Comment from Andrew Smithers on Martin Wolf’s column “Falling dollar saga still has a long way to run.” 6th December, 2006.
I would like to extend the discussion set off by Martin’s article on the dollar.
If we assume, as seems eminently reasonable, that the US external trade deficit needs to fall from nearly 7% to say 3% of GDP, there needs to be a rise in US net domestic savings of around 4% of US GDP, and a fall in the rest of the world net domestic savings by around 1.3% of RoW GDP.
These are not, however, the only adjustments needed. The US also needs to have capacity for the production of traded goods and services, in excess of that required to meet domestic demand. This can either be achieved through a US recession, or a switch of investment from producing non-traded goods and services to traded ones. Martin has previously referred in his article to the work of Obstfeld and Rogoff. They have pointed out that this switch in investment is likely to require a large fall in the dollar, partly because this will enable the needed rise in investment returns on traded goods and services to rise relative to those of non-traded ones.
A straight switch in investment is, however, unlikely to be sufficient. This is because the capital/output ratio of traded goods and service production seems very much higher than that of non-traded ones. It has been a marked feature of the world economy over the past 15 years or so that, among G5 countries, the UK and US have invested least and grown fastest. They have also been the ones with large and growing trade deficits.
The two features are likely to be connected. Rapid growth has been possible with low investment in the US and UK because it has been concentrated in low capital/output production. (The problem is perhaps more acute in the UK, where housing investment, which has a particularly high capital/output ratio, needs to rise, whereas a fall in housing investment in the US should help the adjustment problem.)
If this is correct, an additional adjustment is needed in the world economy. If recessions are to be avoided, not only must US (and UK) net domestic savings rise to finance lower trade deficits, they must rise even more to finance the higher levels of domestic investment which are needed to create capacity in traded rather than non-traded goods and services.
Equally, the rest of the world will have to adjust by reducing investment as it switches to more non-traded investment and, to avoid recession, this switch must be accompanied by an even greater fall in domestic net savings than is needed simply to match the adjustment in external trade. If recession is to be avoided, all these adjustments must take place in a smooth and balanced fashion.
The problem posed by different capital/output ratios for traded and non-trade output is not, of course, the only other difficulty in adjusting to lower trade imbalances, but I thought that one was enough for now!