Tuesday, January 27, 2009

Canard Pekinois

. Tuesday, January 27, 2009

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.
Thus, with the right elasticities, you can balance your household budget by cutting your hourly wage. Your total earnings rise and your total expenditures fall. Yet, if demand by the world for your labor and yours for goods are price inelastic, then cutting your hourly wage just makes you poorer. If your demand for goods is inelastic (maybe you spend all of your income on food, shelter, and health care), you fall deeper into deficit.

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.


Kindred Winecoff said...

the links to the IMF paper are broken, and i'm interested in reading it. working paper #95 in 2007 seems to be about technological development, which doesn't seem like what you were talking about.

Jason Foster said...

I posted a comment on seeking alpha, then I found your blog. I'll summarize it here.

First of all, great article. Your analogy to lower your hourly wage is great. I wonder how you would explain what it does to the U.S. debt?

Now, I had one comment: Couldn't it be that the demand for goods is inelastic in the short-run, but elastic in the long-run? Gasoline is the example I'm thinking of, since U.S. consumers initially seem to consume the same amount of gasoline, but over the long run they switch to more fuel-efficient cars and substitute alternative energies like electricity.

Emmanuel said...

It's Emmanuel reporting for duty ;-) I believe I'm being unfairly lumped into the protectionist camp:

(1) What commentators seem to miss is another IPE point I wish to make. Dollar devaluation will not be the main avenue for correcting global imbalances but rather LDC aversion to footing America's external tab. If capital account flows to the US slow dramatically as China stops piling on reserves and others follow suit, then America will have no choice but to undergo "structural adjustment."

Nor am I claiming this will be a painless process. As I am more of an impartial spectator belonging to neither camp of combatants, I am probably more gung-ho on this point than my American counterparts. A reader also brought this point up about price elasticity of demand to which I made a similar reply. Savings are not exogenously determined; others' willingness to foot America's bill matters a lot and is not really considered in the literature provided. Simply put, price elasticity of demand matters a lot less when there's no one to foot a current account imbalance.

[Also note that the Marshall-Lerner condition was met in the IMF model once correction for aggregation bias was applied.]

(2) People keep hurling this idea at me that a China-US trade row is the slippery slope that leads to Smoot-Hawley II. Like Vietnam-era domino theory, I do not think this is likely. There is this thing called the WTO now, and LDCs have much tariff water to play with anyhow. I dislike protectionism in general, though I am keen on the possibility of the US initiating boneheaded currency legislation against China that makes the PRC reconsider its poor investment choices.

To get things moving, China doesn't have to sell its Treasury stash a la the hyperbole of a "nuclear option." Mainly, it needs to stop buying Treasuries.

(3) I too will establish a scenario of how I believe things may play out. Bear with me as I'm all by my lonesome instead of four of you!

Canard Pekinois
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