Friday, October 12, 2007

Lowered US wages & Current Account

Counterfactual exercises are fun.

In an interesting what-if paper, the authors ask what are the effects of a zero Current Account balance on some key variables of interest (nominal, real and relative wages, share of manufacturing, exchange rates etc.,)

To achieve a Current Account balance, their primary "adjustment mechanism" is the Manufacturing Trade Balances(ceteris paribus). Using an iterative root-finding algorithm, they arrive at the numbers required for Manufacturing Balances to fall or rise which would cause the CA = 0. Then, they ask what does this rise or fall in Manufacturing balances mean for real and relative wages, as well as share of manufacturing. All of this is done using (a) a variant of the Dornbusch-Fischer-Samuelson within a General Equilibrium model (b) parameter estimates from rest of the literature.

The results are interesting. Other than the US, all the other Major countries end up needing an increase in nominal wages. The US in contrast must have a 7% decline in wages in order for the current account balances to go to nill. Reasonable, but different, parameters lead to a nominal decline around 17% -20%. In contrast, if wages are held constant -- the a USD depreciation of around 10% is required for the Current Account balances to hit zero.

From the looks of it, this is a work in progress -- and perhaps Professors Dekle, Eaton and Kortum will be modifying it further. A self-admitted critique is that they perform a standard comparative static exercise, i.e., adjust one variable holding all other variables constant and then measure impact -- so caveat lector.

Given the stickiness of wages, the only perceivable channel through which current accounts hit nill are through the exchange rates. Given Washington's "talk strong and let it slide" approach to the USD -- any month on month improvements in the US current account deficits must come through the dollar's slide. However, since current account deficits reflect other mid-to-long term trends (political uncertainty, productivity etc.,) -- changes in CA deficits, I suspect, predict the intermediate and longer trends of the USD (attributable to "real" factors like exports and imports) -- over and beyond the daily ups-and-downs (attributable to speculative capital flows).

It would be interesting to test if lagged changes in current account have any predictive power on the realized exchange rates.

A subtle critique of the above hypothesis is: whether the current account changes can be trusted to predict the trend in the dollar's movement. This is primarily because the USD has a very low (compared to other OECD) exchange rate passthrough (% change in import prices in response to a 1% change in exchange rate) of around 0.42 (with the 1975-2003 data) . Resultantly, a declining dollar might still not affect the net balances of the current account observed.


ullaas said...

i am trapped in my bootstrap after reading just the first five lines !!

Beni Pegu said...

Err... Come again pls.