To caricature, we could argue that there are two views on how to deal with the growth of the US current account deficit where the difference between the two depends, basically, on the desirability of public sector intervention to reduce the growth. The first view argues that as long as the US current account deficit is the outcome of optimized saving and investment behaviour by private agents with rational expectations under competitive market conditions free of frictions, there is no justification for public sector intervention. This is actually a restatement of the first welfare theorem according to which a decentralized general competitive market equilibrium maximizes social welfare. According to the alternative 'prudential' view, even if deficits reflect optimized saving and investment decisions by private agents, distortions are present that have led to US current account deficits that are too large. Consequently, public sector intervention to reduce the deficit is desirable. The precise distortions and whether these do indeed justify policy measures aimed at reducing the deficit have unfortunately not always been worked out. However, the theoretical justification for public sector intervention as well as the design of optimal policy critically depends on the existence and precise nature of these distortions.
It appears, then, that a sensible approach to analysis of the US current account deficit starts from the assumption that the deficit reflects optimal saving and investment decisions by private agents, ie households and firms. If we further assume that agents have rational expectations, a natural way to proceed is to ask whether the US current account deficit is sustainable and which properties of the private agents' saving and investment decisions are critical from the point of view of sustainability. In his forthcoming Bank of Finland discussion paper 'Adjustment of the US current account deficit' Mika Kortelainen raises these questions with the aim of trying to provide some answers through a quantitative simulation exercise.
To study current account dynamics Kortelainen constructs a dynamic general equilibrium macromodel of two large open economies and estimates the model by Bayesian estimation techniques using quarterly US and euro area time series observations over the period from the first quarter of 1977 to the last quarter of 2004. The model constructed by Kortelainen is actually an extension to an open economy context of the dynamic general equilibrium macromodel for the euro area developed in the Bank of Finland. In accordance with the logic of constructing dynamic general equilibrium macromodels, the behaviour of households and firms in Kortelainen's model is based on intertemporal optimization. Price and wage rigidities in turn give the model a New Keynesian flavour. Since wealth dynamics in dynamic general equilibrium models play such a critical role, these models provide almost ideal tools to analyse issues related to current account dynamics.
Notwithstanding the above, it is a well known fact that it is usually very difficult to find an empirically satisfactory parameterization of these models, ie without extra effort and creative thinking the empirical fit of the models tends to be fairly poor and leaves a lot of room for improvements. Kortelainen matches his model to the data by first calibrating some of the model's parameters, after which he estimates the stochastic properties of the disturbances as well as the parameters of the policy rules and adjustment costs functions using Bayesian estimation techniques. He concludes the empirical evaluation of this calibration and estimation exercise by comparing the moments of the distributions of some of the model's key endogenous macrovariables to their empirical counterparts. This evaluation process seems to suggest that the model's weakest point is the relatively poor correspondence between the theoretical and empirical cross correlations.
Kortelainen uses the model to run a set of interesting dynamic simulations. Assuming that half of the US current account deficit is not sustainable, he considers four alternative scenarios to restore sustainability: an increase in the saving rate of US households, an increase in the US dollar risk premium, a coordinated US fiscal tightening and an uncoordinated US fiscal tightening. According to the simulation results, an increase in the saving rate of US households, implemented through an increase in the household sector discount factor, and an increase in the dollar risk premium both represent an effective means to restore the sustainability of the deficit.
This result is intuitive, as in both cases US households will choose to postpone consumption. Due to opposite interest rate effects, however, investments in the US will grow in the former and fall in the latter case. However, the simulation results also suggest that these two scenarios are not innocuous: the risk of deflation in the US or in the rest of the world will, in the first case, take the US economy, and, in the latter case, the rest of the world into a zero interest rate trap.
If, on the other hand, fiscal policy measures are employed in an attempt to reduce the deficit, countries will, on Kortelainen's results, avoid hitting the zero interest rate floor. However, fiscal policy proves insufficient to restore the sustainability of the deficit. On the other hand, through coordinated fiscal tightening in the US, whereby fiscal policy is tightened in the US and loosened in the rest of the world, the US current account deficit shrinks considerably, almost by a sufficient amount to restore sustainability.
One interesting aspect of the results is that changes in private consumption are smaller in the case of an internationally coordinated fiscal policy action than an uncoordinated one. This result seems to suggest that, from the point of view of welfare, internationally coordinated fiscal policy measures are to be preferred. We should, however, bear in mind that welfare-maximizing optimal fiscal policy does not in this context necessarily coincide with either fiscal contraction or expansion. The relevant research indicates rather that optimal fiscal policy should focus on mitigating or even undoing the adverse effects of sticky prices present also in the model Kortelainen uses in his study. This is not criticism of Kortelainen's exercise. On the contrary, it is a suggestion for further research with his model. Overall, we should not forget that methodologically and in subject matter his study represents an ambitious research effort. It contributes nicely to the process of establishing a practice wherein central banks use dynamic stochastic general equilibrium macromodels in policy simulations and more generally in their policy work. |