Policy Challenges of Global Payment Imbalances

November 4, 2004

Unedited transcript prepared from a tape recording

Proceedings:
MR. LACHMAN:  My pleasure to welcome everybody here to the American Enterprise Institute.  It's my second pleasure to welcome John Taylor, the Undersecretary for International Affairs at the U.S. Treasury for having taken time out of his schedule to make an opening address, which after that address we'll proceed directly on to our panel.  In this case, I can say, you know, without fear of contradiction of a truly distinguished on issues of exchange rates management.  We've got a wide range of different perspectives, and certainly a lot of experience.

I would just like to set the stage a little for this seminar by indicating that we had arranged a seminar on the same topic some 18 months ago, and we did so because, at that stage, we thought that the United States current account deficit did pose a real challenge to economic policy makers.  I would just say that since that time, there have been a number of developments, and I would just draw attention to those developments as way of background.

First, of course, the U.S. current account deficit, while it was wide 18 months ago, it has widened further since.  We are now running a current account deficit in the range of something like $600 billion a year, which is five and three-quarter percent of GDP.  I would note that we haven't had a deficit of this size in the United States history, at least the 120 years that I've looked back on the matter.  What is also of concern is that this deficit is occurring despite the fact that the United States isn't a particularly open economy in terms of exports.  And there are indications that if the United States continues to grow at a faster rate than Europe and Japan we'll get that deficit widening

The second point I'd note if we look back on the last 18 months is that there's been a deterioration in the financing of the United States current account deficit, in the sense that, whereas, perhaps in the '90s, a lot of the current account deficit would be -- would have been financed by foreign direct investment inflows or equity flows from abroad, we are now getting the United States current account deficit being financed largely by portfolio purchase of United States government bonds, and what is of particular note is that something like 50 percent of the United States current account deficit is now being financed by foreign central banks in general and Asian central banks in particular that has led to their holding something close to $2 trillion of United States paper, which raises questions as to sustainability.

The third development I would say is -- relates to the counterpart of the widening in the United States current account deficit that it's a reflection not so much of an increase in the level of investment in the United States as much as an indication of a decline in United States saving.  Net saving in the United States now is at a particularly low level, and we do have issue with public sector savings that would seem to need being addressed.

The last point that I'd like to make in terms of looking at how things have changed in the last 18 months is in terms of is in terms of exchange rate movement.

While we have certainly had a substantial move in the dollar against the Euro, on an effective basis, if we take all other currencies into account, we haven't had much of a move in the U.S. dollar.  It's something like less than 10 percent and this is a reflection largely of Asian central banks being very reluctant to allow their currencies to appreciate.  The fact that you're not getting much of a movement on the exchange rate raises question as to how is this going to adjust in a smooth and orderly way.

I've got absolutely no doubt that my panel is going to be discussing these issues in a heated way and that the issue of sustainability will arise.  I will not express my own view on the matter, but I would like to just recall what Rudy, the late Rudy Dornbush, who was an observer of many balance of payments crises and many situations that he thought were unsustainable.  He made two observations that I thought might be of relevance to the discussion.

First, he said that unsustainable situations last -- generally tended to last very much longer than economists who might believe in rational markets or equilibrium situations might think that they do.  So, one really should not be expecting, not be surprised, if a situation like this persists for a long period of time.

And the second observation, which I think has got pertinence today, that Rudy Dornbush made, he said that in situations where you've got an unsustainable position, what is bound to occur is that you're going to get highly intelligent economists who are going to come up with theories why this puzzling overvaluation of the dollar really does have some foundation, and why this time it's going to be different.

I only raised this because we are getting ideas floated by highly intelligent people at Deutsche Bank, for instance, that maybe we've stumbled onto a Breton Woods II kind of arrangement.

I've probably said more than I should have said.  And with those introductory remarks, it is my pleasure to call on John Taylor to address us.

John Taylor -- I'm not going to take up time introducing him as fully as might be expected, because he is so well known to everybody as a world-class academic with a highly distinguished career at Stanford University, many years in public service in different respects, and the last four years highly distinguished as the U.S. Undersecretary for International Affairs.  John Taylor.

[Applause.]

MR. TAYLOR:  Thank you very much, Desmond.  Thanks for inviting me.  Thanks for organizing a conference on this very important topic of current account adjustments and balance of payment adjustments.  I'm unfortunately not going to be able to stay for the real show, which is the panel, but just get you started.  But I appreciate the opportunity to do that.

I think the -- everybody knows that the current account and the payments adjustment and balances have been a topic of interest to international economists and policymakers for many, many years.  In fact, I'd just like to make a note that 40 years ago, actually slightly more than 40 years ago, concerns about balance of payments adjustment processes and that they were not working smoothly led to the creation of probably a number of international conferences and agencies.  And one which was created is something Working Party Three of the OECD.  It was created simply to look at current account adjustment problems.

And, believe it or not, that Working Party still exists.  I'm actually, one of my responsibilities is to chair that Working Party.  And I can tell you that the subject of global payments adjustments is still a major one, which we address in that group.  It's largely the G-10 deputy of finance international people and central bank deputies as well.

But in the 1960's, of course, the current account deficit was a focus in ways that are different today.  As Desmond was indicating that was then days of Breton Woods One, I should say, and so there's the whole notion of how you discuss the current account adjustment -- was quite a bit different, because now we have a system -- I think a smoothly working system of flexible exchange rates, largely market based, with the exception of several large countries, which still maintain fixed exchange rates.

I think the policy analysis has also changed substantially.  For example, in my remarks, I'm going to focus a lot on the savings-investment gap, in terms of thinking about the current account and thinking about how it adjusts over time.

If you look back in the discussions of the 1960's in groups such as Working Party Three, the savings-investment gap is just never mentioned, not heard of.  It's quite remarkable.  I think -- if I would put it this way a much more of a Keynesian type of analysis than we hear today, where the -- cause the savings-investment gap has a more natural supply-side feature to it.

In any case, let's try to think now about the current account we have today, and Desmond gave you the broad outlines of the numbers.  I think of the current account as increasing.  The current account deficit in the U.S. is increasing steadily, really throughout the 1990's.  In 1990, it was about one percent of GDP; in 2000, about four percent of GDP; and, as Desmond indicated, this year, although we don't have all the data, over five percent of GDP.

So, what explains this increase in the current account?  To me, the best way to think about it is by looking at the difference, as I said, between investment and savings.

When a country, like the United States, is investing more than is being saved domestically, the rest of the investment is financed and comes from abroad, and that's the current account deficit.  If you have a country which is saving more than it's investing, then there will be a current account surplus.

Now, viewed in these terms, let's just think some of the events of this year.  There was a $112 billion increase in the current account deficit in the four quarters ending and the second quarter of this year.  This is measured on national income accounts basis.

Now, this corresponded to an increase in investment in the United States of $335 billion. That outstripped an increase in American saving of $224, and therefore the current account increase.

Now, that increase in investment in the United States that occurred, the $335 billion, of course, was very important for the United States recovery this year.  Growth has been strong.  It's also important for the future, because those investments generate an increase in the capital stock, which raises productivity and brings on new technologies, et cetera.

But, as this example indicates, just this year, the increase in the current account deficit over the '90's is really a reflection of the fact that investment has been larger and growing larger relative to savings through that whole period.

So, investment remains high, and it's savings that has declined relatively speaking.  I should say if you look at the numbers carefully, you can see this investment increase now, which is substantial, it's just larger than the increase in savings.

Of course, the deficit itself implies that the foreigners are acquiring more assets in the United States than Americans are acquiring abroad.  But already, foreigners have more assets in the United States than Americans have abroad.  An interesting phenomena, the data, which many of you are aware of, that even with that net position of about two and one-half trillion, Americans are still receiving more in income than they're paying out.  And that's because of the differences in interest rates -- or returns more generally as best we can measure them, or perhaps it reflects the difficulty in actually measuring the size of those stocks.

So, that's how I think about the situation and why the current has increased is this decadent America is -- remains a very attractive place for investment.  Productivity is remarkably high in the last few years.  And foreigners -- want to invest in the United States. That's what that gap illustrates.

Now, let me talk a little bit about some of the economic policies that have been taken and will continue to be taken and indeed enhanced on in the Bush Administration to -- that are quite related to the phenomenon of the current account and to the way that I've characterized this.

First of all, in terms of the difference between investment and savings, clearly one of the -- a policy that would raise savings is a policy that is -- would tend -- other things equal to reduce the current account deficit.

Now, I say other things equal in my usual economist fashion, because it's important here.  There is not a one-to-one correspondence between national -- between, say, the government budget deficit and the current account deficit.

Indeed, during the period in the late '90's, when there was a surplus growing, and actually you're paying the surplus, that's the period where the current account deteriorated the most in recent years.  Roughly the numbers, if you look at the chart, it increased the most there.  And during the period in the last few years, when the deficit rose and now it's beginning its trend downward, it -- there was relative -- smaller increase in the current account deficit.

So, there's not a one-to-one comparison. There's not a twin deficit, a magical relationship.

Nonetheless, if you hold private savings constant or don't have it come down and don't change investment, then a reduction in the government budget deficit will lead to a reduction in the current account.

