistic "new-economy" view of the United States would consider the possibility that if the speed limit of the U.S. economy is now faster than it once was, then the United States might be in a position where it can safely run larger current-account deficits than was previously the case--with the sustainable shortfall perhaps now as high as 3.5-4.0 percent of GDP.

Overall, it seems likely that the dollar will need to fall at least 20 percent and possibly as much as 30 percent from present levels over the next two to three years to restore the U.S. current-account deficit to a sustainable level. If that is indeed the case, then a policy designed to stabilize the dollar at present levels would be counterproductive. Indeed, if the United States sought to enter into a cooperative arrangement with other countries to stabilize the dollar, that policy would almost certainly lead, over time, to a wider U.S. current-account imbalance, which would push the eventual and inevitable resolution of the U.S. deficit problem to some point in the future. Unfortunately, its ultimate adjustment at some future date might prove to be more painful for the United States than would be the case if the external-imbalance problem were tackled today.

U.S. Interest Rates and the Trade Adjustment Process

To tackle the U.S. current-account deficit problem more effectively, it seems likely that U.S. interest rates will need to play a role as well. The United States faces several policy options that it could take to address its external-balance problem--the United States could set its current-account position on a sustainable course if the dollar were to significantly fall in value or the level of U.S. interest rates were allowed to rise substantially, or if some combination of the two were allowed to occur.