What must eventually fully rebalance the united states current account?
What would a complete "correction" of current account imbalances mean for the worthiness of the dollar, the relative size of the united states economy, and US living standards? What type of adjustments in the US economy will be needed? Exactly what will eventually the major surplus countries aswell concerning smaller players whose economies are tightly from the US, such as for example Canada and Mexico? To answer this question, we should have a means of linking trade flows – specifically US exports and imports – to economic factors including the real exchange rate, US GDP, etc. Here the gravity model will come in.
An effective venture in international trade has been the gravity style of bilateral trade. Pioneers in econometric modelling, such as for example Tinbergen (1962) and Pöyhönen (1963), observed that trade between country A and country B followed a straightforward formula. Exports from A to B correlate perfectly with the size (e.g. GDP) of country A’s economy multiplied by how big is country B’s economy divided by the length between them. For some time, this relationship lacked a theory. Newer work, particularly by Anderson (1979) and Deardorff (1998), tied this relationship to standard types of international trade. In Eaton and Kortum (2002), two folks developed a specific model that allowed for production of a lot of goods which can be traded but at a price. A feature of the model is an increase in exports may appear at both intensive margin (selling more of the same good) and the extensive margin (selling a broader selection of goods). 1
Recently we’ve adapted this framework to handle the united states current account question (Dekle, Eaton, and Kortum 2008). Fitting the model to 2004 data on GDP and bilateral trade flows among 42 countries, we solve for the brand new equilibrium where trade in manufactures (the major element of the existing account imbalances of the big players like the US, Japan, Germany, and China) adjusts to remove all current account imbalances. While achieving exactly this outcome will be a remarkable coincidence, the exercise gives some sense of the magnitudes rebalancing would entail.
The consequences of correcting international imbalances
We perform this exercise making different assumptions about the flexibleness of national economies in adapting to a rebalanced world. How easily can productive resources (most of all workers) move between your production of non-traded goods and manufactures? How easily can countries expand exports by increasing the number of products they can produce and sell abroad?
Table 1 presents a synopsis of our results (for a small number of countries) in both most acute cases.
- Flexible case: Economies are fully flexible in both respects. Workers can seamlessly change sectors, and countries can seamlessly change the portfolio of products that they sell in various markets.
- Inflexible case: Workers are stuck within their initial sectors and exports to market can adjust only at the intensive margin, by selling pretty much of the same group of goods.
One can think about the first scenario as reflecting the best long-term consequences and the next the immediate aftereffect of an abrupt change.
For every scenario, Table 1 reports in the first column the percentage change in the country’s GDP in accordance with world GDP. This change will probably correspond most closely to the change in the country’s exchange rate. The next column reports the percentage point change in the share of manufacturing in the country’s GDP. The 3rd column reports the percentage change in GDP deflated by the change in local prices.
Table 1 . Changes in outcomes under different adjustment scenarios
|Maximum Flexibility||Minimum Flexibility|
|GDP||Mfg. shr||Real GDP||GDP||Mfg.shr.||Real GDP|
Note: First column is percentage change in GDP, holding world GDP fixed. Second column is percentage change in manufacturing share of GDP. Third column is percentage change in real GDP.
Interpreting the results
Beginning with the next column, we remember that in either scenario adjustment takes a substantial increase in how big is the united states manufacturing sector, between 3 and 3.5 percentage points. The reason why behind the change in both scenarios will vary, however. In the flexible case US manufacturing expands because resources move there. In the inflexible case, the wages of workers in manufacturing rise in accordance with those in all of those other economy.
Looking at the implied change in GDP (first column) and taking into consideration the flexible case, we see that the change in the relative sizes of the various economies beneath the flexible case is fairly modest. THE UNITED STATES as a share of the world economy falls by simply 4.5% while Japan’s rises by 3.3%. The inflexible case, however, takes a a lot more radical realignment in the relative size of the major economies. THE UNITED STATES declines by nearly 30% in accordance with the world while Japan grows by over 26%. (Combining the numbers, the adjustment would require over a 50% devaluation of the united states dollar with regard to japan yen).
Turning the implications for the change in real GDP (third column), we see that large changes in relative GDP result in a lot more muted changes in real GDP. For example, the true GDP of the united states falls by only 2%. Associated with that the more the united states relative wage (and therefore relative GDP) must decline to create US exports (e.g., tractors, wide-bodied aircraft) more competitive abroad, the low the cost of what Americans produce for themselves (e.g., medical services, fitness, auto repair), which comprise the lion’s share of what Americans (and other folks) purchase.
The outcomes for the large surplus economies (Japan, Germany, and China) will be the reverse image of these for the US. Remember that in either scenario the united states pulls down the relative GDPs of Canada and Mexico, despite the fact that Canada starts out owning a surplus and Mexico only a little deficit. Associated with these countries’ largest foreign customer shrinks substantially. Regardless of the decline in how big is the Canadian economy, Canadian GDP can purchase more, since goods from its largest foreign supplier have gotten much cheaper still. Hence its real GDP rises.
To summarise, the realignment that’s necessary depends upon flexibility, with an increase of flexibility requiring less adjustment. Even if movements in relative GDP’s are substantial, however, once price changes are considered real effects are a lot more modest.
The adjustment happening
Actually, there are signs that the correction has recently begun. From 1 March 2007 to at least one 1 March 2008 the worthiness of the united states dollar declined by nearly 18% against the Canadian dollar, over 16% against the Mexican peso, by nearly 14% against the Euro, and by over 8% against the Chinese yuan. Various trade-weighted exchange rates reported by the IMF show a US dollar decline of 10 to 13% from the first quarter of 2007 to the first quarter of 2008. In this same period US merchandise exports grew 18.4% and merchandise imports grew 12.7%. A few of this growth may be the consequence of the commodity boom. But even removing soybeans, corn, and wheat from exports leaves growth in the rest of the types of US exports at a hefty 16.8%. Moreover, if imports of crude oil are applied for, US shelling out for imports grew by only 5.9%.
Much bigger changes than they are needed to bring the united states current account into balance. Just how much more of a dollar decline is necessary depends upon how adaptable the united states economy reaches moving resources in to the production of goods that are exported or used to displace imports and on what successfully it expands the number of products it could produce and sell abroad.
Alvarez, Fernando and Robert E. Lucas. (2007) “General Equilibrium Analysis of the Eaton-Kortum Style of International Trade,” Journal of Monetary Economics, 54: 726-768.
Anderson, James E. (1979) “A Theoretical Foundation for the Gravity Equation,” American Economic Review, 69: 106-116.
Dekle, Robert, Jonathan Eaton, and Samuel Kortum (2008) “Global Rebalancing with Gravity: Measuring the responsibility of Adjustment” forthcoming, IMF Staff Papers.
Deardorff, Alan V. (1998) “Determinants of Bilateral Trade: Does Gravity Work in a Neoclassical World?” in Jeffrey Frankel, editor, The Regionalization of the World Economy. University of Chicago Press, 7-32.
Eaton, Jonathan and Samuel Kortum (2002) “Technology, Geography, and Trade,” Econometrica, 70: 1741-1780.
Pöyhönen, Pentti (1963) “A Tentative Model for the quantity of Trade Between Countries," Weltwirtschaftliches Archiv, 90: 93-99.
Tinbergen, Jan (1962) Shaping the World Economy: Ideas for a global Economic Policy. NY: Twentieth Century Fund.
1 Alvarez and Lucas (2007) extended our framework to include the production of non-traded goods aswell.