Exchange Rates & Trade Balance Issue Revisited
While phrased in different ways by different pundits, the argument essentially boils down to the supposed unrealism of reducing unsound external deficits of certain countries through reduced fiscal deficits or by relative deflation. Instead, the only realistic way is for surplus nations like China and Germany to increase the value of their currencies (which in the case of Germany of course would have to involve some form of euro area break up).
But as Scott Sumner pointed out in the post I linked to yesterday, the United States has been calling on Japan to increase the value of the yen for the purpose of reducing its surplus ever since the 1970s, when a dollar stood at 350 yen. The value of the yen has since in accordance with American demands increased dramatically, so that a dollar now stands at just 90 yen, yet Japan still has a surplus (Though it is not bashed as much as before as China has taken over Japan's previous role of scapegoat in America).
Another example is Britain which in 2007 had an average monthly trade deficit of £3.75 billion. Since early 2007, the pound has dropped more than 20% against both the U.S. dollar and the euro, yet in January 2010 it ran a trade deficit (goods & services) of...£3.75 billion. That the number was almost exactly the same as in 2007 is of course just a funny coincidence, but the point is that despite a deeper recession than in the euro area and despite a drop in the value of the pound by more than 20%, the external deficit has barely budged.
This is not to suggest that exchange rates all other things being equal have no effect on trade balances. There are good theoretical reasons for believing that all other things being equal, a weaker currency will reduce a trade deficit (or turn a deficit into a surplus or increase a surplus, depending on the initial position) and vice versa for a stronger currency. But these cases illustrate that the effect is probably smaller than many people think, at least in the context of significant exchange rate uncertainty.
Why would great exchange rate uncertainty limit the export boosting effects of real depreciation? Because British manufacturers can't be sure that the current weak exchange rate will really be there in the future too, they won't invest to expand their operations or reduce prices even though it would have been profitable assuming that the pound would remain weak. Instead, they simply reap the windfall gains (something which of course comes at the expense of reducing purchasing power for others) but won't increase volumes.
There are good reasons for businesses not to act on fluctuations in exchange rates, because they are often temporary. One example is Sweden, which saw its krona depreciate by roughly 20% against the euro between March 2008 and March 2009. Now the krona has recovered almost all of those losses and if you take inflation differentials into account, the real exchange rate is in fact slightly higher than two years earlier. Swedish businesses that expanded a year ago to export more based on the weak krona would have now found themselves in a very awkward position as their new production facilities given the current exchange rate is unprofitable. And if they had reduced prices they would now be forced to raise prices, something which might upset customers.
Because businesses can't know whether the exchange rate weakness will only be temporary as in Sweden, or seemingly semi-permanent as in Britain, they won't respond to exchange rate movements anywhere near as much as they would if they knew that the change was permanent. And for this reason, exchange rate movements in a fluctuating exchange rate system will have a surprisingly (to many people) little effect on trade balances.
And furthermore, all other things usually aren't equal. Weaker currencies are associated with higher inflation which will not only make the real depreciation smaller than the nominal depreciation, it will also often reduce real interest rates, something which will prevent the adjustment in spending needed to reduce external deficit.
This is particularly evident in the case of Japan, where most of the increase in the value of the yen reflects consistently lower inflation rather than a real appreciation. Furthermore, during the latest year its surplus has recovered because deflation has persisted there, unlike in particularly Britain and America where inflation has returned to fairly high levels, meaning that Japan now has very high real interest rates while real interest rates are well below zero in Britain and America.
For Britain, its high inflation rate has similarly not only limited the real depreciation of the pound, but by pushing down real interest rates so far below zero it has encouraged people not to adjust spending. The large U.K. fiscal deficit has also helped prevent a reduction in the trade deficit.
Trying to push exchange rates up or down are thus much less effective than, and for that reason no substitute for, fiscal austerity and/or normalized interest rates to reduce unsound external deficits in certain countries.