The Persistence of the U.S. Trade Deficit (1987)

8/2/2019 The Persistence of the U.S. Trade Deficit (1987)

1/56

The Persistence of the U.S. Trade DeficitAuthor(s): Paul R. Krugman, Richard E. Baldwin, Barry Bosworth, Peter HooperReviewed work(s):Source: Brookings Papers on Economic Activity, Vol. 1987, No. 1 (1987), pp. 1-55Published by: The Brookings InstitutionStable URL: http://www.jstor.org/stable/2534513 .

Accessed: 27/12/2011 05:24

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of

content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms

of scholarship. For more information about JSTOR, please contact [email protected].

The Brookings Institution is collaborating with JSTOR to digitize, preserve and extend access toBrookings

Papers on Economic Activity.

http://www.jstor.org
http://www.jstor.org/action/showPublisher?publisherCode=brookingshttp://www.jstor.org/stable/2534513?origin=JSTOR-pdfhttp://www.jstor.org/page/info/about/policies/terms.jsphttp://www.jstor.org/page/info/about/policies/terms.jsphttp://www.jstor.org/stable/2534513?origin=JSTOR-pdfhttp://www.jstor.org/action/showPublisher?publisherCode=brookings


2/56

PAUL R. KRUGMANMassachusetts Institute of TechnologyRICHARD E. BALDWINColumbia University

T h e Persistence o f t h e U . S .T r a d e D e f c i t

THE FAILUREof the U.S. tradedeficitto show marked mprovementaftertwo years of a falling dollar has become a major source of strain n thepoliticsof economicpolicy. Frustratedwith thepersistenceof the tradedeficit,the administration as demandedreflationby unwillingGermanand Japanese governments. Congressionalcalls for protectionistmea-sures have become increasinglystrident.Also at stakeis the credibilityof mainstream conomists. Since signsof a deterioration n U.S. tradeperformancebecame clear-cutin 1982,most economists have arguedthat the fault lay in the strong dollar,not in other popularvillainssuchas foreigncountries' ndustrialpolicies. Further, heroleof the dollar ncausingthe trade deficit is a key partof the widely accepted doctrinethat links trade deficits to the federalbudgetdeficit. If the tradedeficitremains ntractable, his doctrine, whichhas servedas a potent defenseagainst nationalistic views of the trade problem, will soon lose itseffectiveness.Thepurposeof this paper s to analyzethepuzzlingpersistenceof thetrade deficit. We considerand reject several ideas that have recentlybecome popular nexplaining hatpersistence,and concludethata validexplanationhas three mainparts. First is the acceptedview that there

We would ike to thankWilliamL. Helkie,of the FederalReserveBoardofGovernors,who providedmuchof our dataandalso gave invaluable ssistance n discussion.RichardHaas, of the InternationalMonetaryFund, also providedbothcrucialdata and valuablediscussion. Our thanks also to PeterHooperand CatherineMannat the Board and toHarryFosterandparticipantsn seminarsattheBoardofGovernors ndthe WorldBank.1


3/56

2 Brookings Papers on Economic Activity, 1:1987are substantial ags in the adjustmentof both prices and quantities toexchange rates, probably representinga tendency of firms to committhemselves to suppliers or extendedperiodsof time. The effect of theselags has been heightened by the timing of the dollar's rise and fall:because the dollar rose steeply before it began falling,firms were stilladjusting o the strengthof the dollar and shiftingto foreign supplierseven as the dollar ell. Second, the failureof foreigndemand o grow asrapidlyas U.S. demand since 1980means that, other things equal, thedollarwould have to fall below its 1980 evel to restore the 1980 tradeposition. Finally, the evidence suggests that even if both the realexchange rate and relativedemandwere restored to their 1980levels,the trade balance would still not return o its originalposition. At leastin the years before 1980,there appears o have been a seculardecline intheU.S. real exchangerateconsistentwithany giventradebalance, butwe have beenunable o extractclearevidence of such acontinuing rendfromthe data.Thepaper s insix parts.The firstpartreviewssomebasic facts aboutU.S. tradeperformance, speciallysince the turnaround f the dollar nthe first quarter of 1985. The second part addresses three widelycirculatedviews aboutthe reasons fora persistenttradedeficit thatcanbe confrontedand rejected without formal econometric testing. Thethirdpart presents some "conventional econometrics" on U.S. trade,estimatinga simplemodel of the nonagricultural, onoiltradebalance.The fourthpartconsidersthe issue of lags, presentingand testing somealternativeviews about the reasons for long lags in both prices andquantities.Thefifthpartaddressesthe possibilityof a downward rendin theequilibrium xchangerateandasks whether hestrongdollar tselfshifteddownthe equilibrium xchangerate. The last partof the paperpullsthe resultstogether oranoverallassessment.

Backgroundon the Trade Deficit

As a preliminaryo the discussion of the causes of the tradedeficit'spersistence,we review some basic facts aboutthe U.S. tradeposition.Thesefacts maybe groupedunderfour subjects: exchangerate devel-opments,tradevolumes, tradeprices,and the tradebalance tself.


4/56

Paul R. Krugman and Richard E. Baldwin 3Figure 1. The Real Exchange Value of the U.S. Dollar, 1975:1-1987:1aNatural logarithms2.70

Real exchange rate2.65 -

2.60 -

2.55 -

2.50 -

2.45

1976:1 1978:1 1980:1 1982:1 1984:1 1986:1Source: Authors' calculations. Exchange rate and price data are from International Monetary Fund, InternationalFinancial Statistics, various issues. Manufacturing trade data are from U.S. Department of Commerce, InternationalTrade Administration, United States Trade: Performance in 1985 and Outlook (Government Printing Office, 1986).a. The real exchange rate expresses the ratio of the dollar price of U.S. goods to the dollar price of foreign goodsand is here calculated as the quarterly average exchange rate for the U.S. dollar against the currencies of Japan,Canada, France, Germany, Italy, the United Kingdom, South Korea, and Taiwan, weighted by 1984 shares of U.S.manufacturing trade and deflated by wholesale prices of manufactures for industrial countries, and by overallwholesale prices for South Korea and Taiwan.

EXCHANGE RATESFigure 1 presents a measure of the U.S. real exchange rate formanufactures.The indexincludes the currenciesof six industrial oun-tries, plus Korea andTaiwan,weightedby 1984bilateralmanufacturestradewith the United States. Prices are measuredby wholesaleprices


5/56

4 Brookings Papers on Economic Activity, 1:1987for manufacturesor the industrial ountries,by wholesalepricesoverallfor Korea andTaiwan.The fall in thereal dollarsince its 1985: peakhasessentiallyreversedall of its rise from 1980.Some confusion has been created in populardiscussion by exchange rate indexes that show little fall in the dollar.Figure 1 shows that the dollar has indeed fallen sharply,to levels nohigheron averagethan those of the late 1970s.The overallfall in the dollar'srealexchange rate, however, concealsdisparities n its movementsagainstcurrenciesof differentcountries; nparticular,he realdollarhasfallensharplyagainstcurrenciesof WesternEuropeandJapan,reachinga record owagainst heyen,whileremainingrelatively stable against currencies of both Canada and the newlyindustrializing ountries (SouthKorea and Taiwan).These disparitiesraise a caution aboutspeaking oosely about "the" exchange rate: a 1percentdeclineinone exchangerate indexmaynotmean at all the samethingas a 1percentdeclinein another.Another mportanteatureof theexchangerateforunderstandinghepersistence of the trade deficit may also be seen in figure1: the dollarrose sharply ust beforeit fell. The two-yeardecline in the dollar sincethe first quarterof 1985 followed a four-and-one-half-yearise, whichwas markedby a sharprun-up n the last threequarters. Manyobserversregard his finalrun-up n the dollaras a speculative bubble,but that isoutside the scope of this paper.)The fact that the fall came after a risemeantthatU.S. tradeflows had notfullyadjusted o the strengthof thedollarin early 1985,and lagged responses to the risingdollar before1985:1are crucialto understandinghepeculiardynamicssince then.

It is also important o note that the strongdollar of the 1980s wasactually not all that strong in the light of historicalexperience. Theexchangeratepeak n 1985,universally egarded srepresenting severeovervaluationrelative to the rate needed to achieve current accountbalance,in fact was by some measuresabout the same as the exchangerateof 1970,which appears o have been consistentwithcurrentaccountbalance. This observation suggests a secular downwardtrend in theexchange rate consistentwithany givenU.S. externalbalance.1. For some systematiccomparisonsof indexes with and withoutLDCs, see MartinFeldstein and PhilippeBochetta, "How Far Has the Dollar Really Fallen?"WorkingPaper2122(NationalBureauof EconomicResearch, 1987).


6/56

Paul R. Krugman and Richard E. Baldwin 5Figure 2. Nonagricultural Export and Nonoil Import Volumes, United States,1980:1-1986:4aNatural logarithms

5.8 -

5.6 -

Imports5.4 0/

Exports5.2 -- - V

5 0 I A h I A1981:1 1983:1 1985:1Sources: U.S. Department of Commerce, Bureau of Economic Analysis, The National Income antd ProdluctAccounts of the United States, 1929-82 Statistical Tables (GPO, 1986), and Survey of Cu4rrentBusiness, vol. 66(July 1986), and vol. 67 (March 1987).a. Natural logarithms of nonagricultural exports and nonoil imports in 1982 dollars.

TRADE VOLUMES

Whenthe tradebalanceworsenedfollowingthe dollar'sdevaluation,many observers regarded t as an exampleof the famous "J-curve,"inwhich a sluggish response of export and import volumes that wouldimprovethe tradebalance at unchangedprices is at first outweighedbyvaluationeffects. Thus it is important o note that the U.S. experiencewith trade deficitworsening ollowing a dollardecline is not, or at leastnot yet, aJ-curve. Untilthe lastquarterof 1986, radevolumeswerestillmoving n thewrongdirection.Figure2 shows logarithmsof constant dollarnonagriculturalxportsand nonoil imports since 1980. We focus on the nonagricultural-nonoilbalancerather hanthe overall radebalance or two mainreasons. First,both the oil and agriculturalmarkets have been subject to special


7/56

6 Brookings Papers on Economic Activity, 1:1987developments hatwouldrequireextendedanalysisthatwouldmakethepaper unwieldy.If those marketswere the key to the persistenceof thedeficit, the detour would be unavoidable, but in fact the puzzle ofdeterioratingradeperformance s perfectlyclear n thenonagricultural-nonoil numbersas well as in the total. Second, much of the discussionof U.S. competitive problems has focused on manufacturing, nd wewould like to focus on a measure that mostly reflects manufacturingtrade; while it would in principle be better to focus on manufacturingalone, the nonagricultural-nonoil ata are both more carefully con-structedandmoreup-to-date hanmanufacturing riceandvolumedata.

