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$200

$100

$0
1981




1991




2001
1982
1983
1984
1985
1986
1987
1988
1989
1990

1992
1993
1994
1995
1996
1997
1998
1999
2000

2002
2003
*04
* estimate from part of year



FIGURE 6.1 The United States Consumes Far More Than It Produces
Source: U.S. Commerce Department



current account deficit. We™ve had a deficit for so long that we show the
negative current account deficit as positive numbers. Because we can™t
imagine a world where the United States consumes less than it produces,
we measure the amount of profligacy, not its existence. Residents in the
United States consume far more than they produce. In return for Saudi
oil, Japanese cars, and Canadian lumber, the United States sends the pro-
ducers IOUs to the tune of about $500 billion a year.
How big is $500 billion a year? The short answer is: the biggest cur-
rent account deficit in history. The longer answer is: The current account
deficit is about 5% of the size of the U.S. economy, which still makes it
one of the biggest current account deficits in history. How did we get
here?
Current account imbalances are influenced by currency values. When
Canadian lumber is made cheap by a strong dollar, for example, we
import more logs from Saskatchewan. To understand the U.S. current
account deficit we begin by looking at exchange rates.
When I was first learning about money, the British pound was always
118 The Old Art of Macroeconomics



worth about $2.50. What I didn™t realize then was that currency prices
were fixed by agreement between governments. Thus the $2.50 was a
government-mandated price, not a market price.
In 1944, governments decided that exchange rates were too important
to be left to market irrationality. Economists put part of the blame for the
Great Depression of the 1930s on wild fluctuations in the value of cur-
rencies. Toward the end of World War II, the major economic powers met
in Bretton Woods and fixed the value of their currencies. The govern-
ments wanted to make sure that the excesses that led to global economic
collapse would not reappear.1
In 1971, Richard Nixon devalued the dollar and destroyed the Bretton
Woods pact. Freed from its fixed price, the dollar was free to fluctuate
between irrationally low and high values, and to create current account
imbalances. As seen in Figure 6.1, from the 1980s until now the dollar™s
value has led to large and growing U.S. current account deficits.
Current account deficits are a form of borrowing. There™s nothing
inherently evil about borrowing in general nor in running a current
account deficit. College students borrow to further their education, com-
panies borrow to expand factories, and countries borrow to undertake
projects that may take years to repay.
For example, the Hoover Dam outside Las Vegas was built in the
1930s and now generates very low cost hydroelectric power. Only a cur-
mudgeon would argue against borrowing for the Hoover Dam on finan-
cial grounds (there are, of course, legitimate environmental arguments
against dams). Borrowing to develop something is often better than the
alternative of no borrowing and no development.
While IOUs are nice, and loans can be good, eventually the piper must
be paid. Notice that Wimpy in the Popeye cartoon says, “I™d gladly pay
you Tuesday for a hamburger today.” He doesn™t say I™d gladly eat a ham-
burger on Tuesday for a hamburger today.
“Neither a borrower nor a lender be” says Polonius to his son Laertes
in Hamlet. While this advice appears sound, many scholars think Shake-
speare wrote it as an example of a father droning on with obvious and
Deficits and Dollars 119



unsolicited comments. In the case of borrowing, the advice is essentially
empty. Debts must be repaid, so borrowing and lending are just different
phases, not permanent states. It is impossible to go through life as a bor-
rower (although I suppose Cheapskate did).
The implications are clear. Countries with current account deficits
must at some point swing to surplus. Thus the United States, currently
the world™s biggest net consumer from other countries, will become a net
producer. In the coming years we will be discussing the size of the U.S.
current account surplus. Because the U.S. current account deficit is huge,
the inevitable adjustment to surplus will have profound effects on the
world™s economy and on individuals™ investments. Let™s look at how this
is likely to play out and the implications.



A Euro for Your Thoughts

In November 2002 my wife and I visited Milan. Walking along the
famous shopping street of Via Montenapolean, Barbara spotted a Bottega
Veneta purse for the price of 700 euros. At the time, one dollar bought
just over one euro so this purse was being offered at the price of about
$680.
Both Barbara and I found this $680 purse price to be ridiculous but for
different reasons. “Don™t you realize that I saw this same purse on sale in
New York for over $800!” she said. Biting my lip and suppressing my
horror, I said, “I think you should snap it up.” On our way back from
Europe we flew out of the airport in Cologne. A young German woman
about 23 years old was working the customs desk. She said, “You have
declared an item worth 700 euros; may I see it?” I showed her the purse,
and she gasped, “That™s it?” “Yes, isn™t it a ridiculous value?” I replied.
We returned to the United States with Barbara™s beautiful bargain,
thereby contributing $680 to the U.S. current account deficit.
Were we to go to Europe in 2004 we would find that purses costing
700 euros translate to a dollar-cost of $850. Costs to U.S. consumers
120 The Old Art of Macroeconomics



have increased dramatically because the dollar has lost value relative to
the euro. Currency devaluations change people™s purchasing decisions.
Add up enough 700 euro purses not purchased, throw in a few Mercedes
that Americans don™t buy, and pretty soon a falling dollar leads to a
smaller current account deficit.
A current account deficit means that a country is consuming more than
it is producing. A simple way to cut back is to raise the price of con-
sumption. This can be accomplished almost magically by changing the
value of the currency. Against the euro, the U.S. dollar has lost almost a
third of its value over the last few years. As compared to the Japanese
yen, the U.S. dollar has been in decline for decades. Thus without any
change in dollar wealth, U.S. consumers are now much poorer than we
were a few years ago. This weakening of the dollar works to make us
consume less from abroad. It also makes the American products cheaper,
thus boosting purchases by foreigners.
A cheaper dollar decreases imports and increases exports, reducing
the current account deficit.



