Martin Wolf Commands: "Let the Dollar Fall!"

Martin Wolf channels Maury Obstfeld and Ken Rogoff:

FT.com / Comment & analysis / Columnists - Martin Wolf: Let dollar fall or risk global disorder: A very simple description of the current state of the US economy would be as follows: total demand is 107 per cent of gross domestic product; total output of tradeable goods and services is some 25 per cent of GDP; total demand for tradeable goods and services is 32 per cent of GDP; and total demand and supply of non-tradeables is 75 per cent of GDP. The difference between supply and demand for tradeables, by definition, equals the trade deficit.

Now assume a reduction of only 3 percentage points in the ratio of the trade deficit to GDP. This is just under 10 per cent of total demand for tradeables. Assume, for simplicity's sake, that the incremental demand for tradeable goods and services is proportionate to that for non-tradeables. Without any shift in relative prices, overall demand in the economy needs also to fall by just under 10 per cent, to deliver the desired reduction in the trade deficit. This would generate a fall of about 7 per cent in GDP, all of which would fall upon industries producing non-tradeables. But such a deep recession would create misery, while contributing nothing to the desired improvement in the external deficit.

To avoid the massive recession that expenditure reduction alone would generate, the price of non-tradeables has to fall substantially relative to that of tradeables. Such a shift is a decline in the real-exchange rate. This should move spending towards non-tradeables and potential supply towards tradeables. Under plausible assumptions the real exchange rate changes needed to shift the economy in the desired direction are large. The quicker the adjustment, the bigger they must be. That is a good reason for making those adjustments slowly, which is also a reason for avoiding postponing them indefinitely.

Could these changes in real exchange rates be achieved without moves in nominal exchange rates? The logical answer, again, is yes. But that would require a fall in the nominal price of non-tradeables in the US -- in other words, outright deflation in that country -- and a rise in the price of non-tradeables in the exporting countries -- in other words, rapid inflation there. The former is inconceivable, while the latter is apparently unacceptable. So nominal exchange rates must move.