Does exchange-rate management have a role in the U.S. macro-policy tool kit? Stabilization is not wise policy if the current account continues to deteriorate

Business Economics, July, 2004 by Michael R. Rosenberg

Given the rather large swings that the dollar has undergone in recent years, a number of observers are arguing that policy steps should be undertaken to stabilize the dollar around present levels. We make the case that exchange-rate management should not play a role in the U.S. macro-policy tool kit and, indeed, argue that the United States needs to convince policymakers overseas to allow their currencies to contribute to the U.S. trade-adjustment process. We show that the dollar needs to fall further, and likely quite sharply, in order to promote an orderly return of the U.S. current-account deficit to a sustainable level.

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As Joni Mitchell's famous song goes, the dollar has seen love from both sides now, win and lose. Indeed, the dollar has swung from being a grossly overvalued currency on a purchasing power parity (PPP) basis in 2001 to being an undervalued currency today. The great fear is that if the dollar were to continue to decline at the pace at which it has fallen in the past 2-1/2 years, then (1) the U.S. inflation rate might begin to rise, (2) the price of oil in U.S. dollar terms might continue to rise sharply, (3) U.S. firms might become more vulnerable to foreign takeovers as overseas firms take advantage of the cheap dollar, (4) a large misalignment of the dollar might distort investment incentives, thereby possibly negatively affecting long-run U.S. productivity growth, (5) a significantly undervalued dollar might negatively affect overseas growth--particularly in Europe and Japan, and (6) U.S. interest rates might need to move higher if foreign investors lose confidence in the dollar, which could raise the risk that the U.S. economy might suffer a hard landing at some point in the future.

Given these concerns, the issue of exchange-rate management in general and dollar stabilization in particular is beginning to crop up in policy discussions. It is probably safe to assume that if the dollar continues to slide to new cyclical lows, this issue will attract even greater attention, not just in Washington, but in most foreign capitals as well. Global policymakers have been down this road before--the dollar fell to dramatically undervalued levels in the late 1970s, the second half of the 1980s, and in the mid-1990s--and in each of those instances, policy steps were taken in either the United States or overseas (or both) to stabilize the dollar or reverse its declining trend.

The issue for U.S. policymakers this time around is whether exchange-rate management should play an important role in today's U.S. macro-policy tool kit. While some observers contend that dollar-stabilization should now be an important objective of U.S. policymakers, there are several factors that first need to be considered. For one, can the United States actually manage the dollar's value without seriously compromising its other policy objectives? Also, would a dollar-stabilization effort be appropriate if it impeded the adjustment of the U.S. trade deficit to a more sustainable level? In this article, we make the case that exchange-rate management should not play a role in the U.S. macro-policy tool kit; and, indeed, we go further by arguing that the United States needs to do a better job of convincing policymakers overseas that exchange-rate management should not play a role in their macro-policy tool kit either.

We begin with an assessment of whether an exchange-rate stabilization effort would make sense for the United States today in light of the deteriorating trend in the U.S. current account. Our modeling work suggests that if policymakers were successful in stabilizing the dollar at present levels, and if the U.S. economy were to continue to grow at a relatively brisk pace, then the U.S. current-account deficit would almost certainly continue to deteriorate, with the deficit likely rising from five percent of GDP presently to a new record level of around eight percent of GDP in the next five years. To prevent the current-account deficit from rising to such an outsized level, our modeling work indicates that the U.S. dollar will need to fall sharply and that U.S. interest rates will need to rise sharply to slow U.S. domestic demand down and to help narrow the gap between U.S. investment and savings.

While it is true that the dollar has already fallen significantly, we argue below that the dollar will need to fall considerably further on a trade-weighted basis to help restore the U.S. current-account imbalance to a sustainable level. We further argue that it is, in fact, necessary for exchange rates to overshoot their equilibrium levels from time to time in order to remedy large external imbalances. Given limited pass-through effects of exchange-rate changes on traded goods prices and low price elasticities of demand for traded goods, it is unlikely that modest changes in exchange rates can bring about substantive adjustments in underlying trade imbalances in today's world of floating exchange rates. Hence, exchange-rate overshooting actually plays a vital role in the international trade-adjustment process, and efforts to impede overshooting would only serve to sustain large trade imbalances.