Someone Talking Sense About Exchange Rates, For Once

Nobel Laureate Michael Spence on CNYUSD:

The Exchange-Rate Delusion

MILAN – If one looks at the trade patterns of the global economy’s two biggest players, two facts leap out. One is that, while the United States runs a trade deficit with almost everyone, including Canada, Mexico, China, Germany, France, Japan, South Korea, and Taiwan, not to mention the oil-exporting countries, the largest deficit is with China. If trade data were re-calculated to reflect the country of origin of various components of value-added, the general picture would not change, but the relative magnitudes would: higher US deficits with Germany, South Korea, Taiwan, and Japan, and a dramatically lower deficit with China.

The US Dollar And The US Trade Deficit

Marty Feldstein thinks the US Dollar will weaken…and that’s a good thing:

Feldstein Says Dollar to Weaken, Boosting Exports

Oct. 7 (Bloomberg) -- Martin Feldstein, a Harvard University professor who was chief economic adviser to President Ronald Reagan, predicted the dollar will weaken, boosting exports and strengthening the U.S. economy.

“Dollar weakness will be one of the few things that will improve our trade balance, and that will strengthen our exports,” Feldstein said in a Bloomberg Television interview today on “Surveillance Midday” with Tom Keene. “It will cause Americans to shift from imported goods into domestic services. All of that will strengthen the economy.”

Fund managers with large pools of dollars were converting the currency into euros before “all hell broke loose” during the European debt crisis, Feldstein said. As they resume trading dollars for euros, and the U.S. trade deficit remains high, the dollar will depreciate, he said…

Unwinding Global Imbalances

As a quick follow-up to my last post, the BEA last night posted Febuary data on US international trade. There's been a marked improvement in the trade balance:



That's the lowest level in the trade deficit since November 1999. The bad news is that it's been driven by a sharp contraction in trade:




Interpreting this in light of my last post, I don't think there's any question that global trade and savings imbalances are being unwound right now and fairly rapidly, without a big adjustment in the USD (although I think that's probably still on the cards). Right now funding the deficit has fallen to an average of $1 billion a day, rather than the $1.9 billion required last year.

As to how sustainable this is, about half the reduction in y-o-y imports comes from a lower oil bill, and another sixth or so from lower imports of cars. If and when growth resumes, both these categories are likely to pick up again, so we're not out of the woods yet.

iCapital Lays An Egg

iCapital in an article in the Star today talks about the 'perception' that current global imbalances have to be unwound is wrong:

"One of the most often cited global imbalance is the high saving, low consuming Asians and the high spending, low saving Americans...According to this school of thought, the global economy is heading for a serious and protracted contraction because Americans need to save more while Asians are not spending enough...So if Americans save more, where will the global demand come from? If there is insufficient global demand, how can the export addicts of Asia expand?...So, the way to solve the current end-of-the-world contraction is for the global savings/spending imbalance to be rectified. Unfortunately, this would take years. Now you get the drift of why they think the world economy will be down and out for many years to come?...i Capital really does not buy into this argument. When this is all over, when we are over the Lehman panic, for the record, Capital Dynamics, i Capital, and its boss would want to be known as non-bear...Is there any cast-in-stone law that says the global savings/spending imbalance needs to be rectified now? Is there any rule that says Americans must save more now?"

and...

"First, the less than one billion people in the Western economies plus Japan have enjoyed much higher standards of living for a very long time, while the five billion-plus people in the rest of the world have either been in poverty or struggling for a very long time...This global imbalance should have been corrected a long time ago but it has instead persisted for a very long time despite all the aid given by the wealthy developed economies...Second, the imbalance in the perception of the developing countries by the rest of the world and the perception of the developed world by the rest of the world has existed for a very extended period too...This global imbalance in the perception of the developing countries by the rest of the world and the perception of the developed world by the rest of the world needs to be rectified but will it ever be? So do not be surprised if the global imbalance of high saving, low consuming Asians and high spending, low saving Americans persists for a while longer."

What are these guys smoking? I don't have a problem with their conclusion: capital markets are I think forming a bottom and anybody with the capital and patience to invest should find some great medium term bargains right now. But the basis for their view on the other hand is built on a house of cards. There is a real serious global imbalance, which is also right now being unwound.

Comparing the global consumption-savings imbalance to cultural perceptions is disingenuous at best; there aren't any market forces acting on those, but there are on global trade and capital flows. The US savings rate is rising, not because it was underestimated in the first place, but because Americans are actually beginning to save.

The meme iCapital is disputing is high saving, low consuming Asians; low saving, high consuming Americans - how much of this true? Going back to the national accounts identity:

Y = C + I + G + NX

where Y is income
C is consumption
I is investment
G is government deficit
and NX is net exports
In addition I = S (savings)

For a given level of income and government spending, excessive consumption and investment turns up as a negative value for the NX term, and vice versa. In short, a trade deficit indicates excess consumption and investment (or for that matter, excess government spending). The opposite is true for a trade surplus - savings in excess of consumption.

To get a finer understanding of this, it must be understood that I = savings, does not necessarily imply investment must equal domestic savings - international savings can be involved as well. Second, savings covers not just individuals, but also corporate and government savings. Third, international trade and capital flows are zero-sum; the existence of a trade deficit implies a surplus somewhere else, same with capital flows.

With that background, what's the record on the US trade deficit? (1992-2008)



And as a ratio to GDP (1992-2008):



I dare anyone to say there isn't a problem here, but that it is also beginning to reverse. Here are the countries/regions that have the largest trade surplus against the US as of January 2009:

China - 46.9%
Other Pacific Rim countries 17.4%
Canada & Mexico - 11.8%
OPEC - 9.2%
EU - 7.9%

That's pretty clear. It's actually even easier to see than that, because the US actually compiles statistics on personal income, expenditure and savings. Here's personal savings as a ratio to personal income (1947-2008):



So on that score, I think there is no question that over-consumption in the US is true and that the savings rate has been declining over time, and moreover this over-consumption was financed by savings elsewhere including Asia and the Middle East.

The real question isn't whether there will be a redressing of global imbalances, but rather to what extent and in what form it will take. A country can usually sustain an imbalance of the current account, if it is supported by fundamentals like demographics. An older population base, with a significant ratio of retirees, would generally be dissaving, thus inducing an excess of imports over exports (by that argument, Japan ought to be running a deficit - another imbalance waiting to be fixed).

But the US is not in this position. While it’s true that imbalances can and do persist over time, this crisis is likely to cause a structural change in the US relationship with the rest of the world. The shock to the consumer psyche isn't going to disappear even with the flood of liquidity in the banking system, or the massive stimulus package that's already being rolled out. An increase in the US savings rate should be taken as a given. Will it return to the level of the 1970s? Perhaps not - but a complete redressing of global imbalances doesn't require that.

The easiest way to address the US trade and capital flow imbalances is through a change in relative prices i.e. a fall in the USD or equivalently an appreciation of the currencies of trading partners. The harder, more painful way is through balance sheet adjustments i.e. deleveraging.

I think both are happening or will happen in the case of the USD, especially with the pressure on the exchange rate from monetary expansion and government borrowing. And this will cause a retreat in US imports and Asian exports. And neither is this necessarily bearish for capital markets.

Technical Note:
All trade, personal income and GDP data from the Bureau of Economic Analysis