Thefiguremakestwopoints. First, importvolumenot only continuedto rise after the dollar'speak, it continuedto rise aboutas rapidlyas ithadin theyear beforethepeak,atabouta 10percentannualrate.GivenU.S. GNPgrowthat only a 3 percentannualrate over the sameperiod,the continuingrapidrise in importvolume is fairly startling.Second, while exportvolume rose in the year followingthe dollar'sturnaround, t continued to rise more slowly than import volume;furthermore,t actuallyrose less rapidly n the seven quartersbetween1985:1and 1986:4 hanit did in the year beforethe dollar'speak.Any explanation of the persistence of the U.S. trade deficit mustexplain why tradevolumeswere stillmovingthe wrong way for at leasta year anda half afterthe dollarbeganto fall.

TRADE PRICESThe puzzle of perverse trade volumes may be linked to a secondpuzzle, that of pricingon the importside. Figure3 shows an index ofU.S. nonoil import prices deflated by U.S. manufactureswholesalepricesand an indexof therealimportexchange rate, usingforeignCPIsand the GNPdeflator.What s immediatelyobviousis thatuntil ate 1986therewasessentiallyno discernibleeffectof theexchangerateonimportprices. Foreign producersmust have been taking large cuts in profitmarginsratherthan raise the dollarprices of theirgoods in the UnitedStates. The practiceis most apparent or Japan,where manufacturingunit labor costs in dollarsrose 5.7 percentfrom 1985:1 o 1986:4even

whilemanufactures xport pricesfell 23.4percent.Thepictureon the export side has been different.If U.S. producerswere, like foreign producers,to react to an exchange rate change by"pricingtomarket"holding pricesstable nthepurchaser's urrency-


8/56

Paul R. Krugman and Richard E. Baldwin 7Figure 3. The Real Import Exchange Rate and Real Nonoil Import Prices, United States,1980:1-1986:4

Index, 1980:1 =00.3_

0.2Real import exchange ratea

0.1

0.0

-0.1I

-0.2 Real import pricesb-0.3 __

-0.41.. l l ..1981:1 1983:1 1985:1Source: Authors' calculationswith data from Survey of Current Business, various issues, and from IMF,International Financial Statistics, various ssues.a. Exchangevalue of the dollardeflatedby relative mportprices,calculatedhere as the ratioof the dollarpriceof U.S. goods (GNPdeflator)o the dollarpriceof foreigngoods (consumer rices).b. U.S. nonoil mportpricesdeflatedby U.S. manufactures holesaleprices.

U.S. exportprices in dollarswould have surgedsince early 1985.In factthey have remainedstablein dollar terms. ApparentlyU.S. producershave by and large not taken advantageof the dollar'sfall to increaseprofitmargins.THE TRADE DEFICITThere are two usefulmeasures of the overallnonagricultural-nonoiltrade deficit.The first is the actual or nominaldeficit;the second is the"real"deficit,definedasexportsminus mportsmeasuredn1982dollars.

The real deficit representsan index of the combinedeffects of changesin exportand mportvolumes,leavingaside pricechanges; he differencebetween herealand nominaldeficitscan betakenas a measureof terms-of-trade ffects.


9/56

8 Brookings Papers on Economic Activity, 1:1987From he dollar'speak n 1985: to 1986:4 he nominalnonagricultural-nonoil deficit rose from $81billionto $150 billion,while the real deficitrose from $93 billion to $136 billion.Thisjoint rise reflects the fact thatthe United States has not, or at least not yet, experienceda J-curve, inwhich sluggishadjustmentof the real trade deficitis offset at first by aworseningof the terms of trade. The real deficithas moved the wrongway, while, because of the asymmetricalbehaviorof importand exportprices, there has been littlechangein the terms of trade.

CommonBeliefs about the Trade DeficitThe failure of the trade deficit to fall despite the dollar's decline hasled to wide circulationof explanations hat eitherdeny the actuality ofdollar decline or dismiss it as irrelevant.The three most influentialarethat the dollarhas notreallyfallenagainsta broadbasket of currencies;that resolution of the trade deficit depends not on the dollar but onforeign economic growth, which has been insufficient;and that trade

balancesreflectdifferencesbetween ncomeandspending,andexchangerates are irrelevant.Allthreeexplanationshaveconsiderableappealandtouch upon valid points. However, each can be rejectedas the centralexplanationof thepuzzle.HAS THE DOLLAR REALLY FALLEN?Considerablepress attentionwas given in 1986to the publicationbythe Federal Reserve Bank of Dallas of an exchange rate index thatincluded 131 countries, rather than the limited group of industrialcountriescoveredby mostwidelycirculated ndexes.2According o theDallas index, the dollarhad hardlydeclined at all from its early 1985peak, a finding hatwas widely cited as a key explanationof the failureof the tradebalanceto improve.The reason for the dollar's strong showingin the Dallas index wasthat while it haddepreciated harplyagainst he currenciesof JapanandWesternEurope, the currenciesof manyless developedcountrieshad

actually depreciatedagainst the dollar.In particular, f countries were2. W. Michael Cox, "A New AlternativeTrade-WeightedDollar Exchange RateIndex," Economic Review of the Federal Reserve Bank of Dallas (September 1986), pp.20-28.


10/56

Paul R. Krugman and Richard E. Baldwin 9weightedby theirtradewiththe United States, the continuingdeprecia-tion of the currencies of Mexico, Brazil, and Argentina argely out-weighed the rise of the yen and Europeancurrencies.It was immediatelyobvious to international conomists, however, ifnot to the news media, that the sharp depreciationof high-inflationcurrenciesdidnot explain the persistenceof the U.S. tradedeficit. Costcompetitiveness depends on the real exchange rate, not the nominalrate, and the huge nominaldepreciationsof Latin Americancurrencieshad not been matched by correspondingreal depreciations. A realexchangerate index shows a large dollardeclineeven with LDCs in theindex.The index shownin figure 1, in fact, includesthe most importantLDC exporters of manufactures, South Korea and Taiwan, with asignificantweight. Nonetheless, it showsasharpdollardepreciation hathasessentiallyreversedthe 1980-85rise.

THE ROLE OF FOREIGN GROWTHThe need for foreign growth to create demandfor U.S. exports has

beenacentral hemeof U. S. officialpronouncements nthetradedeficit.Both PaulVolckerand James Bakerhaveplacedstrongemphasison theneed for faster growthin EuropeandJapan,and at times the Treasuryhas usedthe threatof a fallingdollaras a goadto GermanyandJapan oreflatetheir economies. Otherauthoritieshave emphasizedthe impor-tance of demand from LDCs, placing weight on the link between thedebtproblemandthe tradedeficit.Onemightexpectthatanissuegivensuchprominencenpolicydebatemustnecessarilybe of major mportance.Yet while it is truethat fastergrowth abroad would help resolve the U.S. trade deficit, and whiledivergencebetween U.S. andforeigndemandgrowthcontributedsig-nificantly o the emergenceof the U.S. tradedeficit,thepossibleextentto whichforeigndemandgrowthcouldbe expected to reducethe tradedeficit, and thus the extent to which limited foreign demandcan beassigned a key role in the persistence of the U.S. deficit, is almostcertainlyquitelimited.Wewilldocument hispointwith econometricevidencelater,but theargument an be madewith a simpleback-of-the-envelope alculation.Indeed,forthose who distrusteconometrics,such a calculationmaybemore persuasivethan the more careful documentation.In the fourthquarterof 1986, in nominal terms, U.S. imports of nonpetroleum


11/56

10 Brookings Papers on Economic Activity, 1:1987productsexceeded U.S. exports of nonagricultural oods by 74percent.(In the late 1970s, by contrast, nonagricultural xports consistentlyexceeded nonoil imports.) Suppose that all foreign countries weresomehowpersuaded o expand heirdomestic demand5percentrelativeto what it would otherwise have been. Since imports from the UnitedStates are only a small fraction of the rest of world income, such anexpansion n demandwithout a dollardepreciationwould fallprimarilyon foreign goods, leadingto an increase of foreign outputof at least 4percent-which for most countries exceeds the maximum that theybelieve can be achieved without creating dangerous nflationarypres-sure.3Suppose also that the elasticity of U.S. exports with respect toforeignreal expenditure s 3, which is well above most estimates (ourpreferredestimate is 2.1 -see below). Then this unlikely arge reflationwould increase U.S. exports 15 percent, only 20 percent of the increaseneeded to restorebalance nnonagricultural-nonoilrade.Anyplausibleincreaseinforeigngrowthwould contributesubstantially ess. Thus thelack of stronger oreigneconomic growth, while not totallyirrelevant, sa secondary actorinexplaining hepersistence of the tradedeficit.Giventhe numbers,one maywonderwhy the growth ssue receivesso much attention. Oneanswermay be simple misunderstanding, s inthe case of the confusion over the extent of the dollar's fall. A morecharitable xplanation s that theemphasisonforeigngrowthrepresentsshrewdpolitics on the partof U.S. economic officials.Blaming nade-quateforeigndemand s a last lineof defenseagainstprotectionistswhodeny the efficacy of the exchange ratein correctingtrade imbalances.Furthermore, he emphasis on foreign demand,and the assertionthatthedollarmustfall unlesssuchdemand s provided,hasaccomplishedaremarkable ublicrelations eat: SecretaryBakermaybe thefirst inanceminister nhistoryto makecurrencydevaluation eemasignof strength,not weakness.

THE RELEVANCE OF THE EXCHANGE RATERecently an important challenge to the conventional analysis of

exchange rates has been mounted by monetarist advocates of fixed3. The InternationalMonetaryFund estimatesa GNPgapthatis less than 4 percentfor all of the Group of Seven countries and much less for several. See IMF, WorldEconomic Outlook (IMF, April 1987).


