FrAdjustment and the dollar - Paul Krugman Blog - NYTimes.com: Whenever exchange rates enter into discussion, certain zombie fallacies — ideas that you kill repeatedly, but refuse to die — inevitably make their appearance. What I’m hearing a lot now is the old line that exchange rates have nothing to do with international imbalances: the trade deficit is the difference between investment spending and savings, and that’s all there is to it. It’s a fallacy that John Williamson of the Institute for International Economics calls the doctrine of immaculate transfer. So let me try killing the zombie once again.
The starting point is to imagine what the world might look like if it (1) returns to more or less full employment (2) experiences a significant reduction in imbalances — in particular, a much lower US trade deficit.
For (2) to happen, the US must start spending more within its means; overall spending will have to fall relative to GDP. Correspondingly, spending in the rest of the world must rise.
But that’s not the end of the story. Suppose that spending in the United States falls by $500 billion, while spending in the rest of the world rises by $500 billion. Other things equal, most of that decline in US spending would fall on US-produced goods and services. Remember, even if you buy Chinese stuff at Walmart, much of the price represents US distribution and retailing costs. The world, you might say, is a long way from being truly flat.
Meanwhile, a much smaller fraction of the rise in spending abroad will fall on US products. So other things equal, this reallocation of spending would lead to an excess supply of US goods and services, an excess demand for goods and services produced elsewhere. (Trade economists know that I’m talking about the transfer problem.)
So something has to give — specifically, the relative price of US output, and along with it such things as US relative wages, has to fall.
There are three ways this could happen: (1) deflation in the United States (2) inflation in the rest of the world (3) a depreciation of the dollar against other currencies. Leave (2) aside, on the grounds that central banks will fight it. Then the choice is between (1) and (3).
And here’s the thing: deflation is hard (ask Spain), because prices are sticky in nominal terms. How do we know that? Lots of evidence. See, for example, A Sticky Price Manifesto by Larry Ball and some guy named Mankiw. But the most compelling evidence — familiar to international macro people, but oddly uncited by most domestic macroeconomists — comes from exchange rates.
The first person to make this point was probably none other than Milton Friedman (cue Brad DeLong on the decline of the Chicago School), but the really influential quantitative analysis was by Michael Mussa.
Mussa pointed out that a funny thing happens when countries move from fixed to floating exchange rates: the nominal exchange rate becomes much more variable, of course, but so does the real exchange rate — the exchange rate adjusted for price levels. Meanwhile, relative inflation rates remain within a narrow band. The obvious interpretation is that once the exchange rate is freed, it bounces around a lot, while domestic prices in domestic currency are sticky, and don’t move much.
Here’s an updated version of Mussa’s point. The top figure shows quarterly log changes in the US-Germany real exchange rate; the bottom figure divides this into nominal exchange rate changes and inflation differentials. The Mussa point is crystal clear.
So, the bottom line: to narrow international imbalances, we need a lower relative price of US output. Because prices are sticky, by far the easiest way to get there is dollar depreciation.
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