1. US Current Account Balances: Share of GDP

2. Sustainability What does it mean to say that the CA is sustainable? –Can the economy continue to borrow? –When will it be cut off from further borrowing? Start with the current account expression: –(note that i.e, net foreign assets) –Which we can write as, –And thus

3. Substitution Thus, Now use this in the CA expression to eliminate And repeat the process:

4. Result If we keep doing this indefinitely, we obtain: –This should look familiar –The first term on RHS is PV of net imports –Second term is PV of NFA some time very far in the future Call this the terminal value of NFA. Let’s examine this first If finite horizon –PV of terminal assets = 0 If infinite horizon then let T go to infinity, Why is this our terminal condition Why does it make sense?

5. Terminal Value of NFA If we are running a Ponzi game –We never pay back our debts – free lunch If we are forgoing some utility –=> we are gifting foreigners, not optimal Hence, we must have So, our intertemporal constraint must be:

6. Intertemporal constraint This means that, The economy’s net debt today = PV of future trade surpluses –So key to sustainability is economy’s ability to generate future surpluses Is it rational to believe that we can earn sufficient future surpluses? Key is thus expectations of future spending and income –Not much of a criteria Can’t we say more than this?

7. Second try at criteria When is debt non-increasing? –That is, when does Debt/GDP not grow? We cannot have a steady state with exploding debt Why is this important?important Let the growth rate be defined by Start with Then we can show that the change in NFA/GDP is,

8. Hypothetical Path for Debt (growth rate = 4%)Debt Is this path sustainable ?

9. Yes, it is!it is!

10. How do we get this Start with and divide by Y t+1 Then,

11. Implication Why is this expression important? –Decompose the growth in debt ratio to: Primary component – the trade balance Feedback component – the weight of the past debt –If r > g then burden of past debt is growing –If r < g then we can have a party today and the burden still decreases over time »Dynamic inefficiency So debt is sustainable if debt ratio is not growing

12. Sustainability What does this imply? –If we have negative NFA, then r > g implies it will grow Faster growth means it will decrease Or, if we have positive trade balances debt will fall Suppose, r =.05 and g =.03r =.05 and g =.03 –If tb gradually goes to zero we get debt crisis –We need tb to go to 1.5% of GDP to escape If r =.06 and g =.03 things are worser =.06 and g =.03 If r =.08 and g =.03 we are in real troubler =.08 and g =.03 Problem: r depends on k f

13. Simulations (r =.05, g =.03)

14. Simulations (r =.06, g =.03) TB declines at constant rate

15. Simulations (r =.08, g =.03) TB declines at constant rate

16. Dollar price of a Euro

17. Yen Price of a Dollar

18. NFA and Ability to Repay Notice that even if NFA gets more negative what matters is ability to repay –For US, net wealth has been rising relative to net debt debt Foreign debt is still small relative to total US debt –In industrialized countries foreigners cannot be treated differently from residents –So US is better credit risk than one might fear

19. US Net Wealth and Debt PositionsPositions

20. Valuation You might think of, i.e., as the sum of all past current accounts –Think of a bathtub. Level of water is the sum of all the water that has ever been poured in, minus all the water that ever drained out Would be true if we lived in one-good economy But NFA made up of many assets and liabilities, and their relative prices change over time –This => US indebtedness can change even without CA reversal

21. Valuation Effects We need to add valuation effects –NFA may differ from cumulative current accounts –If US earns positive net foreign income this adds to our consumption possibilities Where do they come from? –Differences in rates of return –Capital gains and losses on foreign assetsforeign assets Interest income is reported capital gains are not realized Postpone why, and first adjust our analysis

22. NFA and Valuation Suppose US stock market rises –Then value of foreign holdings of US assets rises So NFA decreases –But has US ability to finance debt fallen? Probably not, if the stock market rose due to higher productivity etc. –Example, Finland and Nokia Nokia widely held by foreigners was a huge share of Finnish wealth When Nokia’s stock price surged, Finnish NFA approached minus 170% of GDP, when the price fell NFA recovered

23. Finland’s NFA and Nokia PriceNokia Price

24. Adjusting for Valuation Separate out income on NFA in the CA expression We want to express everything in ratios again or

25. Capital Gains We need to do something about the term, KG –Suppose they are proportional to assets and liabilities –Then, –If we let real returns be then,

26. Valuation Now we know that So, or

27. Implications The first and last term are familiar from before The middle term is the valuation term –If obviously no valuation effect –Excess return on assets allows NFA to grow even when GDP growing slow or tb is too small If we earn excess returns the scale of NFA matters –Since NFA for US is roughly 25% of GDP this is big25% of GDP this is big How does it impact sustainability?impact sustainability?