12/56

Paul R. Krugman and Richard E. Baldwin 11exchangerates, notably RobertMundelland RonaldMcKinnon.4Theirargument s that the exchange rate is irrelevant o trade balance deter-mination. Instead, the trade balance is determinedby the differencebetweennational ncome andnationalexpenditure,or, equivalently,bythe differencebetween saving andinvestment.TheMundell-McKinnon iew goes beyond asserting hat the equalitybetween the trade balance and the savings-investmentbalance is anidentity. It carries a positive implication:that the trade balance hasnothingto do with the exchangerate and that thereforethe puzzle of afallingdollarand a risingdeficit s no puzzleat all.The view also carriesa normativeimplication:since exchange rates are irrelevantto tradebalanceadjustment, hey shouldbe fixedinorder o achieveotheraims,notablyprice stability.Sincetheirview hasgainedconsiderable nfluence npolicy circles, itis important o consider it carefully. In fact, the Mundell-McKinnonview is logically wrongin its dismissal of any puzzle in the exchangerate-trade link and is almost surely empiricallywrong in its policymessage.To see why, it is helpfulto have a rudimentarymodel inwhichtheconsequencesof assumptionscanbe fullyworkedout.A SimpleModel. In a world economy consistingof two countries,the United States and the rest of the world (ROW),each country isassumedto producea single good that is both consumeddomesticallyand exported. We let ROW'soutputbe numeraireand definep as therelativepriceof the U.S. good.In Mundell's and McKinnon's discussions there is an implicitas-sumptionof full employmentand constant output. The assumptionisnotrealistic,butto do awaywith it wouldcreatethe impression hat thisis anotherKeynesian-classicaldispute,whichit is not. So let us assumethat the United States producesa fixedoutput y andROWproducesafixedoutputy*.The determinationof demand s another issue that is importantbutnot central to understandinghe exchange rate-tradebalance linkage.Let us thereforetreat total U.S. expenditure,measured n terms of the

4. RobertA. Mundell,"A New DealonExchangeRates," paperpresentedatJapan-United States Symposiumon Exchange Rates and Macroeconomics Tokyo, Japan,January 9-30, 1987); ndRonald . McKinnon ndKenichiOhno,"Getting heExchangeRate Right: Insularversus Open Economies," paper presented at the meetingof theAmericanEconomicAssociation,December1986.


13/56

12 Brookings Papers on Economic Activity, 1:1987U.S. good, as a parameter,a. For the world as a whole income mustequal expenditure.Thus if a* is ROWexpenditure,measured n termsof theROWgood, it mustbe true that(1) pa + a* =py +y*,or

a* = y* + p(y - a).Now itis certainly rueas an accounting dentity hatthe tradebalanceis equalto the excess of income over expenditure,so that the U.S. tradebalance, t, in termsof the U.S. good, is simply

(2) t = y - a,an expression nwhich the relativeprice of U.S. goods does not directlyappear.The absence of that termdoes not, however, allow us to forget aboutrelative prices. There is still a requirement hat the market for U.S.output clear, in whichcase the market or ROWoutputclears as well,by Walras'sLaw. Eachcountrywill divide its expenditurebetween thetwo goods. For simplicity, let us make the Cobb-Douglasassumptionthat expenditure shares are fixed, with the United States spending ashare m of its income on importsand 1 - m on domestic output, andROWspendingm*on importsand 1 - m*on domesticgoods. Thenwecanwrite the market-clearingonditionas(3) py = (1 - m)pa + m*a*,or

p[y -(1- m)a] = m*a* = m*[y* + p(y - a)],implying(4) p = m*a*/D, where

D = (1 - m)y - (1 - m - m*)a.The implicationsof this small modelare illustrated nfigure4, whichis muchmore generalthanthe example. On the horizontalaxis is theU.S. level of realexpenditurea; on the vertical axis is the relativepriceof U.S. output p. The line TT is an iso-trade-balance ine, that is, itrepresentsa locus of pointsconsistentwith somegiventradebalance n

terms of U.S. output. The accounting identity that equates the tradebalance to income minusexpenditure,regardlessof relativeprices, isreflectedbythe factthatTTisvertical.Meanwhile, he lineUUrepresentspointsof marketclearing or U.S. output.It is here drawnwith apositive


14/56

Paul R. Krugman and Richard E. Baldwin 13Figure 4. Relative Price AdjustmentRelative price of U.S. output

T' T

U

/ElE

T' TI

U.S. real expenditure

slope, whichwill be the case if (1 - m) > m*, thatis, if U.S. residentshave a highermarginalpropensityto spendon U.S. output than ROWresidentsdo. PointE is the equilibrium ora giventradebalance.Is ThereaPuzzle? The firstpartof theMundell-McKinnon rgument,to repeat, s thatone shouldnot be surprisedbythe failureof devaluationto improvethe U.S. tradeposition. Devaluation s irrelevant,becausethe trade balance is determinedby the income-expenditurebalance.That s, at a pointlikeE' in figure4 the relative price of U. S outputhasfallen, but U.S. expenditurehas not, so there will not be a reduction nthetradedeficit.It shouldbe immediatelyclear what is wrongwith this argument: tfails to look at the whole story. If we observe what looks like a movefromE to E', we should be puzzled, becauseE' is not an equilibrium: tis aposition of excess demand orU.S. goods. Ifwe like,we can describe


15/56

14 Brookings Papers on Economic Activity, 1:1987the puzzle as one of the failureof demand or U.S. outputto rise ratherthan one of the failure of the U.S. trade balance to improve, but this issimply logic-chopping.The pointis thatany fully described modelwilldetermine he relative priceof U.S. goods, and must offer some expla-nation of how it is possible for it to have fallen witha rising U.S. tradedeficit. An accounting dentity does not set relativepricesfree to movewithoutreal consequences.WhatMundell,McKinnon,and othersholdingsimilarviewsprobablybelieve is thatexchangeratechangesdo not in fact producechangesinrelativeprices.That s, anominaldepreciations nota realdepreciation.A devaluation might briefly push the world economy to E', but theresulting excess demand for U.S. output and excess supply of ROWoutputwouldquickly ead to some mix of inflation n the United Statesand deflation n ROW hat returned he worldeconomyto E.If this is the argument, however, any claim that the expenditure-income balanceapproachhelps explainwhathashappenedover thepasttwo yearsbecomes clearly alse. For aswe havedocumented, hedeclineinthe dollarso far hasindeedbeen reflected n a largedecline n thepriceof U.S. outputrelativeto thepriceof ROWoutput.Thus in termsof thefigure we have moved from E to E'. Yet there has been no surge ofexcess demandfor U.S. output-to the contrary. No appeal to theSaving-Investment-Trade balance identity, S - I = X - M, can doaway with the need to understandwhy the relativepriceof U.S. goodshas fallen so muchwithoutanyvisible substitution romforeignto U.S.goods.

The Need for Exchange Rate Adjustment. The second part of theMundell-McKinnonrguments thatsince the tradebalancedependsonthe income-expenditure alance, not the exchange rate, exchange ratesshould be set to ensure price stability rather than varied to facilitatetradeadjustment.Unlike the dismissal of any real exchangerate-tradebalance connection, this view need not be wrong on a logical level.However,MundellandMcKinnonboth treat t as somethingnecessarilytrue, whichitis not. It isanempirical ssue, on whichtheirview is almostsurely wrong.If thepicture s as we have drawn t infigure4, areduction nthe U.S.tradedeficitwillnecessarily be accompaniedby a declinein the relativeprice of U.S. output.In the figure,a reductionof U.S. real expenditureshifts TTinwardo T'T';this shiftrequires hatthe equilibriumhiftfromE to E",which involvesa fall in therelativepricep.


16/56

Paul R. Krugman and Richard E. Baldwin 15Figure 5. Expenditures, Substitution Effects, and Relative Price AdjustmentRelative price of U.S. output

T

U U

T

U.S. real expenditure

Now there are two circumstances n which this relativeprice adjust-ment need not take place. The first, the case in which U.S. and ROWgoods are perfect substitutes, can surely be dismissed pretty much outof hand, on the basis of casual observation,on the basis of the hugerelativeprice movements of the 1980s, and on the basis of econometricevidence like that presented ater thatindicates,if anything, hatsubsti-tution effects in trade are surprisingly mall. The other is the case inwhich spending patterns are identical between the countries, so that(1 - m) = m*. In either case, the effect is to make UU horizontal (figure5), so that a reduction n U.S. expenditureneednotbe accompaniedbya decline in the relativepriceof what the United Statesproduces.


17/56

16 Brookings Papers on Economic Activity, 1:1987The case of identical spendingpatterns is famous in international

economics as BertilOhlin'sposition on the transferproblem.It relies onthe view that as expenditure alls inthe United Statesand rises abroad,foreignresidentswillspendasmuchoftheir ncrementalncome on U.S.goods as the reduction n U.S. spendingon these goods. After decadesof analysis of this point, it is also clear why this will not happen inpractice. Briefly,because most outputis not traded,residents of eachcountrywill spendrelativelymore of theirincome on local goods, bothon average and at the margin.If U.S. expenditure were to fall $150billion, while expenditure n the rest of theworldrose the same amount,U.S. residents would cut theirdemand for U.S. goods something ike$125 billion while foreignerswouldraise their spendingon U.S. outputno more than $25billion.A fall in therelativeprice of U.S. goods wouldbe necessary to close theresulting$100billion excess supply.The relative price changes that tradeadjustmentrequires need notcome through exchange rate adjustment.They could come insteadthrough nflation n the country that increases its spendingor deflationin the other country. One wonders whether even an economist whobelieved in flexibleprices would regardeitherof these alternativesasthe desirableroute. In any case, price inertiagives a strong reason forpreferring o adjust he exchange rate.

The ConventionalEconometrics of the Trade BalanceIn this section we set out some basic, "conventional"econometricanalysis of the U.S. nonagricultural-nonoilrade balance. By conven-tional we mean that it follows the approachestakenby standard ore-casting equations. Real expendituresand prices of goods other thanthose of U.S. importsand exports are taken as exogenous. Lags areestimated on an ad hoc basis, unconstrainedby any formaldynamicmodel. The experiencewith volatile exchange rates since 1970has inimportant espectsbeen a vindication or such conventionalmodeling.

With plenty of variation in the data even the simplest estimationtechniquesyield plausibleresults,andthe simpleequationshaveby andlarge successfullytrackedthe impactof the exchangerateon the tradebalance.


