Monday, December 6, 2004

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Equilibrating mechanisms at work

In theory, a declining dollar should help the U.S. balance of trade by making imports relatively more expensive to Americans and exports relatively inexpensive to foreigners. However, the current macroeconomic imbalances cause this equilibrating mechanism to carriy some risks. Among the many fears about the current dollar depreciation are:

1) U.S. demand for imports is so inelastic that price increases won't have much of an effect;

2) A sizeable chunk of the U.S. deficit is bilateral trade with China, and the dollar's fall has not affected that exchange rate too much;

3) East Asian central banks will only tolerate so much of a fall before they decide to liquidate their dollar reserves, which would trigger a financial panic/run on the dollar/cats and dogs living together/mass hysteria (see Brad Setser for more on this -- as well as the Economist)

Given all of this, it is nice to read about these equilibrating effects at work. Which leads me to today's front-pager in the Wall Street Journal by Emily Nelson and Brooks Barnes:

As the dollar has fallen to a 12-year-low against the British pound and an all-time low against the five-year-old euro, Europeans now view the U.S. as one giant half-off sale on everything from clothes to coffee to restaurant meals. Because so many businesses now operate globally, comparison shopping is easy.

At the London outpost of Nobu, the New York Japanese restaurant, a special set meal costs between $136 and $233 per person, at Friday's exchange rate of $1.94 to the pound. A la carte, the monkfish paté with caviar costs $24.29, and the baby spinach with whitefish salad $22.35.

All of which is out of the question for Catherine Watson, a 38-year-old photographer from Cardiff, Wales -- except when she can snap up cheap dollars to pay for the same meal at Nobu in Manhattan. There, one night recently, armed with dollars purchased at about $1.89 to the pound, she and a friend started with the monkfish pate for $17 and the spinach salad for $16. The chef's special dinners in New York are $80, $100 and $120, about 40% off London prices.

"Things seem so cheap that you turn into a bit of the child in a candy store," says Ms. Watson....

The hordes from the Old World streaming across the Atlantic are likely only to increase as the dollar, down about 10% against the pound and down 12% against the euro since April, is expected to fall further in 2005. Basic goods, such as household supplies, clothing and food have long tended to be less costly in the U.S., where sales and big discount chains are more prevalent than in Europe. But the disparity currently is much greater. And businesses, from airlines to hotel chains, are stepping up promotional efforts to portray the U.S. as a shopper's paradise.

Travel from some European countries to the U.S. is up nearly 25% so far this year, says Gabriella Vecchio, international marketing manager at the Travel Industry Association of America.

That pace well exceeds the forecast that the U.S. Department of Commerce office of travel and tourism industries made last April for 9.3 million Europeans to visit the U.S. this year, a 7% increase from 2003. American Airlines says its trans-Atlantic flights are 81.3% full, up 3.9 points from a year ago, and it has added flights as well. In London subway advertising, the airline's slogan is: "America Reduced."

"A weak dollar means bargain holidays," declared a recent article in London's Sunday Times. Other travel sections of British newspapers are filled with stories detailing how Christmas shopping in Manhattan promises savings even after hotel and airfare costs.

One can question whether the magnitude of these kind of flows will put a larger dent in the current account deficit. However, there is an intriguing question that this kind of story raises. As previously discussed, American productivity in nontradable sectors such as retail is considerably higher than other parts of the globe, which is one source of lower prices. If transport costs continue to decline, it would be interesting to speculate whether these sectors become an important comparative advantage for the United States on trade matters.

