I just returned from Colombia, and I was ready to start bashing Latin American countries (and Brazil in particular), when I read that European Ministers are talking about a Dollar that is “too depreciated”. I mean, I comprehend that the US slow down, and the current pace of depreciation, are hurting the tradable sector in Europe, but to conclude that the dollar is “too depreciated” from that observation is probably responding more to politics, than economics.
So, sorry, no Brazilian smashing this time… I know this will disappoint so many, but I want to concentrate on the statement coming from the IMF and the European ministers, rather than continuing stating the obvious. So, at least this time, in this blog… Brazil is safe for once.
Let me turn my attention to the real exchange rate…
Since the seminal contributions by Salter and Swan in the 60’s, which were later properly explained to human kind by Rudi Dornbusch (issues that he coined within “The Dependent Economy” framework), we know that the equilibrium real exchange rate is defined as such in which economies achieve internal and external equilibrium. Where the internal equilibrium usually refers to equilibrium in the labor market, and where the external equilibrium is defined through the current account.
In that framework, a real exchange rate is appreciated – for sure – when the economy suffers from unemployment and current account deficit, and it is appreciated – again for sure – when the labor market is overheated and the current account is in surplus. The other combinations, unemployment with current account surplus, and overheated with deficit, are like the Florida elections – too close to call. They can indeed go either way and mostly reflect disequilibriums of the aggregate demand rather than the real exchange rate.
If the dollar is “too depreciated” as claimed by some European ministers it must be the case that the US economy should have an overheated labor market, and a current account surplus. Well, the last time I checked we have a current account deficit, and the labor market is far from overheated.
First, even if we account for all the possible capital gains of US investor’s portfolios, and even counting all the “dark”, “grey” and “purple” matter you want, the US barely breaks even in the most optimistic calibrations I have seen. And this is making a huge assumption about the behavior of consumers that is unlikely to take place in reality (maybe my next blog should be about this….). Therefore, there is no evident surplus here that could justify one of the main symptoms of a depreciated currency.
Second, in this circumstance to have a depreciated exchange rate the labor market should be excessively overheated – i.e. to compensate the lack of surplus in the external accounts the labor market must be incredibly tight. But the labor market is not overheated at all. Average real wages are flat or coming down which is a reflection of a loose labor market. And if you want to push it by concentrating in the high skill sector, you can make it as far as roughly in equilibrium.
Therefore, it is incredibly difficult to justify the “too depreciated” statement based on economic grounds. The dollar is not depreciated. In fact, given the current situation in the US if something is going to happen is that the real exchange rate is going to continue to depreciate in the medium run. I understand that this will hurt the manufacturing sector in Europe, and that political pressures will mount.
The US is going to slow down, which will mean more depreciation and more suffering to Europe. So, it is time to prepare for the adjustment. Embrace the opportunity and make your economy more flexible in order to manage the restructuring that is likely to take place. In fact, do everything except follow the Yankees lead that blame some “insects” for a disappointing performance. At some point in time you have to stop digging excuses for your future failures in the neighbors yard – i.e. stop behaving like a Brazilian politician… oh man…. here we go again… even when I am trying to trash somebody else, Brazil always makes it to the final “bashing sentence”.