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Trade Deficits and the Dollar

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Tuesday, 14 May 2013 08:48

In prior posts I have often referred to the run-up in the dollar engineered by the Clinton-Rubin-Summers team in the 1990s as being the root of all evils. The point is that their over-valued dollar policy led to a large trade deficit. The only way the demand lost as a result of the trade deficit (people spending their money overseas rather than here) could be offset was with asset bubbles.

To fill this demand gap, the Clinton crew gave us the stock bubble in the 1990s and the Bush team gave us the housing bubble in the last decade. In both cases the bubbles crashed with disastrous consequences, the latter more than the former. (It took us almost 4 years to replace the jobs lost in the 2001 recession, so that downturn was not trivial either.)

Anyhow, my take away from this story is that, using the advanced economics from Econ 101, we need to get the dollar down. I have made this point in the past and readers have often commented that trade does not appear to be responding as would be predicted from a falling dollar. I would argue otherwise. The graph below shows the non-oil trade deficit measured as a share of GDP against the real value of the dollar.

non-oil-trade-deficit-and-dollar

Source: Bureau of Economic Analysis and the Federal Reserve Board 

This picture looks pretty much like the textbook story. The dollar has fallen nearly back to its 1995 level and the deficit as a share of GDP has fallen almost back to is 1995-1997 level as well. (There are lags, so trade does not adjust immediately to changes in the dollar's value.) Before anyone starts jumping up and down about pulling oil out of the picture, let me explain.

Oil prices have more than quadrupled over this period causing us to have a much larger deficit from oil imports. (Sorry, I have not deducted oil exports because they were not available from the same table.) Demand for oil is relatively inelastic. This means that when oil prices go up, if nothing else changed, we would expect our trade deficit to rise as the increase in the price of oil more than offsets the decline in quantity.

The textbook response to the increase in oil prices and the rise in the trade deficit would be that the additional outflow of dollars would cause a further decline in the value of the dollar. This decline in the dollar leads to reduction in imports and an increase in exports, which effectively allows the country to pay for higher priced oil.

In other words, if we followed the textbook story, we should expect to see a somewhat lower valued dollar today than in 1995 as a result of higher oil prices. This would cause us to have a reduced deficit, or even trade surplus, on non-oil products. This would mean that the dollar has to fall somewhat more than it already has in order to bring our trade deficit back to its mid-90s level.

It looks to me like the intro textbook story is still doing pretty well.

Comments (12)Add Comment
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written by JSeydl, May 14, 2013 10:42
Sounds good, Dean. But I need to see this in a dynamic model where consumers optimize consumption time paths under uncertainty. Otherwise, what you say is just too darn simple that it obviously must be wrong.
Warren Mosler on the Trade Deficit
written by tyler healey, May 14, 2013 10:57
Dr. Baker,

According to Warren Mosler, the trade deficit is not our enemy. One of his books which discusses the trade deficit can be read here: http://moslereconomics.com/wp-...s/7DIF.pdf
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written by Chris Engel, May 14, 2013 11:02
Haven't we been in an oil export boom?

http://www.wallstreetdaily.com/wallstreet-research/charts/1211OilExports.png

Right around where the deficit bottoms in your graph (2005), we have had a corresponding surge in oil production and exports, which when taken out would dent the increase in the deficit shown in the graph ex-oil-imports.

It could be if oil exports are taken out of your graph (as imports were) that the relationship is not so strong, because since 2005 there really has been a huge boom in O&G exports.

I'm with you on the dollar needing to be lower, but I suspect the current overvaluation is a result of our dollar's international reserve status. And it will drop once the BRICs continue the de-dollarizing that sucks out the extra demand we have right now on international markets.
Who's Your Nanny? Meet the MNC Dynamic Duo, Pillage and Plunder
written by Last Mover, May 14, 2013 11:50
Well of course Mr Who's Your Nanny, the MNCs were pulling the levers behind the curtain through manipulated foreign exchange rates all the while as they planted themselves in other countries and began selling products back to themselves in the USA. Talk about creating your own demand, this is Says Law on steroids.

Meanwhile, back at the Cowboy Walmart Ranch in good 'ol US of A, economists were falling all over themselves to explain how good Walmart was for America as it fed so efficiently the consumption demand for imports driven by asset bubbles.

After all, something had to replace the demand lost due to more productive wage income plundered by less productive capital income. What better stuntmen to fill in for the role of true economic performance than the dynamic duo of Walmart and asset bubbles? What a team!

Or as economists would say, two are better than one any day when it comes to the scale and scope efficiencies necessary to maximize Pillage and Plunder by the Dynamic Duo.
hmmm hard to say bush caused the bubble in 2002?
written by pete, May 14, 2013 1:04
But thats when Shiller and Dean Baker were sending up warning flares about the Housing bubble.

Meanwhile, going to be hard to compete with the Japanese who are already racing to the bottom. And the solution proposed for Europe was also a weaker currency, to get Greek real wages down (Krugman suggested the need for a 25% delcine). That is, the solution for every country appears to be to weaken its currency. Well, I am sorry, I just don't see how that all can happen.
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written by James Davies, May 14, 2013 2:48
You refer to the "run-up in the dollar engineered by the Clinton-Rubin-Summers team in the 1990s" quite often. How exactly did they do this? What policy levers did they use, and what may have happened had they not pursued these policies? A little economic history would be enlightening for me.
a few items
written by matt mcosker, May 14, 2013 3:27
Tyler, I spoke to warren about this and there are benefits to trade, but it is a drain on the economy reducing domestic private savings. To offset this, the government must offset the drain with deficit spending.in 2007-08 the trade deficit was about 6% of gdp, but budget deficit was just over 1% of gdp when we needed at least a 6% budget deficit just to offset the balance of trade.
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written by Amileoj, May 14, 2013 3:35
The dollar has fallen nearly back to its 1995 level...