18/56

Paul R. Krugman and Richard E. Baldwin 17Table 1. Determinants of Nonagricultural Export Volume, Selected Periods,1977:2-1986:4a

Independent variable Elasticityand summary statistic 1977:2-1985:1 1977:2-1986:4Foreignreal expenditure 2.47 (0.18) 2.42 (0.13)Real exchange rate (sum of lags) - 1.40 (0.13) - 1.33 (0.11)Lags: 0 - 0.29 (0.09) - 0.23 (0.05)1 -0.25 (0.05) -0.21 (0.03)2 -0.21 (0.03) -0.19 (0.02)3 -0.18 (0.02) -0.17 (0.01)4 -0.14 (0.03) -0.15 (0.02)

5 - 0.11 (0.04) -0.12 (0.02)6 -0.09 (0.04) -0.10 (0.02)7 - 0.06 (0.04) - 0.08 (0.02)8 -0.04 (0.03) -0.05 (0.02)9 - 0.02 (0.02) - 0.03 (0.01)Summary statisticR2 0.904 0.916Standard error 0.032 0.033Durbin-Watson 0.77 0.72

Source: Authors' alculationswith oreign ealexpenditure atasuppliedbythe BoardofGovernors f the FederalReserve;exchangerateand pricedata rom he InternationalMonetaryFundandfromIMF,International inancialStatistics,various ssues; and manufacturingradedatausedinthe exchange atecalculationsromU.S. Departmentof Commerce, International Trade Administration, United States Trade: Performance in 1985 and Outlook(Government rintingOffice, 1986).a. Quarterly ata.Dependent ariable s U.S. nonagriculturalxportvolume in 1982prices). ndependentariablesare definedas follows. Foreignreal expenditure s GDP plus importsminus exportsin 1982 prices for eighteencountriesweightedby U.S. export shares;the realexchangerateexpressesthe ratio of the dollarpriceof U.S.goodsto the dollarpriceof foreigngoods and is here calculatedas the averageexchangerate of the U.S. dollaragainst he currencies f Japan,Canada,France,Germany, taly, the UnitedKingdom,SouthKorea,andTaiwan,weightedby 1984 haresof U.S. manufacturingradeand deflatedby wholesalepricesof manufacturesorindustrialcountriesandby overallwholesaleprices or SouthKoreaand Taiwan.Elasticitieshereandelsewheremeasure heeffect on the dependentvariableof a 1 percentchange n the independent ariable.Numbers n parentheses restandardrrors.

TRADE VOLUMESTables 1 and 2 present simple equations for U.S. nonagriculturalexport and nonoil import volume. The explanatoryvariables are realdomestic expenditure in the importing market(definedas GDP plusimportsminusexports in 1982prices)anda distributed ag on the realexchangerate.Many estimatedtrade equations use GNP ratherthan expenditurebecause the data are morereadilyavailable.On groundsof theoreticalclarity,expenditure s preferable; n practice, the resultsare not muchaffectedby the choice.


19/56

18 Brookings Papers on Economic Activity, 1:1987Table 2. Determinants of Nonoil Import Volume, Selected Periods, 1977:2-1986:4a

Independent variable Elasticityand summary statistic 1977:2-1985:1 1977:2-1986.4U.S. real expenditure 2.78 (0.12) 2.87 (0.12)Real exchange rate (sum of lags) 0.92 (0.13) 0.86 (0.14)Lags: 0 0.14 (0.05) 0.03 (0.04)1 0.14 (0.03) 0.07 (0.02)2 0.13 (0.02) 0.09 (0.02)3 0.12 (0.02) 0.11 (0.02)4 0.11 (0.02) 0.12 (0.02)5 0.09 (0.03) 0.12 (0.02)

6 0.08 (0.03) 0.11 (0.03)7 0.06 (0.03) 0.10 (0.02)8 0.04 (0.02) 0.07 (0.18)9 0.02 (0.01) 0.04 (0.01)Summary statisticR2 0.98 0.99Standard error 0.025 0.028Durbin-Watson 1.71 1.34

Source:Authors' calculationswith U.S. expendituredata from U.S. Departmentof Commerce,Bureau ofEconomic Analysis, The National Income and Product Accounts of the United States, 1929-82 Statistical Tables(GPO, 1986),and Surveyof CurrentBusiness, various ssues; exchangerateandprice datafrom he IMFand fromIntertiationalinatncial Statistics,various ssues;andmanufacturingradedatausedintheexchange atecalculationsfromInternational radeAdministration, nitedStates Trade.a. Quarterly ata. Dependent ariable s U.S. nonoil mports in 1982prices). Independent ariablesare definedas follows. U.S. realexpenditures GNP plus importsminusexports n 1982prices; he realexchange ateexpressesthe ratioof the dollarpriceof U.S. goodsto the dollarprice of foreigngoods. It is calculated s described n table1. Numbers n parentheses re standard rrors.

The equationsareestimatedboth from 1977:2 o 1985: , the dollar'speak, andfrom 1977:2 o the end of 1986. The estimates are not muchaffectedby the recentbadnews aboutU.S. tradeperformance.However,if the estimatesover the shorter ime periodareused toforecastforward,they do predicta U. S. traderecovery that hasnot yet happened.Exportvolume in 1986:4 was 5 percent less, and import volume 7 percentgreater, hanthese equationspredict; he real tradedeficitwas therefore$43 billion arger han we wouldhavepredicted.One possibility is that there is a secular trend due to technologicalchangethat s notcapturedntheseequations;we discussthetheoreticalrationale for such a trendbelow. To test for the trend, we have alsoestimated the equationswith a trend term and, for good measure, withtime squared, to allow for a shiftingtrend. At first sight, the results,


20/56

Paul R. Krugman and Richard E. Baldwin 19Table 3. Alternative Trade Volume Equations, 1977:2-1986:4

Independent Elasticityvariable and Exports Imports Exports Importssummary statistic (1) (2) (3) (4)Real expenditurea 5.54 3.08 2.56 2.80(0.64) (0.25) (1.35) (0.37)Real exchange rateb 0.23 0.98 -2.77 0.54(0.34) (0.13) (1.26) (0.44)Timec -0.024 -0.0028 - 0.036 -0.011(0.005) (0.002) (0.007) (0.008)Time squared ... ... 0.0008 0.0002

(0.0003) (0.0002)Summary statisticR2 0.95 0.99 0.96 0.99Standard error 0.025 0.017 0.014 0.016Durbin-Watson 1.18 1.94 1.46 1.88

Source:Authors'calculationswith data as described n tables 1 and 2. Numbers n parenthesesare standarderrors.a. For the exportequations, he variable s foreign real expenditure,as described n table 1. For the importequations, he variable s U.S. real expenditure, s described n table2.b. Expresses he ratioof the dollarprice of U.S. goods to the dollarprice of foreigngoods. It is calculated s intable 1andequals he sumof a ten-quarter istributedag.c. Equals 1.0 for 1985:1.

reported ntable 3, suggestmuch ess confidence nthe simpleequations.Both price and especially incomeelasticities shift aroundconsiderably;in particular, f the estimate of a foreign demandelasticity of 5.5 weretakenseriously, t wouldconsiderablymodifyourconclusion hat oreignreflationcan have only a modest impact on the trade deficit.However,we suspect that the trendtermsare overexplaining he data, allowingrandom hocks anderrors n variables o distort heresults.An indicationis that these equations do much worse than the simplerequations atforecasting out of sample. For example, the equationswith a simpletrend underpredict 1986:4 export volume by 11 percent and importvolume by 15 percent; the equations with time and time squaredoverpredict xportvolumeby23percent although etting mportvolumewithin 2 percent). Thus while additional terms are significant n theestimation,we suspect that the simplestequationsareto be preferred.Animportantmplication f these results s thatwhileprice elasticitiesin trade are clearly significant,and well outside the Marshall-Lernercondition hat the sum of the price elasticities on exports and imports


21/56

20 Brookings Papers on Economic Activity, 1:1987Table 4. Determinants of Nonagricultural Export Prices, Selected Periods,1976:2-1986:4a

Independent variable Elasticityand summary statistic 1976:2-1985:1 1976:2-1986:4Real exchange rate (sum of lags) - 0.35 (0.04) - 0.47 (0.04)Lags: 0 -0.11 (0.05) -0.08 (0.04)1 -0.09 (0.02) -0.04 (0.02)2 -0.06 (0.01) -0.12 (0.01)3 -0.04 (0.03) -0.15 (0.02)4 -0.03 (0.03) - 0.15 (0.02)5 -0.01 (0.02) -0.09 (Q.01)Summary statisticW2 0.72 0.77Standard error 0.014 0.018Durbin-Watson 0.51 0.39

Source:Authors'calculationswith U.S. export price data from ThleNatiotnal Incomze atnd Product Accountts,1929-82 Statistical Tables, andSurvey of CuirrentBusiness, various ssues;manufactures holesalepricesarefromtheIMF.a. Quarterly ata.Dependent ariable s the logarithm f the ratioof the U.S. nonagriculturalxportdeflator oU.S. manufactures holesaleprices. The realexchangerateexpresses he ratioof the dollarprice of U.S. goods tothedollarpriceof foreigngoods. It is calculated s described ntable1. Numbers nparentheses re standard rrors.

exceed 1, they arefairlysmall-not toofar aboveunity.Beforethe 1980sit was often difficult to estimate price effects in trade with muchconfidence, because of the lack of variation n the data;the volatilityofthe dollarhas now provideda good experiment.What s clear from theestimates is that the Mundell-McKinnon iew that U.S. and foreigngoods are close substitutes,and that therefore the equilibrium elativeprice is unrelated o the tradebalance,is veryfar fromthe truth.TRADE PRICESTables4 and5 presentestimatesof the effects of the exchangerateon prices of U.S. nonagricultural xports and nonoil imports, respec-tively. In each case the dependentvariableis the price of the gooddeflated by U.S. wholesale prices for manufactured oods-the samepricedeflatorusedinconstructing herealexchangerate ndex. Likethetrade volume equations, both equations are estimated over both theshorterperiod eadingup to the dollar'speak andthe periodup to 1986:4.At first sight the export price equationand the importprice equationappearanalogous,with the real exchangerate affectingboth the relative


22/56

Paul R. Krugman and Richard E. Baldwin 21Table 5. Determinants of Nonoil Import Prices, Selected Periods, 1976:2-1986:4a

Independent variable Elasticityand summary statistic 1976:2-1985:1 1976:2-1986:4Real exchange rate (sum of lags) -0.98 (0.05) - 1.07 (0.05)Lags: 0 -0.52 (0.06) -0.27 (0.05)1 - 0.31 (0.02) - 0.24 (0.02)2 -0.15 (0.01) -0.21 (0.01)3 - 0.04 (0.03) - 0.17 (0.02)4 0.02 (0.03) -0.12 (0.02)5 0.03 (0.02) -0.06 (0.02)Summary statisticRj2 0.95 0.93Standard error 0.016 0.018Durbin-Watson 0.52 0.26

Source: Same as table 4.a. Quarterly ata. Dependentvariable s the logarithm f the ratio of the U.S. nonoil importdeflator o U.S.manufactures holesaleprices. The real exchangerate expresses the ratioof the dollarprice of U.S. goodsto thedollarprnce f foreigngoods. It is calculated s describedn table 1. Numbersn parentheses restandard rrors.

import and export prices with a substantial ag. However, the setupactuallyembodies a majorasymmetry nthetimingof importandexportpriceresponses. Onthe importside, a decline in the dollar s reflectedonly gradually n a rise in dollar mportprices, andthus reflected onlygradually n a rise in the relative price of foreign goods. On the exportside, a decline in the dollar is at first met with no changein the dollarprice of U.S. exports, and thus with an immediatefall in the price ofU.S. goods relative to foreign goods. Only over time is there someupwardadjustment n U.S. goods prices.

