A stronger US economy requires a weaker dollar

Sometimes economics can be helpful even if it does not allow you to make point predictions with any degree of confidence. This is the case, for instance, when it can rule out certain combinations of outcomes for different economic variables as unlikely or even nigh-on impossible. An example of such an unlikely configuration of outcomes is (a) a strong and sustainable recovery of the US economy and (b) a strong (let alone a strengthening) US dollar. A very similar statement can be made about the prospects for a speedy recovery of the UK economyTo argue this point it is helpful to start with the basic output-expenditure identity from the national accounts:

Here C is aggregate consumption, I aggregate gross investment or domestic capital formation, X exports of goods and services (excluding foreign factor income receipts), M imports of goods and services (excluding foreign factor income payments) and Y is gross domestic product, or GDP. Consumption is the sum of private consumption, Cp and public consumption, Cg; investment is the sum of private investment, Ip and public investment, Ig; private investment is the sum of inventory investment or stockbuilding, Is, investment in housing (residential construction), Ih and business fixed investment, Ib.  All variables are measured in units of real GDP.

I start from the assumption that today and for the next two or three years at least, output in the US economy will be demand-constrained.  There is large and growing excess capacity in the form of idle labour and capital resources.  I cannot relate in any way to those who view the Great Depression of the 1930s as the Long Vacation, or who argue that the increase in the US unemployment rate from 4.4 percent of the labour force in March 2007 to 9.7 percent of the labour force in August 2009 represents an increase in the demand for leisure by the US proletariat and salariat or a particularly nasty exogenous shock to labour productivity.

For those who would like to dip their mental toes into the ‘Long Vacation’ tradition, a good place to start is a paper written by Casey Mulligan of the University of Chicago (Casey Mulligan, “What Caused the Recession of 2008? Hints from Labor Productivity”, NBER Working Paper No. 14729, February 2009). It pays to have a sense of humour when attempting to wade through this paper, as can be gleaned from the Abstract which starts with the following assertion: “A labor market tautology says that any change in labor usage can be decomposed into a movement along a marginal productivity schedule and a shift of the schedule.”

There is, of course, no labor market tautology saying anything like that, unless you also assume that actual employment always has to lie on the marginal productivity schedule of labour.  I consider such a view to be bonkers. But nuff said.

For me, an unreconstructed Keynesian when it comes to the interpretation of the drivers of business cycle fluctuations, the key question concerning the speed of recovery from the Great Recession of the Noughties, : where will the demand come from.

Let’s consider the drivers of domestic demand.  Private consumption is dead in the water and likely to remain so for quite a while.  US households still have a debt-to-annual disposable income ratio of around 150 percent, which, if the debt is hard (that is, not easily repudiated) is a source of vulnerability that can encourage precautionary saving as well as saving for life-cycle or other reasons.  The US consumer has by now been cured of the previously well-entrenched belief that saving is for sissies because real men count on capital gains on homes and equity to see them through the night.

It is, of course, very easy to walk away from personal debt in the US.  Mortgage debt is overwhelmingly non-recourse, so the rational response to negative equity is to send the key to you home back to the mortgage lender.  As regards other consumer debt, personal bankruptcy is just a couple of phone calls and a quick court judgement away.  Shame and feal of stigma appear to be rapidly weakening deterrrents to such a course of action.

So is US household debt not a drag on demand?  If the debt can be repudiated swiftly and at little cost to the debtor, US household debt won’t be much of a drag on consumer demand.  The creditors will, of course, take the blow.  Given the precarious condition of the US financial system, the negative effect on demand (through the credit channel and other financial linkages) of large-scale discretionary default on housing debt is likely to be non-trivial.

