Exchange Rates, Wages, and International Adjustment:

Seldom have the pages of the financial press in Europe and America been so full of grave editorializing on the need for a major depreciation of the dollar to correct the “unsustainable ” current account and trade deficits of the United States. Much of this international moralizing directs the East Asian countries to stop pegging their currencies to the dollar—or, in China’s case, to allow a large appreciation of the renminbi before moving to unrestricted floating. The message is that, in order to reduce their trade surpluses and thereby reduce America’s trade deficit, the East Asian economies and many European ones should let their currencies appreciate against the dollar. The Exchange Rate and the Trade Balance Unfortunately, this conventional wisdom is wrong. The common presumption that an exchange rate change by itself has a predictable effect on a country’s trade balance is incorrect. In particular, a deep devaluation of the dollar would have (is having) unacceptable worldwide macroeconomic consequences without correcting the U.S. trade and current account deficits. Among financially open economies, sustained exchange rate changes must reflect relative monetary policies expected in the future: relatively tight money and deflation in the appreciating countries, and relatively easy money with inflation in the country whose currency depreciates. The high-saving countries in Asia and Europe (and including Canada), all creditors of the low-saving United States, face the specter of a growth slowdown or outright deflation should their currencies appreciate. For example, the repeated appreciations of the yen from 1985 to 1995 created the bubble in Japanese land and equity values from 1987 to 1990 and then, with the inevitable collapse of the bubble, threw Japan into a deflationary slump in the 1990s. In 2003 and 2004, the Japanese economy staged a partial recovery on the back of the China boom. But the current rise of the yen toward 100 to the dollar could well throw Japan into a renewed deflationary slump in 2005. Similarly, with the 60 percent appreciation of the euro against the dollar in 2002-2004, continental Europe is facing slower economic growth—although not yet as protracted as the earlier Japanese experience.

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