The Theory
The consensus view of how to solve the burgeoning U.S. trade deficit gives the falling dollar a key roll. This view follows traditional economic theory which supposes that a fall in the value of a nation's currency, relative to the currencies of its trading partners, will eventually improve the trade balance of that nation. Alan Greenspan himself, the Chairman of the Federal Reserve, has made this argument. Early in 2004 he said: "The currency depreciation we have experienced of late should eventually help to contain our current account deficit as foreign producers export less to the United States."
In the chain of reasoning behind this theory, the falling dollar presumably affects the trade balance in two different ways. First, as the value of the U.S. dollar falls, the value of foreign currencies will rise; consequently the U.S. dollar price of imports will also rise. Since, as a general economic principle, higher prices should reduce demand, the level of imports to the U.S. should fall. And as demand for higher-priced imports falls, the U.S. trade deficit will improve. Greenspan's comment, quoted above, refers specifically to this effect. As a corollary of this, the higher price of imports will stimulate demand for equivalent goods that are produced domestically (so-called domestic substitution, such as buying U.S. produced wine instead of imported wine).
Second, in the traditional theory, the lower dollar will also improve the U.S. trade balance through the export side of the equation. Just as imports will become more expensive because of the lower value of the dollar, U.S. exports will become less expensive in their foreign markets. And just as higher prices should curtail import demand, the lower dollar prices of U.S. exports should stimulate demand for U.S. made goods and services in foreign markets. In theory, through the intermediary of the lower dollar, the combination of higher prices for imports here and lower prices for U.S. exports abroad will gradually bring down our huge trade deficit.
The Reality
Very briefly, that describes the traditional theory of how the declining value of a nation's currency should improve its trade balance. But, how has it worked in reality? The U.S. dollar has indeed fallen in value - for over two years now, beginning in early 2002. At that time the dollar had a value of about 117 (the U.S. Dollar Index), measured against a group of major foreign currencies. It now stands at about 85, a decline of nearly 27%. Half of this decline has occurred since early this year when Greenspan made the comment quoted above. A decline of this magnitude and over this length of time should certainly be sufficient to see whether the lower dollar has begun to have the desired effect of increasing U.S. exports and decreasing imports.
To estimate the effectiveness of the lower dollar, we can compare the level of exports, imports, and the trade deficit in March 2002 with the most recent figures available when this was written. Over this time period, exports have increased 21% while imports have increased 35%. The monthly trade deficit itself has increased 70%, from $31.5 billion in March 2002 to $54 billion in August 2004. In other words, while the lower dollar may certainly have helped to increase exports, its effect on imports contradicts theoretical expectations as they have grown even faster than exports. The result is a mushrooming trade deficit that expands even as the dollar falls. The situation not only runs counter to theoretical expectations, but to Mr. Greenspan's expectations as well. We can only wonder what might be wrong with the theory.
When reality contradicts theory like this (whether in economics or another science), the source of the problem often lies in the assumptions that a theory makes about reality. In this case, traditional theory assumes that the value of our trading partners' currencies float against the dollar. That is, the values of currencies are relative to each other: when the dollar falls in value, foreign currencies should increase in value relative to the dollar, and vice-versa. But the real world is different. The value of some currencies does rise and fall against the dollar. However, the value of other currencies, notably those of some Asian countries, is either tied directly to the level of the dollar (a so-called hard peg) or tightly controlled relative to the dollar (a so-called soft peg).
Trade and Currencies Tied to the Dollar
Pegging a currency to the dollar tends to insulate a country's U.S.-bound exports from changes in the value of the dollar. The dollar price of such imports does not rise or fall substantially as the dollar changes value against floating rate currencies. For example, because the Chinese currency is pegged to the dollar, the dollar price of Chinese imports is not affected by the dollars fluctuation in foreign exchange markets (of course, factors other than currency can affect the dollar price of these imports). On the other hand, the price of European imports will tend to rise and fall as the dollar increases or decreases in value relative to the Euro.
Since the value of pegged currencies moves with fluctuations in the dollar, the U.S. cannot leverage a falling dollar to reduce the trade deficit with these countries. If the value of U.S. imports from these countries was relatively small, then the effect on the U.S. trade deficit would be correspondingly small and could possibly be ignored. Unfortunately, the reality is quite different; imports from countries with pegged currencies account for a considerable percentage of the trade deficit. For the year to date (August 2004), 47% of the trade deficit is with countries whose currencies are pegged in some way with the U.S. dollar. China by itself accounts for 24% of the entire U.S. trade deficit so far this year (its currency has been pegged to the U.S. dollar for 10 years).