Just a thought.

posted by Dan on 12.06.04 at 02:05 PM


One of the things (maybe among a very few) that the Kerry camp got right on economics was the observation that export demand had fallen during the 1st Bush term. You and I may put different weights on the role of Bush's fiscal stimulus for this - but I agree with you that a dollar devaluation is welcome news if we are hoping for an export-led recovery.

posted by: pgl on 12.06.04 at 02:05 PM [permalink]

Most of my UK friends have told me they doubt they will ever travel to the US again due to TSA and the fear of being sent to Guantanamo. Anecdotal evidence, but I wonder if the quoted story is just an exception to the general rule.


posted by: Cranky Observer on 12.06.04 at 02:05 PM [permalink]

When you consider that, according to the Washington Post, the dollar was much weaker in 1995 than it is today, its hard to see what all the hand-wringing is about. I admit, the weaker dollar is keeping me from planning that big european vacation next summer. I'll cope.

posted by: Iconic Midwesterner on 12.06.04 at 02:05 PM [permalink]

Cranky, who in God's name are your friends? They must be a decidedly dicey lot.

posted by: Iconic Midwesterner on 12.06.04 at 02:05 PM [permalink]

Quickly checked the GDP data, might get slightly different results using other data.

But last quarter imports were $1.8 T and exports were $1.2T . With imports roughly 150 % of exports just to keep the problem from getting worse exports would have to grow 150% faster than imports. That is very, very far behind the 8- ball.

Moreover, in the 1990s we found that import and export prices reacted much less to exchange rate variations than they use to. So the size of the dollar adjustment may have to be much larger than generally thought. For example, despite the large drop in the dollar already, prices of imported consumer goods - excluding autos and oil -- have not started rising -- they just quit falling.

From the prices I paid for everything in London this summer compared to NY tourist prices the exchange rate should be 1 to 1 to make them comparable.

posted by: spencer on 12.06.04 at 02:05 PM [permalink]

The synthetic Euro in my data base shows it at 1.60 in 1980 and 1.45 in 1991. So we still have a way to go.

posted by: spencer on 12.06.04 at 02:05 PM [permalink]

"Most of my UK friends have told me they doubt they will ever travel to the US again"

There is a section of the UK population who won't travel to the US, but (anecdotal evidence) they're a minority. They may make more of a splash in the US thanks to the Guardian, but as the article says

"Travel from some European countries to the U.S. is up nearly 25% so far this year".

Brits are some of the most determined bargain hunters in the world, camping out in the rain for days before store sales. Oh, and it's still a majority who actually like the US (just).

posted by: DaveVH on 12.06.04 at 02:05 PM [permalink]

2) A sizeable chunk of the U.S. deficit is bilateral trade with China, and the dollar's fall has not affected that exchange rate too much;

There certainly is more pressure on the Chinese to adjust the exchange rate. And they would only do it if under pressure, so the decline in the dollar is also helpful on the Chinese front, even if they have been slow to respond.

3) East Asian central banks will only tolerate so much of a fall before they decide to liquidate their dollar reserves, which would trigger a financial panic/run on the dollar/cats and dogs living together/mass hysteria

No. The very fact that dumping the dollar would cause a financial panic inhibits them from liquidating reserves, except in a very circumspect manner.

posted by: Al on 12.06.04 at 02:05 PM [permalink]

I admit, the weaker dollar is keeping me from planning that big european vacation next summer.

Go to Argentina instead. You get the reverse currency effect: everything is 3X as cheap. You can get a beautiful meal in a fine restaurant for $10/person. And, of course, BA, at least, is quite European. Or hell, go to China (if you get there before the gov't changes the exchange rate). Shanghai is a wonderful, extremely modern city. Or, hell, there are enough places to go in this country!

posted by: Al on 12.06.04 at 02:05 PM [permalink]

1. I read an article this weekend (NYT?) about the nervousness of a central banker in Japan. Clearly, there are foreign central-bankers who are afraid of - and willing to act against - a "hard fall" of the dollar, but...

2. Is the "hard fall" avoidable? I hope we can count on foreigners' ability/desire to prevent it. But what if a run from the dollar begins with Americans? Then extends, as runs do, to others? We shouldn't count on foreign governments' ability to prevent a run.

3. Do we want higher productivity in non-tradable sectors such as retail to be our salvation? It's a depressing thought. Retail, for line-level employees, is a thankless, low-pay job. I've been there; it's the assembly-line job of the future, with lower pay. Even a non-tenure job at UC is far better.

posted by: Andrew Steele on 12.06.04 at 02:05 PM [permalink]

Dan -- thanks for the plug.