28. Simulations with Valuation

29. US Net Foreign AssetsForeign Assets

30. Is it Ending?

31. Role of Size Size of net debt matters We know that net interest income is For this to be positive we require So,

32. Implications We are assuming that so Let’s suppose that and Thus, What about RHS? In US, L is about equal to Y –So is approximately equal to -.26 –So the condition for positive net income is satisfied, since –But what if net debt rises to -.35? –Or if r A falls to.05?

33. Why was this calculation interesting?interesting? We showed that even though US NFA < 0, it is still possible to earn positive interest income –This is possible because returns on assets we hold are greater than returns paid on our liabilities But it also requires that liabilities not be too much greater than assets –Why this is the case is interesting.

34. Valuation Effect: Causes What causes this? –Imperfect substitutability If assets and liabilities were perfect substitutes, returns would be equalized –Risk could be a factor –Exorbitant privilege We borrow in our own currency –Liability mismatch US is like a bank, borrow short lend long From Central Banker to venture capitalistventure capitalist –Share of portfolio in risk assets has risen –But liquidity mismatch can be trouble –Future Triffin Problem?

35. World Banker to Venture Capitalist

36. Gold vs other US gross foreign assets (share of GDP)

37. US Gross Foreign Assets by Class

38. US Gross Foreign Liabilities by ClassLiabilities by Class

39. Income Balance Broken Down

40. Path of a Debtor

41. Net Income and Government Interest Payments

42. Dark Matter In 1980 NFA of US$365bn and net foreign investment income of US$30bn. Cumulative current account deficits between 1980 and 2004 were US$4.5tn, but net income relatively constantrelatively constant –Yet the US net foreign factor income in 2004 was still US$30bn –Seems paradoxical –Especially if we assume that the net foreign investment income data is to be trusted more than trade balance and net foreign assets data

43. Dark Matter HS assume that the latter miss systematic income streams –Global liquidity services –Insurance services –Knowledge services These do not show up in historical capital flow data, or in market value data –Why? went unrecorded, is that these services were bundled with financial instruments: US currency, US sovereign debt and US-originated FDI. But once abroad they produce income streams US has been so good at exporting these services that conventional current account balance data is irrelevant –Notice this is opposite to the savings glut type or investment boom hypothesis

44. Dark Matter Suppose that the $30 billion in net income is real Discount this at 5% –Equals $600 billion –Since, measured NFA = $-2.5 trillion, HS conclude that there must be missing $3.1 trillion in assets –This is Dark Matter Curious that H-S apply discount factor to net rather than gross income –Gross income in 2004 was $376 billion, so by their procedure, gross assets = $7.52 trillion, less than measured official gross assets of $10 trillion Perhaps there is dark anti-matter! –Since foreign assets in US generated $340 billion, by H-S this implies $6.8 trillion, so dark anti-matter for foreign assets is $5.7 trillion!

45. Dark Matter: Assessment Perhaps FDI income is mis-measured, but why should we trust net income measures more than asset trade balance data? Why is the mis-measurement one way? –US has had lots of inward FDI too –Does the historical cost of foreign direct investment in the US understate the fair value of the assets it created by less than the historical cost of outward US direct investment abroad understates the fair value of the assets thus created? Why are receipts always larger than liabilities?receipts always larger than liabilities Dark matter or cold fusion? –Seems pretty clear that the paradox is going away –Implies adjustment will be necessary Even less exotic theories justifying massive capital inflows seem problematic in hindsight

46. Valuation Effect This does not mean that the valuation effect is irrelevant –Valuation effects do lessen the need for adjustment –Consider an unexpected 10% depreciation of the $ Suppose that A/Y =.7, and that 85% is held in dollars –Assume all liabilities are in dollars This implies a transfer of 5.9% (0.7*0.85*0.1) of GDP from the rest of the world to the US –This would more than cover the trade deficit. –But why would foreigners hold $ if they expect it to depreciate?