Trade and Currencies Floating against the U.S. Dollar
But what of the other countries, those whose currencies float against the dollar and who account for the other half of the trade deficit? According to traditional theory, as the dollar falls, U.S. exports to these countries should rise and imports from them should fall, gradually reducing the trade deficit. To see how the dollar's decline has affected trade with these countries, we looked at the ratio of imports to exports for Western Europe and North America (as defined by the Census Bureau) for each year from 1999 through August 2004. If everything worked according to theory, then the ratio of imports to exports should have decreased (imports down and exports up) over this time. But, again, reality defies theory as the ratio of imports to exports has increased each year. In fact, imports from these countries grew as fast or faster than U.S. exports to these countries, increasing the trade deficit even as the dollar fell against these currencies.
While these facts call into question traditional theory, they don't necessarily demonstrate that exchange rate adjustments haven't worked. Perhaps the trade deficit with countries having floating rate currencies would have been worse if the dollar had not fallen as much: no one can answer that. But if, in fact, the lower dollar has kept the trade deficit from getting worse with these countries, then we do have to ask how much farther the dollar must fall before the trade balance would approach equilibrium. Given that only half the trade deficit is with countries having floating rate currencies, we question whether the dollar could ever fall enough to reduce the U.S. trade deficit significantly - without causing other serious economic consequences.
A New Reality
This reality creates a bleak picture of the U.S. trade deficit right now. On the one hand, the declining dollar can have little or no positive impact on the trade deficit with countries whose currencies are pegged to the dollar. As we said, trade with these countries accounts for about half the total trade deficit. On the other hand, even after an average 27% decline in the dollar, the trade deficit continues to worsen with countries whose currencies float against the dollar. Trade with these countries accounts for the other half of our total trade deficit.
We must conclude that traditional theory does not provide an answer to this particular reality. It doesn't work because the assumptions of the theory no longer describe the realities of international trade for the U.S. In fact, it appears that the huge increase in the trade deficit is not really an exchange rate problem at all.
But what are the new realities for U.S. international trade that make the trade deficit so intransigent? In our view, the jump in recent trade deficits reflects long-term structural changes transforming the U.S. economy: changes brought about by the globalization of corporate business activity. In particular, the relocation of U.S. based facilities to offshore locations has accelerated since the 1980's. They have also become more concentrated: U.S. corporations have increased their capital spending, investment and plant location particularly in China. This offshoring has two negative effects on the trade balance. First, when part or all of an export industry is moved offshore, U.S. based exports will decrease. Second, for domestic industries whose products were consumed domestically, offshoring has the effect of increasing imports as these goods or services are brought back for domestic consumption. Until new domestic industries and services develop to fill this void, the U.S. trade balance will be under severe pressure.
One of the least discussed and least understood consequences of the large-scale offshoring of economic activity by U.S. companies is the disaggregation of the benefits of international trade. By 'disaggregation of benefits' we mean that the economic benefits of trade are being split, divided across international boundaries, as production of goods and services become geographically separated from the controlling corporation.
How the economic benefits of international trade are dispersed will depend on how ownership and production are dispersed. When a U.S.-based corporation exports goods or services from domestic facilities, the corporation earns a profit and the production or service employees earn an income. Each of these benefits, the corporate profit and the employee income, has multiplier effects in the domestic economy. But when a facility is located offshore, the income of the production or service employees, along with its multiplier effects, stays in the offshore economy and are lost to the domestic economy. Only the profit from the operation of that facility returns to the domestic economy through the corporate entity. Some of the multiplier effects of that corporate profit may be lost to the domestic economy as well. That would occur if the reinvestment of profits in the domestic economy was foregone or reduced to permit investment in offshore facilities. As a larger percentage of total investment is funneled offshore, the domestic multiplier effects for the domestic economy would also be reduced.
These changes are irreversible, long-term, and are profoundly affecting the structure of the U.S. economy. We believe that while these changes are in process, the U.S. will find it extremely difficult to find any means, short of a recession, of significantly reducing the trade deficit.
