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...the United States in the global economy, an increasingly controversial subject in the research, financial, and policy communities. Since the early 1990s, U.S. current account deficits have grown almost without interruption, reaching $666 billion, or about percent of GDP, in 2004. The U.S. international investment position is now one of net indebtedness approaching 30 percent of GDP, and in recent years a substantial portion of the buildup in net debt has come in the form of additions to dollar reserves by foreign central banks. Some observers see the present situation as unsustainable and warn of an abrupt depreciation of the dollar, which could destabilize financial markets and disrupt the global economy. Others are more sanguine, arguing that the present situation reflects the relative strength of the U.S. economy, consumer and business preferences, and rational financial decisions, all of which could evolve so as to make any needed adjustments gradual.
Each of the four articles takes a different approach to analyzing the situation, focusing on issues that the authors see as key. The first article models portfolio choices and how they moderate the pace of adjustment in exchange rates and current accounts. The second stresses the relative price changes that will be needed, both in the United States and abroad, to move the U.S. current account toward balance. The third considers the motivations of policymakers in China and elsewhere for accumulating dollar reserves. The fourth assesses the likelihood of an abrupt depreciation of the dollar and the economic instability that might result in the United States and abroad. The volume concludes with an article on the possible impact of slowing labor force growth on stock market returns.
THE U.S. INTERNATIONAL INVESTMENT position is affected by developments in both foreign trade and international capital flows--the market for imports and exports of goods and services and the market for foreign and domestic assets. The sustainability of the U.S. current account deficit and the consequences of reducing that deficit depend on features of both those markets. Most economic models that have been used to analyze the current account deficit assume imperfect substitutability between foreign and domestic goods and services but perfect substitutability between foreign and domestic assets. These assumptions carry strong implications for how the economy adjusts to new developments. In the first article in this volume, Olivier Blanchard, Francesco Giavazzi, and Filipa Sa provide a distinctive analysis that allows for imperfect substitutability between domestic and foreign assets and between domestic and foreign goods. With this feature, movements in exchange rates and asset prices have potentially important effects on the portfolios of international investors and strong implications for the speed with which exchange rates adjust to shocks. Compared with popular discussion and with earlier, simpler models, this rich specification provides a better understanding of past developments in the U.S. current account balance and the dollar exchange rate and a more realistic framework for assessing future prospects.
In its simplest form the authors' model has just two regions--the United States and the rest of the world--each of which supplies interest-bearing assets. The wealth of each region is given by the value of domestic assets plus net claims on foreigners. Investors diversify their portfolios, holding both foreign and U.S. assets, but exhibit home bias: given equal expected returns, they place a larger fraction of their wealth in domestic than in foreign assets. As a result, a shift in wealth to foreigners reduces the demand for U.S. assets, causing the dollar to depreciate. Similarly, an increase in private or government demand for dollar assets causes the dollar to appreciate. Because of imperfect substitutability, the relative returns on foreign and U.S. assets can vary with changes in relative supplies or shifts in the distribution of world wealth, and uncovered interest parity does not hold.
In the model the effects of a depreciation on the path of the current account balance and changes in U.S. net foreign indebtedness are conventional. The current account balance is the sum of the trade balance and net interest earnings. Dollar depreciation improves both, immediately reducing the dollar value of net interest payments and eventually reducing the U.S. trade deficit. Changes in U.S. net foreign indebtedness reflect the sum of the current account balance and the revaluations of U.S. and foreign portfolios that arise from exchange rate movements. In the real world, asset values and therefore net debt will also change with changes in domestic interest rates, but the model ignores these so as to focus on exchange rate movements, which are the key for understanding the model's distinctive implications.
