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The dollar has not fallen far enough to eliminate the US external
deficit, argued Rudiger Dornbusch at a lunchtime meeting on 15
January. A further decline of 15-20% in the dollar's trade-weighted real
exchange rate would be needed to restore external balance by 1990. In
addition, the dollar would also need to depreciate steadily for the rest
of the century. The US market is more open than those of Europe or
Japan, so the newly industrializing countries (NICs) have grown by
capturing an increasing share of US markets. In order to achieve
external balance given increased US imports from the developing world,
the dollar must therefore experience a sustained depreciation relative
to Europe and Japan. The real trade-weighted exchange rate of the dollar has now fallen back to the same level as in the 1970s. Even though the US enjoyed an external surplus in this earlier period, Dornbusch argued that developments in the 1980s required a lower value for the dollar. These included the sharp shift in US trade with the NICs: the US has experienced a $60 billion deterioration in its manufactures trade balance with these countries since 1980. In addition, the emergence of a large current account deficit has reduced the external assets held by the US, further worsening the current account deficit. Econometric studies supported the need for further dollar depreciation, Dornbusch claimed. Even allowing for significant lags in the adjustment of trade flows to real exchange rates, forecasts of the US external account revealed that large deficits would continue at least until 1990. The latest OECD forecast, for example, showed a US deficit of more than $100 billion in the second half of 1989. How large should the dollar depreciation be? The answer, according to Dornbusch, depends on what is believed to be the sustainable level of the deficit and what is assumed about relative growth rates of spending in the US and abroad. His earlier research indicated the need for a fall of 30% in the trade-weighted real dollar exchange rate from its early 1987 level, or 15-20% from the December 1987 level. Since inflation differentials are small, large falls in the nominal dollar/DM and dollar/yen rates are needed to achieve such a real depreciation. Furthermore, since there is considerable downward price flexibility in Japan, the nominal exchange rate of the yen may have to appreciate very far in order to achieve the required real adjustment, perhaps to a rate of 100 yen/$ by late 1988. Although a sharp rise in aggregate demand outside the US could also eliminate the deficit, Dornbusch thought this unlikely to occur. Japan is currently experiencing a major increase in the growth of domestic spending, but this is not the case for Europe. Dornbusch's calculations suggested that aggregate demand growth in the rest of the OECD would have to be at least an extra 2.5 percentage points higher in each of the next three years to balance the US external account. If the dollar is significantly overvalued perhaps as much as 20% why have there not been more decisive speculative attacks? Interest rate differentials alone could not explain holding US assets. Dornbusch attributed this to the short horizon of speculators. Regulatory reporting requirements and above all quarterly performance competition prevent financial institutions and corporations from engaging in long-term speculation, because of the possibility of short-run movements in the opposite direction. Even if there were, for example, a market consensus that the dollar would depreciate by 30% over a two-year period, institutions would not act on this belief because of the possibility of short-run movements in the opposite direction. Depreciations therefore tend to occur at irregular intervals. Sporadic depreciations might also be explained as part of a policy of controlled dollar decline. Continuous depreciation may dominate the adjustments in trade volumes and hence disguise any improvement in the current account. This may cause speculators to take an excessively pessimistic view and result in a run on the currency, so the authorities may wish to space out depreciations to encourage stabilizing speculation. Dornbusch also argued that the dollar would need to depreciate steadily in the longer term. The emergence of NICs as suppliers of manufactures in world trade has had its greatest impact on US markets, which are larger and more open than those of Europe or Japan. Over the next decade the US will absorb an increasing share of NIC exports, and this creates a need for improved US competitiveness in order to increase net exports to Europe and Japan. The dollar must therefore continue to depreciate steadily relative to the currencies of Europe and Japan for the rest of the century. The post-crash budget summit in the US guaranteed that during the election year there would be no discussion of the budget and no budget cuts. Dornbusch outlined two possible scenarios for January 1989, when the new President takes office. In the softlanding scenario, rising inflation in 1988 (due to the dollar's depreciation) persuades the incoming President to implement budget cuts immediately. These cuts are accommodated by a loose monetary policy to assure full employment. As a result investment and net exports in the US improve while consumer spending growth declines; GNP growth is sustained and the twin deficits evaporate over the next few years. The soft landing is only possible, Dornbusch argued, if rising inflation provides the political excuse for raising taxes that was missing in 1987. He predicted that a hard landing would result if there is `too little' inflation in 1988 and presidential candidates are tempted to promise not to raise taxes. By 1989, dollar depreciation will have brought rising inflation, but fiscal policy will be slow to respond since 1990 is also an election year. The monetary authorities will raise interest rates, keeping the dollar overly strong and creating a recession. The external balance improves but the budget deteriorates, and the problems of 1987 will reappear. |