So, an important policy that's in place now, which has many attractive features, but one of them was, other things equal, will reduce the current account is this fiscal consolidation, the effort to reduce the budget deficit as this expansion continues, and, as the President said, by half over the next four years.

I think it's important to note that there is -- we've already seen with the recovery we have had the changes in the deficit.  At the beginning of this year, both CBO and the Administration, forecast a larger deficit than has occurred thus far.  It focused just on fiscal year '04 which already closed.

The Administration forecast a budget deficit for fiscal year '04 which was a $108 billion larger than actually took place.  In other words, because of the faster growth, largely because of the faster growth, the deficit came down relative to forecasts by $108 billion.  And so, those are the kinds of improvements that you're going to -- we're going to expect if spending control is maintained, and we continue to get this expansion, which I very much expect that we will.

But that's public saving.  What about private saving?  Well, private saving also is important to raise, and here there are some policies that have already been put in place that go in the right direction, help savings accounts, for example, reduce the disincentive to save, an extra reason to save.  The proposals for retirement savings accounts which the Administration has put forth, and the Treasury has done a lot of work on, another, way to reduce the disincentives to save.  And, hopefully, if we're able to get personal accounts in Social Security, as President Bush has mentioned so many times, that will be another way in which you'll have more incentives to say.

So, these are some of the things that stimulate private saving.  And they're good on their own account, of course.  These are of beneficial impact in more general form, but they do go in the direction, based on my explanation and analysis of reducing the current account.  So, this is some of the things on the savings side.

There's a whole second set of policies which I want to mention, if you like.  The first has to do with saving.  The second has to do with efforts to raise economic growth abroad, in fact make other countries attractive places to invest as well.

And here it seems to me there's a lot of progress that's being made.  I would note, by the way, that we're moving into a year of the forecaster.  Now, as the IMF says where global growth will be as high as it's been in 30 years.  Now, that faster global growth will generate demand for U.S. exports and will go in the direction of reducing the current account deficit.

There's a whole host of international engagements that the Administration has been involved with endeavoring to raise economic growth in other countries.  I would just mention a few.

One which I think is very important is how the G-7 discussions have shifted to this agenda for growth.  The G-7 agenda for growth, which really was launched over a year ago, has brought in these discussions more to efforts that will raise productivity, reduce unnecessary regulations, reduce marginal tax rates, all the things that induce higher growth on the structural side, and that's really where it's needed in much of the G-7, certainly Europe and Japan.  And those will raise economic growth and reduce the current account.

One important bilateral engagement on growth is the U.S.-Japan partnership for growth, which President Bush and Prime Minister Koizumi set up in 2001.  That led to an engagement on economic and other areas.  And the economic side I can speak to.  That led to an engagement with Japan which I think has been helpful to Japan in dealing with the deflation problems and not performing own problems, and ultimately it got Japan growing in a more sustainable than it has for a dozen years.

There's other initiatives like that.  There's something called the Group for Growth between the United States and Brazil, where we meet and engage with the Brazilians about how to raise economic growth on the structural side.  And there's initiatives with Mexico and other countries.

There's the development, the DOHA, the development round, of course, which is aiming to raise economic growth. And I would just mention on the -- although we don't focus on it in these kinds of current account discussions, there's a lot of opportunity for higher growth in the poorest countries in the world.  So, even the Millennium Challenge Account, which aims to raise economic growth in the poorest countries, ultimately will be a way to put -- something to put on the list in terms of raising economic growth in all countries.

Now, all those things I mentioned are good in their own right.  They're good policies to do.  Raising economic growth is good for reducing poverty.  But they also have the benefit of reducing this current account.

The third set of policies which I want to mention relates to the exchange rate flexibility.  And we certainly have put a lot of time into this in recent years.  Of course, there is a considerable degree of flexibility compared to when WP3 as first put together, and we had the Breton Woods system.  But there are still large countries, including China, which have a fixed exchange rate vis a vis the dollar.

So the third part of the overall set of policy, which again I think has benefit on their own rights, but also can help with these adjustments, is to urge exchange rate flexibility in China.  Now, this is an initiative which does not involve just the United States and China.  It involves many countries in the world, including the whole G-7.  In this case, I'd like to just read from I think important language from the G-7 communiques of this year, in Boca Raton in the winter, and Washington, just a little over a month ago.  And the language from this communique says, and I'll quote now: "more flexibility in exchange rates is desirable for major countries or economic areas that lack such flexibility to promote smooth and widespread adjustments in the international financial system based on market mechanisms."

So, this is an effort, if you like, to work towards the greater degree of flexibility that I think will help with these kinds of adjustments in general.  We have been engaged with the Chinese on a bilateral basis and multi-lateral, as I've just indicated, to work towards this goal, which is, in our view, in the interest of China and the whole world economy.  Secretary Snow traveled to China.  The President engaged with the President.  The Secretary of State has discussed the importance of opening and moving towards flexibility.  And, of course, in October 1st of this year, the Chinese met for the first time in history with the G-7, discussed exchange rate issues and other issues related to opening of the financial system.  I happened to be at that meeting.  It was a very candid exchange, and I think it shows the kind of engagement that is ultimately going to improve flexibility and improve adjustment.

Most recently, the Peoples Bank of China announced an increase in their one-year lending as deposit rates . That kind of stuff is consistent with the move towards flexibility of exchange rates, and we think that represents a significant step of China towards a more market-based monetary system.

So, anyway, just as -- in a nutshell, those are three areas of things that are going on that are in the direction of trying to address the current account.  And all of them, I had -- I don't want to underemphasize this, all of them are good in their own right.

And I say that because a lot of the times when people raise questions about the current account, there's sort of some implicit request to do something that might not be so good.  And so, I think you always have to ask when you hear complaints or recommendations or ideas about the current account that you filter out the policy that might be so good, such as something that would lower economic growth.  Why would you want to lower economic growth and do something harmful in order to improve the current account deficit.  So, this is -- this is what we stress here in these policies.

Now, let me say -- this is not the only group I've discussed policies like this with -- I discussed it with ex-financial experts in other countries, with ministers, and a whole government at many times, and we do realize there are concerns that are out there about the adjustment of the current account, and how long will it take these policies to come into place.  Maybe Desmond's call for this meeting, as to say, something related to how long will these policies actually take to really have the impact which they will have and should have.

And here I think it's important to mention, and so I'm going to conclude with several points: that even if they take some time, there's no reason in the meantime to think that there's going to be problems financing or adjusting the current account in a smooth and adequate way.  And I want to spend a few minutes on this very important issue, 'cause, after all, groups like this Working Party of Three, which I began with, were created to address questions and concerns about balance of payments adjustments.  So, it is an issues which a responsible policy maker should think about.

The first thing I want to say in thinking about financing an adjustment is to put the U.S. current account in the context of the enormous amount of capital flows that are going through our international financial system in a very smooth and market-oriented way.

And to do that, I actually want to work through a table I've distributed to you.  So, if you could take a look at the table.  I know it's unusual in a set of remarks like this, but to refer to a table, but the panelists don't have the table, which is essential.  But what I want to do is look at the most recent data that we have on the current account and its financing in the United States.  And I've just taken a table from our international accounts, and what we've done is circled a few numbers, the kind of numbers that actually Desmond was referring to in his remarks.  And then each of the circles is labeled with a little box to bring your attention to it.

So, what we're looking at is what happened between the first and the second quarter of this year.  And you can see at the bottom that the box labeled one, that the current account deficit, increased from the first quarter to the second quarter by $19 billion.  That's what that circle says: $19 billion increase. And people are concerned about how does this get financed?

Well, let's think about how it was "financed" -- that increase was financed in this period of time.  Well, let's first look at official purchases of U.S. assets, because people are talking a lot about official purchases these days.  Did official purchases increase to take care of this increase in deficit?  No.  Official purchases declined.  In fact, that shouldn't be surprising if we look in closely at the operations of central banks, because the Bank of Japan intervened heavily in the first quarter of this year.  They stopped on March 16th, and have not intervened since.  They did not intervene in the second quarter at all.

So, for that reason and other reasons, official sector purchases of U.S. assets declined by $54 billion.  You can see the circle identified by box two, decline in official purchases.

That goes in the wrong direction.  Well, it must -- maybe the private purchases from abroad of U.S. assets financed that increase in deficit.  Well, that's box number three.  Well, no.  Private purchases of U.S. assets also declined by $126 billion, and you can see that that obviously goes in the wrong direction, too.

So, for those of you who think about how current account deficits are financed by looking at purchases by the official sector of U.S. securities or even purchases of foreign -- of U.S. securities by the private sector will be looking for something else.

And, of course, that something else is box four.  And you can see what happened in the first quarter, is Americans purchased a smaller amount of securities abroad, something you don't hear about much about.  It's not that they decreased their purchases.  They increased their purchase by $118 billion.  It was just smaller than the amount of purchases in the first quarter.  So, the amount of purchases declined by $188 billion, and that was effectively how things were financed.