Whereas the response of the current account in the model is quite familiar, the effect of depreciation on asset demands is quite different than in conventional models where assets are perfect substitutes. Depreciation of the dollar reduces U.S. net indebtedness directly, increasing the dollar value of foreign assets held in U.S. portfolios while decreasing the value of U.S. assets in foreign portfolios. If assets were perfect substitutes, these changes in portfolio shares would be of no importance, and the expected returns on U.S. and foreign assets would always have to be equal. With fixed domestic interest rates, the expected change in exchange rates would then be zero. In such a world, real exchange rate changes are always unexpected. With imperfect substitutability, in the absence of compensating changes in expected relative rates of return, investors in both regions will want to rebalance their portfolios following an unexpected exchange rate movement. Thus an unexpected depreciation of the dollar in response to a trade shock actually increases the relative demand for U.S. assets, reducing but not reversing the depreciation. Unlike in the case of perfect substitutability, the expected returns on U.S. and foreign assets do not have to be the same after the initial adjustment. Rather than jump all the way to a new equilibrium from which no further change is expected, the dollar undergoes a sharp initial, unexpected depreciation followed by a more gradual, expected depreciation. The expected depreciation merely reduces the desired shares of U.S. assets in investors' portfolios rather than causing massive flight from dollars. The rate at which the dollar depreciates after its initial response to an adverse shock depends on the elasticity of asset demands with respect to the relative rates of return: the lower the elasticity, the more gradual the depreciation and the improvement in the current account.
Since observed outcomes are always the result of past and present shocks, the dynamics of adjustment toward the steady state are of particular interest. The authors analyze two representative cases. In response to a shock that increases the trade deficit, such as an increase in U.S. economic activity or an enlarged preference for imports, there is, as explained above, an initial, unexpected depreciation of the dollar, followed by a gradual further, anticipated depreciation and an increase in U.S. net debt. How much of the depreciation is immediate and how much takes place on the subsequent path of adjustment depend on the response of trade to the depreciation and on the responsiveness of portfolio demands to the anticipated changes in relative rates of return. The less substitutability between foreign and U.S. assets, the smaller will be the initial depreciation, and the more rapid the subsequent depreciation. However, the eventual depreciation in the new steady state is the same, and large enough to generate a sufficient trade surplus to offset the higher interest payments on the larger debt.
The second case involves a response to a shock that increases the demand for U.S. assets, such as an increase in demand by foreign governments. In this case the reduced supply available to private portfolios leads to an initial dollar appreciation. This enlarges the trade deficit, adding to the future flow of dollar assets supplied. The subsequent path is one of a gradual, anticipated depreciation and increase in net debt. Despite the initial favorable portfolio shift, the new steady state requires a weaker dollar, since, as in the previous example, the trade surplus must be larger to offset the interest payments on the now-larger debt.
The authors suggest that the U.S. experience of recent years can be understood as responses to shocks like those just described. In their view a shift in private portfolio preferences toward U.S. assets led initially to an appreciation of the dollar. Independently, a shift in the preferences of U.S. consumers toward foreign goods worsened the trade balance by more than can be explained by exchange rate and income effects. As described above, both kinds of shifts predict an eventual sustained dollar depreciation to a level below that prevailing before the shift. Although the accumulation of reserves by foreign governments has supported the dollar against some currencies, the authors argue that the United States has entered the depreciation phase of the adjustment that their model predicts.
To assess future prospects, and in particular how large an eventual dollar depreciation should be expected, the authors quantify their model using estimates of present wealth, assets, portfolio shares, and net debt for the United States and the rest of the world, together with estimates of model parameter values based on existing empirical studies and some assumptions about adjustment speeds and policy preferences. For 2003 these estimates include the following: U.S. assets of $36.8 trillion, foreign assets of $33.3 trillion, and U.S. net foreign debt of $2.7 trillion; 77 percent of U.S. wealth invested in U.S. assets, and 71 percent of foreign wealth invested in foreign assets. In the model these shares imply that a transfer of one dollar of U.S. wealth to foreigners leads to a decrease of 48 cents in demand for U.S. assets. The estimated trade elasticities imply that a 1-percentage-point reduction in the ratio of the trade deficit to GDP requires a depreciation of 15 percent.
Armed with these quantifications of their model, the authors use it to predict where the U.S. international position is headed. First they calculate the exchange rate adjustment that would be needed to maintain the present net debt position as a steady state, under the implicit assumption that the economy has already adjusted to past shocks, and introducing no important asymmetries between foreign and U.S. interest rates or growth rates. In this case the ratio of the current account deficit to GDP that can be sustained indefinitely is given by the economy's growth rate times the ratio of net debt to GDP. With 3 percent annual growth in U.S. GDP, maintaining a net debt ratio of about 25 percent requires...
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