June 10, 2010
Exchange Rate Angst and Rebalancing
As the euro has plummeted against the USD, there's been concern that efforts to rebalance the global economy will face increasing headwinds. [Bergsten] [Duy]. This worry is only added to by the already widening US trade deficit . In this post, I don't want to dispute the difficulty of effecting global rebalancing. It was already a difficult task, even before the euro area's recent debt-related travails. What I do want to do is to put the recent exchange rate movements in perspective. My three observations are as follows:
- The euro is a relatively small component of the US trade weighted exchange rate.
- The persistence of exchange rate movements is important in determining the impact on trade flows.
- Rebalancing was never going to be effected by exchange rate re-alignments alone.
The euro and the dollar. First, here is a graph of the dollar/euro exchange rate expressed in units of USD per EUR.
Figure 1: USD/EUR exchange rate, monthly averages (blue line); synthetic euro before 1999M01. USD/EUR exchange rate on 6/4/2010 (blue square), Deutsche Bank forecasts as of 6/4/2010 (red squares) and forward rates (green triangles). Source: Fed via FREDII, Deutsche Bank, Exchange Rate Perspectives, June 8, 2010 [not online].
Clearly, the euro has declined precipitously since late last year. As of June 4, the USD/EUR rate was 1.2. Forward rates (which have little predictive power, and usually point in the wrong direction  ) imply no change. The Deutsche Bank forecast is for strengthening against the dollar, rising to 1.35 USD/EUR in a year's time.
Clearly, that's just one forecast, and given the uncertainties regarding the resolution of the euro area's fiscal problems, there is little reason to put too much credence on this particular forecast. But this brings me to the second point. Despite the euro's depreciation, the dollar has exhibited much less movement on a real, trade-weighted, basis.
Figure 2: Log broad trade weighted real USD (blue bold), CNY (red) and EUR (green). Source: BIS and author's calculations.
The data on this graph only extend up to 2010M04. The USD in nominal terms, on a broad basis, has appreciated by 2.8% (log terms, not annualized) in May. Still, that puts into perspective the fact that the USD is roughly where it was on the eve of the Lehman collapse.
Persistence. Deutsche Bank forecasts a 10% depreciation in the DB US trade weighted dollar (10.7% in log terms) in one year's time. (I know that simple univariate tests cannot typically reject the null that the trade weighted dollar follows a unit root process, but there seems to be some evidence of threshold cointegration of the nominal exchange rate with price levels, which is consistent with stationarity in the real rate -- see this post.)
Further note that the real, trade-weighted euro is not particularly weak by historical standards. And the Chinese yuan, interestingly enough, is pretty close to a trend line drawn from 2005m07 to 2010m04. (Which is not to say it is at equilibrium, or that more appreciation wouldn't have a salutory effect on the Chinese and global economies -- see this post).
Exchange rates and rebalancing. I'm currently working to update my research on trade elasticities (which explains the brevity of this post). One point that comes out is that econometrically, the exchange rate impact on trade flows is pretty small; price elasticities seldom exceed 0.5 even in the long run (short run can be much different). This highlights the point that in rebalancing, growth effects, and composition of GDP effects, might be of comparable importance to relative price changes effected via exchange rates (almost heresy for an open economy macro guy, but there it is). I mentioned this point in a series of posts:     . We need consumer retrenchment in the US, increased consumption/GDP ratios in China, as well as in other perennially surplus countries (e.g., Germany, Japan). To the extent that fiscal retrenchment occurs in the euro area, that will make rebalancing more difficult than otherwise, at least in the short run.
But as I say, nobody ever said rebalancing would be easy .
Posted by Menzie Chinn at June 10, 2010 09:52 AMdigg this | reddit
All that the forward rates are telling you is that there is no interest differential between the dollar and the euro.
Deutsche Bank should fire their currency forecasters.
Estimates of the extent of currency misalignment and of trade elasticities are not very relevant for telling us what impact the proper redress for Chinese currency policies would have on trade. The proper redress is to stop the currency interventions. The net decline in China's CA balance should be in line with the decline in currency purchases.
Posted by: don at June 10, 2010 03:24 PM
it is time for reality check. since 2007 there are already 4 moves, 3 of 30 (23%) cents and one of only 20 (15%) cents. what has done this so far to rebalance trade? i dare to say nothing.
exchange rates are not a determining factor due to the nature of the economies and goods being produced. europe, the u.s. produce high value added and specialized products such as machinery, software, chemicals, pharmaceuticals etc. most being protected by patents.
how does our complex economic system fit against a generic enonomic model based on totally flexible supply chains, totally free trade, immense immediate capital investments to set up production in new places, etc.?
Posted by: baychev at June 10, 2010 10:22 PM
...that puts into perspective the fact that the USD is roughly where it was on the eve of the Lehman collapse.
Lehman Brothers declared bankruptcy on September 15, 2008 when gold was at $775/oz. Yesterday gold closed at $1,218. That is a 57% increase. It is absurd to say that the USD is roughly where it was in 2008. That is so "rough" as to have no meaning.
Posted by: RicardoZ at June 11, 2010 08:07 AM
Correlation could be causation or this time is different ?
Series: BOPOPD, U.S. Private Direct Investment Abroad see 2005 pivot point
and 2005 pivot point for the USD 5years
That does not say enough on real rebalancing of the economies I admit
Posted by: ppcm at June 11, 2010 09:51 AM
Menzie said: "...the euro area's recent debt-related travails."