So, this is an illustration about how when you think about financing, it can be extraordinary misleading to think about ratios such as the fraction of the current account that's financed by the official sector.  I have the numbers here of what fraction of the current account was "financed" by the official sector in the first quarter of this year.  You can do the arithmetic yourself.  92 percent.  In other words, the ratio of official sector purchases to the current account deficit in the first quarter was 92 percent.  It fell to 50 percent in the second quarter.  Oh, it went from 92 to 50.  That must have caused some turbulence.  Well, it didn't cause turbulence.  In fact, this has been a very -- period of stability and low volatility and in fact declining long-term interest rates during this period of time.

And, of course, the reason why ratios like that are really not the thing to focus on is that there's so many other flows moving, and in this case the simple fact that Americans purchased securities abroad.  Not decreased their purchases.  They purchased fewer made all the difference.

So, I think when you think about financing, think about it in this very, this is a complicated table perhaps, but I don't think there's any alternative to getting the numbers out and looking at what's happening rather than to focus on a few ratios that might suggest scare stories, if you like.

There's a lot of other questions, good questions, that people raise about current account adjustment.  One is that some econometric models now are used to show that the size of the currency adjustment has to be large by a given change in the current account.  We use those models in our discussions.  In fact, in this WP3 Group I mentioned, Working Party Three, we look at models like this all the time.  And what you have to realize is that frequently these simulations are done with the exchange rate changes in isolation, not with the adjustment -- all the other adjustments that would take place, such as I've illustrated in these opening remarks, the changes in savings patterns, the changes in investment that take place.  So, you have to look at those with a grain of salt.

Moreover, there's no magic target or level for the current account to aim for.  So, frequently these simulations are done as how much of the currency change or adjust to give you a certain current account adjustment.  But those choices of what the current account level should be are arbitrary.
` Another question that people ask a lot is this longstanding empirical observation that the U.S. income elasticity of demand for imports substantially exceeds our trading partners' income elasticity demand for exports.  This has been a finding that's been around for many years.  I should say if you look at more recent research, as we've tried to do in the Treasury and other places, the elasticity asymmetry seems to be declining.  If you look at the 1990's that's especially the case.

And to me, that's not particularly surprising because as countries deregulate, open up their markets, have fewer regulations, especially in the consumer markets, you could very much expect that your income elasticities would grow, and, in fact, that's what we've been observing in Japan, and you can focus on a specific action that Japan has taken place to make that happen.  So, these elasticities I think are changing as well.

So, let me not go on too much longer.  I actually have to go back to work.  But what I've tried to do is illustrate in these remarks -- is -- let me just summarize the following things.

First, give you an explanation of how we think of the current account, this gap between saving and investment.

Second, illustrate the policies, the very positive policies, that are actually -- we're taking on to try to deal with this.

Third, address some of the concerns that people have raised, the good concerns that people have raised as objectively and informatively as we possibly can.

Ultimately, I believe this faster growth in the rest of the world is one that we need to keep stressing.  It's beginning to come about.  The fastest growth in 30 years globally is a good sign.  That's not trade-weighted for the U.S -- the growth on a trade-weighted basis; that is, U.S. trade-weighted partners is somewhat lower in the U.S. so far, but it's picking up.  And when it does, I think you'll begin the improvements in the current that are more sizeable in a long time.

And one long lasting, one last point, and maybe long lasting point to conclude on, I believe the current global expansion that we're seeing now has all the elements of a very long expansion.  It is balanced in the sense inflation is low, interest rates are low.  There is no economy that's in recession.  The Chinese economy is being slowed down ain a responsible way.  So, there's an element here of sustainability in this global expansion that I think is very promising for the future.  And if that's the case, it should certainly begin to have impacts on the U.S. current account that would make people feel a little more relaxed.  Thank you.  Okay.

[Applause..]

MR. LACHMAN: Well, I would just like to thank John Taylor for those remarks.  And we'll now start, now turn to the panel.  And I'm going to have them speaking roughly in the order in which they're sitting.

John Williamson will start.  John Williamson is probably known to everybody in this room as the one who coined the phrase the Washington consensus many years ago, but he's done a whole lot more than that, focused on exchange rates for much of his career, and is currently a senior fellow at the Institute for International Economics.  John Williamson.

MR. WILLIAMSON: Well, thank you very much.  It's a pleasure to be here.  Let me start off exactly where John Taylor ended.

In many ways, this is indeed a balanced world expansion, but there is one way in which it is very clearly unbalanced, and some of us think that that constitutes something of a threat to the future of the world, and that is this massive United States current account deficit.  And the fact that this is larger than any large country has I think had in the lifetime of any of us, and the lack of confidence that it can be perpetuated indefinitely.

Why did this come about?  Well, I think the -- I don't actually think that we view these things so differently to what we did in the 1960s.  If you go back and look at the WP3 discussions of the 1960's, I'm sure that savings and investment will figure very prominently.  I do think that there are two important differences between the discussions and the discussions now.  One was, indeed, mentioned by John Taylor, the fact that we now have a flexible exchange rate system, and many of those discussions in the 1960's were simply civil, because they would say it's important to have an adjustment, and then there would be no adjustment instrument.  And now, the adjustment instrument is there. We do have a flexible exchange rate system.  So, that's one very important difference.

In terms of savings and investment, I think those did figure prominently in the 1960's, but I think they were viewed almost exclusively from the demand side, and now, they are viewed, well, some of us at least like to look at them from two sides.  We think both demand and Keynesian demand and traditional structural development, and you have to look at both factors.  And that's what one does.

So, of course, it is true that when there's a current account gap, one can look at it as a savings-investment as one can look at it in terms of the methods of financing, which John also did.  But in terms, when one comes to ask what drives those changes, then I think one is driven back to talk about the value of the dollar relative to other currencies, the fiscal situation in the United States as the biggest policy influence over savings rates for this, and then also the weak demand in Europe and Japan.  That also is something that John mentioned has to say it's correct.

So, I think it's not quite as unambiguous as he suggested; that faster growth necessarily -- faster growth abroad necessarily improves the U.S. current account situation.  Again, one has to ask is this demand or supply.  If it's a supply increase that's providing additional capacity to export, and this may well be that that's not going to lead to an improvement in the U.S. current account position.  So, I think that is something that's relevant, but not quite as unambiguous as you suggested.

Let me spend just a moment or two talking about projections of the balance of payment situation.  The projections -- we have two competing projections that have been produced in our institute in recent months.  The most pessimistic one is by Kathy Mam, who has the U.S. current account deficit with the present exchange rate and present perpetuation of recent growth rates expanding to something like 12 percent of GDP by the year 2010.

Bill Kline has a competitive model, and he is rather less pessimistic.  He gets -- but he also gets an increase in deficit rather than a decrease in deficit even after the reduction in the dollar of the past two years.  His figure is something like 7.6 percent of GDP by the year 2010.  And that, again, is assuming a perpetuation of current exchange rates and growth of three and one-half percent in both the United States and the rest of the world.

Well, should one worry about this?  You may have looked at your Financial Times on Monday, in which case you will have had the opportunity to see two very different views as to whether one should worry about this.

On the one hand, there was Dick Cooper saying nothing to worry about.

And on the other hand, there as Murray Obstfeld of Berkeley and Ken Rogoff now at Harvard, formerly chief economist at the IMF, who were saying -- who were full of gloom and doom.

Now, I think that -- I would have to say that Fred Bergsten [sp?] and I who have edited this conference volume for the recent conference that we had with a remarkably title to this afternoon's, and you have in your paper -- in your pack, the summary that I think that our view one would have to say is closer to that Rogoff and Obstfeld.  But at the same time, one should not rule out Dick Cooper's sort of projection.  I mean, slow adjustment of this type is conceivable.  Things might work out as comfortably as he said.  I want you to note three things about his projection, however,

First of all, he starts off assuming a current account deficit of the United States this year of $500 billion, which is about 4.2 percent of GDP, and that's a good bit less than where it looks like it's going to come in as our Chairman already said.

It looks like it will come at something like 5.7 percent.  And, so, it effectively -- even -- one would need a fairly vigorous adjustment program to get down even to his starting point.

The second point to note is that from then on, one would have to be continually the trade deficit every year if one was to keep the current account deficit equal to $500 billion a year, because while this is true, as John Taylor said, but still last year the receipts on investment income account were greater than the payments.  That is not going to remain true indefinitely if the United States continues to rack up a current account deficit of $500 billion or $600 billion a year, debt service is going to increase in the medium term, and that means that to keep a constant nominal deficit, even as a proportion of GNP, let alone a declining proportion of GNP, as Dick Cooper has it, will require continuing adjustment year by year between now and 16 years time, when he has the debt to GDP ratio at a maximum of 42 percent GDP.

The third point to note is that, of course, there is a danger of crisis inherent in that situation.  Just about -- it is very difficult to believe that the danger of a crisis doesn't increase as a country's foreign indebtedness increases.  And if that's all you have to believe, you don't have to believe that a crisis is inevitable or let alone that you can pick the date.  You simply have to believe that a crisis becomes more likely in order to think it would be better to have a prompt start to adjustment rather than a delayed start.

So, in answer to your first question: how soon?  Like now.  The sooner this adjustment process tarts, the better.

