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Managing exchange rates: achievement of global re-balancing or evidence of global co-dependency? The United States and its trading partners have serious vested interests in the status quo.

Article Excerpt
Long-term global economic health requires that external imbalances and the internal imbalances that support them be corrected by both the United States and its trading partners. The current path of external imbalances appears to be unsustainable, but relying on exchange rate adjustments is unlikely to suffice as long as there is a co-dependency of structural characteristics and policy choices between the United States and its trading partners. There is a real possibility that the entanglements created by this co-dependency cannot be undone by anything short of a global economic crisis.

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How are exchange rates related to the U.S. external accounts and macro policy management? There is no doubt that further depreciation of the dollar will be part of the package of policy moves and economic responses that will yield "global re-balancing." (1) This term implies the complementary narrowing of two imbalances around the world. One is the yawning U.S. current account deficit, and the other is the widely geographically disbursed but nevertheless persistent dependence of the rest of the world on net exports to the United States. Underlying these external imbalances are internal imbalances in both countries and regions with respect to savings and investment and to domestic demand and production.

Is the dollar depreciation to date moving the imbalances along a path of adjustment? Moreover, can any realistic magnitude of change in the value of the dollar do the job of global re-balancing? Relying on exchange rate adjustment is likely to be more difficult than it appears, for evidence suggests a global co-dependency of policy choices and structural characteristics in both the United States and other countries. U.S. structural characteristics and policy choices are revealed in domestic and external behaviors that stand in the way of the dollar 'doing its job' to rectify the U.S. side of the global imbalance. By the same token, policymakers in the rest of the global system, for their own structural reasons, are actively inhibiting the dollar's move toward broad-based depreciation. Taken individually, the U.S. path and the rest-of-world path are not sustainable, but together they may well be sustained for an extended period--thus the term global co-dependency.

Hence, in the near-to-medium time period, despite much theory and empirical suggestion that the dollar should depreciate a lot, it likely will not; and global imbalances are likely to widen further. Global co-dependency, which keeps the dollar from steady and significant depreciation and keeps the current configuration of global imbalances in place, could have a very long duration. But, with cumulative imbalances weighing ever more heavily on the individual countries and the global system, it will become increasingly difficult to untangle the global co-dependency without precipitating a crisis in currencies, international exchange of goods and financial assets, and domestic and global growth.

The Dollar and Global Re-Balancing in Historical Perspective

The dollar has played a role in global re-balancing in the past. Figure 1 shows the historical record of the current account, trade balance, and the Federal Reserve's broad real effective exchange rate (REER)

index for the dollar. The current account is driven predominantly by trade in goods and services, which in turn is largely determined by U.S. and foreign income growth, along with relative prices, for which the exchange value of the dollar is a good proxy.

With respect to growth differentials, movements in the U.S. trade balance are in part influenced by the degree to which the U.S. and foreign economic cycles are out of sync (Ch. 8 in Mann, 1999 and Mann, 2002). In the early 1980s, and again in the early 1990s, the U.S. economy slipped into recession and imports slowed. During those cycles, world growth remained relatively robust, so U.S. exports rose. The trade deficit...

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