Thisasymmetrybetweenexportand importpricingreflectsobservedprice behavior, as the contrastbetween the United States and Japanmakesclear.Japaneseexportpricesinyen havefallen sharply; neffect.the Japanesehave chosen to cut into profitmarginsfirst, thinkaboutraisingdollarprices later.By contrast,U.S. exportprices ndollarshaveremained lat; that is, U.S. firmsdo not seem to holdtheirprices stableinforeigncurrency.The reasonfor the asymmetryprobably ies both in the size of theUnitedStates and nthespecialrole of the dollar ninternationalmarkets.As we willargue ater, lagsinthe effect of exchangerates on bothpricesandquantities n international radeare best explainedas consequencesof commitments-implicit contracts-between buyers and suppliers.


23/56

22 Brookings Papers on Economic Activity, 1:1987Pricingbehavior n these implicitcontractspresumably eflectsthe sameconsiderations hat affect moreformal nvoicingdecisions, in which thechoice of invoice currencyreflectsthree broadrules.First, otherthingsequal, invoice in the exporter's currency; second, other things equal,invoice in the currency of the largertradingpartner; hird, use dollarswhere both parties are small countries. Since the United States is bothlargeand the key currencycountry,the bulk of U.S. trade s invoicedindollars on both the importand export side. It appearsthat the same istrue for the implicitcontractsthatgoverntradepricing.5

The importantpoint to note is that in the long runthe exchange ratehas plausibleeffects on prices;a dollardepreciation aises importpricesroughly one-for-one while depressing export prices. In the short runthere are significant ags in the effect of the exchange rate on prices.These lags help explain why the decline of the dollar has not yet beenseen in a corresponding isein importprices, especiallysince the dollarrose before it fell, and it has taken time for the effects of that rise toappear. However, both equations develop some forecasting problemswhen extrapolated out of sample; export prices are overestimated9percent, and importprices 9.5 percent.

THE SOURCES OF THE TRADE DEFICITThe estimates in tables 1, 2, 4, and 5 allow us to do an accountingexercise, asking what the proximatecauses of the trade deficitwere.Table 6 performsthe exercise by askingthe following questions:howmuchof the tradedeficitwouldhave been avoided feachoftheproximate

causes hadbeen absent?First,we askhowmuch he 1986:4deficitwouldhave been reducedif U.S. andforeign domesticdemandhadgrownatthe same rate;then we ask how muchsmaller t would have been if therealexchangerate had remainedat its 1980:1 evel; finally,we askwhatwould have happened f boththe divergence n demandgrowthand thereal appreciationhad been avoided.Effect of Differential Demand Growth. It is widely believed that amajorcause of thetradedeficit s that the UnitedStateshas grownmuch

more rapidly han the rest of the world in the 1980s.Somewhat surpris-5. See PaulKrugman,"The InternationalRole of the Dollar:TheoryandProspect,"in JohnF. 0. Bilsonand RichardC. Marston,eds., ExchangeRate Theoryand Practice(Universityof ChicagoPress, 1985),pp.261-78.


24/56

Paul R. Krugman and Richard E. Baldwin 23Table 6. Sourcesof the Nonagricultural-Nonoilrade Deficit, 1980:1-1986:4Billions of 1982dollarsunless otherwise ndicatedChangewith equal ChangeActual U.S.-foreign with novalue in demand real dollar CombinedMeasure 1986:4 growtha appreciationb changeReal exports 218 21 27 51Real imports 354 - 27 - 36 - 61Export prices (index, 1982 = 100) 92 . . . 2 2Import prices (index, 1982 = 100) 99 ... 6 6Nonagricultural-nonoil trade balanceReal - 136 49 63 111Nominal(billionsof dollars) - 150 50 51 103

Source: Authors' alculations asedon estimates ntables 1, 2, 4, and5. Actualvaluesfor 1986:4 re romSuirveyof Current Business, vol. 67 (March 1987).a. Assumes hat both U.S. and foreigndemand rew 15percent rom 1980:1 hrough1986:4.b. Holding he exchangerateconstantat its 1980:1evel.

ingly, it turns out that since the first quarterof 1980 the GNP of U.S.tradingpartnersweightedby their shares in U.S. export markets hasgrownat almost exactly the same rate as U.S. realGNP. The disparitybetween the data and the general impressionmaybe explained by twofacts. First, the United States experienceda deeperrecession in 1982and a faster recovery than the rest of the world, so that U.S. growthsince 1982appearssignificantlyaster.Second, before 1980U.S. exportmarketcountries, which included Japan and fast-growingLDCs, onaveragegrewsignificantlyasterthandid the United States(3.9 percent,as comparedwith 2.9 percent, annuallyfrom 1973 to 1980).Thus theequalityof growth rates since then does representa changerelativetopreviousexpectations.Also, while output has grown at the same rate in the United Statesand its export markets, demand in U.S. export markets has indeedgrownmoreslowlythan thasin theUnited States.From 1980:1 hrough1986:4U.S. realdomesticdemandgrew 21 percent,while we estimatethat in U.S. export markets real demandgrew only 11 percent. Bycontrast, n the 1970sdemandandoutputgrewat the same ratesbothintheUnited States and abroad.Theestimate of demandeffects reported n table 6 makesa counter-factualassumptionof 15percentgrowth nboth U.S. and oreigndemand


25/56

24 Brookings Papers on Economic Activity, 1:1987from 1980:1 hrough 1986:4. Given the other factors pushing the U.S.real tradebalance nto deficit, such equalgrowthrates indemandwouldhave impliedsignificantly aster growthin the rest of the world than inthe United States, as in the 1970s. It is questionablewhethersuch anexpectation was reasonable given the economic difficultiesof Europeand the slowing of Japanese economic growth. Thus in our view thisestimate of the effect of demandin causing the tradedeficit is ratherhigh. Nonetheless, it is clear thatthe divergence n demandgrowth hasbeen a significant actor. On thisestimateU.S. exports would have beenabout 10 percent higher, U.S. importsabout 8 percent lower, with boththe nominaland realtradedeficits owerby aboutone-third.TheExchange Rate. The next columnof table 6 reportswhatwouldhave happened f the U.S. real exchange rate had remainedat its levelinthe firstquarter f 1980.Eventhough hedollar'srise during he 1980shad been all but reversed by the end of 1986, lagged effects of the risewere still in evidence, anda constant 1980:1real exchangeratewouldhave had argeeffects onthe volumes of exportsand mports.Accordingto the estimates, importvolumewouldhave been 10percentless, whileexport volume would have been 12 percent greater. Thus about 45percent of thereal tradedeficitwouldnot have occurred.The effects on the nominaltrade balance are a bit smaller becausedepreciationraises importprices morethanit raises exportprices andthus creates a valuationeffect thatrunscounter otheeffectonvolumes.Aboutathirdof thenominaldeficitwouldhave beenavoided f thedollarhadfailed to appreciate.TheResidual. Theresultspresentedabovesuggestthattheexchangerate and lower foreign demand growth do not explain all of the U.S.tradedeficit.Had realdollarexchangeratesremainedat their 1980 eveland had demandgrown at the same rate in the United States and itsexport markets,animportantpartof the tradedeficitwould still be withus. Thelast column of the table shows that thecombinedeffect of equaldemandgrowthand no realappreciationwouldundoonly 80percentofthe real trade deficitand two-thirds of the nominaltrade deficit. Thisresidual s comparablen importance o the two basicdeterminantshatwe have includedin the estimation and is crucial to the puzzle of thepersistenceof the tradedeficitat thispoint.Thereare threeplausiblehypothesesthatmightexplainwhythe tradedeficitappearsto be morepersistentthan demand and relativeprices


26/56

Paul R. Krugman and Richard E. Baldwin 25would warrant.First is that the lags in the adjustmentof trade to theexchange rate aresimply ongerthanourestimatessuggest-so that thefact thatthe tradedeficit continuedto rise for two years afterthe dollarbegan allingrepresentedhe continuing umulative ffects ofthe dollar'sprevious rise. Second is that the well-publicized "competitiveness"problems of U.S. industry, notably lagging productivitygrowth anddiminishing echnologicaledge, requirea seculardownward rend nthereal dollar exchangerate, so that the falling dollar has been chasing amoving arget.A slighttrend s ineffect present n ourestimatesbecausethe estimatedexpenditureelasticity of importdemandexceeds that ofexportdemand,but exponents of this hypothesis would arguethat theeffect is larger hanthis.Third s the possibilitythat the strongdollardidpersistentdamage o the U.S. tradeposition, thehypothesisof "hyster-esis" in the trade balance. In the remainderof this paper we considereachof these hypothesesin turn.

THE OUTLOOK FOR THE TRADE DEFICITA naturalquestionis whatthe econometricanalysis predicts for thefuture of the U.S. trade deficit.Figure6 shows the result of simulatingthe U.S. nonagricultural-nonoilradebalancethrough1990:4undertwoassumptions: ndefinitemaintenanceof the realexchangerates of April1987 and 2.5 percentgrowthin the real demandof both the U.S. andrest-of-world conomies. Since theequationssignificantlyunderpredictthe trade deficit during 1986, we also show the comparisonbetweenactualand fittedvaluesduring1985and 1986.The estimate suggests that the April1987exchangerates would leadto a significantreduction in the nonagricultural-nonoilrade deficit,which would fall about $50 billion by the end of 1988. (Because ofworseningU.S. termsof trade,this reductioncorresponds o a consid-erablylargerreductionin the real deficit, almost $100 billion in 1982dollars.)However,theimprovementwouldbefar shortofwhat s neededto restore henonagricultural-nonoilurplusesof the late 1970s.Further,the improvement omes to an end in 1989and then reverses. The main

reason or the reversal s the "gapfactor";sinceimportsare much argerthanexports,even equalrates of growthof importsandexportslead toa wideningabsolutedeficit.To the extent thatpartof the presenttradedeficit resulted from slower growthabroad than in the United States,


27/56

26 Brookings Papers on Economic Activity, 1:1987Figure 6. The Nonagricultural-Nonoil Trade Balance, United States, 1985:1-1986:4,and Forecast, 1985:1-1990:4Trade balance(billions of dollars)

0

-40 _

-80 ,- do- - FForecasta

Actual%~~~~~~~~~~

- 120 -

-160 L I . . . A1986:1 1988:1 1990:1Sources: Authors' calculations and Survey of Current Business, various issues. See text description.a. Forecast assumes that real exchange rates are maintained at April 1987 levels and that both U.S. and rest-of-world real demand grow at 2.5 percent annually.

projectingequal growthratesin the futureperpetuates he effect of thisoutputdifferential.It is interesting to ask what it would take to balance U.S. trade,although he answer s hardlyreliable.According o the simpleequationspresentedhere, eithera 15percentfallinthe dollarbelow its Aprilvalueor a 10percent growth n foreignaggregatedemandover andabove the2.5 percent a year assumedhere would be enoughto producea 1989


28/56

Paul R. Krugman and Richard E. Baldwin 27balance in nonagricultural-nonoilrade. One should bear in mind,however, thatthe equationsareunderpredictinghe current radedeficit,so these projectionsmaybe underestimatesof the adjustmentneeded.Thisis about as far as one wants to push the conventionaleconomet-rics. The next step is to ask what kind of microeconomic oundationsmightunderly hekey featuresof lagsand a seculardownward rend.