Finally, then the question: well what to do?  What should be the elements of the adjustment process?  I think it has to involved as far as the United States is concerned both the dollar and fiscal policy.  Fiscal policy, I don't myself think there's any realistic alternative but to rescind some of the tax concessions that the people like me have had in recent years.  But that's one reason that I'm pessimistic as to whether we shall, in face, see the adjustment program is that not I'm not sure that the political system is going to deliver that sort of fiscal adjustment that we need.

I think the chances of any significant cuts in government expenditure strike me as -- I can personally think of ways I would like to cut government expenditure, but I can't.  So, I feel any confidence that that's going to happen.  So, I think if anything is to happen on that side, it almost certainly has to be on the tax side.

In terms of the dollar, it's not a policy variable.  That's absolutely true.  We have -- it's a  floating exchange rate, but that doesn't mean that not anything can be done.

The first thing that can be done is to change what is said about the dollar.  Now, it is possible that that will have no effect at all, but it is not going to strengthen the dollar if this ridiculous rhetoric about a strong dollar is dropped once and for all.  It's not going to do any harm, and it might conceivably do some good.  We actually have a paper in this volume, in which Marcel Fratcho [sp?], an economist at BUCP, tried to look at whether jawboning has an impact, and he detected an impact.  I don't think anyone could say that it's a very reliable impact.  I don't think you can turn jawboning into a policy variable, but it's something that should be changed, which is to stop talking about a strong dollar; one should recognize that a realistic value of the dollar is going to be an essential part of the adjustment process.

We have a lot of discussion in volume about how much further the dollar would have to fall.  As of the date of our conference, we think it's somewhere in the range of 10 percent to 20 percent.  We had some people going as high a further 20 percent.  Other people as low as an additional 10 percent.  But everybody in terms of the overall dollar value was in that sort of range.

My own best guess would be somewhere in the middle of that, maybe 15 percent, maybe a bit more; something of that sort.  That's what one would like to see, but it's really not a policy variable we know that.

What can be done?  Well, maybe intervention is worth something, but the more important element is what John Taylor already discussed, namely the fact that there are some Asian countries that currently peg their exchange rates, and the bulk of the additional adjustment is going to have to come vis a vis the Asian countries.  There's no doubt about that.  The Euro has already appreciate a long way.  The pound. The Canadian dollar.  The Australian dollar.  These other currencies have moved a long way already, and I think one cannot say that they won't have to go any further.  I think they probably will have to go some further, at some stage.  But the big adjustment is going to have to be against the Asian currencies, and it should be a matter of priority to try and get them participating in the adjustment process.

Now, there is one aspect of Treasury's policy towards China that seems to me to have been extremely unconstructive.  John Taylor didn't mention it this afternoon.  I don't have any quarrel with what he said, but I do think that Treasury has made a bid mistake in urging the Chinese to go to an agenda of free capital movements and freely floating exchange rates.  They are not going to do that in short run.  There is much more chance that they would react positively to a suggestion that they devalue; that they go to a system of limited flexibility as a way of learning to float.  Other countries have done this and moved to a floating system without a crisis.  And I think that sort of agenda would have had more chance than the one that the Treasury has tried to sell to them.

I think that's -- the other aspect of adjustment is indeed trying to persuade other countries to grow faster, and here I frankly think it's the important part of the agenda from the standpoint of facilitating U.S. balance of payments adjustment is old -fashioned demand stimulation.  I think it is getting demand to grow stronger.  I mean, if one wants foreign countries to grow faster, that's admirable, but getting them to grow faster on the supply side probably doesn't do a lot for the U.S. balance of payments.  It does much more for their welfare, and so, it's a good agenda, but it's not nearly

[Tape flip.]

-- I think has to focus primarily on the dollar and on U.S. fiscal policy.

Thank you.

MR. LACHMAN:  Thank you very much for those remarks, John.

Our next speaker is David DeRosa.  David DeRosa has been [inaudible] in different respects.  He's written widely on exchange rate policies and is associated with Yale University.  I call on David.

MR. DeROSA:  Well, if the current account deficit is going to 12 percent, then I know what I'm doing.  I'm going to buy up the shares of those companies that make those really snappy customs inspector uniforms.

But, seriously, the issue of what we're talking about here is that the U.S. is running these large current account deficits; to put it another way, capital is flooding into the country.  And curiously enough, if you look at the most recent just arrived World Economic Outlook, September 2004, it contains forecasts.  The forecast for 2004 as a percent of GDP, 5.4 percent, not much change in the forecast for 2005, 5.1 percent.  Doesn't look like, according to these forecasts, anything's going away soon.  And if you look in these books, if you can just sort of see this, I'll tell you what this is.  You get sort of seduced by this diagram, and it shows Asia and fuel exporters in the Middle East, other countries, Western Europe.  And it looks like--you know, you see all these arrows pointing into the U.S. and capital flows, 2003, $550 billion.  And you look at this and you say, My God, with these numbers, just based on the numbers, there has to be some adjustment mechanism.

But you sort of lose sight of some basic questions.  At least they're questions to me.  Maybe you know the answer.  But for one thing, what does it mean to have an unsustainable level of a current account deficit?  Who's to say what's unsustainable beyond whether or not investors continue pouring money into the country?

Now, of course, economics is full of examples of convexity arguments.  You saw it in basic microeconomics with ISO curves for indifference curves for investors and that there has to be some happy--preference for like a happy medium.  But I've always wondered this.  If you have floating exchange rates, who's to say that there is an adjustment mechanism on a large country that has a large current account deficit?  And, you know, I've scoured through books and I don't see--it's true that in the old days of the gold standard--and maybe this is where this is sort of a remnant of it.  You had  (?)   flow mechanism.  You say all the gold is going to move in opposite directions and stuff like that.  But is this really a law of economics or is this just a presumption that because it's a big number historically speaking there has to be an adjustment?

I don't know that there is such a mechanism.  I don't know that there is such a requirement.  And if there were, I would want to know this:  What size deficit equates to what size movement in exchange rates?

Secondly, what's the stopping rule?  If there is some adjustment mechanism through exchange rates and through income or through price levels or whatever, is the stopping rule that the deficit goes to zero?  And if so, how fast does it go to zero?  So we really don't know except by some historical anecdotes that exchange rate movements will actually follow current account deficits.

Now, if you look at an OECD paper by Brook, Settlow, and Olivad (ph) that came out May 18, 2004--you can find that easily on the Internet--they talk about a study they did that the shocks--so they're implying that because of the size of this deficit there are going to be these shocks, and they list them:  it's dollar depreciation, fiscal consolidation, and an improvement in non-price competitiveness of U.S. products.  "Our key conclusion is that the shocks would have to be very large in other to materially reduce the U.S. external deficit."  Hmm, let's put it this way:  Maybe that means they're not going to happen.  And they're not predicting it.  They're just doing this econometric study.

This year, Fed Chairman Greenspan gave a speech--I'm going to refer to it a little later--and cited a paper by someone who works at the Fed, an economist, Caroline Freund (ph).  This lady went back and did studies of current account adjustments.  So looking at the times when there was a, quote, adjustment, found the adjustment typically happened after the current account has grown four years in a row and reaches 5 percent of GDP.  That implies a real depreciation of 10 to 20 percent and slow growth in real income for the next three years.

I don't have any problems with what this economist did except to point out that it would be tempting to look at this and assume that this means an adjustment must happen.  She's only looking at cases where there is a so-called adjustment.

So if you put it another way, not just a macroeconomist, what would a financial economist say, somebody who's looking at this as an investment decision?  The thing is you don't know which side the driver is coming from.  Is it coming from a savings imbalance?  Or is it coming from the fact that the United States over the long run presents an extraordinary--apparently an extraordinary investment opportunity?

Now, that said, I understand that the central banks have been footing the bill, but nonetheless, an awful lot of foreign money has come into the economy.

As of the election results, essentially--let's put it this way:  If you really want to know what's going to happen to the current account deficit, you have to make a forecast of whether Bush's policies are going to actually succeed, whether or not these tax policies are going to succeed.  And, parenthetically, by having Kerry not get elected--and I don't mean to get political here--you probably dodged a war of words on the dollar a la Senator Bentsen or Secretary Bentsen and Mickey Cantor.

Now, so what's driving the process?  Is it something in the United States, or simply that it's a better investment opportunity?  Well, here's something special about the dollar.  The dollar is not only the world's reserve currency, but I would say it has super-reserve currency status.  The dollar has held this status since the creation of the Bretton Woods agreement.  On the most basic level, it means that foreign central banks like to hold assets denominated in dollars, and usually these turn out to be U.S. Government notes.  But it means a lot more than that.  Reserve currency meaning the reserve--the structure of central bank reserves.  The dollar is still the main currency of capital markets, and if you look at--there's always an interesting--the Bank for International Settlements every three years, in coordination with other central banks, does a study in the month of April on foreign exchange trading.  They recently released the new study.  So this goes to 2004, and I find this to be very interesting.

What percentage of all transactions involve the U.S. dollar?  What percentage?  And the answer is in 1989 was 90 percent.  FX is a dollar game.  In '92, it dropped to 82.  It then rose in' 95--it's every three years--to 83.3; in '98, 87.3; and in 2001, 90.3.  And it dropped a little to 88.7 in the 2004 study.

The dollar is still what trades in the foreign exchange market, and not surprising, world commodities are primarily denominated in dollars.