47. NIIP and Net IncomeNet Income

48. Interest-Sensitive Returns

49. Equities

50. FDI

51. Net Income by Asset Class

52. Changes in NIIP, Explained The -$333.0 billion change in the net investment position from yearend 2004 to yearend 2005 was largely due to record private net foreign purchases of U.S. securities, including U.S. Treasury securities, and to the depreciation of most major foreign currencies against the dollar, which lowered the dollar value of U.S.-owned assets abroad. The impact of these net purchases and exchange-rate changes was partly offset by price appreciation of U.S.-held foreign stocks that surpassed by a large amount price appreciation of foreign-held U.S. stocks. U.S.-owned assets abroad were $10,008.7 billion at yearend 2005, compared with $9,186.7 billion at yearend 2004. Foreign-owned assets in the United States were $12,702.5 billion at yearend 2005, compared with $11,547.4 billion at yearend 2004.

53. Real Exchange Rate For adjustment to occur the real exchange rate must change Why can’t an increase in r solve the problem? –Increases CA surpluses for all countries –A differential change in relative price is needed Real exchange rate is the relative price of foreign goods relative to our goods Big swings since 1973 –Not just volatile, but not mean-reverting

54. US Real Exchange Rate, (Trade-weighted Broad )

55. Real Exchange Rate Define the real exchange rate as –It is the relative price of foreign goods Nominal exchange rate is the relative price of monies –An appreciation of the real exchange rate thus means that we are more competitive –changes in Q will impact net exports, and hence, the current account. –If a current account deficit is to be reversed an appreciation of the real exchange rate may be one of the mechanisms of adjustment.

56. An Important Detour: PPP Suppose all goods tradable and that US and Japan produce identical basket of goods Then arbitrage, “LOP,” implies that dollar price of goods will be equal, net of transport costs, so –SP* = P –but this implies that Q = 1, and S = P/P* So nominal exchange rate is driven by price differences Or movements in the exchange rate are driven by relative inflation rates,

57. More PPP Big Mac Index Predicts –Euro depreciation, Rand appreciation, Yen appreciationEuro depreciation So not perfect, why? –Not all goods are tradable –Consumption baskets differ –Theory based on trade flows, ignores capital flows Relative prices not independent of incomeindependent of income –Why?

58. International Prices International prices differ from domestic prices –International prices refers to common prices for the same goods –Differ from domestic because of the presence of non-traded goods Haircuts are cheaper in poor countries Leads to differences in the relative prices of tradable goods across countries Differences can be significant –in 2004 Chinese per-capita income measured at market exchange rates was $1272, but at international prices it was $6200. At international prices China is the second largest economy in the world. Only about 7th at market exchange rates. –Japan, on the other hand had per-capita income of $37,600 at market prices, but at international prices it was only $31,400.

59. Simple Example 2 countries (A and B), 2 goods (T and N) Country B is richer –Identical preferences for simplicity –GDP at market prices in country A is –Assume market exchange rates cause –Ratio of GDP’s is in the figurefigure Notice that N is relatively more expensive in B

60. International Prices Now use a common set of relative prices to value the consumption basketsconsumption baskets At common international prices the choices of A are more expensive. We have People in poor countries spend more of their income on N because these are relatively cheaper

61. GDP at Market Exchange RatesExchange Rates

62. Market versus PPP exchange ratesexchange rates

65. Hyperinflation Germany after World War I. –The ratio price index in November 1923 to the price index in August 1922 was 1.02 × 1010. Equivalent to a monthly inflation rate of 322 percent. On average, prices quadrupled each month Hungary after WW2 –Between August 1945 and July 1946 the general level of prices rose at the rate of over 19,000 percent per month, or 19 percent per day. Extremes were even higher –In October 1923, German prices rose at the rate of 41 percent per day. –And in July 1946, Hungarian inflation reached the rate of 4.19 × 10 16 percent per month (prices double every 15 hours) Led to the issue of the 100 quintillion pengo note100 quintillion pengo note

66. Largest banknote ever

67. Real Exchange Rate and the Current Account

68. Trade Deficit and the real value of the dollar

69. Real Exchange Rate Why does Q vary? –One factor, trade costs Trade cost, c, assumed to be equal to some fraction of the unit cost of the good at its source. Price of good exported at home is P, but when sold in the foreign country price is: P(1+c). –Existence of trade costs affects arbitrage incentives of traders. Difference in prices in the two locations. –Arbitrage occurs only if difference in prices are large enough to compensate for trade cost.

70. Trade costs in practice Transportation costs U.S. imports: freight costs from 1% to 27% of unit cost. Landlocked countries: prices 55% higher (vs. coastal) –Trade policy Average tariffs: 5% (advanced), 10% (developing) –Summary of estimates for advanced economies

71. Deviations in PPP are not random Big Macs less expensive in poorer countries. Big Macs are 21% cheaper in Mexico and 53% less in Malaysia (vs. U.S.) –Similar pattern with Starbucks tall lattes. Lattes cost 15% less in Mexico and 25% less in Malaysia, compared with the U.S. price. Explained by existence of nontraded goods. –Big Mac is produced using a combination of traded goods (flour, beef and special sauce) and nontraded goods (cooks, cleaners, etc.).

