[Viewpoint] The exchange-rate delusion

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[Viewpoint] The exchange-rate delusion

If one looks at the trade patterns of the global economy’s two biggest players, two facts leap out. One is that, while the United States runs a trade deficit with almost everyone, including Canada, Mexico, China, Germany, France, Japan, Korea and Taiwan, not to mention the oil-exporting countries, the largest deficit is with China. If trade data were recalculated to reflect the country of origin of various components of value-added, the general picture would not change, but the relative magnitudes would: higher U.S. deficits with Germany, Korea, Taiwan and Japan, and a dramatically lower deficit with China.

The second fact is that Japan, Korea and Taiwan - all relatively high-income economies - have a large trade surplus with China. Germany has relatively balanced trade with China, even recording a modest bilateral surplus in the post-crisis period.

The U.S. has a persistent overall trade deficit that fluctuates in the range of 3 to 6 percent of GDP. But, while the total reflects bilateral deficits with just about everyone, the U.S. Congress is obsessed with China, and appears convinced that the primary cause of the problem lies in Chinese manipulation of the renminbi’s exchange rate.

One problem with this view is that it cannot account for the stark differences between the U.S. and Japan, Germany and Korea. Moreover, the real (inflation-adjusted) value of the renminbi is now rising quickly, owing to inflation differentials and Chinese wage growth, particularly in the country’s export sectors. That will shift the Chinese economy’s structure and trade patterns quite dramatically over time. The final-assembly links of global-value added chains will leave China for countries at earlier stages of economic development, such as Bangladesh, where incomes are lower (though without producing much change in the balance with the U.S.).

A somewhat more sensible concern might be that the dollar’s reserve-currency status causes it to be “over-valued” with respect to every currency, not just the renminbi. That could create additional pressure on the tradable part of the U.S. economy, and thus might help to explain why the U.S. tradable sector has not generated net employment for two decades. But, in order to explain performance relative to Japan and Germany, one would have to argue that the euro and the yen have been undervalued, which makes no sense.

In fact, the employment generated by the tradable sector has been in services at the upper end of the distributions of value-added per person, education and income. As a result, growth and employment in the tradable sector have gone separate ways, with healthy growth and stagnant employment. In Germany, by contrast, the tradable sector is an employment engine. The same is true of Japan.

The U.S. economy’s distinctive features for at least a decade prior to the crisis that began in 2008 were an unsustainably high level of consumption, owing to an illusory wealth effect, under-investment (including in the public sector) and savings that fell short of the investment deficiency. That excess household and government consumption fueled the domestic economy - and much of the global economy as well.

In several European countries that now confront fiscal and growth challenges, the pattern was somewhat different: most of the excess consumption and employment was on the government side. But the effect was similar: an unsustainable pattern of income and employment generation, and lower productivity and competitiveness in these economies’ tradable sectors, leading to trade deficits, stunted GDP and weak job creation.

One could argue that the euro has been and still is overvalued, and that this has hindered many euro zone economies’ productivity relative to non-euro-zone countries. But the relative productivity deficiencies within the euro zone are more important for growth, and have nothing to do with the exchange rate.

The focus on currencies as a cause of the West’s economic woes, while not entirely misplaced, has been excessive. Developing countries have learned over time that real income growth and employment expansion are driven by productivity gains, not exchange-rate movements. This, in turn, requires public and private investment in tangible assets, physical and telecommunications infrastructure, human capital and skills, and the knowledge and technology base of the economy.

In the United States, productivity deficiencies have led to a pattern of disconnection from global supply chains. So the challenge for America is not only to restore productivity, but also to restore its links to the main currents of world trade.

China’s growth - and, more generally, that of the major emerging economies - provides a substantial potential tailwind. That is certainly true nowadays for Germany, Japan and Korea. The U.S. and others can take advantage of it as well, but only if productivity relative to income levels in specific areas of potential competitiveness begin to rise.

As long as U.S. economic policy remains focused primarily on deficits, domestic demand, exchange rates and backsliding on trade openness, its investment deficiencies will remain unaddressed. That means that its employment and income-distribution problems will remain unaddressed as well.

The good news is that, at a deep level, incentives across advanced and developing countries are aligned. The emerging economies would like nothing more than the restoration of sustainable patterns of growth in the advanced economies, and are prepared to be cooperative players in that process. But focusing on these countries’ exchange rates is not the right way to go about it.

*Copyright: Project Syndicate, 2011.
The writer, a Nobel laureate in economics, is professor of economics at New York University’s Stern School of Business.


By Michael Spence
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