The same fate was not shared by the EMS, the euro, in which trading--percentage of trading dropped from 2001 from 37.6 to 27.2 percent.  That doesn't say--that's not a good sign for the euro becoming a reserve currency in a major way, and also the yen continued to drop now to 20.3 percent.  Simply put, it's very hard to take away the dollar's reserve currency status.  Perhaps you could say that the EU blew its chance when it decided to go on this enlargement program to 25-plus nations.  And the Bank of Japan, the yen, we're going to take on the dollar, it would have happened in the '80s--the '70s and '80s, right?  It's not going to happen now.  It's not going to happen now.  That train has gone.

The greatest single threat, however, to the dollar, the thing that could generate a very--a short-run substantial drop in the dollar is if the Asian central banks not just reversed their policy of accumulating dollars but began a public sale, a liquidation of their dollar portfolios.  I don't see that happening.

Now, as for China, it's now in a precarious position that it has so many dollars that a decision to revalue the RMB presents a portfolio problem.

Now, what about--you asked about the G-7, right?  Should the G-7 get involved?  I sincerely hope not.  I hope they don't touch this problem.  Plaza failed to coordinate sterilization.  In my mind, the   (?)   didn't work.  I hope they just let this go, don't touch it, guys.  Don't touch it.

Now, here's an interesting quote, and then I have some conclusions.  This came from Fed Chairman Alan Greenspan, and the title was "The Current Account," and he gave this on March 2, 2004, and the Economic Club.  There are a couple of things in here.  It's actually kind of an interesting document.  "My experience is that exchange markets have become so efficient that virtually all relevant information is embedded almost instantaneously in exchange rates to the point that anticipating movements in major currencies is rarely possible."  He became an efficient markets advocate.

The exception to this conclusion are those few cases of successful speculation in which governments have tried and failed to support a particular exchange rate.  That's absolutely right on the money, as far as I'm concerned.  Nevertheless, despite extensive efforts on the part of analysts, to my knowledge no model projecting directional movements in exchange rates is significantly superior to tossing a coin.  Bad news for currency strategists, right?

I am aware that of the thousands who try, some are quite successful.  Some are winners of coin-tossing contests also.  The seeming ability of a number of banking organizations to make consistent profits from foreign exchange trading likely derives not from their insight into the future changes in rates, but from market making.  Another interesting concept.

One more thing from the Chairman.  There may seem a rather surprising conclusion given that so many commentators apparently believe they know the real value of the dollar must decline further because of the record current account deficit in the United States.  It should be sobering to recall that three years ago, February 2001, to be exact, for similar reasons a vast majority of panels of forecasters were projecting a lower dollar against the euro.  In the subsequent 12 months, the dollar rose nearly 6 percent against the euro.

I draw the following conclusions from this topic.  How long can this continue, meaning a rising current account, without whatever an adjustment is?  My answer is a long, long time.  A long, long time.  And this current account situation, does this mean the dollar must drop like a stone?  And my answer--I look at this and I say, Don't count your chickens.  There are lots of reasons to be agnostic.

MR. LACHMAN:  Thank you, David.

I'm going to ask Allan Meltzer to talk from where he's sitting right now, and Allan Meltzer, it's a pleasure to have him as a colleague at the AEI.  He's pretty well known as a monetary policy historian, policy adviser to many governments, and a distinguished professor at Carnegie Mellon.

MR. MELTZER:  Thank you, Desmond.

At the end of September, note these numbers, because a few years ago I think most people predicted that we would never get there:  China held $515 billion.  People like John Williamson, for example, I'm sure, said the dollar then was unsustainable.  Plus Hong Kong, $118 billion; Singapore, $103 billion; Taiwan, $233 billion--that's a tiny country.  India, already up to $113 billion; and Japan with a modest $810 billion.  And all of them are continuing to grow.

Now, all recent positive current account balances in these countries, most of them are between $25 and $50 billion a year, so they're going to add to their holdings.  And elsewhere you see that Japan's current account surplus is $150 billion, Germany's is $90 billion, and the United States, which finances--or which provides the market for most of these countries, has minus $580 billion, the 5.5 percent of GDP that you heard about before.

The first forecast for 2005 is that all will remain in about the range they're now in.  Is this a crisis, a potential crisis, a future crisis in the making?  I'm much more with David and John Taylor.  I'm going to begin with how did we get here.  Remember the Committee to Save the World?
They were on the cover of Time Magazine.  This is the overhang of that Committee.  The current account deficit went from $150 to $450 billion now to $550 billion.  Why didn't it reverse?  I think there are two principal reasons:

One is because, as David said or John Taylor said, people want to invest in the United States, but that's not the only reason.  An equally powerful, maybe more powerful reason, is what I describe would call modern mercantilism.

China's main problem is not its exchange rate, at least not as seen by the Chinese.  What they see as their problem is that they have to create 150 to 200 million jobs.  I mean, to put that number in perspective, that is, they have to add the size of the U.S. labor force to their current labor force, and they want to do it as quickly as they can.  So they practice export-led growth.  They have capital investment running at 40 percent of GDP average for the last 10 years.  I don't think there's ever been a case of any country which ran 40-percent investment as a percentage of GDP for 10 years before.

Now, the cost to them is that they have to continue to buy U.S. assets, treasury bills, for the most part.  And they lose on those assets the opportunity costs which will be rising, we expect, over the year, and they could invest it in something more productive, perhaps, in China.   That's a small cost to them compared to the waste of capital from building the many buildings that they have in China that are unoccupied and will never perhaps be occupied or at least not in the near term.  And they're building those buildings to create unemployment, that is, their being mercantilistic.  With a current account surplus, they get productive investment.

The productive part of the investment comes from foreign and, to a very considerable extent, U.S. firms to who want to export to the rest of the world and to the U.S. economy.  That's the Chinese problem, as seen, in my judgment, as seen by the Chinese.  It is not about the current account deficit.  As I'll mention in a few moments, people got very excited because they moved the interest rate by 27 basis points.  I think that's like the Fed moving the federal funds rate by a quarter of a point, except we do it regularly.  They don't do it very often.  Twenty-seven basis points is hardly going to do very much.  As a matter of fact, in my opinion, it's going to do absolutely nothing, but I'll come back to that.

So other people point to the U.S. budget deficits, which they say are a big part of the problem, and no doubt the financing of the U.S. budget deficit does have something to do with the current account deficit, but we're fighting a war.  We have a homeland security problem.  Is that where we're going to make the big expenditure cuts.  I don't think so.

We had a recession.  The person had a tax cut.  I was amazed when I debated Roger Altman a few weeks ago, and he told me about the fact that this tax cut went to the rich and that the rich were, therefore, the people who should be taxed.  He was taking the Kerry position line.  I asked him, as an investment banker, what did he do with his money.  Did he put it in a mattress?  Is that what Senator Kerry did or did he, in fact, put it in a bank and help us to have zero interest rates which created consumer spending here and financed automobiles.

We went through a recession, in which unemployment rose very little, investment declined a lot, profits declined a lot.  Couldn't that have something to do with the fact that we had very low interest rates in this country and that the money that went to the so-called rich also financed, as an investment banker might know, financed private spending in the U.S. economy.  He didn't answer the question for reasons which I think you can imagine.

So I don't buy many of these arguments.  Many people look at the current overvalued dollar; that is, they think the market has perhaps got it priced wrong, but the Chinese look at the unemployed labor force, and we should understand that the jobs, jobs, jobs, which is a political slogan that has great appeal here, that those same pressures exist elsewhere in the world, too, and that the Chinese have a much perhaps deeper reason for worrying about jobs, jobs, jobs than they do for worrying about their exchange rate.

Having dealt with Oriental governments, I learned long ago that you really want to think about--that they don't like to say, no, when you say to them, you should revalue your exchange rate.  So what they do is they say, yes, we're thinking about it, but they follow what I refer to as the Paul Samuelson rule.  Never give the price and the forecast in the same sentence with a date.

[Laughter.]

MR. MELTZER:  So, looking at this from a U.S. standpoint, four facts seem to me to stand out:

First, this crisis is a crisis in which we get valuable goods, and we offer the rest of the world paper.  Most expect, here, at least, that it's going to depreciate, the paper is going to depreciate.  No evidence that that deters.  They must read the newspaper.  So they know that people, many people here think that the dollar is going to depreciate--Ken Rogoff, I mean, people have been saying that for years.  There's no evidence that they don't know that we think the dollar is going to depreciate, but they continue to buy this paper and to give us valuable goods and services, especially goods, in exchange for that paper.  So are they irrational or are they pursuing a goal that is different from the goal that we think they ought be pursuing?  They made a goal of increasing their employment.

Second, the U.S. record, which surely supports the idea that paper may be worth less at some time in the future.  The yen, let me remind you, began the post-war at 360 to the dollar.  It's now less than 1-10.  Did that stop the Japanese from buying dollars?  No, it hasn't stopped the Japanese from buying dollars.  They continue to buy dollars and, in fact, they probably bought more in the year ending March 15th or whatever the date John gave us than in any other year in their history, and they have stopped buying them now because the exchange rate there, their exchange rate, has stabilized, but they too were interested in coming out of the recession and didn't want to see their currency appreciate.  So they too chose employment over exchange rate.

