Thursday, March 03, 2005

So what's with the exchange rate? 

I've written less here lately because I've been busy writing up the new Quarterly Business Report for the St. Cloud area*. One of the questions we keep coming back to in writing this is whether or not foreign trade makes a difference to the local economy. We asked some special questions in the survey last summer, and were surprised to find nobody really interested in international markets. So while we economists keep worrying about the effect of exchange rates on area businesses, their owners and managers seem not to feel affected.

The Wall Street Journal (subscribers only) runs a story today about a new Federal Reserve Bank study that argues that rapid changes in exchange rates don't seem to cause problems for financial or product markets in the U.S. If anything, the rapid decline in the dollar recently should help, not hurt, the U.S. economy. From the WSJ:
The study responds to growing concerns that the U.S. current-account deficit -- the shortfall on all trade and investment income with the rest of the world -- could trigger a crisis. The deficit topped an estimated $600 billion, or more than 5% of gross domestic product last year, which was financed by the U.S. selling an equivalent sum in stocks, bonds and other assets to foreigners. Some analysts worry that foreigners will soon balk at buying more U.S. assets, triggering a sharp drop in the dollar, a drastic increase in interest rates, and a recession.

But the study finds almost no evidence of such "disorderly corrections," the phrase it uses rather than "crises," in its review of previous episodes when the U.S. and other countries had to shrink large deficits. "We ... find no evidence that current account reversals are associated with sharp declines in asset prices," says the study, posted this week on the Fed's Web site.

Far from currency depreciation leading to a recession, the study finds that economic growth was "positively correlated" with the decline in the exchange rate. While in some cases economic growth did slow, the study argues that "shortfalls in growth led to declines in currency values rather than vice-versa."
The authors of the study are pretty cautious in their evaluation of their results, which were based on a study of 23 "disorderly corrections" in 16 (by my count) different countries. Only one of the episodes are in the U.S., which would be the 1987 decline after which we had three years of economic expansion (up to the first Gulf War.) They are concerned about extrapolating those results to current day.

If the study is right, however, it would suggest that we should not be too concerned about rising interest rates in the near term. This would be a positive development for the economic expansion we are in currently.
The study cautions that some of its findings may not apply to the U.S. now. The U.S. economy is the largest in the world, and its current-account deficit is larger than for most episodes examined. On the other hand, its economy is less dependent on trade and more flexible than others.

Still, the study's authors are clearly skeptical that a crisis would befall the U.S. since it happens so seldom among developed countries. It is more likely in a developing economy, perhaps due to heavy borrowing in foreign currencies, meaning a depreciation drastically raises the burden of repaying those debts. Those countries also often peg their exchange rates to other currencies, and when the peg breaks, a disorderly decline often ensues.
*By the way, the new QBR should be out in its new vehicle, ROI, later this month. I can't tell you all that's in it, but this report has some really great survey results that my co-author Rich MacDonald gathered for us. I will get to talk a little about them at the St. Cloud Annual Economic Outlook on March 15, though, if you want to get an advance peek. Free registration required; go here.