Semi-Daily Journal Archive

The Blogspot archive of the weblog of J. Bradford DeLong, Professor of Economics and Chair of the PEIS major at U.C. Berkeley, a Research Associate of the National Bureau of Economic Research, and former Deputy Assistant Secretary of the U.S. Treasury.

Monday, October 30, 2006

Unwinding the Current Account

Mark Thoma cites Diego Valderrama of the San Francisco Fed on what happens when large current account deficits are unwound:

Economist's View: Current Account Adjustments and Economic Growth: The San Francisco Fed looks at the likely consequences of a sudden reversal in the current account and concludes that should a "sudden stop" occur, the risks of substantial disruption are low:

What Are the Risks to the United States of a Current Account Reversal?, by Diego Valderrama, FRBSF Economic Letter: The U.S. current account has been in deficit since the beginning of the 1980s, except for a brief period in 1991, and has grown to 6.6% of gross domestic product (GDP) in the second quarter of 2006. The growing deficit has clearly caught the attention of policymakers and analysts....

Economic theory does not offer a robust prediction as to how a current account reversal impacts economic growth, asset prices, or the exchange rate. Indeed, in the simplest models of open economies, countries can run very large current account deficits without much impact at all, as long as they reduce those deficits eventually by repaying old loans. However, other models predict that current account reversals can have a negative impact on economic output, asset prices, and the exchange rate (Mendoza 2006, Obstfeld and Rogoff 2005). Still other models predict that adjustments leading to strong exports and current account surpluses can boost income. Given the lack of a theoretical consensus, this Letter turns to the recent empirical literature to learn more about the potential risks to the U.S. economy of a possible current account reversal and about the factors that are associated with more disruptive corrections....

Not all reversals in developing countries are associated with output contractions. Milesi-Ferretti and Razin (2000) study reversals in a sample of 105 low- and middle-income countries between 1970 and 1996. They find that, for the median country, the current account deficit shrank dramatically--by 7.4% of GDP (going from 10.3% to 2.9%). They also find varying consequences in terms of economic growth after the reversals.... [T]he more closed the country, the greater the relative need to reduce investment and expenditures to close the gap. Another factor is the degree to which the exchange rate has appreciated; specifically, the greater the appreciation, the greater the needed depreciation to induce the transfer of resources into the export sector to boost exports and reduce the current account deficit.

What can we learn from past adjustments in industrialized countries?... Croke, Kamin, and Leduc (2005) study 23 episodes of current account adjustments in industrialized countries. They find that current account adjustments were associated with modest decreases in economic activity about two-thirds of the time.... For contraction episodes... output growth turns slightly negative about one year after the current account reversal.... In the expansion episodes, typically large currency depreciations occurred without an asset price collapse. This latter finding is significantly different from the sudden stop episodes in developing countries, where large currency depreciations are associated with economic slowdowns and asset price collapses....

There have been many instances of disruptive current account adjustments, particularly in developing countries.... However, on average, adjustments have coincided with either small increases in output growth (in developing countries) or very moderate reductions in growth (in industrialized countries). From the experience of industrialized countries we learn that the larger the deficit, the faster and the greater the associated fall in output.

Based on the historical evidence, the likelihood of a rapid and disruptive current account adjustment in the United States remains low...

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