Current Account Imbalances and Exchange Rates

The debate on the possible undervaluation of the Chinese Renminbi is in full force among politicians and academics. Most agree that the Renminbi is undervalued but there are disagreements on the effects of exchange rate misalignments (are they they ultimate cause of current account imbalances?).

Are exchange rate misalignments the main cause of current account imbalances? Here are two Nobel prize winners who disagree: Stiglitz says no and Krugman says yes. I will not resolve the debate here but there is something that I cannot understand in Krugman’s argument. His argument is that current account imbalances cannot be corrected without an exchange rate change. While he does not say so, he almost implies that current account imbalances are always the result of exchange rate misalignments. This position is too extreme. The current account is the difference between national saving and investment. It is true that saving and investment will react to relative prices (which are determined by the exchange rate). But we can observe changes in saving and investment that are driven by many other factors and that have minimal impact on relative prices. Krugman’s argument is that an increase in Chinese consumption will not reduce its current account surplus unless this consumption will translate into imports, and for this to happen we need a relative price change.

Krugman is right in the sense that if an increase in Chinese consumption is directed towards local goods, their price will increase, which amounts to an exchange rate appreciation. But the fundamental question is what needs to happen for the imbalance to be corrected. His view is that we first need to get prices right and then the adjustment will happen. The alternative view is that Chinese will have to get used to consume more, Americans will need to understand that they need to save more and this will be the main factor that will drive the current account adjustment. Relative prices are likely to adjust and therefore the (real) exchange rate will have to change. How much? It will all depend on how easy we can find substitutes for the goods currently produced in China. It might be that it will not take much of an increase to find an alternative location for production (with cheaper labor) and prices will change very little.

By the way, here is an interesting piece of data: while both the US and the Euro area have a large bilateral trade deficit with China (which can be interpreted as a signal of the undervaluation of the Renminbi), the Euro area has an overall current account surplus while the US has a current account deficit. You can argue that for the Euro area, an undervalued Renminbi shifts demand from other countries goods to Chinese goods. But this does not get reflected in the overall current account balance. Clearly there is more than an undervalued Renminbi in the dynamics of the current account in the US and the Euro area. And, yes, I am aware that we can argue that the Euro is undervalued relative to other currencies, as Martin Fedstein does, but then the argument becomes a tautology, every time we see a current account imbalance we conclude that it is because exchange rates are not right.

The debate has extended to the broader issue of current account imbalances and the potential blame that the countries with current account surpluses (China or Germany) have on the weakness of the economic recovery. As an example, here is Martin Wolf (FT) arguing that Germany cannot be a model for the Eurozone because of its current account surplus. Germany is accused of having kept wage growth too low and therefore forcing a “depreciation” to be more competitive. I am not sure what Martin Wolf proposes as a solution. Charles Wyplosz gets it right in his article: Germany should be running a current account surplus to save for the future and this is what many other advanced economies should be doing.

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