Why Deficits Matter: And Why the Coming Soft Dollar Policy Is No Solution to America's Huge Imbalances
Chinn, Menzie, Steil, Benn, The International Economy
Chinese president Hu Jintao's recent visit to America provided ample grist for the media mills, but despite all the attention surrounding protocol gaffes the real story of the meetings was lack of progress along any policy front, including economic relations. In spite of Washington's chiding and threats over the growing trade imbalance, Beijing knows it has Treasury by the bonds. Roughly a third of China's central bank reserves, approaching an astounding $1 trillion, are in U.S. Treasury notes.
The question is therefore when the Administration and Congress will finally face up to the fact that America's deficits are American problems requiring American action. The current account deficit is now running at record heights of $805 billion, 6.4 percent of GDP, requiring about $2 billion of imported capital each day to sustain. Fueling the current account deficit is the Federal budget deficit, which, while down from 3.6 percent of GDP in 2004 to 2.6 percent in 2005 after a year of exceptional tax receipts, is set to soar anew on the backs of hurricane and war costs, runaway entitlement spending, and Washington's revealed preference for foreign borrowing over cutting pork and raising revenues at home. The recent $39 billion in projected spending cuts adopted by Congress for programs such as Medicare and student loans amounted to great dramatic theater, but a mere seven one-hundredths of 1 percent of GDP.
The Administration's response to the so-called "twin deficits" has been a yawn. In accordance with the vice president's neoeconomic postulate that "deficits don't matter," there is no policy beyond sending out the U.S. Treasury secretary at the bottom of a news cycle to cajole the Chinese into allowing greater currency "flexibility," which the whole world had feted them for not doing during the Asia crisis. These are therefore merely thinly veiled calls for a weaker dollar, no different from the devaluation cries heard routinely around the world from export interests.
But outsourcing deficit management to the currency market is junk economics and irresponsible geopolitics. Even if China revalues by the large levels demanded in such proposals as the Schumer-Graham bill, the yawning American trade gap will remain. Recent econometric analysis of the trade and currency data show the responsiveness of U.S. imports to movements in the dollar to be vastly lower than politicians assume. Thus, particularly because imports currently exceed exports by such a large amount, the higher dollar price of imported goods will make the trade deficit larger, at least until exports start growing rapidly. And that may take a very long while.
Furthermore, readjustments of relative prices via exchange rates won't bring much production back onshore. Textile factories that have closed over the past decade won't reopen even after a steep dollar decline. A significant Chinese revaluation will lead to higher imported sock prices at Wal-Mart, not a sprouting of new American sock plants.
America's comparative advantage vis-a-vis China is clearly in high-technology goods, particularly those with potential military applications. Yet these are precisely the goods the Administration is determined to keep out of Chinese hands, even in the face of European delight at the prospect of cashing in as Beijing continues its prodigious military build-up without American suppliers. It is difficult to envision, therefore, what precisely would stoke the sort of surge in U.S. exports to China that could make a serious dent in the ballooning trade gap.
The second flaw in a soft dollar policy is the naive belief that a dollar decline will be orderly and painless. This is what the Administration is banking on, but its own policies are guaranteed to undermine it. As U.S. policymakers continue to push forward with unbridled spending and tax cut plans that raise the trajectory of future budget deficits, foreign investors are certain at some point to turn their backs on the ever-expanding stock of U. …