Reversing the U.S. External Deficit

The spring 2007 edition of the International Monetary Fund's World Economic Outlook is titled "Spillovers and Cycles in the Global Economy." One of several topics in this not-yet-fully-released semiannual publication covers exchange rates and the adjustment of external imbalances.

It couldn't be timelier, given the scale of the U.S. current account deficit. On the other hand, given the persistence of that deficit, this discussion would have been topical at any time in the past 10 years.

In brief, the IMF's conclusions are somewhat more upbeat than the schools of thought that hold that external adjustment in the U.S. requires that we suffer either a protracted recession or a deep plunge in the dollar's value. The work tends to support the commonsensical view that if it took many years of globe-leading domestic growth and currency overvaluation to get in so deep a hole, it will take years of globe-trailing domestic growth and currency undervaluation to get out. Adjustment can take place with persistence over time; it need not happen cataclysmically.

Among the key findings of the IMF staff's investigation of 42 episodes of "large and sustained external reversals" over the past 40 years is that real exchange-rate depreciation can help to minimize the otherwise contractionary effects -- i.e., an increase in domestic saving rates and fiscal consolidation -- that are often part of a successful reversal of external deficits. (A large and sustained reversal is defined as "swings in the current account balance of at least 2.5% of GDP and at least 50% of the initial current account imbalance that are sustained for at least five years.")

A second finding is that external adjustment in the U.S. "may involve a smaller real depreciation of the U.S. dollar than sometimes claimed in the recent policy and academic debates." This conclusion is based on what the IMF staff argues is a correction of "standard empirical trade models" for biases that tend to underestimate the responsiveness of U.S. trade volumes to changes in exchange rates.

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Jim Griffin is economic consultant and portfolio adviser to ING Investment Management and its Hartford-based unit, ING Aeltus, which manages institutional investment accounts and acts as adviser to the ING Mutual Funds. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. While Griffin cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.