Current account adjustment

A couple of quick thoughts on the Federal Reserve Board’s recent paper on current account adjustment.

There are two broad paradigms or models for current account adjustment. One might be called the emerging market crisis model. The other is the no worries advanced economy model. I would argue that the US right now fits poorly into both models.

Model 1 comes from emerging economies. It is not pleasant. Capital inflows come to halt, other rather quickly. Current account deficits can no longer financed; the country has to swing quickly into current account balance, if not a current account surplus (to pay down debt/ finance capital flight). The currency tanks. Most of the improvement in the current account surplus comes from a collapse in imports. The country enters into a recession. Because a large fraction of the country’s debt, both external and internal, is denominated in a foreign currency, the fall in the currency dramatically increases the real burden of much of the country’s debt. Domestic interst rates typically soar; real rates often rise sharply. The higher real rates rarely attract large inflows back to the country; they typically serve to convince domestic residents not to flee. Think Mexico 1995, Thailand in 97, Korea in 1997-98, Argentina and Turkey more recently.

Model 2 comes from advanced economies, often European economies. Typically the country’s real exchange rate is a bit overvalued, leading to a current account deficit. Often the country pegged its currency to the DM (at the time) as part of the ERM. Think of the UK in 1992 (though the pound crisis did not qualify as an episode in the Fed Study), or Italy before the ERM’s trading band was widen. Real interest rates are typically high before the crisis, as the country has to maintain high real interest rates to attract capital inflows, given than investors worry about the risk of a future devaluation and given that the country finances itself largely in domestic currency.

Letting the currency float is typically not all that tramatic. Real interest rates do not typically surge, in some cases they fall. Because the country finances itself in its own currency, the real burden of its debt does not surge. There is no balance sheet crisis. And, as the Fed notes, the current account adjustment comes largely from a surge in exports. In many cases, imports -- and the overall economy, continue to grow quiet nicely.

I don’t think either model fits the US well.

The emerging economy model does not fit for two reasons. One. The US finances itself in dollars, so a devaluation, in the first instance, does not increase the real value of US debts. Rather, it increases the real value of the United States external assets. By financing itself in dollars, the US has pushed the risk of a devaluation on to its creditors. Two. While the US does fund itself with short-term debt, notably short-term Treasuries, a large fraction of that short-term debt is owned to other governments (i.e. the world’s central banks). They may not always be willing to keep adding to their dollar hoards at their current rate, but they are unlikely to precipitate an outright rollover crisis either.

The advanced economy model also seems to fit poorly though, also for two reasons. One, the US has not been paying high real rates to foreign investors to finance itself. Nominal and real rates are currently rather low actually. Since real rates are so low, it seems likely to me that real rates will rise, not fall, should the US enter into a serious current account adjustment. Two. Most other economies export (and import) more than the US, and don’t have as large a gap between their current export and import bases. It is a lot easier to grow out of a current account deficit is you import 33% of GDP and export 30% of GDP than if you import 15% of GDP and export less than 10% of GDP. Do the math. If imports grow at modest 5% annual rate, and exports grow at 10%, the US trade deficit shrinks, but not by much (exports have to grow 50% faster than imports just to keep the trade deficit from growing). That makes it hard for the US to reduce its trade deficit just by growing its exports. Import growth has to slow too, and that may require a bit more than just a dollar depreciation.