That is a question posed by Martin Feldstein in his latest paper and as usual he answers it pretty well. (For the uninitiated high means the currency is overvalued….say 1 dollar = Rs 40.50
There are a few economists who put across facts as simply as Feldstein does. The paper has no jargon, no stats and fuzzy maths. His papers are very short, up to the point (few references) and really focused.
First a few basics: (Y= Income, C= Consumption, I+ investment, G+ Govt. Expenditure, X + Exports, M= Imports)
The standard macro identity is: Y = C + I +G+ (X-M)
Now S = Y-C-G
hence S – I = X-M
or in English, any gap between savings and investment is equal to the gap between exports and imports. So if savings are lower than investments than we have a trade deficit and hence we would need capital flows to finance the trade deficit or the savings-investment gap.
Now the paper summary:
In US we have a high trade deficit (almost $ 800 bn) which is a problem of either little savings or higher investment. As per him savings are low because of:
- increasing wealth
- mortgage financing
The puzzle deepens as Investment should fall given the low rate of savings. Feldstein has showed in his earlier paper that I does not drop given a fall in S in the short term. But then US has hade current account deficit for time immemorial.
To which he explains that ‘I’ continued to be high as interest rates did not increase. ( Higher r leads to lower I) r did not increase as there were huge capital inflows from abroad via China (to maintain its currency), Japan (carry trade) and Middle east (oil).
So his take is that trade deficit would reduce if savings increase and USD depreciates. The former would happen over a period of time as we see wealth reducing (it is a cycle after all) and the latter would happen as Chinese and Japanese are already reconsidering their policies. Chinese are unhappy over huge dollar exposures and Japan is considering allowing interest rates to increase which would reduce yen-carry trade.
He says at the end that what would matter is what happens first whether USD depreciates or savings increase. His idea is it is better if former happens first as that would lead to lesser weakening of the national economy.
The paper is disappointing in 1 aspect. He says most papers (IMF in particular) mention that there is a need to reverse global imbalances i.e. a mix of events are needed- higher US savings, increased productivity in Europe (so capital flows shift a bit there), Chinese exchange rate felxibility but none mention USD depreciation.
However, he does not make it clear how the USD would depreciate. Now this is a point he does not make clear or provide references to. I don’t see Japan reducing rates as again signs of deflation have resurfaced and not much of the hype about interest rates rise has died down.
He says in the end:
The best hope for a smooth adjustment of both the global and U.S. imbalances would be a substantial fall of the dollar followed by a significant rise in the U.S. saving rate and a policy of fiscal stimulus in other countries. Achieving this will require both good policies and good luck.
Feldstein is a giant in the profession and I expected some better advice than good luck. But the, it is the simple analysis by Feldstein that stands out.
Mostly Economics 