72. Big Mac and Incomes Dollar price of the Big Mac is strongly correlated with the local hourly wage (in dollars).

73. General Case This association is true in general –Most goods have nontraded and traded components, so the economy-wide price level should follow the same patterns observed above. Strong positive relationship between U.S. price level and GDP per person. Deviations in PPP vary systematically.systematically Explain this with simple model that has traded and non-traded goods

74. GDP and Price Levels

75. Non-traded goods and the real exchange rate How does Q depend on the presence of N? Let the price level be given by Then we write the real exchange rate as But LOP applies to traded goods, so Thus,

76. Implications Q changes if relative prices change in either country Q changes if consumption basket changes Take logs of Q to get –Then the rate of change of the real exchange rate is –If Then or

77. Implications Movements in Q depend on differential growth in non- traded goods prices. –If non-traded goods prices rise faster in the foreign country then the real exchange rate will appreciate and foreign prices will rise faster than domestic prices. This real appreciation occurs with development and is called the Balassa-Samuelson effect –economic growth is associated with increased productivity in traded goods, so that they fall relative to the price of non- traded goods. –Why does economic growth cause the relative price of tradables to fall? Key point, labor market equilibrium

78. Balassa-Samuelson Again start with Profit maximization implies And given LOP for tradables, we have, So ratio of dollar wages depends on ratio of marginal products of tradables

79. Labor market equilibrium Labor market equilibrium implies Profit maximization implies So, Now assume that or –Simplifying assumption => all productivity differences are in traded goods Then –but we know that Q depends on the LHS, and that RHS depends on productivity differences because of labor market equilibrium condition

80. Put the pieces together –So Q depends on the ratio of the marginal product of labor in tradables, the B-S proposition, or

81. Yen Price of a Dollar

82. Implications First, if all goods tradable,, then Q is constant The higher the share of non-tradables, the greater the impact of differential productivity on the change in Qdifferential productivity Explains rising yenrising yen –Differential productivity and catchup After WW2 non-tradables very cheap Recovery meant rising productivity in tradables Led to rise in relative price of non-tradables –More noticeable for CPI based measures than WPI based measuresCPI based measures than WPI based measures Same holds true in transition economiestransition economies

83. Balassa-Samuelson EffectEffect

84. RER and the Current Account Deficit We know that Q must change to close deficit –But by how much? Two key issues –Home bias How difficult to shift consumption towards domestic goods –Tradables versus non-tradables How hard is it to shift to production of tradable goods

85. Role of non-traded goods Consider a small economy so the country is a price taker in traded goods. –Then we can treat foreign and domestic traded goods as a composite good, T. –The country can transform capital and labor into traded and non-traded goods given the PPFPPF Suppose the country initially received a transfer from the rest of the world equal to NX. –Then consumption initially takes place at Q 0Q 0 the transfer allowed consumption of T to be larger than what the economy produced –Now suppose the transfer is withdrawn this is the equivalent to improving the trade balance by the amount, NX –PPF shifts down by NX

86. Adjustment to withdrawal of the transfer Production is now at P 0at If no change in RER, we prefer to be at –But this is infeasible, it is outside the PPF – there is an excess demand for tradables –Relative price of tradables must rise, we move to The higher price of traded goods causes production to shift towards traded goods and reduces the consumption of them. So the real exchange rate increases — the real value of domestic currency falls.

87. Size of Adjustment Required change in RER depends on –How difficult it is to switch production to T If PPF were flat it would require no change in RER to shift production In short run it requires even more changemore change –Overshooting –Depends on Preferences between T and NT Elasticity of substitution If low is farther to northwest – greater excess demand If people were indifferent, no need for change in RER

88. RER and openness If the economy is more open a smaller change in RER is required –In that case more goods are tradable –So initial consumption are farther to the northeastnortheast PPF is flatter in that region Key point is that we cannot trade NT –Greater the share of NT in GDP the larger the required change in Q to cause production to shift And to cause the rest of the world to buy our exports

89. Key Point Greenspan and others argue that greater capital market integration eliminates need for RER adjustment –Improved financial integration means we can borrow more easier But this misses the whole point –It is imperfect integration of goods markets that is the reason why Q must change –Impact of capital-market integration is on amount we can borrow to finance CA deficits. Thus, it effects the timing of when the dollar will depreciate. –How much the dollar must decline in real terms depends on how easy it is to increase net exports

90. Subtle Conclusion We have seen that for CA to improve Q must rise This does not mean that Q rising (or dollar falling in real terms) means CA will improve –These are two different questions!! –CA improvement requires S to rise relative to I We did not show that Q rising causes S to rise relative to I –We showed that if S is to rise relative to I then Q must rise That is, whether savings can rise relative to investment without the dollar having to depreciate Adjustment required depends on how open the economy is and how easy it is to shift to tradables. –Real exchange rate puzzle: why is deficit so large given the current weak dollar?

