Economics, Politics, Social Commentary and occasionally Superstring Theory.

Saturday, February 05, 2005

Greenspan's Wand

Alan Greenspan, chairman of the Federal Reserve, has expressed his confidence that normal market forces will solve the U.S. "twin deficits" problem. The FT has the story here. I, for one, am skeptical.

"Normal market forces" generally means that the devaluation of the dollar should lead to more American export growth as well as domestic substitution for imports that become more costly. Of course, the foreign exchange (forex) markets responded in exactly the wrong way by bidding the dollar up. I think it'll go back down on Monday. Especially because Robert Rubin, the former Secretary of the Treasury, expressed the exact opposite view on the same day.

Jousting aside, is there any truth in the belief that export readjustment in the U.S. can solve the deficit problem? Can a falling dollar help the world's largest economy export its way out of its debt? The answer is, of course, yes and no.

No. There is substantial evidence that the U.S.' export supply has contracted significantly in the last decade. Simply put, having outsourced a large amount of our production facilities to capture cheap labor savings, a diminished dollar isn't going to do us as much good as it normally would. It won't change much on the services side, either, as the U.S. already has something of a monopoly on international tradeable services. A simple reliance on export-led growth isn't going to do the trick. But that's only one side of the coin.

Yes. A falling dollar means that imports become more expensive. Faced with higher prices, consumers will switch to domestic products which have become relatively cheaper. If the dollar decline is slow, then we should first see the effect at the margins. Namely, on those products which are necessary and which consumers are very sensitive to price. Shoes, textiles, food, etc. There is some debate as to why we haven't seen a bigger effect already. Some economists think it's the J curve, which contemplates a lag between currency shifts and imports. Others (including Greenspan) think that the Europeans and Japanese are absorbing losses against a falling dollar so as to not sacrifice market share.

Greenspan should have put a big "IF" in his statement. Normal market forces should start to have an effect on the deficit IF Asian central banks let the dollar depreciate and stop financing U.S. debt on the cheap. IF Geroge Bush's budget proposal shows international markets that the U.S. is committed to reining in its budget deficit (a tax increase proposal, however insignificant, would do an enormous amount to this end, but is at the outer frontiers of possibility.) The Treasury is going to have a big auction later this week. The amount of demand from the Asian banks (always a tricky proposition to measure) should add some substance to the first IF. The President is supposed to submit his budget during the same time. That will go a shorter way in answering the second IF.


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