Remember that part of the US retail advantage has nothing to do with service sector productivity, and everything to do with the absence of a VAT here (that, and service is priced into restaurants rather than added on in the Euro bit of Europe -- the list price here in NYC is 30% less than the final price if you add in taxes and tip, so you need to adjust a bit). True, you can get a VAT refund in Europe as an American for EU goods, but it is a hassle.

Even with the VAT, Europe felt cheap when one dollar bought $1.20 euro or so (0.82 dollars/ per euro at one time), so exchange rates do matter for tourism. But the US also competes with Greece, Turkey, Croatia, Tunisia, even Bulgaria (Black Sea resorts are cheap and popular with the German working class ...) for the tourist euro ... Every bit helps but realistically, US import demand also has to slow to cut into our external borrowing need: 10% import growth and 10% export growth = a widening of the US trade deficit (goods and services) by more than $50 billion. There is not yet evidence in the trade data the pace of import growth is slowing -- maybe Americans are taking fewer European vacations, but spending more on each one, or they just are importing other things ...

Also want to mention goats, since my cousin just started RAISING goats in Mizzou (I have rural red state roots). Apparently, the US imports goat meat, so the business may have some legs. Right now, there is enough demand on the east coast that someone sends a truck out to Eastern Mizzou to pick up the goats. A bit more evidence of import substitution/ exchange rate adjustment in action?

posted by: brad setser on 12.06.04 at 02:05 PM [permalink]

The dollar is going to coninue sliding to a level that is actually an inferior reflection of its strength unless one of two things happen. The reason the dollar is going to keep falling is China. Because an enormous amount of our imports come from China, any devaluation of our currency to compensate for the trade deficit is not meaningful unless it has an effect on our consumption of Chinese imports. This will not happen. China continues to artificially peg its currency to ours, and so a devaluation of the dollar means a devaluation of yuan.

One of two things have to happen. 1) China has to unpeg its currency in some manner. Whether that means just letting it float (which seems unlikely) or some sort of semi-floating arrangement is unknown. But the drop in the dollar has to be compensated by a relative rise in the yuan for the devaluation to have any meaningful effect. Otherwise, all we're doing is screwing over the EU. Which brings me to 2) moderate to massive foreign central bank intervention. Japan, the EU and South Korea have already publicly contemplated this. To put it simply, all of their markets are too sensitive to U.S. demand for their exports. A falling dollar means their exports get relatively more expensive (but not China's, because their currencies float while China's doesn't.) So, in order to protect their export industries, they may go an a coordinated buying campaign to shore up the dollar. All this does is prolong the inevitable and reward fiscally reckless behavior, but that hasn't been stopping the Japanese and Chinese from doing it for the last ten years.

The central banks aren't going to be the first to dump the currency. It'll start off in the private sector. Some central banks will try to react by buying the dumped dollars, but if the market acts like it should, we'll see another clash along the lines of Soros v. Bank of England. Only after the yuan is allowed to float to some degree will dollar exchange rate fluctuations have any meaning.

Oh, and check out my blog at for more of a discussion along the same lines (or to tell me how much of an idiot I am.)


posted by: Branden Bell on 12.06.04 at 02:05 PM [permalink]

Oh, and before I forget, Muck Fizzou! Go Jayhawks!

posted by: Branden Bell on 12.06.04 at 02:05 PM [permalink]

My family vacationed in Colorado instead of Italy this year. With the dollar so low, Italy was out of the question. On Friday my wife and I are taking our first cruise. The ship's currency... the Euro. We're dreading our bar bill! (*GRIN*)

Regarding European and Japanese tourists, unless they're buying American *MADE* goods while here in the States, I fear that the boon for our economy is less than meets the eye. Besides subsidizing low wage sales people selling Chinese made goods in American stores, the profits we're making from foreign tourists go mainly to the service industry - hotels, restaurants, etc.

Neither Greenspan, Bush, nor Snow will take my calls... (*GRIN*)... but I think our cheap dollar policy is a disaster. Sure, we're screwing the French and other "old" Europeans to an extent - which does my heart good - but in the long run I fear we risk cutting off our nose to spite our face.

posted by: William R. Barker on 12.06.04 at 02:05 PM [permalink]

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