From that thought I have these questions:
OK, we have a deficit approaching 1/3 of every Fed dollar spent. That deficit far exceeds the portion of the budget that represents discretionary spending. A large portion of that non-discretionary budget is interest on the existing Fed debt built by deficit spending. The largest portion of the non-discretionary budget is entitlements.
As I see it, something will need to be done, and very soon to reduce deficit spending lest we follow the EU into our own debt-related travails. If you do not agree with this statement please explain why.
So, assuming we need to eventually slow spending, where would you cut and how deeply? Where and how would you add revenue, and how much? If you add revenue by stimulating the economy, how would you do that and how much?
If you have alternative options please define them.
Posted by: CoRev at June 12, 2010 11:58 AM
"As the euro has plummeted against the USD,"
The euro is just about at its long run average rate since the currency was introduced. For awhile, it was substantially overvalued, a combination of Bernanke beating Triche to the interest cutting game and Bernanke's swap agreements. Those swaps may make it hard for the U.S. to take the high ground on currency interventions - they were a potent force for short-term dollar depreciation. I guess he automatic reversal could be cited...
I don't think it is at all appropriate to confound the German surplus with those of China and Japan. First off, Germany does not control its currency. Its surplus is the result of a prudent aging and declining population saving for retirement. They make the savings available to anyone who wants them. China's currency policies are the equivalent of someone putting money into your checking acount without your permission and then holding you to the 'loan.' Japan is not intervening currently, but the yen is undervalued. It's zero interest rate combined with implicit guarantees that Japan will not allow the yen to appreciate too dramatically combine to encourage a strident carry trade.
Posted by: don at June 12, 2010 02:06 PM
CoRev: First, a question -- what non-discretionary items are not entitlements. I think in the budget lexicon, they're pretty much the same (with the exception of interest payments).
In response to your query -- in numerous instances, I've cited ending the Bush era tax cuts. I would consider other measures, including raising additional taxes; impose carbon taxes; and/or impose a gasoline tax. Do not cap tax payments for social security. Raise the retirement age for social security. Raise taxes on health care plans, especially higher end ones. End the mortgage deductibility for housing. End most if not all subsidies for agriculture. These are not original ideas. A lot of these are laid out each year in the CBO's enumeration of budgetary savings.
By the way, it is important to recognize the challenge to sustainability is the long run one, and is driven by the growing entitlements and the Bushian refusal to tax. So, we need to pare expenditures at the long term, i.e., entitlement transfers versus revenues. Cutting short term will (1) not address the fundamental problem, and (2) increase the likelihood of a double-dip.
Posted by: Menzie Chinn at June 12, 2010 03:05 PM
Thanks for responding Menzie. You asked: "...what non-discretionary items are not entitlements." I thought I made that clear with the reference to interest.
I see you believe that taxing/taxes will solve the problem of deficits. I do agree that the long term problem/entitlement/xfer payments needs to be addressed.
I am also not surprised that you hardly touched on cutting spending nor incentivizing the economy. The list you mentioned are in total too small to matter when we are over spending at the current rate.
My solution would include a 1/4 to 1/3 cut in discretionary spending. Freeze current entitlements. Delay implementation of the Healthcare Bill. Increased depreciation and writeoff of business capital investment. A 1 year holiday for payment of FICA. let the Bush tax cuts expire. These would all sunset at five years, unless the economy had taken off then they could sunset a little earlier.
Never, never would I implement a Carbon or Cap & Trade tax. Their reason for even discussion is based upon poor science. I would, however, implement either a flat tax or a VAT. But, they would only be implemented if we dramatically cut Income tax the first year and eliminated it within three years.
We need to start fresh with the tax codes. The tax codes and entitlements are where many of the ideological arguments are implemented.
I haven't done the math, but think that we could have a balanced budget within 5 years without devastating our economy.
Posted by: CoRev at June 12, 2010 04:35 PM
CoRev: Oh, I see. I was confused by the term "Fed debt". You meant the net Federal debt incurred via the Treasury.
Posted by: Menzie Chinn at June 12, 2010 06:29 PM
There are political reasons that China is not interested in 'rebalancing'. China remains a deeply authoritarian state, probably more so than 5 years, ago, that has little to gain from an independent capitalist class (as opposed to state connected princelings) or a distribution of income that erodes state power.
Wedding the survival of the CCP to the health of the world economy was probably not the best idea.
(This is not to say the US is free of problems.)
Posted by: purple at June 13, 2010 02:50 AM
Calculations of impact for my proposal. 2010 Deficit is: ~$1.53T
1/3 cut in discretionary spending $463B
Stimulating the economy to gain 2% annual
growth for one year adds revenue of ~$36B
Annual avg of Obama's tax increase ~$89B
Deficit at end of first end of year ~$942B
This is a very aggressive plan, getting us to a balanced budget in ~ 3Yrs. the place to play with the numbers is in taxes increases and spending cuts.
By reducing discretionary spending by just 20% and leaving everything else we could get to a balanced budget in ~3.6 Yrs.
So what happens if we just freeze discretionary spending leaving everything else proposed intact? In that scenario we could get to a balanced budget within ~12.25 Yrs. That obviously is too long to wait. In that period we would probably have 2 recessions.
So, those are my simplistic proposals. What's yours?
Posted by: CoRev at June 14, 2010 05:28 AM
CoRev, read Martin Wolf for instance to consider whether cutting Government spending will reduce the deficit 1:1. I think cutting federal spending now would reduce the deficit something like 0.2:1. Example: You cut $100bn, the economy shrinks, tax revenues decline fed, state and local, gov layoffs on all levels; result: fed state local tax revenues decline sharply in response. net result: federal deficit barely moves.
Posted by: Hal Horvath at June 16, 2010 01:59 PM