Why higher savings may hit the dollar


In economics, as in life, a little knowledge can be a dangerous thing. Often the most misguided policy prescriptions come from those who know enough about the economy to convince themselves that they have it all figured out, but not enough to understand how the pieces actually fit together.

A case in point is the relationship between the US budget deficit and the weak dollar. It is almost universally accepted by finance ministers, central bankers and the markets that the key to strengthening the dollar is to increase the US savings rate. This, the orthodoxy contends, could best be accomplished by eliminating the budget deficit. The diagnosis sounds both hard-headed and sophisticated. But, in fact, it involves a classic analytical fallacy. John Williamson of the Institute for International Economics, the Washington-based think tank, has dubbed this the 'doctrine of immaculate transfer'.

It is a fact of accounting that the surplus or deficit on any nation's balance of payments on current account is precisely equal to the difference between national savings and national investment. It is therefore reasonable to expect an increase in savings to be reflected in a reduced trade deficit. It is also true that foreign exchange markets often - though not always - react to good news about the trade balance by bidding up a currency.

So the story seems clear: a higher savings rate will mean a better US trade balance, which in turn means a stronger dollar. What could possibly be wrong with this analysis?

The problem becomes apparent if one asks how a higher savings rate translates into a smaller trade deficit. It is not enough to insist that the accounting ensures that it must. A consumer deciding between a Ford and a Honda cares nothing about the US's national income accounts. How does a lower US budget deficit persuade Americans to buy fewer foreign goods and foreigners to buy more US products?

A partial answer is that higher US savings imply a fall in consumption and thus a reduction in consumer goods imports. More subtly, higher US savings will mean lower world interest rates and higher levels of investment outside the US. This will in turn help to increase demand for US exports.

This stimulus for US producers will be more than matched, however, by a corresponding fall in domestic demand for US goods. A fall in US consumption - which is the same thing as a rise in US savings - will in other words have a much bigger direct impact on domestic demand for US goods than on the trade balance.

Does this then mean that a higher savings rate does not show up in the trade balance, after all? That all it does is cause a recession? No. What it means is that something has to happen to induce people to switch to US goods. And it means that higher savings will normally reduce the trade deficit because they result in a weaker dollar.

The chain of events would look something like this: a fall in the budget deficit reduces demand in the US economy; to avoid a recession, the Federal Reserve lowers interest rates; as a result, the dollar falls; this lower dollar makes US goods cheaper compared with foreign substitutes, causing the necessary switch in expenditure.

As this sequence illustrates, it is naive to imagine that changes in the government's financial balance can translate directly into changes in physical trade flows, without working through a mechanism such as the exchange rate.

That is the fallacy of 'immaculate transfer' - confusing the accounting principle which says that the current account balance equals the savings-investment balance with the process that enforces that constraint on decision-makers.

Unfortunately, the belief that government finances can some-how directly affect the trade balance has become virtual orthodoxy among top US officials.

A US functionary recently asked me if I knew any way that a lower government deficit could lead simultaneously to a stronger dollar and a lower trade deficit without causing a recession. When I said no, he was disappointed: his superiors were insisting that he produce a report asserting that it could.

It is possible that this financial mysticism will do no harm - indeed, that it will simply encourage the US finally to bring its budget under control.

But it is also possible that it will lead to a dangerous miscalculation: that the US will try to combine deficit reduction with an unrealistic strong-dollar policy, or even - if some conservatives have their way - a return to a real or simulated gold standard.

Now that would mean a recession. In other words, what you do not understand can hurt you.

Originally published, 5.24.95