New research on the current account adjustment process

Insights on how global current account imbalances might be resolved

In my last post, I recounted the results of several papers presented at a conference held last week at UW Madison. The conference is part of a long term project on current account sustainability in major advanced economies; the conference was sponsored by the University of Wisconsin Center for World Affairs and the Global Economy (along with the Robert M. La Follette School of Public Affairs, the Economics Department, and EU Center)

As I mentioned before, we will be posting a set of proceedings from the conference (including abstracts, discussants’ comments, and general discussion), but in the meantime, I thought it would be interesting to highlight the main points of the papers. About half of the papers can be thought of as focusing on the determinants of current account imbalances, while the other half focus on the manner in which adjustment will take place. In the last post, I recounted the main points of the the first set of papers; today, I’ll cover the remainder. I want to stress that these are the views of the authors, rather than mine (or for that matter, of their respective institutions).

“Three Current Account Balances: A ‘Semi-Structuralist’ Interpretation,” co-authored by Menzie Chinn and Jaewoo Lee:

Three large current account imbalances — one deficit (the United States) and two surpluses (Japan and the Euro area) — are subjected to a minimalist structural interpretation. Though simple, this interpretation enables us to assess how much of each of the imbalances require a real exchange rate adjustment. According to the estimates, a large part of the U.S. current account deficit (nearly 2 percentage points of the 2004 deficit of 5.5 percent of GDP) will undergo an adjustment process that involves real depreciation in its exchange rate. For Japan, a little more than 1 percentage point (of GDP) of the current account surplus is found to require an exchange rate movement (real appreciation) as the surpluses adjust down. For the Euro area, less than half a percentage point of its current account surplus is found to require an adjustment via real appreciation.

“Trade Adjustment and the Composition of Trade,” co-authored by Christopher Erceg, Luca Guerrieri and Christopher Gust:

A striking feature of U.S. trade is that both imports and exports are heavily concentrated in capital goods and consumer durables. However, most open economy general equilibrium models ignore the marked divergence between the composition of trade flows and the sectoral composition of U.S. expenditure, and simply posit import and exports
as depending on an aggregate measure of real activity (such as domestic absorption). In this paper, we use a SDGE model (SIGMA) to show that taking account of the expenditure composition of U.S. trade in an empirically-realistic way yields implications for the
responses of trade to shocks that are markedly different from those of a “standard” framework that abstracts from such compositional differences. Overall, our analysis suggests that investment shocks, originating from either foreign or domestic sources, may serve as
an important catalyst for trade adjustment, while implying a minimal depreciation of the real exchange rate.

“Could Capital Gains Smooth a Current Account Rebalancing?” co-authored by Michele Cavallo and Cedric Tille:

A narrowing of the U.S. current account deficit through exchange
rate movements is likely to entail a substantial depreciation of the dollar, as stressed in the widely-cited contribution by Obstfeld and Rogoff (2005). We assess how the adjustment is affected by the high degree of international financial integration in the world economy. A growing body of research stresses the increasing leverage in international financial positions, with industrialized economies holding substantial and growing financial claims on each other. Exchange rate movements then leads to valuations effects as the currency compositions of a country’s assets and liabilities are not matched. In particular, a dollar depreciation generates valuation gains for the U.S. by boosting the dollar value of the large amount of its foreign-currency denominated assets. We consider an adjustment scenario in which the U.S. net external debt is held constant. The key finding is that while the current account moves into balance, the pace of adjustment is smooth. Intuitively, the valuation gains stemming from the depreciation of the dollar allow the U.S. to finance ongoing, albeit shrinking, current account deficits. We find that the smooth pattern of adjustment is robust to alternative
scenarios, although the ultimate movements in exchange rates are

“The Valuation Channel of External Adjustment,” co-authored by Fabio Ghironi, Jaewoo Lee and Alessandro Rebucci:

Ongoing financial integration across countries has greatly increased two-way foreign asset holdings, enhancing the scope for a “valuation channel” of external adjustment (i.e., the changes in a country’s net foreign asset position due to exchange rate and asset price changes). We examine this channel of adjustment in a dynamic stochastic general equilibrium model with international equity trading. We find that two-way foreign asset holdings are necessary for the emergence of a valuation channel. Its quantitative importance depends on features of the international transmission mechanism such as the size of financial frictions, substitutability across goods, and the persistence of shocks. We also find that the model can replicate key
moments of changes in the U.S. net foreign asset position.

These papers do not in general say much directly about the difficulties that might occur in adjusting to smaller imbalances. The Chinn and Lee paper indicates that over time, about two percentage points of the U.S. current account deficit will disappear, accompanied by dollar depreciation. Over a longer horizon, the current account will tend to stabilize at 3 percent of GDP, if historical correlations persist. The Erceg, Guerrieri and Gust paper does suggest that adjustment to a smaller U.S. current account deficit might be easier if the accelerated growth abroad is based on investment, rather than consumption, expenditures.

One other paper does not directly relate to the adjustment process, but documents the trajectories of net international investment positions, and the degree of international financial integration over time. “The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970-2004,” by Philip R. Lane and Gian Maria Milesi-Ferretti:

We construct estimates of external assets and liabilities for 145 countries for the period 1970-2004. We describe our estimation methods and present key features of the data at the country and the global level. We focus on trends in net and gross external positions, and the composition of international portfolios, distinguishing between foreign direct investment, portfolio equity investment, official reserves, and external debt. We document the increasing
importance of equity financing and the improvement in the external position for emerging markets, and the differing pace of financial integration between advanced and developing economies. We also show the existence of a global discrepancy between estimated foreign
assets and liabilities, and identify the asset categories that account for this discrepancy.

