Dollar Adjustment: How Far? Against What?

The Dollar: Where are we going?

by
C. Fred Bergsten and
John Williamson, editors

excerpt conclusions:
In summing up the conference, C. Fred Bergsten pointed to the stalemate that the system has reached. There is general agreement that the United States needs to curb quite substantially the size of its current account deficit. Most observers acknowledge that doing this will require a siz-able depreciation of the dollar. That implies a need for other currencies to appreciate against the dollar. Some currencies have already done so: the euro, the pound, the Swiss franc, the Canadian dollar, and the Australian and New Zealand dollars. (Indeed, some participants felt that several of these currencies might have overshot, although it is hard to believe that this remains true after the renewed strengthening of the dollar in early 2004.) Despite these corrections, the US dollar remains substantially over-valued.

One thing the conference did not reach agreement on is the magnitude of the current dollar overvaluation. Wren-Lewis went straight to estimates of equilibrium bilateral exchange rates, but if one weights and averages these, one would estimate on his measure that the dollar was overvalued by a little under 10 percent at the time of the conference. The figure of Bénassy-Quéré and her colleagues would seem to be about 4 percent, if one looks at their estimate of the dollar’s real effective overvaluation, although weighting their estimates of bilateral misalignments with the Federal Reserve’s weighting system would suggest a rather larger figure, again approaching 10 percent. O’Neill’s preferred estimate would also seem to be about 10 percent.

Mussa, conversely, asserted that a further dollar depreciation of about 20 percent or more would be needed to complete the adjustment process. Mann (2004) is even more alarmist, predicting that an immediate adjust-ment of close to 20 percent (enough to bring the Fed’s broad real index down to an index value of 85, as against its July 2004 value of 101.5) would do little more than stabilize the size of the US current account deficit. And to prevent the deficit from growing again in future years, the initial depre-ciation would need to be followed by a secular depreciation of about 10 percent a year (to offset the Houthakker-Magee asymmetry in the import elasticities and the growing deficit on the investment income account as the United States piles up foreign indebtedness, and to allow for an initial situation in which the value of imports vastly exceeds that of exports). What one can conclude is that the dollar is currently overvalued by at least 10 percent or so, and possibly by substantially more.

Yet the world has run out of volunteers for currency appreciation. Japan has already undertaken some appreciation, and its authorities fear that much more might derail the incipient recovery that looks as though it may finally be under way. China has a fixed nominal exchange rate with the dollar, and its officials parrot phrases about “keeping the yuan stable around a rational and balanced level” (ignoring the facts that stability in the bilateral rate against the dollar implies instability in what really mat-ters, the effective exchange rate, and that the present rate is by no stretch of the imagination reasonable and balanced). Other Asian countries resist substantial appreciation, even when their exchange rates are nominally floating, when this would also mean losing competitiveness against China. Canada and the eurozone are both relieved that the full appreciation of 2003 did not stick. Latin American countries seem determined not to re-peat their past mistake of acquiescing in overvalued exchange rates, and they may well be tempted to err in the opposite direction.

In this situation, there is an acute need to reach some measure of inter-national understanding about a consistent set of balance of payments ob-jectives and the resulting policy implications. Yet this is one responsibility that the IMF, the institution that is supposed to be in charge of supervising the adjustment process, seems singularly reluctant to fulfill. The G-7 and G-20 should tell the IMF that it is high time for it to accept its responsibility to negotiate an agreed-on and mutually consistent set of current account objectives. Unless the Institute’s conference was chronically mistaken, these objectives will have as a corollary an obligation to orchestrate a concerted Asian appreciation against the dollar and to encourage coun-tries with both deficits and surpluses to make the needed complementary adjustments in their policies regarding domestic demand.

No one doubts that adjustment will eventually happen. The sooner it starts, the less the chance that it will take a catastrophic form. If and when the worst happens, the world will surely not look back forgivingly at the present generation of officials who told themselves reassuring sto-ries about the omniscience of markets while allowing the disequilibria to explode.... The Dollar: - Link