Update: Link to the IMF WEO fixed.
Emmanuel-across-the-pond and my co-blogger Will have been discussing the dollar-renminbi exchange rate and current account adjustment. They both seem to accept (along with Congress and the Obama administration) that a devaluation of the dollar will correct the current account deficit. I think this conclusion is wrong. Moreover, I think that only political economy analysis can help us understand why the political elite are obsessed with the exchange rate. As we shall see, it has nothing to do with current account adjustment.
Correcting the US current account deficit with a dollar devaluation is like trying to eliminate a deficit in your household budget by cutting your hourly wage. Although it could work, it's a bad idea because it makes you poorer. It is a doubly bad idea because it might not work, either. Let's focus on why an hourly wage cut might eliminate the deficit in your household budget. Then we can think about the conditions that determine whether it will work.
- i. price elasticity of demand for your labor: One might think that cutting your hourly wage would merely reduce your income. Yet, businesses might demand more of your labor at this lower wage so that total hours worked rise more rapidly than your hourly wage falls so that at the end of the (longer) work day you have higher total income. Hence, household earnings (exports) rise by cutting your hourly wage (devaluing).
- ii. price elasticity of your demand for consumption goods: Because everything you buy is now more expensive relative to your hourly wage, you consume less. Moreover, because your demand is highly sensitive to rising prices, the fall in the quantity you demand is greater than the price increase. Hence Quantity times Price yields a smaller total expenditure bill than at the prior real wage. Hence, household expenditures on goods from the outside (imports) fall.
Devaluing the dollar therefore makes us poorer. It might eliminate our current account deficit if demand for US imports and exports is highly price elastic. Or if demand is price inelastic, it could push us deeper into deficit. So, the question is, how price elastic is the demand for US imports and exports? The preponderance of evidence suggests that the answer is, "not very." To quote a relevant summary: "...price elasticities tend to be quite small...Thus, an exchange rate depreciation would weaken the trade balance as its negative effect on the terms of trade would outweigh its positive effect on trade volumes" (The IMF WEO linked above, at page 95). Devaluing the dollar will make us poorer and is more likely to worsen than improve the current account position. Devaluing thus seems to be a doubly bad idea.
All of which raises the political economy question: why does Congress want the Obama administration to implement a policy that will make us all poorer? I'll answer this in the next post. Until then, let me say that I think Congress' focus on the exchange rate misleads the public. I'll leave it to individual readers to decide whether the deception is intentional.