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7 thoughts on “New research on the current account adjustment process

  1. T.R. Elliott

    All I know is that, this morning, Stephen Roach at Morgan Stanley said “I must confess that I am now feeling better about the prognosis for the world economy for the first time in ages”
    Stephen Roach changes his meds
    I think this means all hell is going to break loose.

  2. RSM

    A possibly misguided question:
    Granted, valuation effects can help to facilitate a smooth adjustment if investors passively accept capital losses on their dollar denominated holdings. But, how realistic is this assumption? While investors may accept unexpected losses, surely they are not so passive as to accept a pefect foresight of future losses associated with dollar depreciation. As Paul Krugman has noted, the key issue is the extent to which investors have priced in a dollar depreciation. The interest rate “conundrum” suggests that they haven’t. What investors have done is look at Asian central bank — they of “non economic objectives” — reserve accumulation and have assumed that central bank purchases of Treasuries will provide support for the dollar going forward. While this game can be (has been) played for some time, it can’t go on forever (unless you believe in Dark Matter, or some other reason why this time is different). Once investors get the wake up call, they are likely to reprice assets — Treasuries will still be held, it’s just that to induce holdings, the risk premia piper will have to be paid. What does this entail? A dollar undershooting that gives investors an expected capital gain through subsequent appreciation. Does this make sense?

  3. menzie chinn

    RSM: I take it you are referring to the paper by Cavallo and Tille. In this case, I agree that it is a strange assumption to make that continuous ex post exchange rate depreciation does not manifest itself into expected dollar depreciation. Of course, in defense of the paper, this appears to be what has exactly happened over the 2002-04 period. And as noted in the paper itself, the data seem to indicate that historically, exchange rate changes have not been manifested in expectations.
    On the other hand, in the general discussion, one participant observed that in the past dollar decines, the depreciation was quite rapid (e.g., 40% depreciation in two years during the mid-1980′s). It is unclear whether a continuous ten year depreciation would exhibit similar characteristics. With such gradual depreciation, it may be that something more akin to uncovered interest parity holds, and hence the returns on dollar denominated assets will have to rise relative to what is posited in the paper.

  4. Stormy
    America’s ‘Near Poor’ Are Increasingly at Economic Risk, Experts Say
    Americans on the lower rungs of the economic ladder have always been exposed to sudden ruin. But in recent years, with the soaring costs of housing and medical care and a decline in low-end wages and benefits, tens of millions are living on even shakier ground than before, according to studies of what some scholars call the “near poor.”
    “There’s strong evidence that over the past five years, record numbers of lower-income Americans find themselves in a more precarious economic position than at any time in recent memory,” said Mark R. Rank, a sociologist at Washington University in St. Louis and the author of “One Nation, Underprivileged: Why American Poverty Affects Us All.”
    In a rare study of vulnerability to poverty, Mr. Rank and his colleagues found that the risk of a plummet of at least a year below the official poverty line rose sharply in the 1990′s, compared with the two previous decades. By all signs, he said, such insecurity has continued to worsen.
    For all age groups except those 70 and older, the odds of a temporary spell of poverty doubled in the 1990′s, Mr. Rank reported in a 2004 paper titled, “The Increase of Poverty Risk and Income Insecurity in the U.S. Since the 1970′s,” written with Daniel A. Sandoval and Thomas A. Hirschl, both of Cornell University.
    For example, during the 1980′s, around 13 percent of Americans in their 40′s spent at least one year below the poverty line; in the 1990′s, 36 percent of people in their 40′s did, according to the analysis.
    [Italics mine]
    I think it is time for economists to start seriously addressing this problem. Old canards about globalization, automation, the Information Revolution, or education simply do not wash.
    Something serious is happening here, very serious. Those who run the show, those who counsel them, and those who perpetuate the myth we are living in unparalleled prosperity should look beyond their cloistered, well-heeled friends and communities.
    The rising disparity in wealth is not disappearing; it is increasing. Nor will all the well-intended economic theories make it disappear.
    Your models must reflect the facts on the ground. They simply must.

    Menzie, I place this here especially for you. You are among the brightest. I am an old dullard who has perhaps lived two of your lifetimes. Maybe my plea is worth nothing; but I am pleading. Explain the rising disparity in wealth; address it in terms everyone can understand. Then offer a solution.

  5. menzie chinn

    Stormy: Thanks for the post. I’m well aware of these statistics, and I have my views. But my charge is to focus on open economy macroeconomics, and given that I have no particular expertise in labor economics, I will defer to those who have conducted research in this area.

  6. Kent Welton

    Original Article at
    May 9, 2006
    Currency Ruin Or Compensating Tariffs
    - A Lack Of Compensating Tariffs Ruins Our Economy And Dollar
    By Kent Welton
    Currency Ruin Or Compensating Tariffs?
    - A Lack Of Compensating Tariffs Ruins Our Dollar And Economy -
    ?An unspoken, yet widely accepted reality is that the United States will have to massively debase its currency to deal with the fiscal mess it has created. A weaker dollar means more competitive U.S. exports and more expensive foreign imports, both of which are meant to counter the growing trade deficit. It also means big losses over time for any foreign financial institution with significant dollar reserves. The elephant in the room is whether or not the greenback’s managed decline will turn into a downside blowout. The soaring gold price suggests that the world’s dollar-holders are becoming a little nervous?The endgame for the Fed comes down to a Hobson’s choice: destroy the economy or destroy the currency. Is there any doubt which option Ben Bernanke would chose??
    [edited by JDH for length]

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