Third, we do have a World Trade Agreement with the Chinese which hasn't been mentioned.  They've offered to open more sectors of their economy to foreign direct investment, particularly insurance, telecoms and banking.  So U.S. investment in China is rising.  And with the opening of new sectors, it's likely to continue to rise, and with more U.S. investment in China, that will probably mean more current account deficits.

Well, of course, the people who, when you tell them, of course, that we get valuable goods from the rest of the world and then give them a fair amount of depreciating paper, they say, well, of course, that's true, but how sustainable is that and for how long?  I believe that's an economic question, but that it has a political answer.

The likely outcome?  Continued small steps toward protection here, particularly as the textile agreement comes off.  Those will be politically popular here, and they'll be acceptable, acceptable to the mercantilist overseas because they understand that they have plenty of protection of their own.

Depreciation of the dollar?  Perhaps.  Higher saving rate here?  I don't have much hope for that.  Americans are consumers not savings.  We have a symbiotic relationship with the rest of the  world.  We consume, and they produce.

[Laughter.]

MR. MELTZER:  They save, and we invest.

The current account deficit and the capital inflow sustain investment here.  It's not as high as it was a couple of years ago, but that's because we've been through an investment glut, especially because we had a high investment period in the 1990s capped by a lot of investment for Y2K.  Remember Y2K?  Everybody who was going to buy a computer in the next two years bought it just before Y2K.  So we've slowed down, but that's a temporary bulge, and we're going to have more investment, and the foreigners are going to help us to improve and sustain the above long-term average growth of the U.S. economy.

The pessimists have to answer this question.  First, these questions:

Would the U.S. be better off with a smaller deficit and a substantially lower investment in income? which is what they are advocating, although they don't mention the second.  I don't think so.

Would the world be better off if the U.S. had a smaller investment and grew more slowly?  Like John Taylor, I don't think so.

So the economists' approach to this problem is, rightly, to find an optimal solution, but this is a problem where the politicians as usual are in charge, and several more important issues with China than the exchange rate, like Taiwan, North Korea.  The trade imbalance is in third place.

For the politicians, the obvious solution to this problem is to kick the problem, as with most problems, is, if you have to do something, the best thing to do is to kick the problem down the field so the next guys will have to take care of them--a little protection, perhaps a little depreciation, a lot of hope for recovery in our main export markets.  And that's what we probably will do.

The final word, my final word is China raised the interest rate by 27 basis points.  What is the importance of that?  Answer: Mine, none.  They have a fixed exchange rate.  They can't control saving and investment.  Will they put on tighter controls?  That's the only way in which they can make--the higher interest rate is just going to attract more capital.  The capital will come in despite the controls that the Chinese have.  So, if they want to make the higher interest rate effective in slowing down the capital inflow, they're going to have to tighten controls even more, either that or they're going to have more inflation.  You can't change the interest rate in a fixed exchange rate system and just expect that it's going to work.  It's not going to work.  It's just going to attract more capital.  So the inflation will get China to move, if they haven't, but I doubt if 3 to 4 percent, which is where they currently are, is going to frighten them into doing very much.

My best guess, they will put on more internal controls before they will to revaluation.  And I remind you, in closing, of the Samuelson rule, which is what the Chinese practice.  Never talk about the amount that you're going to appreciate the exchange rate or the date on which you're going to do it, but talk a lot to satisfy people that you are going to do it.

Thank you.

MR. LACHMAN:  Allan, thank you very much.

I'll ask Tom Byrne to say a few words, and he'll be focusing more on the Asian side.

MR. BYRNE:  Yes, I was asked actually [inaudible] China and Japan, and I'll do that.  I'll follow what Professor Meltzer had said and talk about China's role and also Japan's role, assuming, in the context, do they have any--can they contribute to this international adjustment of the large U.S. current account deficits?

Well, assuming that there is a need for this, I'll just say that I don't think they will have a large role in contributing to any adjustment in the near future.  They certainly haven't in the past.  And the reasons for this is because they have their own internal prerogatives or imperatives to take care of, and they don't see the exchange rate as a major solution, at least an exchange rate adjustment, as a major solution.  In fact, it could be an impediment to their internal imperatives.

Starting with China, I have to agree fully with Professor Meltzer in that growth and stability are the strategic policy objectives of the government.  The use or nonuse of all policy tools, exchange rate policy, interest rate policy, are examined in that context, but certainly the overall prerogative is growth with stability in the system, both financial system and macroeconomic stability.

An interesting feature about the Chinese economy since the Asian crisis is that exports have become a much more important component of GDP and GDP growth.  The share has just about doubled since 1998 to about 40 percent of GDP in real terms.  Also, take into account that the export sector is probably the leader in innovation in the Chinese economy.  It's certainly the leader in productivity.  It's also probably the only large, reliable source of stable employment.

The Chinese authorities have to ask themselves why would they take any move that could hurt the competitiveness of their export sector by revaluing their exchange rate, particularly when their trading rival may or may not follow suit.

So I think that the Chinese would probably only take a drastic measure on their exchange rate if they're forced to for political reasons abroad  if their trading partners restrict access to their markets, and I don't see that happening at any time soon.

Also, China is an anomaly.  When China grows fast, it doesn't absorb more imports.  In fact, in 2003, when China grew by more than 9 percent, its current account deficit reached a record level, in terms of dollar values, and also it was large in terms of GDP.  And the reason for this is because its exports are driving GDP growth in China.

The large build-up in official foreign exchange reserves poses perhaps some challenge to monetary policy and price stability, but if this is the case, it's only evident this year.  Through 2003, the contribution of net foreign assets to broad monetary growth is actually on a declining trend.  It was down to 16 percent in 2003.  In the first 7 months of this year, it jumped to very high.  The last time I talked to the Chinese authorities was in mid year, and they weren't too alarmed about this.  They thought that they could handle this and keep monetary stability.

And the PBOC is also not concerned about holding half a billion dollars in official foreign exchange reserves.  They think they can do this with good stability.  And as a central bank, I don't think they really have to worry too much about the effects of any exchange rate movements on their balance sheet.  I think the government would come in and support them.  The central bank is not a commercial bank.  It doesn't really have to worry about its balance sheet.

Also, one reason why I think the Chinese may be reluctant, although it may not be a permanent reason, is that there is an aspect of credibility or institutional pride.  And the PBOC, my conversations with the PBOC is that they have said that they don't want to be seen as giving in to speculators.

Now, maybe they would have to do that at some point, but there is this element here that I think there'd have to be overwhelming interests of the nation at stake for the PBOC to revalue their exchange rate and reward speculators because it actually has been capital inflows that have been driving the large accumulation of reserves not the current account surpluses over the past several years.  Most of the accumulation in reserves is due to capital inflows--FDI, but increasingly, probably speculative inflows as to evade the capital controls and come in one way or another.

That being said, I think that China probably, with the WTO accession, China will be opening up its current account more and perhaps will see some diminution in the current account surpluses.  There may be some minor role that China could play to the international adjustment.  Also, another method that China is taking is opening up its capital in a selective way, the capital account in a selective way, to outflows so that you'll have, China already has a qualified foreign financial investor scheme for inflows into the bond market and stock market, and likewise they're setting up a qualified domestic institutional investor scheme, where they can invest abroad to take some pressure off the capital account and take some pressure off this huge accumulation of foreign exchange reserves.  But I think this will be very marginal and gradual over time.

Turning to Japan.  Again, I don't see Japan playing a bigger role in any international adjustment process mainly because, like China, exports are an important component of growth.  And until Japan is confident that its recovery is sustainable, which means a well-balanced recovery, where you have domestic demand playing a much more important role in economic growth, I don't see the Japanese willing to let the yen appreciate to any substantial degree.

From the Japanese viewpoint, at least what I understand it, last year's, well, over the past 12 months, ending in March or whenever it ended, in April, the aggressive intervention in the foreign exchange markets had the merit of preventing the economy from slowing down at a time when it was challenge by disturbances in the international economy.  You had the war, shocks coming from the Iraq war, and also SARS in Asia, which was intense, but brief at that time.  And last year exports, in 2003, exports provided a large share of the recovery and economy growth much larger than this year.  This year is a bit more balanced.

Looking forward, though, I think there is some hope that the downside risks have been eliminated, at least over the near term, and that there may be a little more upside in Japan.  And that comes from the corporate and financial sectors.  They were less vulnerable to external shocks and downswings in asset prices.  Firms have de-leveraged and banks have shed some NPLs and equity holdings.  In fact, the banks are on target to achieve the government's goal of reducing NPLs in half by April of next year.

What this means is that firms are investing again, and domestic demand is driving growth more than in the past, but still there is a big reliance on exports, even though exports are a small share of GDP in Japan, to provide growth.

Let me see, two things, and then I'll begin summing up.

I don't think the foreign exchange intervention was a policy tool aimed at deflation.  Firstly, the Bank of Japan, even under the new governor, has been loathe to employ unorthodox tools to fight deflation.

And, secondly, given the modest range of depreciation, at least what would have been likely, probably the effect on the price level would not have been that great.