Real and Nominal Exchange Rates

While exchange rates are a bit abstract for many people, for others they
are of visceral importance. I learned this during a 1992 visit to Victoria
Falls. I was staying in Zimbabwe across the Zambezi River from Zambia
(Zimbabwe used to be called Rhodesia, and Zambia was Northern
Rhodesia). One day I rented a bicycle and crossed a bridge into Zambia,
intending to peddle a few miles to the museum in the town of Livingstone.
Two interesting things happened on the road to Livingstone. First, my
bicycle got a flat tire. There was no place to fix the tire, so I decided to
ride on the metal rim and pay the owner for any consequent damages.
This meant that my already slow pace in the hot sun was further reduced.
Second, a group of Zambians descended on me. The Zambians were
hungry to get their hands on some Zimbabwean currency. I found this
Deficits and Dollars 121



interesting because I was able to get so much Zimbabwean currency for
my U.S. dollars that I felt like a rich man in Victoria Falls. While the
Zimbabwean currency was weak compared to the U.S. dollar, it was rock
solid compared to the currency of Zambia. So motivated were these Zam-
bians to get some “hard” currency that they chased after me for more than
a mile”running beside my damaged bicycle in their street clothes and
hard-soled shoes.
If one were to visit Victoria Falls today, the situation would be
reversed. The Zimbabwean currency is now extremely weak compared to
that of Zambia. What happened? The current inflation rate in Zimbabwe
is over 640%. By comparison, the Zambian rate of 18.5% looks posi-
tively tame.2 Because of the different inflation rates, the Zimbabwean
currency is dropping on a daily basis. People who want to store their
money in a stable currency are willing to work hard to avoid Zimbab-
wean currency.
Of the two currencies, the Zambian is now rock solid because of the
difference in inflation rates. The lesson from this is that whenever we dis-
cuss exchange rates, we need to be sure to consider relative inflation
rates. We care about the purchasing power of our money (the real exchange
rate), not the number of bills we can get (the nominal exchange rate).
The real exchange rate takes into account inflation rates.
With high inflation rates, the difference between nominal and real
exchange rates can be enormous. In January 1913, one U.S. dollar con-
verted into 4.2 German marks. In October 1923, the same dollar was
worth over 25 billion German marks! Because German prices had risen
even faster than the exchange rate, however, the purchasing power of
these 25 billion marks was less than the 4.2 marks in 1913.3 The nominal
value of a U.S. dollar in marks had gone up astronomically while the real
value actually fell.
Wouldn™t it be nice if we could just ignore the difference between real
and nominal exchange rates? Yes, and we will. Most of our discussion
focuses on the three big currencies: the U.S. dollar, the euro, and the Jap-
anese yen. All three regions have similarly low inflation rates these days.
122 The Old Art of Macroeconomics



When countries have similar levels of inflation, it is okay to use nominal
exchange rates.



Two Roads to Times Square

In The Out of Towners, the protagonists George and Gwen Kellerman
(played by Jack Lemmon and Sandy Dennis in the 1970 original; Steve
Martin and Goldie Hawn in the 1999 remake) make a hellish trip to New
York City.
When their flight intended for New York is diverted to Boston, the
Kellermans improvise and push on to Manhattan by train. After a very
long night including a mugging, a police chase, and sleeping outdoors,
the Kellermans run into one of their fellow passengers from the original
flight. Unlike the frazzled Kellermans, their calm compatriot rested
overnight in Boston and took a morning flight. Both parties ended up in
Manhattan for breakfast, but by very different routes.
Similarly, there are various paths the world can take as we adjust from
the United States having the biggest current account deficit in history to
a future with U.S. current account surpluses. Two relevant and recent
examples exist in North America. In these sagas, Mexico took a painful
Kellermanesque path of adjustment, while Canada eased through its tran-
sition with many fewer aches and pains.
In the 1960s and 1970s my family used to vacation in Canada™s Point
Pelee National Park. As an industrious child, I scavenged for discarded
bottles with my sister Miranda to make money on the deposits. On good
days, we would gather more than 100 bottles, which, depending on
the brand, each carried a 2 cent or a 3 cent deposit. We were able to get
our hot little hands on 2 or 3 dollars for a few hours of work. But there
was one small catch; we earned Canadian dollars (now also known as
“loonies”), not U.S. dollars.
When we began our bottle collecting, the loonie was worth slightly
less than its U.S. counterpart.4 So we had a bit of disdain for the Canadian
Deficits and Dollars 123



currency. Furthermore, because some of the coins were of similar size
(particularly the quarters), people who lived in Detroit and the neigh-
boring Canadian town of Windsor would often exchange the coins at an
even rate. I was always happy if I could unload my Canadian quarters at
full value, whereas I felt cheated when someone slipped me a Canadian
quarter.
In the early 1970s something magical happened. The Canadian dollars
that we earned from our bottle work became worth more than a U.S. dol-
lar.5 Although the adjustment was quite small, the movement to more
than a buck was accompanied by tremendous pride. Instead of shyly slid-
ing my Canadian dollar across the counter at Harry™s hobby shop and
hoping I wouldn™t get yelled at, the crisp Canadian bills became some-

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