Behind the Econometrics:LagsInourversionof conventionaleconometrics,as inall standardmodelsof the tradebalance, a key element is the presence of long lags in theadjustment fbothpricesandvolumestotheexchangerate. Butalthoughthe lagsare central o explaining hepuzzleof aworsening radebalanceinboth real and nominal erms afterearly 1985, heyareentirelyadhoc.Can a plausiblemicroeconomicustification orthe lagsbe offered?Webegin by considering he simplestview, thatlagsrepresentshort-run supply inelasticitydue to limits on the rateat whichphysicaltrade

flows canbechanged.Theymight, orexample,representorder-deliverylags or bottlenecksin distribution. f the lags take this form, however,we ought to find income effects on tradeprices andlags in the effect ofincomeon tradevolumes. We areunable, however, to findevidence ofanysuch effects.We then develop an alternativeview, which emphasizeslong-termcommitmentsby importers o suppliersand accounts for the fact thatincomeaffects tradevolumes much morerapidly handoestheexchangerate.

SLOW ADJUSTMENT OF QUANTITIESThe simplest explanationof lags in the effect of exchange rates onbothprices and volumes mightbe that the physicaltrade flows cannotberapidlyadjusted,or that t iscostly to adjust hemrapidly.This wouldhave theeffect of making heshort-run upplycurvefor importsupward-slopingandwould lead to slow adjustmentof bothprices and volumesto anexchangeratechange.66. The analysisthat follows drawson CatherineL. Mann, "Prices, ProfitMargins,andExchangeRates," FederalReserveBulletin,vol. 72(June 1986),pp. 366-79.


29/56

28 Brookings Papers on Economic Activity, 1:1987Figure 7. Market for U.S. ImportsPrice

s s~ ~ s

?~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ ILI\

. ~~~~~~~~~~~~~~~~~~~~~I

Quantity

Figure 7 makes the point. It shows a hypotheticalmarket or a U.S.importedgood. D is the demandcurve;Ss is the short-run mportsupplycurve, while SL is the long-runsupply curve. The steeper slope of Ssreflects difficulties associated with adjusting the volume of importsquickly, such as longorder-delivery ags and the need to establish newdistributionnetworks. In the long run we show supply as perfectlyelastic, reflecting he fact that even U.S. importsaregenerallya smallfraction of world production of any given good. That is, the upwardslope of the supply curve reflectsthe inelasticityof short-run upplytothe United States rather han thatto the world at large.A dollar devaluationwill shift both Ss and SL UP,so that in the longrun the price will rise by the full amountof the devaluation.However,initiallythe inelasticity of supplywill lead to only partialpass-through


30/56

Paul R. Krugman and Richard E. Baldwin 29Figure 8. Effects of Demand on U.S. Import VolumePrice

ss

SL

Quantity

of the exchangerate into importprices.The initialrise in importpriceswill be only fromE1 oE2.Overtime therewillthen be furtheradjustmentas the supplyadjusts, eading o gradually ising mportpriceandfallingimportvolume, as indicatedby the arrowheads,untilE3 s reached.So far so good. However, this interpretationhas two other implica-tions: thatdomesticdemand n the importingcountryshould affect itsimportprices and that the effect of demand on import volume shouldalso involve a lag comparable o the lag on the exchangerate. Figure8illustrates he point. If realexpenditure n the importingcountryrises,D willshiftoutward.Theinitialeffectwill bea risein thepriceof imports,as theequilibrium hiftsfromE1to E; importpriceswill then fallas thesupplycurve shifts out andequilibriummoves to E3.Meanwhile, mportvolume will rise only part of its long-runamount nitially,then rise forsometime afterthe rise inreal demand.


31/56

30 Brookings Papers on Economic Activity, 1:1987Table 7. Tests for Short-Run Import Supply Inelasticity, 1977:2-1986:4a

ElasticityIndependent variable Import volumeand summary statistic (1) (2) Import priceU.S. realexpenditure 1.75 1.77 - 0.25(0.46) (0.41) (0.04)Lagged 1.03 0.77 ...(0.41) (0.31)Two lags ... 0.19 ...(0.32)Three lags .. . 0.04 ...

(0.34)Real exchangerateb 1.00 1.03 -0.84(0.14) (0.14) (0.05)Summary statisticStandard rror 0.026 0.026 0.014Durbin-Watson 1.32 1.31 0.45R2 0.99 0.99 0.97

Source: Authors'calculations.See text and tables1-5.a. Quarterlydata. Dependentvariablesare U.S. nonoil imports in 1982 prices) and importprices, which arecalculatedas the logarithm f the ratioof the U.S. nonoil importdeflator o U.S. manufactures holesaleprices.Numbers n parentheses re standard rrors.b. Therealexchangerateexpresses heratioof thedollarpriceof U.S. goods to thedollarpriceof foreign oods.It is calculatedas described n table 1. For the importvolume equations, he realexchangerate is estimatedas aten-quarteristributedag;for the importpriceequation, hevariables estimatedwithsix lags.

This gives us two testablepropositions:effects of aggregatedemandon prices andlags in the effect of demandon volumes. Table7 reportssome tests of these propositions.The results on prices do not supportthe idea that importsupply isinelastic in the shortrun. Theredoes not appear to be any significanteffect of U.S. aggregatedemand on importprices. Admittedly,tradepricesas measuredare often setinimplicitor explicit ong-term ontractsand may not reflect the shadow price of imports that is relevant todemand.However, the resultson quantitiesarealso unsupportive.Wefind no evidence of lags in the effect of real expenditure on importsreachingbeyond one quarter.As usual,we should accept econometricresultsonly if they seem tomakesense givena broaderview of the way thingsseemto work.Whatthe results seem to say is a propositionembodied n most econometrictrademodels:namely,that ncome effectsworkmuchmorequickly hanprice effects. Is this reasonable?Experience suggests that it is. Forexample,the slump n 1982was immediately eflected n adeclineinrealnonoil imports despite the rising dollar;nonoil import volume fell 7


32/56

Paul R. Krugman and Richard E. Baldwin 31percent rom 1981:4 hrough1982:4.As soonas the U.S. recoverybegan,importvolume began rising;from 1982:4 hrough 1983:4nonoil importvolume rose 37.7 percent. Thus demandeffects seem to work throughvery quickly. On the other hand, the experience of the last two years isas strongevidence as one couldhopeto have of long lagsintheresponseof tradeflows to the exchangerate. Thus we need a model that allowsfor a disparity n the rate of adjustmentof trade flows to income andprices.

IMPLICIT CONTRACTSAn interpretation f trade thatallows quick income effects but slowprice effects is the following: mportersmakefairly long-termcommit-ments about whomto buy from,butnot about how muchthey willbuy.Wehavecometo thinkof this as the Book-of-the-Month-Clubmodel.Asubscriber o the Book-of-the-MonthClubcommitsherselfto buy onlya minimum,above which her purchasesmay vary quite sharply fromquarter o quarter.However, she willnot arbitrageon a continualbasis

between BOMCand QualityPaperbackBooks; decisions aboutthe clubto whichto belongwillcome relatively seldom.There s anecdotalevidence thatthe same sort of behavior akes placeininternational rade.Executivesof U. S. firms o whomwe have spokenreportthat they makefairly long-termcommitments o particular up-pliers and that they are continuingto fulfill their commitmentto usesome foreign supplierseven thoughat this point U.S. supplierswouldbe cheaper.Since the commitment s to the particular upplier,butnotto thevolume of purchases, mportvolumemayshiftrapidly nresponseto changes in desired sales. But the compositionof demand betweendomesticgoods andimportswill shiftonly slowly.This description seems to lend itself naturally to a Taylor-styleoverlappingcontract formulation,as shown in the following simplemodel. Imports and domestic products compete for consumers; forsimplicity,we take the total volume demand of consumers as beingtotally inelastic with respect to prices. Thus let Q be the total volumedemandfor both importsand import-competingdomesticproduction;we assume(5) Qt= Q(At),whereAtis real domesticexpenditure.


33/56

32 Brookings Papers on Economic Activity, 1:1987This total demandin turn is divided among domestic and foreign

goods.We assume thateachpurchasermustdecideonceeverynperiodswhetherto committo a domesticor foreign supplier.Ineach periodthefractionof purchaserswho choose importswilldependon the expectedaveragepriceover the next nperiods:(6) t f(t)

The natural next assumptionis that there is a distributionof pur-chasers,witha fractionlln making he decision eachperiod.Theresultwill be that the volume of imports,Mt,dependson GNP, Y, and on a flatdistributed ag on expected prices:(7) Mt= Q(Yt)[>f(Ptl1),or, linearizingnthe logs,

ln(Mt) = bo + b1ln(Yt) + b2 ln(P )j.What determinesprices?Since there is an implicitcontractbetweenbuyerandsupplier,avarietyofpricingbehaviorsmightbepossible. Oneplausiblecandidate s thatpricesarekeptfixedin thebuyer's currency;anotheris that they are kept fixed in the seller's currency.In the firstcase, the price will be set in advance and will be proportional o theexpected exchangerate;in the second, the pricewill be unknown,butthe expected pricewill be proportional o the expected exchangerate.

Thus in eithercase, we willhave(8) ln(Pe) = k + ln(Ee).

Finally,we needto specifyexchangerateexpectations.Suppose thatthese expectationstake a simple regressiveform. Thatis, the expectedexchangerate over the lengthof a commitment s a weightedaverageofthe actual exchange rate at the beginningof the commitment and a''normal"exchangerateE:(9) ln(Ete)= aln(Et) + (1 - a)ln(E).Ifa = 1we have the case of staticexpectations.


