4. DOES DEPRECIATION WORK AND IS IT COSTLY?

Discussion of U.S. external balance adjustment has raised several challenges to depreciation as the easy way out. There is first the concern about the inflationary impact at home and the recessionary consequences abroad. Inflation at home was a dramatic issue in the aftermath at two previous major dollar realignments: 1970-73 and 1978-80. In each of those instances inflation reached double digit levels and led to hard-landing scenarios when the monetary authorities used tight monetary policy to bring about a recession with the aim of stopping inflation. At present, inflation does, of course, reflect the continuing depreciation. The level and increase in inflation, for the time being, has been so moderate that it is not a political issue. But, for the time being, wages have not reflected the increase in inflation and thus the full effects remain to be seen.

The consequences of further depreciation of the dollar for Europe and Japan are prominent in public discussion. The authorities favour the view that a steep dollar decline could trigger so large a recession abroad - including as a trigger a sharp decline in investment - that in the end the U.S. might be hurt, rather than benefitting from depreciation. That view is not broadly shared in the academic comniunity, or at least it is not seen as decisive. The prevalent view is that Germany needs enough heat - directly or from EMS partners - to implement a major shift to growth-oriented policy. Such a shift toward growth is necessary if, in the face of U.S. restrictive budget policies in the next few years, world growth is to continue at a satisfactory rate.

The next concern is that depreciation does not work, at least not on the side of imports. The striking fact is that import prices of manufactures have scarcely increased relative to domestic despite a major depreciation over the past few years (see Figure 4). The explanation is the entry of newly industrialized countries and strategic pricing (including major cost reductions) of U.S. trading partners, especially Japan. The large initial profit margins and major cost reductions have allowed Japanese firms to maintain their competitiveness in the U.S. market. As a result U.S. import volume continues to rise (see Figure 5). On the side of exports, real depreciation is showing strong results; on the import side, there is continuing deterioration. An obvious answer to this challenge is to test Japanese cost cutting ability by further depreciation. Depreciation should be rapid to forestall the ability of U.S. trading partners to adjust and thus force price adjustment.

The final argument, brought very effectively by Professor Michael Piore, is that depreciation is a policy of immiserization. His point is that depreciation, while allowing U.S. firms to sell, also takes away pressure for productivity adjustment. Because productivity is the only source of sustainable growth in the standard of living, depreciation is the wrong policy. It is a cheap labour policy, not a growth policy.

But there is a matching, strong argument for depreciation. Until recently protectionism was a major issue in the U.S. Partly as a result of full employment, but also as a consequence of dollar depreciation, protectionist pressure has subsided. Further dollar depreciation is a safe way of killing off the dangerous prospect of U.S. protectionism.