91. Real Exchange Rates and Global Imbalances: Two Views The transfer problem refers to the question of how the trade balance will adjust to correct global imbalances. Do large changes in the trade balance necessitate large adjustments in the real and nominal exchange rates? How to think about this? –Immaculate transfer, vs. –differentiated goods

92. Steady State Trade Balance Determine the steady state trade balance –Country chooses trade balance to offset borrowing (or lending). At steady state, TB is equal in each period: –Based on initial external wealth, W 0, make predictions about its future trade balance: A debtor country (W 0 < 0) must run a trade surplus from now and into the future. A creditor country (W 0 > 0) must run a trade deficit from now and into the future.

93. Immaculate Transfer Identical Economies, Purchasing Power Parity, and the “Immaculate Transfer” –Scenario: Foreign borrows $1 from Home Foreign income and spending and increase. Home income and spending decrease. Demand for each of the goods is unchanged, so the price of the two goods is unchanged. This leaves the real exchange rate, Q, unchanged. Home external wealth decreases and trade balance is positive.

94. Identical Economies, Purchasing Power Parity, and the “Immaculate Transfer” Decrease in Home consumption offset by decrease in foreign consumption As Home TB rises, there is no change in the real exchange rate,

95. Differentiated Goods and Home Bias Goods are differentiated across Home and Foreign, spending patterns are not the same across countries. –Home bias: Home prefers Home goods and Foreign prefers Foreign goods). –Same scenario: Foreign borrows $1 from Home Demand for Foreign goods increases relative to demand for Home because Foreign prefers Foreign goods. Relative price of Foreign increases, so real exchange rate rises as the Home trade balance increases.

96. Differentiated Goods and Home Bias Patterns of demand across two countries change, adjustment in real exchange rate Home real depreciation and Foreign real appreciation, i.e., Q rises

97. Implications Real and Nominal Exchange Rates during Adjustment –If the assumption of differentiated goods is correct, then large changes in real exchange rates are needed to correct global imbalances. –These adjustments will happen through: adjustment in the nominal exchange rate, and/or adjustment in relative prices –If both countries have similar inflation targets, then the adjustment will work through the nominal exchange rate.

98. Conclusions: Two Views Pessimists –Benchmark calculations Debt service requirements: 0.5% of real GDP. IMF report estimates a 1% (of GDP) trade surplus would require a 27% depreciation of the U.S. dollar. –Implications for U.S. spending and production Dollar depreciation may occur slowly. Hard landing scenario would mean a dramatic shift in U.S. consumption and production. –J-curve effects might prolong and exacerbate adjustment, as foreign return increases, bidding up U.S. interest rates.

99. Conclusion: Optimists Optimists –Additional factors that will mitigate the effects: Same IMF report estimates a trade surplus equal to 1% of GDP would require only a 7% depreciation. U.S. received higher interest payments on its foreign assets than it has paid on its domestic assets owned by foreigners, supporting the trade deficit. –Large nominal depreciations would cause large valuation effects in favor of the U.S. because: nearly all U.S. external liabilities are denominated in dollars, but most external assets are denominated in foreign currency.

100. Real Dollar Indices

101. Weighting and the Real Exchange Rate

102. Adjustment in more open economyopen economy Greater share of tradables in consumption basket for the open economy

103. Adjustment with short-run rigidityshort-run rigidity Production possibilities are more inelastic in the short run

104. PPF Axes are traded goods and non-traded goods

105. AdjustmentAdjustment with non-traded goodsgoods At this point there is an excess demand for tradable goods

106. Rising YenYen

107. B-S effect stronger with CPI based RERRER

108. Dollars per Euro

109. Rand/$

110. Yen has weakenedweakened

111. Relative price levels and per-capita incomesper-capita incomes

112. Relative GDP and Relative Price levels

113. B-S and the transition economiestransition economies

114. Yen and PPP

115. Euro and PPP