May 2007
Does a Falling Dollar Threaten Global Economic Recovery?
Since the beginning of the year, the U.S. dollar has fallen significantly, especially against the euro. By raising the domestic cost of imports, the declining dollar could pose a challenge to the Federal Reserve in its quest for non-inflationary economic growth.
Participants at this seminar considered the likelihood of a further fall in the dollar. They also discussed the action that major industrialized countries and China should take to minimize the risk of a disruptive dollar decline. Anne Krueger, former International Monetary Fund first deputy managing director; John H. Makin of AEI; Kenneth Rogoff of Harvard University; Brad Setser of University College, Oxford; and Edwin M. Truman, former U.S. Treasury assistant secretary for international affairs considered these and other issues at a May 31 AEI conference.
Anne Krueger
Johns Hopkins University, School of Advanced International Studies
American economic growth has been strong in recent years. Over the last decade, the American economy has performed better--not worse--than expected. In this environment, the current accounts deficit and falling dollar do not pose major threats to American economic growth. A slowdown would more likely result from limited capacity than from the current accounts deficit. Future growth necessitates increases in productivity and capital investment to expand capacity.
Global imbalances do exist, but the American economy has proven to be resilient and adaptable. The American economy benefits from low unemployment, low inflation, and a young labor force relative to other Organisation for Economic Co-operation and Development countries. The focus on the current accounts deficit and falling dollar should not overshadow more pressing concerns. Prospective problems include the low savings rate, public education, and the fiscal deficit. Given the volume of U.S. outstanding liabilities, an unexpected event could trigger a reaction and a market sell-off, but the flexibility of the U.S. economy reduces the probability of such an outcome.
John H. Makin
AEI
The movement of the dollar and the current accounts deficit are sideshows to the accommodative conditions in global asset markets. In recent years, while asset markets in the United States and Europe have risen considerably, China's stock markets have skyrocketed. In China, the central bank and the government continue to resist rapid currency appreciation; they attempt to peg both the price and quantity of their currency. Consequently, the path of the yuan has been steady and upward by design. These policies have precipitated tremendous liquidity growth, and this liquidity surge strongly supports global asset markets. Funds are pouring into the Shanghai stock market and fueling growth in the world's riskiest markets. The chief concern is that the current monetary policy of industrial countries and the situation in China will continue to drive asset markets and under-price risk. In the resulting environment, an unexpected event could disrupt global economic recovery by making risk less attractive.
Kenneth S. Rogoff
Harvard University
America's slowing economy, compared to the acceleration seen in Europe, is nothing more than a "healthy rebalancing." China's current economic situation has been labeled as tremendously vulnerable. Unless China begins to experience faster reform, it is unclear whether or not it will be able to sustain its current growth rate. The slow depreciation of the yuan signifies a broader slowdown in terms of economic reformation. In order to continue economic expansion, the yuan must appreciate several hundred percent over the next few years. It is difficult, however, to know exactly how much the yuan must appreciate, as its current value can hardly be defined beyond the general label of "undervalued." The yuan is held up through capital controls and excess labor. As excess labor flows into the market in the next few years, the real exchange rate will be held down. In the prima facie case, there is a massive reserve accumulation that is accelerating and unsustainable. Reform appears to be the most beneficial long-term option, but in fixed-exchange-rate regimes, this option appears to be risky and undesirable due to its short-term impact.
Brad Setser
University College, Oxford
A strong global economy may actually threaten the dollar. From this standpoint, the U.S. slowdown has not created much adjustment in current accounts. Furthermore, relative to the global economy, the U.S. slowdown has led to a meaningful decrease in private investors' willingness to finance the U.S. deficit. Lastly, the Chinese exchange rate adjustment is central to global adjustment, and should become a greater policy focus. Concerning the U.S. external balance, the minor adjustments have been misleading. This deception can be attributed to several factors. Firstly, the role of strong debt elsewhere has been significantly overemphasized in the reduction of U.S. debt. As the performance of markets outside the United States has continued to improve, the expectations of interest rates have changed, leading to a reduction in private investors. Finally, the depreciation in Chinese exchange directly correlates to growth in exports.
Edwin M. Truman
Peterson Institute for International Economics
While a strong dollar is in the national interest, the United States' current situation is not as severe as it might appear. External adjustment has been underway for five years, and adjustments are slowly correcting the problems. On the other end of the spectrum, China is currently experiencing exchange rate adversity. Although China has experienced real, effective depreciation, the economic decline is not seen as a dire matter. China's continued economic success depends on whether or not the dollar experiences another large adjustment. In any instance, currencies will adjust, and the level of adjustment countries will have to undergo will depend on the level of resistance they encounter.
AEI interns Amy Kaufman and John Nelson prepared this summary.