34/56

Paul R. Krugman and Richard E. Baldwin 33Then the importvolume equationwill take the form

(10) ln(Mt)= bo+ bjAt+ b2a> n(E,-)I.This formulation, n which real demand enters on a current basis,while the exchange rate enters only as a distributed ag, is capable ofexplaining ast income but slow exchange rateeffects.The tradeprice equationwilldependonwho bearstheexchangerisk.If the price is set in supplier currency, the import price will respond

immediately o the actual exchange rate:(lla) ln(Pt) = k + ln(Et).If the price is set in buyer's currency, t will have the same overlappingcontractstructureas the volume:(llb) ln(Pt) = k + (1/n) a E ln(Et-1)iIf some mix of the two pricing schemes is present, it can be capturedwith the compromiseequation:

n-(lIc) ln(Pt) = k + wln(Et) + (1 - w) E ln(Et11i=O

Now equation 1Ic is very similar to the actual equationswe haveestimated, except for the constraintof a "horizontal"lag structure,which is itself the result of the arbitraryassumptionthat commitmentlengthsare the same forall importers,andwe do notwishto impose theconstraint in practice. Instead, equation 1Ic should be seen as anillustration of how lag structures like those estimated in standardequationscan be justified.

EXPLAINING SLOW TRADE RESPONSEWe can now explainthe slowness of response of trade flows to the

fallingdollar.Taking irstdifferencesof equation10,we have(12) ln(Mt) - ln(M, -1)= bl[ln(At) - ln(At-1)] + b2a[ln(Et) -ln(Et- A


35/56

34 Brookings Papers on Economic Activity, 1:1987The change in GNP that affects importvolumeis from last quarter; hechange in the exchange rate is from n quartersago because buyerscurrentlychoosing a supplierarejust coming off commitments madesome time ago.The potential role of lags in explainingthe apparentparadox of adecliningdollarand a risingreal tradedeficitcan now be seen. Becausethe dollar rose before falling, it was not until late 1985 that exchangerates were lower than they were two years previously. Thus buyersgettingfree of theircommitments n 1985may still havebeen switchingto foreign suppliers,even thoughthe dollar had fallen from its peak,because they madecommitments o domesticsupplierswhenthe dollarwas still relatively low. If we imaginethat commitmentsextend evenmore than two years, it is possible to arguethat this lagged responseextended some time into 1986.If thisis theright nterpretation f lagsintheeffect of exchangerates,however, a turnaround hould surely have come during1986.By thesecond quarterof 1986the exchangerate was at levels not seen since1981;while theremayhave been a few long-termcommitments o U.S.supplierscoming to an end and being replacedwith commitmentstoforeign firms, surely most firmsconsideringnew commitments werealready facing more favorableprices from U.S. suppliersthan the lasttimethey made such a choice. Thus the U.S. tradebalanceshould havestarted to improve, at least in real terms, during 1986; indeed, theconventionaleconometricestimatesreportedearlier n thispaper,whenestimated up to the dollar's peak and projected forward, do indeedpredict considerable mprovementbeginning n the second quarterof1986. Since that improvementdid not take place, we need to turntootherpossibleexplanationsof the tradedeficit'spersistence.

Does the Dollar Need to Decline Secularly?There s a widespreadbeliefthat norderto restoreequilibriumntheU.S. tradebalance, the dollar mustnot only decline now but continue

to decline in the future. This view arises from threekinds of evidence:thefact thattheroughlybalancedcurrentaccount thatthe UnitedStatesmaintained hrough he 1970swas achieved only throughan exchangerate thatdeclinedsubstantially rom the beginningof the decade to its


36/56

Paul R. Krugman and Richard E. Baldwin 35end;econometricestimatesthathave normallyshown an income elas-ticityof demand or U. S. exportsthat s far ess than heincomeelasticityof importdemand;and the sense that the decline in U.S. technologicaland productivityleadership requires an offsetting decline in relativeU.S. laborcosts.The exchangerate evidence is clear-cutfor the decade of the 1970s.For example,the InternationalMonetaryFundcalculates iveindicatorsof U.S. competitiveness n manufacturing, singas pricedeflatorsunitlabor costs, value-addeddeflators, wholesale prices, and export unitvalues.7All fivemeasuresdeclinedfrom 1970 o 1980,although he sizeof thedeclinevaries from37percentforrelative unit laborcosts to only13 percent for relative export unit values. For relative unit laborcostsandrelativevalue-addeddeflators heaveragerealexchangerates at thedollar'speakwereonly roughlycomparableo the ratesof the late 1960s.Since the United Stateskeptits currentaccountposition relatively eveloverthis period,theimplications that thedollarconsistent with agiventradebalancewas decliningsecularly.The econometricevidence comes primarily rom the comparisonofexportandimport ncome elasticities of demand. Until recentlynearlyall studies found that the income elasticityof demand or U.S. importswas considerablyhigherthan the income elasticity of export demand;this impliedthat in orderfor importsand exports to growat the samerate it was necessary to have continuingdollar depreciation.8Thisdisparity n income elasticities could simplybe an accidental result ofthe mixes of goods that the United States andothercountriesproduce,but it seems unlikely;manyhave concluded that the underlyingcausehas somethingto do with the catch-upof the rest of the world to theUnited States in capacity and technology. The widely used FederalReserve model of the tradebalance ncludesa "relativecapacity"termdesigned to capturethese factors; when that term was included, theincome elasticitiesbecame morenearly equal,but the downward rend

7. IMF, International Financial Statistics, 1984 Yearbook (IMF, 1984).8. Theclassicreferenceon income elasticities n worldtrade,which firstpointedoutthe apparentneed for secular decline in the dollar (and the pound sterling) is H. S.Houthakkerand Steven P. Magee, "Income and Price Elasticitiesin World Trade,"Review of Economics and Statistics, vol. 51 (May 1969), pp. 111-25. The massivesubsequentiteratures surveyed nMorrisGoldsteinand MohsinS. Khan, "IncomeandPriceEffects nForeignTrade," n RonaldW. JonesandPeterB. Kenen,eds., Handbookof International conomics,vol. 2 (Amsterdam:North-Holland, 985),pp. 1041-1105.


37/56

36 Brookings Papers on Economic Activity, 1:1987Table 8. Comparative Productivity Levels in Manufacturing, 1973 and 1984Index, United States = 100United UnitedYear States Canada Japan France Germany Italy Kingdom1973 100 89 56 62 78 67 571984 100 86 93 81 90 84 59

Source: Adapted from Molly McUsic, "U.S. Manufacturing: Any Cause for Alarm?" Newv EniglanidEconiomicReview (Jan.-Feb. 1987), table 9.

was reintroducedby the fact that capacity grew more rapidly n the restof the worldthan in the UnitedStates.9Our econometrics, using more recent data and somewhatdifferentvariables rommost otherstudies,shows onlyasmalldifferencebetweenexport and import income elasticities. This by itself would seem tosuggestthat the need for secular dollardecline, althoughpresentin the1970s, may have faded awayin the 1980s,as othercountriesconvergedon the United States. On the otherhand,we have seen that a substantialpart of the currentdeficit remainsunexplainedby our estimated priceand income effects. Skepticismabout the ability of econometrics toseparate he effects of the strongdollar romany possible seculardeclineleads us to askwhether here is other evidencebearingon the issue.This brings us to the third kind of evidence for the hypothesis ofsecular decline: the diminishingU.S. productivityand technologicaladvantageover competingnations. The widespreadconcern over U.S.competitivenessreflects not only the tradedeficit,butalso the fact thatU.S. productivity s being overtakenby other countries (table 8). Inaddition o whathashappened o measuredproductivity, here s a sensethat the United States has lost its edge in the introduction of newproducts. Businessmen and some economists tend to assume that thisloss of productivity-technological dge requires a decline in the realexchangerate over time. However, the conclusionis notas clear-cutasone mightsuppose.

9. This pointwas firstmadeby PeterHooper, "The Stabilityof Incomeand PriceElasticitiesn U.S. Trade,1957-1977," nternational inanceDiscussionPaper119 Boardof Governorsof the FederalReserveSystem,June1978).Hooper ntroduceda "relativesupply"variablemeasuringheratioofU.S. andrest-of-worldapital tocks.Thepresenceof thisvariableaccounts orthe equalityof importandexport ncomeelasticities ound nWilliamL. HelkieandPeterHooper,"TheU.S. ExternalDeficit n the 1980s," n RalphC. Bryant and others, eds., Empirical Macroeconomics for Interdependent Economies(Brookings, orthcoming).


38/56

Paul R. Krugman and Richard E. Baldwin 37

PRODUCTIVITY AND THE REAL EXCHANGE RATEThat other nations are catching up to U.S. productivity levels isundeniable, and the catch-up necessarily requires a decline in U.S.relative wages. However, it is not necessarily the case that the declinein relative wages must be accompaniedby a decline in the U.S. realexchange rate, as measuredby the relativeprice of U.S. goods.To see this, consider irst he case of a productivitygrowthdifferentialbetween the United States and a competitor country that is uniform

across all goods. To keep U.S. costs competitive, U.S. relative wagesmust then fall at the rate of the productivitydifferential.However, thedecline in wages will only keep the relative price of U.S. goods un-changed,not lead it to fallover time.The story becomes more complex when productivitygrows at differ-ent rates in tradableand nontradable ectors. Influential ecent work byRichardMarstonhas shownthatduring he 1970s he differential etweenproductivity growth rates in the United States and Japan was muchgreater in tradablethan in nontradable ectors.10The implicationwasthat one could expect measures of the real exchange rate based onaggregateprice ndexes suchas consumerpricesto showa strongseculartrend; rom1973 o 1983 he U.S.-Japaneserealexchangerate basedonvalue-addeddeflatorsin manufacturing hifted more than 4 percent ayearrelativeto that based on consumerprices.In our estimates, however, we have used a realexchangerate indexthat uses only manufacturesprices, and thusis, we hope, essentiallyanindex of tradables.If thereis anytrend n thisexchange rate, it must bebecausethe difference nproductivitygrowthrates variessystematicallyacrossindustrieswithinthe tradable ector.To see how this can happen, it is helpful to consider a numericalexample.Table9 showsa case where the tradable ector canbe brokenupintothree subsectors:high-tech, medium-tech,and low-tech. For the pur-poses of the example we will assume that the United States has asufficiently arge productivityadvantage n the high-techsector that it

10. RichardMarston,"RealExchangeRates and ProductivityGrowth n the UnitedStatesandJapan," nS. ArndtandJ. D. Richardson, ds., Real-FinancialLinkages ntheOpenEconomy MITPress,forthcoming).


