“For travelers to America from Europe or Asia, American prices are dramatically lower than at home. A hotel room or dinner in New York is a bargain when compared to prices in London, Paris, or Tokyo. And shoppers from abroad are loading up on a wide range of products before heading home.
But, despite this very tangible evidence, it would be wrong to conclude that American goods are now so cheap at the existing exchange rate that the dollar must rise from its current level. Although the goods and services that travelers buy may cost less in America than abroad, the overall price of American products is still too high to erase the enormous trade imbalance between America and the rest of the world.
To be sure, the falling dollar over the past few years has made American products more competitive and has caused the real value of American exports to rise sharply — by more than 25% during the past three years. But the trade deficit in 2007 nevertheless remained at more than $700 billion, or 5% of GDP.
The large trade deficit and equally large current account deficit, which includes net investment income, implies that foreign investors must add $700 billion of American securities to their portfolios. It is their unwillingness to do so at the existing exchange rate that causes the dollar to fall relative to other currencies. In falling, the dollar lowers the value of the dollar securities in foreign portfolios when valued in euros or other home currencies, shrinking the share of dollars in investors' portfolios. The weaker dollar also reduces the risk of future dollar decline, because it means that the dollar has to fall less in the future to shift the trade balance to a sustainable level.
But what is that sustainable level of the trade balance and of the dollar? While experts try to work this out in terms of portfolio balances, a more fundamental starting point is the fact that an American trade deficit means that Americans receive more goods and services from the rest of the world than they send back — $700 billion more last year. The difference was financed by transferring stocks and bonds worth $700 billion. The interest and dividends on those securities will be paid by sending more "pieces of paper." And when those securities mature, they will be refinanced with new stocks and bonds.
It is unthinkable that the global economic system will continue indefinitely to allow America to import more goods and services than it exports. At some point, America will need to start repaying the enormous amount that it has received from the rest of the world. To do so, America will need a trade surplus.
So the key determinant of the dollar's long-term value is that it must decline enough to shift America's trade balance from today's deficit to a surplus. That won't happen anytime soon, but it is the direction in which the trade balance must continue to move. And that means further depreciation of the dollar.”
Martin Feldstein, “Thinking About the Dollar”, The New York Sun (28 July 2008).
http://www.nysun.com/opinion/thinking-about-the-dollar/82714/
Mr. Feldstein is a professor of economics at Harvard. He was formerly chairman of President Reagan's Council of Economic Advisors and president of the National Bureau for Economic Research.
Professor Feldstein is right when he says the dollar must fall more and must remain low for a considerable time, many years in fact, before the trade deficit disappears. And it must be understood that the adjustment involved is much more than simply having the value of American exports match the value of American imports. We have, after all, been transferring all those “pieces of paper” abroad and each one of them requires that we continue to send a stream of even more “pieces of paper” in the form of interest and dividends, money, I might add, that could have gone into our pocket but will now fatten the wallet of foreigners. The bill for three decades of unrestrained overspending is not going to be cheap and it is going to involve more than money.
Many people are of the opinion that the U.S. is going through a transitory period of difficulty linked to financial excesses, oil prices that are temporarily high, and a weak and undervalued dollar. In their view, once financial stability is regained, oil prices ease, and the dollar strengthens the economy will resume its previous pace of expansion, and output and incomes will increase as they have in the past.
But the adjustment to huge external imbalances such as those that now describe the economy -- over 5 per cent of our GDP -- are a heavy tax on its future and will lower its possibilities for rapid growth. To eliminate the trade deficit, for example, domestic production must exceed domestic absorption, that is, we must produce more than we use at home. As we do so we will have fewer goods and services at home to support our own consumption and capital formation.
Moreover, the needed adjustment extends far beyond the external sector. Foreigners have been financing much of our domestic investment for many years, and, as Professor Feldstein notes, they are increasingly unwilling to do so in present circumstances. Consequently, we must now finance more of our investment ourselves. This means channeling resources from domestic consumption to domestic capital formation at the same time we must send additional output abroad to eliminate our trade deficit. Thus, not only must our pattern of trade change, our pattern of domestic expenditures must change. One may add to these budgetary pressures that are building at all levels of government.
Finally, we are also at the point where baby boomers are about to retire, and this, too, although separate from trade problems, necessitates a reallocation of our domestic production to support a more elderly population, with their very different consumption patterns. One might also add to this the need to address problems of an ageing infrastructure and the incessant need to adapt to technological advance in an increasingly competitive world economy.
All these changes must be made. We have no choice but to make the adjustments necessary to avoid a collapse of the dollar, finance our capital formation domestically, care for an increasing number of elderly, and upgrade our public infrastructure.
Every period of intense adjustment involves some slowdown in the pace of economic growth as the economy faces new challenges and adapts to new circumstances. We are about to experience a period of deep and intense adjustment to problems that have been allowed to accumulate for decades. It will not be easy. Once the adjustments have been made, however, the potential for growth can be re-established, and the performance of the U.S. economy could once again be the wonder of the economic world.
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