Government policy and the open economy. A government deficit can contributeto a current account deficit if the budget deficit raises aggregate demand,resulting in rising imports. The government can even contribute directly to acurrent account deficit by purchasing foreign output. A current account deficitmeans the rest of the world is accumulating claims on the domestic privatesector and/or the government. This is recorded as a “capital inflow”. Exchangerate pressure might arise from a continual current account deficit.
While theusual assumption is that current account deficits lead more-or-less directly tocurrency depreciation, the evidence for this effect is not clear-cut. Still,that is the usual fear—so let us presume that such pressure does arise.
Implicationsof this depend on the currency regime. According to the well-known trilemma,government can choose only two out of the following three: independent domesticpolicy (usually described as an interest rate peg), fixed exchange rate, andfree capital flows. A country that floats its exchange rate can enjoy domesticpolicy independence and free capital flows. A country that pegs its exchangerate must choose to regulate capital flows or must abandon domestic policyindependence. If a country wants to be able to use domestic policy to achievefull employment (through, for example, interest rate policy and by runningbudget deficits), and if this results in a current account deficit, then itmust either control capital flows or it must drop its exchange rate peg.
Floatingthe exchange rate thus gives more policy space. Capital controls offer analternative method of protecting an exchange rate while pursuing domesticpolicy independence.
Obviously,such policies must be left up to the political process—but policy-makers shouldrecognize accounting identities and trilemmas. Most countries will not be ableto simultaneously pursue domestic full employment, a fixed exchange rate, andfree capital flows. The exception is a country that maintains a sustainedcurrent account surplus—such as several Asian nations. Because they have asteady inflow of foreign currency reserves, they are able to maintain anexchange rate peg even while pursuing domestic policy independence and (if theydesire) free capital flows.
Inpractice, many of the trade surplus nations have not freed their capitalmarkets. By controlling capital markets and running trade surpluses, they areable to accumulate a huge “cushion” of international reserves to protect theirfixed exchange rate. To some extent, this was a reaction to the exchange ratecrisis suffered by the “Asian Tigers”—when foreign exchange markets lostconfidence that they could maintain their pegs because their foreign currencyreserves were too small. The lesson learned was that massive reserves arenecessary to fend off speculators.
Do floating rates eliminate “imbalances”? In the global economy, every tradesurplus must be offset by a trade deficit. The counterpart to the accumulationof foreign currency reserves is accumulation of indebtedness by the currentaccount deficit nations. This can create what is called a deflationary bias tothe global economy. Countries desiring to maintain a trade surplus will keepdomestic demand in check in order to prevent rising wages and prices that couldmake their products less competitive in international markets.
At the sametime, countries with trade deficits might cut domestic demand to push downwages and prices in order to reduce imports and increase exports. With bothimporters and exporters attempting to keep demand low, the result isinsufficient demand globally to operate at full employment (of labor and plantand equipment). Even worse, such competitive pressure can produce tradewars—nations promoting their own exports and trying to keep out imports. Thisis the downside to international trade, and it is made worse to the extent thatnations try to peg exchange rates.
Someeconomists (notably, Milton Friedman) had argued in the 1960s that floatingexchange rates would eliminate trade “imbalances”—each nation’s exchange ratewould adjust to move it toward a current account balance. When the BrettonWoods system of fixed exchange rates collapsed in the early 1970s, much of thedeveloped world did move to floating rates—and yet current accounts did notmove to balance (indeed, “imbalances” increased).
The reasonis because those economists who had believed that exchange rates adjust toeliminate current account surpluses and deficits had not taken into accountthat an “imbalance” is not necessarily out of balance. As discussed previously,a country can run a current account deficit so long as the rest of the worldwants to accumulate its IOUs. The country’s capital account surplus “balances”its current account deficit.
It is thusmisleading to call a current account deficit an “imbalance”—by definition, itis “balanced” by the capital account flows. As discussed earlier, it “takes twoto tango”: a nation cannot run a current account deficit unless someone wantsto hold its IOUs. We can even view the current account deficit as resultingfrom a rest of world desire to accumulate net savings in the form of claims onthe country.
Currency regimes and policy space: conclusion.
Let usquickly review the connection between choice of exchange rate regime and thedegree of domestic policy independence accorded, from most to least:
*Floating rate, sovereigncurrency àmost policy space; government can “afford” anything for sale in its owncurrency. No default risk in its own currency. Inflation and currencydepreciation are possible outcomes if government spends too much.
*Managed float, sovereigncurrency àless policy space; government can “afford” anything for sale in its owncurrency, but must be wary of effects on its exchange rate since policy couldgenerate pressure that would move the currency outside the desired exchangerate range.
*Pegged exchange rate, sovereigncurrency àleast policy space of these options; government can “afford” anything for salein its own currency, but must maintain sufficient foreign currency reserves tomaintain its peg. Depending on the circumstances, this can severely constraindomestic policy space. Loss of reserves can lead to an outright default on itscommitment to convert at the fixed exchange rate.
The detailsof government operations discussed throughout this part of the book apply inall three regimes: government spends by crediting bank accounts, taxes bydebiting them, and sells bonds to offer an interest earning alternative toreserves. Yet, ability to use these operations to achieve domestic policy goalsdiffer by exchange rate regime.
On a peggedcurrency, government can spend moreso long as someone is willing to sell something for the domestic currency, butit might not be willing to do sobecause of feared exchange rate effects (for example, due to loss of foreigncurrency reserves through imports).
To be sure,even a country that adopts a floating rate might constrain domestic policy toavoid currency pressures. But the government operating with a pegged exchangerate can actually be forced to default on that commitment, while the governmentwith a floating rate or a managed float cannot be forced to default.
Theconstraints are thus tighter on the pegged regime because anything thattriggers concern about its ability to convert at the pegged rate automaticallygenerates fear of default (they amount to the same thing). The fear can lead tocredit downgrades, raising interest rates and making it more costly to servicedebt. All externally-held government debt is effectively a claim on foreigncurrency reserves in the case of a convertible currency (where governmentpromises to convert at a fixed exchange rate). If concern about ability toconvert arises, then only 100% reserves against the debt guarantees there is nodefault risk. (Domestic claims on government might not have the sameimplication since government has some control over domestic residents—it could,for example, raise taxes and insist on payment only in the domestic currency.)
Next week: what happens if a country adopts aforeign currency? (Hint: look at the PIIGS!)