So, just a little bit lower and we'll have eradicated 'the root of all evils' and be back to the glory years of--the early 90's?

Look, I get that we don't want unsustainable bubbles built on private credit expansion. But we (or at least I) do want the tight labor markets that come with the kind of growth we experienced in the latter half of the 90's.

Do you honestly think we're going to get there by lowering the dollar and having an export boom? Where is the demand going to come from? Europe? China? Really?

Engineering currency levels...and the benefits
written by Nassim Sabba, May 14, 2013 6:01
@Amileorj,

1) When the dollar drops, not only others will find US made products cheaper, but our domestic producers will be relieved. When the dollar goes down 10% it will be like an invisible tariff of 10% imposed on imported products which would allow domestic producers to compete with imports. From auto-makers (no matter who owns the plant) to clothing manufacturers, etc.
At the same time, that 10% is like a drop in others' tariffs on our produces, or a discount for their consumers.
US services also becomes cheaper to all consumers, as the cost of foreign software engineers, for example, will go up by 10%.

2) To manage currency values, the government, through the Fed, can manage interest rates and supply of dollars domestically and internationally.
The point that Dean Baker has raised is that we don't need bubbles to have tight labor markets. We can increase demand through higher exports AND lessening of more expensive imports. Lower dollar exchange rate will result in both.
Lower dollar exchange rate will give us the needed increase in exports AND decrease in imports. The NET of these two is the deficit in trade. It doesn't require a boom per se in one direction only.
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written by skeptonomist, May 14, 2013 8:15
It looks like Dean may have identified at least one reason for the failure of the trade balance to turn around, but the point was not that currency values are insignificant, rather they are not the only things that influence trade balances.

Labor costs in China and other developing countries have been important - if the standard of living goes up there as workers demand more, this will probably be more important than operations by central banks. In the long run this is probably inevitable, and the only question is how fast it occurs.

But oil price is obviously a major factor and will continue to be in the future. If the US can develop its own oil and gas resources this should greatly improve the balance of payments - or if it can develop alternative energy sources. If there are disruptions of oil supply as there were in the 70's the trade balance will probably get worse. These things are not under the control of central banks.

The Fed has been printing money as fast as it can since mid-2007, and this presumably tends to keep the dollar down. Will this continue if the economy finally turns up? What if there is a restriction in oil supply as there was in the 70's and inflation kicks up again? Will the Fed be able to hold to its supposed current policy of reacting to core and not headline inflation? The trade balance is only one of the things that the Fed may be concerned with.

The main alternative to currency manipulation is tariffs. These are more direct in controlling trade with specific countries. These have fallen out of favor - big-money interests and the media say "we don't want trade wars", but how are currency wars not trade wars? What the big-money interests don't want is interference with their taking advantage of low foreign labor costs. Unions have usually favored tariffs, but they have much less influence than they did 40 or 50 years ago. Tariffs may be politically difficult but that does not mean that monetary solutions are more likely. Is the Fed going to favor policies that benefit US labor, or US capital? At the moment US capital is not seriously concerned about the trade deficit - capitalists and managers want to make money in the short term.

One thing that the US can do is provide more direct support to the industries which affect the trade balance. Anything related to energy would be important, and of course oil and gas are already getting major support through tax policy (not to mention military involvement in foreign countries). But why are wind turbines being bought from China?
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written by watermelonpunch, May 14, 2013 11:33
It seems to me that there's this segment of the population who thinks that for any small lessening of the US Dollar's value, it would mean a corresponding huge reduction in the size of every American male's hoo-ha.
Quite frankly, when it comes to the value of the US Dollar, some people are not thinking rationally with the head that has the brain in it.

These may be grossly inappropriate things to say... But the grossly hysterical way the value of the dollar declining a bit is presented, by some factions, is also way out of the realm of reasonableness, and most of the time, quite honestly, in the realm of Jesus faces on tortilla chips, apocalypse fetish style.

Unfortunately there's a subtle campaign to plant seeds of doubt into the minds of the uninformed and regular people who don't have time to look into the source of these sound bites & find out it's related to people stockpiling food for when they have to hole up in their house while demons knock on their doors masquerading as dead relatives.
E. Asian mercantilist currencies must rise, rise, rise
written by indiana way, May 14, 2013 11:37
Reply to Pete:

"Everyone" conveniently left out the 2.5 billion people living in East and S. East Asia (yes, 2.5 billion: S.E. Asia is larger than all of Europe; China is twice as large as Europe and N. America combined)

The mercantilists of E. Asia have huge trade surpluses with both EU and US of roughly similar scale. The euro and dollar both need to fall dramatically against the RMB, Won, NT Dollar, Singapore Dollar and S. East Asian currencies.

You're "everyone" is only 8% of the world's population. What percentage of the global economy this 8% accounts for depends on currency values, the US economy needs to shrink down to 10% of global GDP or less for US companies to regain competitiveness (a depreciation of 50% or more against the RMB is warranted)

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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