2. ARGUMENTS: WHY THE DOLLAR MAY NOT NEED TO FALL FURTHER

Most observers who feel that the dollar now is correctly valued place their confidence in one of two arguments. Either they argue that adjustment lags to the depreciation of the past two years are very long and that patience is required to await the full benefits, or alternatively, they believe that there is basically no need for correction of the U.S. current account balance because deficits can be financed almost indefinitely.

The adjustment lag argument does not stand up to scrutiny. Econometric studies almost uniformly reveal significant lags in the adjustment to real exchange rates. But forecasts of the U.S. external balance, taking into account these lags, still reveal continuing large deficits by 1990. The latest OECD forecast, for example, shows a U.S. deficit of more than $100 billion in the second half of 1989. There is virtually no model, public or commercial, that does not predict continuing large deficits.

The alternative is to argue that the U.S. does not really need to adjust since deficits can be financed for a very long period. This view is most frequently supported by reference to an almost unlimited ability of the U.S. to finance current account imbalances by selling off assets. It is correctly observed that the rest of the world holds as yet only a small share of its portfolio in the form of U.S. assets and that accordingly there are years worth of saving from all industrialized countries available to finance a continuation of the deficit even at $100 billion levels. Just as a country with a terms of trade improvement can spend the extra real income without impairing its creditworthiness, so the U.S. can spend the rents that flow from the attractiveness of its assets.

It is certainly true that if the world economy had newly discovered U.S. assets, and if as a result there were massive capital gains, U.S. residents could spend some of that increased wealth. The question is, however, what happens when the capital gains run out? If the exchange rate is allowed to stay overvalued this leads inevitably to disinvestment in the traded goods sector. If ultimately a cut in absorption and a reversal of the current account becomes necessary, that adjustment will have to be extra large because of the disappearance of capacity and other hysteresis effects. The fact that in 1987 central banks rather than private savers have been financing the U.S. current account calls into question this thesis.

An alternative variant of this no-need-to-adjust view is that after a long spree of borrowing inflationary finance can be used to wipe out the real value of the accumulated external debt. The argument has some merit. but there are two related limitations. One is the ability to maintain very negative real rates for a long period, the other the public's willingness to accept the required high rates of inflation.

An entirely different argument asserts that the dollar needs to appreciate, not depreciate, because it has already moved far outside the range of purchasing power parity. In this view, which is nothing short of peculiar, the low purchasing power of the dollar in terms of foreign goods is seen as an aberration rather than as a corrective step to enhance U.S. competitiveness.

Since none of the above arguments carries much persuasion, the question now is how much further dollar depreciation is required?