The Federal Reserve tackles the current account deficit

I’ve been a worrywart about the size of the current account deficit — but yesterday Alan Greenspan said the currency markets and I should relax. Andrew Balls and Chris Giles explain why in the Financial Times:

Alan Greenspan, Federal Reserve chairman, on Friday played down concerns over the US trade deficit ahead of the meeting of finance ministers and central bankers from the Group of Seven leading countries. Speaking in London, Mr Greenspan stressed that the combination of market forces and greater budgetary discipline in the US should allow a reduction in global economic imbalances. Officials from other G7 countries repeated calls for more urgent action to address the US’s current account and budget deficits…. Mr Greenspan suggested that European companies may soon choose to defend their profit margins as the dollar weakens, rather than protect market share. If US exporters similarly boosted market share abroad, this would begin to close the trade deficit. “Market forces [appear] poised to stabilise and over the longer run possibly to decrease the US current account deficit and its attendant financing requirements,” he told an audience of business leaders.

Here’s a link to the full text of Greenspan’s speech. Some highlights:

To understand why the nominal trade deficit–the nominal dollar value of imports minus exports–has widened considerably since 2002, even as the dollar has declined, we must consider several additional factors. First, partly as a legacy of the dollar’s previous strength, the level of imports exceeds that of exports by about 50 percent. Thus exports must grow half again as quickly as imports just to keep the trade deficit from widening–a benchmark that has yet to be met. Second, as is well-documented, the responsiveness of U.S. imports to U.S. income exceeds the responsiveness of U.S. exports to foreign income; this difference leads to a tendency–even if the United States and foreign economies are growing at about the same rate–for the growth of U.S. imports to exceed that of our exports. Third, as of late, the growth of the U.S. economy has exceeded that of our trading partners, further reinforcing the factors leading imports to outstrip exports. Finally, our import bill has expanded significantly as oil prices have risen in recent years…. The voice of fiscal restraint, barely audible a year ago, has at least partially regained volume. If actions are taken to reduce federal government dissaving, pressures to borrow from abroad will presumably diminish…. Interestingly, the change in U.S. home mortgage debt over the past half-century correlates significantly with our current account deficit. To be sure, correlation is not causation, and there have been many influences on both mortgage debt and the current account. Nevertheless, over the past two decades, major innovations in the United States have improved the availability and lowered the costs of home mortgages. These developments likely spurred homeowners to tap increasing home equity to finance consumer expenditures beyond home purchase. In contrast, mortgage debt is not so readily available among our trading partners as a vehicle to finance consumption expenditures…. [N]umerous issues that have arisen with respect to the adjustment of the U.S. current account remain unresolved. One is the effect of Asian official purchases of dollars in support of their currencies. Such intervention may be supporting the dollar and U.S. Treasury bond prices somewhat, but the effect is difficult to pin down. Another issue is the influence of still-growing globalization, arguably one of the key factors that has facilitated the financing of the U.S. current account deficit. There is little evidence that the growth of globalization has yet slowed. The dramatic advances over the past decade in virtually all measures of globalization have resulted in an international economic environment with little relevant historical precedent. I have argued elsewhere that the U.S. current account deficit cannot widen forever but that, fortunately, the increased flexibility of the American economy will likely facilitate any adjustment without significant consequences to aggregate economic activity. That argument will be tested, I suspect, by possibly new twists and turns that will emerge in a seemingly ever-more complex international economic and financial structure.

However, Greenspan footnoted the same article to which Brad DeLong links — “Expansionary Fiscal Shocks and the Trade Deficit,” by Christopher J. Erceg; Luca Guerrieri; Christopher Gust. The paper’s punchline:

Our salient finding is that a fiscal deficit has a relatively small effect on the U.S. trade balance, irrespective of whether the source is a spending increase or tax cut. In our benchmark calibration, we find that a rise in the fiscal deficit of one percentage point of GDP induces the trade balance to deteriorate by less than 0.2 percentage point of GDP. Noticeably larger effects are only likely to be elicited under implausibly high values of the short-run trade price elasticity.

If the paper is correct, then the alleged return to fiscal sanity doesn’t matter all that much. Of course, the crux of Greenspan’s argument is that European firms can’t afford to cut prices to counterbalance an appreciating Euro. He may well be correct, and I hope he’s right — because China won’t be devaluing revaluing the yuan anytime soon:

The US has been campaigning strongly for China to unhook its currency, the yuan, from the US dollar as soon as possible. US Treasury Department officials led by John Taylor, the under-secretary for international affairs, pushed their case yesterday during talks with People’s Bank of China Governor Zhou Xiaochuan and Chinese Finance Minister Jin Renqing. The US emphasised that market forces are important and will help China as it grows into the world’s largest developing economy, a senior treasury official said after the talks. The official said the US acknowledged China has taken steps but the US isn’t yet satisfied. Zhou, however, hinted in his speech that China will be asking for a reprieve. He did not address the issue directly, but said China needed more time to reform its economy – a position Chinese officials have maintained in the run-up to the meeting, where China has guest status.

Developing….