39/56

38 Brookings Papers on Economic Activity, 1:1987Table 9. Exchange Rate Trend with Differential Productivity Growth Rates,Hypothetical Example, United States and JapanPercentagechange

UnitedSector States JapanProductivityHigh-tech 2.0 ...Medium-tech 2.0 12.0Low-tech ... 4.0Wages 5.0 5.0Prices

High-tech 3.0 ...Medium-tech 3.0 - 7.0Low-tech ... 1.0Exchangerate - 10.0 10.0Source: Authors' calculations. For a description of the example, see the text.

faces no Japanesecompetition.Wewillalso assumethatJapanesewagecosts aresufficiently ower that theUnited Statescannotcompeteat allin the low-techsector. So the directcompetitionbetween the countriesis in the "battlefield"medium-tech ector.In the example we suppose that the United States has uniformproductivitygrowth in the two subsectorsin which it produces. In thecase of Japan,however,we supposethatthe average8 percentproduc-tivity growth ntradables omes froma 12percentgrowth nthe medium-tech sectors averagedwith a 4 percentgrowthin the low-tech sector.U.S. andJapanesewages areassumedto grow5percenta year.Inthis case theprices of bothmedium-tech nd high-techgoods in theUnited Stateswould rise 3 percenta year. InJapan,however, medium-tech prices would fall 7 percentwhilelow-techpricesrise 1percent.Now thepointis that the relevantcompetitivesectoris thebattlefieldmedium-tech rea. For U.S. firms o remaincompetitivehere,thedollarmust now decline 10 percent a year. By almost any aggregativerealexchange rate measure, the decline would appearto be a steady realdepreciation.BothaJapaneseunit aborcost indexanda manufacturingprice index would presumably ind a weightedaverage of the rates ofpriceincreasein medium-andlow-tech, thatis, somethinga good dealhigher hanthe 7 percentfallinthe relevantsector. Thusanyonelooking


40/56

Paul R. Krugman and Richard E. Baldwin 39Table 10. Rates of ProductivityGrowth,UnitedStates, Japan, and Germany,1975-84Average annualpercentagechange UnitedSector States Japan Germany

Totaleconomy 1.0 3.5 2.0Manufacturing 2.2 6.0 2.4Electricalmachinery 4.5 13.2 3.5Sources: Data for the total economy from Commission of the European Communities, "Annual Economic Review1985-86," in European Economy, no. 26 (November 1985), Statistical Annex. Manufacturing and electrical machineryfrom Organization for Economic Cooperation and Development, OECD Economic Surveys: Japan (OECD, November1986).

only at these aggregates would conclude that the yen was quicklybecominggrossly overvalued.Thisrealdepreciation f the dollar s not something hathas to happen,even if the United States does have slower productivitygrowththanitscompetitors.It depends on the bias in foreign productivitygrowth-whether other countries have higher productivitygrowth in battlefieldsectors wherethey competewith the United States than nsectorswherethey have an establishedcomparativeadvantage.International omparisonsof productivitygrowth, especially by sec-tor, are not highlyreliable. The evidence summarizedn table 10 seemsto suggest, however, that the case of biased productivitygrowthjustdiscussed is relevant,at least in the case of Japan. The table comparesratesof growthof productivity t three evels of aggregation:he economyas a whole, the manufacturing ector as a proxy for tradables, andelectricalmachineryas aproxyforthe battlefield ectorsinwhich Japaninparticular s challenging heUnited States. It is clearfor Japanat leastthatthe bias in productivitygrowth helps to explain why the yen mayneed to appreciateon a secularbasis againstthe dollar.

THE COUNTERPARTS OF THE POSSIBLE DOLLAR DECLINEIf there s a seculardecline n thedollarduetodifferential roductivitygrowth, we would expect to see the apparentneed for secular declineconcentrated n the U.S. exchangerate vis-a-vis the high-productivitygrowth countries of East Asia. Table 11 presents some suggestiveevidence supporting his view. It comparesthe realdepreciationof the


41/56

40 Brookings Papers on Economic Activity, 1:1987Table 11. Exchange Depreciation and Trade Adjustment, 1980-85

Realcurrency Change in real trade balancedepreciation as percent of GDPagainst theU.S. dollar Bilateral withCountry (percent)a United States TotalFrance -43 1.1 0.6Germany - 43 1.7 3.9Japan -17 3.9 4.7Korea - 25 6.5 5.7

Source: IMF, International Financial Statistics, various issues.a. Using relative consumer prices as deflators.

currenciesof several majorU. S. tradingpartnersagainst he U. S. dollarwith the changein their trade balances, both total and with the UnitedStates alone, as a share of their GDP from 1980 to 1985.It shows thatwhilethe Europeancurrenciesdepreciatedmost dramatically, he shiftin Europe's tradeposition with the United States was considerably essthanthat of Japan,whose currencyappreciatedagainst he Europeans',and of Korea, which achieved an enormousshift in its trade position.Theresults are similar f the countries'overallrather hanbilateral radebalances are compared. The suggestion is that there was an ongoingstructural hift that allowed Japanand Korea to achieve growingtradesurplusesat any givenrealexchangerate.Intable 12 reduced-form nnual radeequations orJapanand Koreaexplainthe tradebalanceas a share of GNPby thelaggedrealexchangerate, industrialproductionrelative to all industrialcountries, the realprice of oil, anda time trend.In Japan'scase the realexchangerate ismeasuredby relativeunit laborcosts; inKorea'scase, it is measuredbyan index based on consumerprices. For each countrythe time trend islarge and significant, ndicatingsome kindof "competitiveness"factortending to lead to secularappreciation.For Japanthe secular rate ofappreciationwouldbe approximately5 percenta yearif there were nodifference n growthrates of industrialproduction;even if the Japanesegrowthratewere to exceed the worldgrowthrateby 3 percent, an annualappreciation of more than 2 percent relative to unit labor costs inmanufacturingwould still be needed to keep the trade surplus fromrising. Since the unit labor costs in manufacturing ave tended to fall


42/56

Paul R. Krugman and Richard E. Baldwin 41Table 12. Reduced-Form Trade Balance Equations, Japan and South Korea, 1969-85a

Independent variable Southand summary statistic Japan KoreaLaggedrealexchange rate -0.111 -0.171(0.025) (0.066)Relative industrialproduction - 0.087 0.021

(0.053) (0.042)Realprice of oil -0.029 -0.103(0.008) (0.026)Timetrend 0.006 0.014(0.001) (0.006)Summary statisticK2 0.81 0.81Standard rror 0.007 0.02Durbin-Watson 1.62 1.60

Source: Authors' calculations using data from IMF, International Financial Statistics. See text description.a. Dependent variable is the ratio of the trade balance to GNP in each country. Real exchange rates are relativeunit labor costs for Japan, ratio of consumer prices to world export prices for South Korea. Relative industrialproduction is the ratio of domestic to world industrial production. The real price of oil is the ratio of the Ras Tanuraprice to world export prices. Numbers in parentheses are standard errors.

relative o the economywideprice evel, therequiredappreciationwouldbe even larger by most other measures. In Korea's case the requiredappreciation s a remarkable10percenta year.The distinctive feature of Japanand Korea is theirunusually highrates of productivitygrowth.Thus the evidence is consistent with theview that the historical need for continuingdollardecline is related totherapidriseinrelativeproductivityandtechnologicalcapacity of U.S.tradingpartners,especially those inAsia.HYSTERESISMany observers have wondered whether the markets lost by theUnitedStates asa resultof the dollar'sstrength anberecaptured implyby bringing he dollar back to its previous level. They have worriedabout some form of irreversibility, n which foreigners, once havingincurredthe marketingand distributioncosts necessary to establish

beachheads n U.S. markets,are difficultto dislodge. They worrytoothatU. S. firms,havinggivenupandabandonedheirbeachheadsabroad,will findthem difficult o regain. We have offered a formalization f thisconcernwithmodelsof "hysteresis"in the tradebalance.


43/56

42 Brookings Papers on Economic Activity, 1:1987Table 13. Tests for Hysteresis, Selected Periods, 1977:2.1986:4a

Independent Export Import Export Importvariable and volume volume volume volumesummary statistic (1) (2) (3) (4)Real expenditure 2.19 2.85 2.33 2.91(0.12) (0.14) (0.14) (0.13)Real exchange rate - 1.59 0.85 - 1.38 0.88(0.12) (0.14) (0.12) (0.14)Dummy variable 0.08 0.007 0.029 -0.013(0.02) (0.021) (0.024) (0.019)Summary statisticStandard rror 0.028 0.028 0.033 0.028Durbin-Watson 1.07 1.33 0.78 1.36K2 0.94 0.99 0.92 0.99

Source: Authors' calculations. See text and tables 1-5.a. The equations estimated are reestimates of the export and import volume equations in tables 1 and 2 with twoalternative dummy variables added, one equal to 1.0 beginning in 1984:3 (first two columns) and the other equal to1.0 beginning in 1985:2 (last two columns). Numbers in parentheses are standard errors.

The idea of hysteresis resulting from the sustained strength of thedollar seems highlyplausibleand is supportedby numerousanecdotes.We have not, however, found clear-cut evidence that hysteresis hascontributed o the persistence of the U.S. tradedeficit.Table 13reports ests of the proposition hat the strengthof the dollarhas led to adverse shifts n the constant ermsof the trade low equations.We reestimate he export and importvolume equationsof tables 1and 2with two alternativedummyvariables:one beginning n the thirdquarterof 1984, when financialmarketsseem to have concluded that the dollarwould be strongfor a prolonged ime, and one beginningwith the onsetof dollardeclinein 1985:2.Neithergives any suggestionof a shiftin theconstanttermthatadverselyaffectsthe U.S. tradeposition; f anything,there is afavorable shiftin the export equation.Now it is true thatby late 1986the equationswere seriouslyunder-predicting he U.S. real tradedeficit;dummyvariables or 1986alone doshowa negativeshift.However, giventhat there is no signof anadverseshiftduring heperiodof the strongdollar tself, we have to say thattheevidence does not support heview of hysteresisin the tradebalance.The conclusion seems to be that the decline in the exchange rateconsistentwith tradebalancereflectsthecontinuationof along-standingtrendrather han a result of the strongdollar tself.


44/56

Paul R. Krugman and Richard E. Baldwin 43

Summary and ConclusionsMost of the U.S. trade deficit results fromwell-understoodcauses.Fasterdemandgrowth ntheUnited States than n othercountrieswouldhave led to a substantialdeficit even if the dollarhadnot appreciated;laggedeffects of the strong dollar continueto be a majorsource of thetradedeficiteven though he rise of thedollar rom 1980 o 1985has nowbeenreversed.Thefailureof the nominal radedeficitto showimprove-ment through 1986was, however, surprising,as was the only slightimprovement n the real trade

Documents

The Persistence of the U.S. Trade Deficit (1987)