Lastly, I think, going forward, Japan probably still has some potential to help encourage domestic absorption and therefore help in the international adjustment.  And it can do this through deepening reform not only in the financial sector and corporate sector, but also in its Social Security system.  By enhancing confidence in the national pension program, perhaps you'd get households willing to avoid excessive saving and to consume more.

However, the new reforms that were instituted this year and will be implemented over the medium term probably are not aggressive enough to face the challenges.  Japan's population is to forecast to start the decline soon, and Japan will have to do more.  But, certainly, if Japan is on a track to deepen reform in this area and in all of those other areas, perhaps they can encourage more domestic absorption, and therefore have lower current account surpluses in the future.

I would also be worried less about supporting the dollar against the yen and perhaps letting the yen appreciate more in the future.

MR. LACHMAN:  Thank you very much, Tom.

Lastly, I will call on Yusuke Horiguchi, who is the first deputy managing director at the Institute of International Finance.  And prior to that, he's very well known to people in this room as having been a director of the Asian Department at the International Monetary Fund.

MR. HORIGUCHI:  Thanks.  Thanks for inviting me for this discussion.  It's a nice thing to be the last speaker, provided you are still awake, and also being the only one who prepared a PowerPoint presentation because the local IIF has been here for two hours--good advertisement, and thanks, Desmond.

Now, my story is a bit convoluted, so let me give you, first, an outline of the expense of potentially spending one extra minute.

First, I'm going to talk about the reasons why the current account deficit of a large size, such as 5.5 percent, is likely to persist perhaps for some time to come.

Then, I'll make a point that a current account deficit of this size is not likely to be sustainable for a very long time.  It's like global warming.  Eventually, the day of reckoning will come.

And then I'm going to talk about a sensible adjustment strategy to facilitate the external adjustment that will inevitably have to come.

Then, I will talk about whether authorities of the countries or economies concerned would follow such a strategy.

And, finally, conclude my discussion with what would happen if they don't follow such a strategy.  That's my plan.

Now, in terms of the causes of the current global imbalances, in particular, with large U.S. fiscal, no, the current account deficit, there are two main causes.  One is the persistent growth gap, particularly the demand growth gap.  As you see in this picture, "Deadline United States," from the index of hundreds.  In 1991, it is approaching or exceeding 150.  And by the way, total domestic demand in the U.S. now is about 4-percent bigger than the supply potential in my calculations.

In the meantime, EUROGON and Japan really have been barely able to raise the level of domestic demand.  No wonder why there is a huge current account gap between those countries.

The second reason or second cause is the reluctance of the Asian emerging market economies to allow the exchange rates or the currencies to appreciate in any meaningful way or fear of loss of export market and all the ramifications that it might have.

So they have been intervening in a massive manner in the foreign exchange market, and as many of you have or other economists have discussed, there has been a huge increase in their U.S. dollar holdings.

Now, let me dwell a little bit on the first point of growth differential.  As long as there is a growth differential, particularly in domestic demand, they have dependency for the current account gap to widen.

And I just wanted to illustrate the point for the people who are not too familiar with economics, here, there is Country A and B.  B is not growing at all, like Japan and Eurogon, Country A is like United States, growing at, say, exactly 10 percent.  And you see if their propensity to import, which is assumed to be constant here, at 0.2, stayed that way, in 10 years' time there would be something like 12-, 13-percent of GDP deficit for Country A, and the mirror image would be the surplus of Country B, which is not growing at all.

The point of this is that as long as there is a growth gap, even before, the U.S. current account deficit, just to stay at 5.5, there's a need for some real depreciation of the dollar.

Now, the next point I wanted to make was once you have the current account gap of this size, say, 5.5 percent of GDP, it's very difficult to change or to shrink the current account deficit in nominal terms or in percent of GDP.  In order for a nominal current account to shrink, the ratio of the growth of exports to growth of imports has to be bigger than the ratio of initial levels of imports and exports.  For example, in the United States' case, N0 divided by X0 is about 1.5, which meant that export growth has to be 1.5 times as big as the import growth.  So, if import growth is about 8, export growth has to be about 12, 13 percent in order for nominal current account deficit to shrink.

Now, in terms of the percent of GDP, the formula, condition for shrinking the current account deficit is a bit more complicated, and this is the ratio between the export growth minus real GDP growth, divided by the ratio to import growth minus growth of GDP has to be bigger than the initial ratio between the level of import and export.

And this minus G term somehow makes it look as if it's simpler than the case of shrinking nominal dollar deficits, but if you recognize that and, one, this import growth is tied or related to the growth of GDP, it's not that easy even to reduce the current account deficit as a ratio to GDP because the MDG [inaudible] is typically bigger than one.  So this is one other reason why current deficits of 5.5 percent or even 6 might persist at least for some time.

Another reason for thinking that potentially this kind of current account deficit could persist for some time, I think what John Taylor has already mentioned, but since I prepared the chart with the help of David [inaudible], I might also tell you this is the balance on investment income.

U.S., despite the fact that it has been running a huge current account deficit and implied increase in net liability position vis-a-vis the rest of the world, it is still running a sizable surplus in the balance on investment income.  So this may mean that it's really not necessary for the current account deficit to shrink in a rush.  It can last for some time.

However, over the longer term, there is a great question about the sustainability of such large current account deficits, and I don't really know when the day of reckoning will come and to what extent it has to adjust.  But just to show you  the kinds of vulnerability that the U.S. is accumulating in recent period with respect to the sustainability of the current account, is this picture of the sort of deterioration in the configuration of the domestic saving and investment counterpart to the current account imbalance.

And now much of the current account deficit is, in [inaudible], accounted for by the fiscal deficit.  And shrinkage of the previous saving and investment gap of the private sector has been not due to any increase in the private savings ratio, but more due to the large decline in the investment to GDP ratio, as you see in the red bar, which means that things, seen from a domestic savings and investment point of view, is not really a favorable picture as it used to be before.

In addition, if you look at the composition of capital inflows into the United States, two facts sort of stand out:  One, there is much more official flows in the form of dollar purchases through foreign exchange market intervention, as many people have discussed.  And out of the sort of shrinking share of the private amount of shrinking private flows, the proportion accounted for by the FDI in the portfolio equity flows are coming down in a massive manner, and the debt proportion is rising.

Again, as Desmond pointed out at the beginning, it is not a more favorable picture relative to several years ago.

Now, in some sense, against these kinds of  backgrounds, there have been some external adjustments, not necessarily the current account deficit, but external adjustment in--

[Tape change.]

-- you see that in the broad index provided by the Federal Reserve, which is a very comprehensive index in terms of the trading partners that are included, it's been--the dollar has depreciated in real effective terms by, say, 13 or 14 percent over the last two years.  But if you look at the composition of that broad index, the narrow index refers to G-10, there was a 25-percent real effective depreciation of the dollar.  But vis-a-vis the emerging market countries, which is another part of the broad index, there has been no dollar depreciation at all.

Also, you know, relying only on exchange rate changes is not the way to go, and in order to complain--instead of complaining about the quality of the adjustment process to date, I wanted to talk now about what a sensible adjustment strategy ought to look like.  And here I think in terms of economy of the time that I'm going to spend talking, I'm going to follow what I wrote because Desmond is a bit anxious that I finish up quickly.

First, there are three components to the sensible adjustment process.  First is strengthening of economic activity in the euro zone and Japan, and as John Williamson mentioned, these countries should take a demand management policy to strengthen their economic activity in order to close the gap first between the potential GDP and the actual GDP.  This potential--this gap currently is very big.  Structural policies for the sake of shrinking the current account deficit of the U.S., structural policies are important only to the extent that it does increase the effectiveness of the macroeconomic policy.

Second, in addition to ensuring continued strength of their domestic demand growth, Asian emerging economies should allow a meaningful appreciation of their currencies in real effective terms by either stopping or at least moderating to a large extent their   (?)   intervention.

Third, the U.S. should strengthen its fiscal position and the main instrument for current account adjustment.

Now, I want to emphasize that these things should be done all together.  If just one is done, just for example the U.S. fiscal deficit reduction and nothing else is done, it's not very good because world demand will diminish and not much will be accomplished in terms of the current account adjustment and also hurt growth.

It is difficult to answer the question how much should the dollar depreciate in real effective terms to bring about the needed current account adjustment because the answer depends on what other things are done and by how much.  The kind of adjustment strategy that I have just outlined in sort of skeleton, if carried out seriously, would minimize the reliance on exchange rate changes as an instrument for global external adjustment.  The real question, however, is the likelihood for such an enlightened or sensible strategy to be followed in reality, and I have grave doubts about it, at least for the time being.  Why?  First, it is difficult to see the euro zone and Japan succeed in closing the existing output gap anytime soon, let alone raising the trend growth rate of either demand or the supply.  The only hope I have is that they will start moving in the right direction and continue with it.

Second, I don't believe until I see it that Asian emerging market countries will allow their currencies to adjust in any meaningful way anytime soon.  In their present value calculation, higher exports--higher economic activity and higher employment they can now enjoy based on undervalued currency is much more important than the capital loss on their reserve holdings resulting from any depreciation of the dollar that may happen sometime in the future.  And some of them might even be betting on the continued tendency of the dollar toward mean reversion in the long term, as you see in this picture.  Look at this.  This is 30-year average, and it goes up and down.  But at the end of the day, it sort of comes back to where it started.  So they may be thinking that there won't be any capital loss in holding onto the dollar.