Government spending on goods and services (both current and capital) will remain strong for at least the first half of 2010, because most of the Obama fiscal stimulus plan is still in the pipeline.  But in the second half of 2010 that stimulus will wear off and the US administration simply does not have the fiscal means to implement a further fiscal stimulus without seriously spooking the financial markets.  The US has to commit itself soon to a severe future fiscal retrenchment (tax increases and/or public spending cuts) if the government is to retain (or rather regain) its reputation as a solvent entity and the Fed its reputation for taking inflation seriously.

Inventory accumulation will no doubt bring joy to the US and other overdeveloped economies for two or three more quarters.  One of the nicer non-linearities is economics comes from the robust empirical observation that stocks cannot be negative.  Inventory decumulation (de-stocking) therefore grinds to a halt at some point, often quite early in a recession, and restocking will take its place, making for a nice little recovery while it lasts.

Unfortunately, businesses build stocks in the hope and expectation of future sales.  Unless final demand picks up, the lift given to economic activity by re-stocking will peter out again.  Private consumption and public spending (consumption and capital) are not going to provide any material stimulus.  That leaves private investment and net exports.

Investment in residential housing is unlikely to bring much joy even if home prices continue to stabilise and recover further, because massive excess capacity has been built up and depreciation rates on housing are low.  Commercial property makes residential housing look like a growth industry.  That leaves business fixed investment and next exports.

These two hang together.  Business fixed investment growth requires healthy growth of net external demand.  US production has to shift from non-traded goods and services to traded goods and services, both exports and import-competing goods and services, at the same time that the national saving rate rises.  That will happen only if the rest of the world grows healthily and if the dollar takes a beating – by about 30 percent in effective (trade-weighted) real terms on my back-of-the envelope calculations.  Because this depreciation in the US real exchange rate has to happen swiftly if the country is to experience a health recovery rather than an anaemic stroll through 10% plus unemployment territory, most of the real exchange rate depreciation will have to come through a nominal depreciation.

Which currencies would the dollar depreciate against?  Not the euro, surely, which has been too strong for compfort since before the crisis.  Not against sterling (the UK is pretty much in the same boat as the US, with the balance sheet position of the household sector if anything worse than in the US), and certainly not against the yen.  The US dollar will mainly have to depreciate, if a long spell of over-capacity, high unemployment and low growth is to be avoided, vis-a-vis the currencies of the roughly 50 percent of the known economic universe that we call emerging markets and developing countries.  China is the largest of these, but amounts to only about 6 or 7 percent of global GDP.

China, India, Brazil, Turkey and a dozen or more other EMs are providing the kind of domestic demand-driven growth stimuli that could drag the US along in its wake.  But the key relative price adjustment has to occur also: there has to be a real depreciation of the US dollar and a real appreciation of the EM currencies.

Because I consider it likely that too many EMs will continue to be reluctant to let their real and nominal exchange rates appreciate sufficiently, I consider it unlikely that the external stimulus to the US recovery will be sufficient to close the US output gap swiftly.  I hope to be proven wrong.

While I find myself in broad sympathy with Michael Mussa’s approach to the drivers of the US (and global) economic recovery in his recent IIE paper (Michael Mussa, “Global Economic Prospects as of September 2009: Onward to Global Recovery”, Peterson Institute for International Economics Paper presented at the sixteenth semiannual meeting on Global Economic Prospects, September 17, 2009), I disagree with his numerical/quantitave calibration, which I consider to be too optimistic, especially for the overdeveloped world.  Mussa underestimates the domestic-demand dampening effect of the financial crisis and the bad/disastrous balance sheet configurations of the US household sector, banking sector and government sector.  The V-shaped recovery and Victor Zarnovitz law, the deeper the recession – the steeper the recovery, are unlikely to be relevant for a deeply financially challenged economy like the US, where massive financial damage was done before the recession – and where this financial collapse was indeed the cause of the recession.  The recession continues to feed back adversely on an already impaired financial sector, further undermining its capacity for lending and other intermediation.  Mussa could turn out to be right, but if he turns out to be right, it will be because he is lucky.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website