Third, the third element, the third reason why I am doubtful about the implementation of any such sensible adjustment policy is that U.S. fiscal adjustment might prove elusive.  Now, if my pessimism is not badly misplaced about policy implementation and if the largest sustainable U.S. current account deficit is of the order of magnitude of 2 to 3 percent of GDP, as many people claim that they know, then the U.S. current account would be adjusted eventually by the brute force of markets, which would manifest itself in a plummeting of the dollar, particularly vis-a-vis the euro and the yen.  Unlike some of you, I guess, perhaps including John Williamson, I don't think such a plunge of the dollar is a big problem for the U.S., but it's a huge blow to the euro zone and Japan.  The global growth I also think will be hurt, and even Asian emerging market economies who would be ready to take any steps to keep their currencies competitive cannot remain immune for a long time from the weaker global growth.  And I'm sure policymakers in the U.S., Japan, and the euro zone and Asian emerging market countries are all well aware of the cost to their countries and to the global economy of such a scenario.  Hopefully the enlightened self-interest of those countries pushes their economic policy leaders toward an adjustment strategy of the kind I outlined above before a plunge of the dollar actually happens.

Thank you.

[Applause.]

MR. LACHMAN:  Thank you very much.

Well, I guess we've got quite a lot of differences of view.  We have time just for a few questions.  Anybody wanting to ask a question, if they could just identify themselves and perhaps indicate to whom they're wanting to direct the question.

MR. SAMUELSON:  Bob Samuelson, Newsweek.  This is for Mr. DeRosa and Professor Meltzer.  You basically advocate a policy of benign neglect, and my question to you is:  Do you see any risks of a currency crisis or financial crisis along the following lines?  It's my impression--and I could be completely wrong about this--that most of the private inflows have come from Europe and to some extent from Asia, but Europe is heavily--and so if Europeans for one reason or another would decide that they no longer wanted to hold U.S. assets, they wouldn't have to sell their existing U.S. assets, they'd just have to stop buying new ones.

Then it seems to me it's at least plausible that that would have an effect on U.S. financial markets, a decline in the stock market, some sort of effect in the bond markets; and that the effect on--so that would be a depressing effect in the United States on the American economy.  Their currencies would then rise in foreign exchange markets.  Presumably, unless they were able to take offsetting actions at home, that would have a depressing effect on their domestic economies.  You now have, depending on how you calculate the world economy, but roughly 50 percent of the world economy that has a problem.  And it strikes me that that might have further psychological effects.

So, again, to come back to my original question, if one follows your benign neglect policy--and it may be correct--are there residual dangers of some sort of crisis occurring?

MR. MELTZER:  Good question.  First let me say I'm not an advocate of benign neglect.  I'm just describing what I think is going to happen.  It may be that there's an optimal policy, but most of the suggestions that I hear, as I said earlier, are suggestions which are going to solve these problems by slowing down the world growth rate, and I don't think--you know, I think we all live in a world in which that's not the thing that politicians who have to make these decisions are likely to want to do.

I agree wholeheartedly with the view that there is a risk.  I mean, there's a risk that we could run this--that this problem will not end up in a nice way or an orderly way, that it will end up in a crisis.  Although I don't think the risk is very great, I certainly don't think that it's not there.

The picture you described has to begin at a different point, Bob.  It has to begin by saying that the expected return to dollar assets somehow is going to come down, that is, a slowing in the growth rate of the U.S. economy, and I think a slowing in the growth rate precisely because a slowing in the growth rate of the U.S. economy, which is expected to be sustained over a long period of time, that is, not a recession in the ordinary sense but a thing that says that the productivity growth rate that has pushed our sustainable growth rate to 3.5 percent falls back to the level, expected level of the 1970s, so we're expected to grow at 1.5 to 2 percent.  That would surely have a sizable effect and help to bring on the kind of problems you have.

You know, how long will the productivity growth rate stay high?  I don't think anybody knows that.  The computer scientists with whom I live at Carnegie Mellon think that there's just an awful lot that's going to happen yet in biotech and computers that will keep the growth rate up for a while, and if they're right, then Europeans will continue to want to participate in that, and that's a good thing for them because the rates of return here are better than the rates of return they're likely to get in Germany.  And where else is a sink for all that capital except here?

So to sum that up, I certainly share the view that there is a risk, that we are on the edge of a risk.  My problem is more with the solutions that people come up with, which are to bring about that risk by slowing the U.S. economy, that is, by raising the tax rates on investment or on the limited amount of saving that we actually do, most of which is done by these so-called high-income people.

MR. LACHMAN:  Before asking for the next question, I'd perhaps like to give John Williamson a chance that there were a number--

MR.           :  Could I just say one thing?  I'm going to have to leave because I have a plane to catch, and so that should not be interpreted as an editorial comment on what John Williamson is going to say.

MR.           :  But I wanted to comment [inaudible] exactly.  May I just do that?  May I just make two points about what you said.

The first one about the Chinese rise in interest rates of 27 basis points, that is indeed, I agree with you, inconsequential, but it was accompanied by something that really is important, and that is that for the first time the Chinese central bank lifted the controls over the maximum lending rate by the banks, which means that banks now can lend to smaller enterprises without losing money in the process, and that is something that's important and is potentially going to increase internal demand in China.  And I think one really shouldn't dismiss that element of the package.  That's important.

Secondly, I thought that your story, the Deutschebank story that you repeated about how the Chinese have to create 150 million jobs by running export surpluses is--if I may say so, it's extreme Keynesianism.  It ignores the supply side of the analysis.  It says that you can never use additional resources.  Okay, the Chinese maybe don't need to invest anything extra, but there are an awful lot of Chinese who could benefit by increasing their consumption in the short run.  There are still over 100 million Chinese who do not earn a dollar a day.  I mean, they're back at that basic standard.  And these people are saving, believe it or not.  It's something to help the bigger part of the Chinese economy, maybe the non-tradable part.  That's a way of using resources which could be much more better employed than invested in U.S. treasury bills, and that would be to the Chinese advantage, to the U.S. advantage, to everybody's advantage.  So that's what I think the rest of the world should be trying to persuade the Chinese to do.

MR.           :  I have to leave.  I just want to say I'm heartened by the fact that you don't think that the Keynesian solution--not my solution.  That's the one I think the Chinese have.  But you've decided that the Keynesian solution is not the right solution.  That's very heart-warming and it shows that there is progress in this world.

MR.           :  If you think that I have all these--look, way back in 1970, I met Nicky Caldor (ph) outside the British treasury, and he said to me--Nicky Caldor, and he said to me with a big grin on his face, "Here's the man who believes in the existence of supply constraints."  Yes, I believed a long time, Allan, that there's a supply side that matters as well as a demand side.  But I don't dismiss the demand side because of that.

MR.           :  Mr. Samuelson, just two fast things.  You said the word "crisis."  I don't believe--it's certainly the case that you could have adjustments in asset prices, in exchange rates and interest rates, and in income.  But you're not going to have a crisis, and the reason why is that there is an absence of fixed exchange rates and capital controls on the dollar.  And I submit that all of the true currency crises that have occurred in the last 20 years have come about because of fixed exchange rates and capital controls.

One other thing.  You said I--your words, "benign neglect."  Well, maybe it is neglect, but that's a little bit pejorative.  It's allowing a system to work, allowing markets to work.  And you're not the first one to come up with that.  But it certainly is benign in the sense that other alternatives of interfering with that system have shown to be anything but benign and, in fact, malignant.

MR. LACHMAN:  John Williamson would just like to--

MR. WILLIAMSON:  I'm sorry, but one point on that.  I mean, Brazil came awfully close to having a meltdown with a floating exchange rate in 2002.  Yes, they fought it off--

MR.           :  Why?  Why?

MR. WILLIAMSON:  Why?  Because their debt was expanding in relation to GNP.

MR.           :  Wouldn't it have something to do with the leading presidential candidate convinced markets that he was going to repudiate the debt?  That was--yeah, right, if the guy who's going to get elected President of the country goes around making speeches that we should default on the debt the same way our neighbor Argentina did, yes, prices of bonds are going down.  But that's not a currency crisis.

MR. WILLIAMSON:  I'm sorry, but he had renounced that months in advance.  If markets couldn't understand that the joint minimum program didn't contain that, then they're pretty thick.

MR.           :  If you say it, it's out there.

MR. LACHMAN:  Let's just take another couple of questions.  Maybe if we take two of them at the same--

MR.           :  Thank you.  Jean  (?)   with the French Embassy, but in a personal capacity.  I've seen here two members of the panel take what I would call the Louis XV consensus.

MR.           :  I'm sorry, the what?

MR.           :  Louis XV consensus.  He's the guy who said, "After me, the diluvium."  "After me, the big mythical flood of the Bible will come."  So my question is--

MR.           :  He was right.

MR.           :  He was right.  Probably he did not know it at the time.  And I wonder how much of that consensus is really based on supply side intellectual foundations, i.e., we cannot do anything about the problem because it would be politically too difficult, so let's