The US dollar is having a hard time of it. But why is this so? Why has the dollar been falling? The basic argument is that the trade deficit is unsustainable and is driving down the dollar. But this argument does not tell us what is driving the deficits. However, some commentators are pointing an accusing finger at aggregate demand, arguing that if the economy grows "too fast" this will suck in imports. But this is to admit that the Fed has implemented a loose monetary policy. Keynes made the same point:

...some part of the new demand will be met, not by increasing home output, but by imports... (Borrowing for Defence: Is it Inflation?, The Times, 11 March, 1937).

Let's look at some figures. During the last year the dollar fell by about 11 per cent against the euro. In September imports fell by 2 per cent and exports rose by 0.5 per cent while in November the dollar once more dropped against a range of major currencies. How do we explain these movements? The answer lies in the supply and demand for dollars. Any first year student of economics understands that to increase the supply of any product while demand for its services remains unchanged will lower its price. Commentators still miss the point even when they observe that imports fall when the economy contracts. A reader sent me the following which he had taken from an article:

The deficit rose throughout the 1970s, from $1 billion in 1971 to $24 billion in 1979 -- all this despite a dollar that mostly fell during that decade. The dollar strengthened throughout the 1980s, yet the trade deficit's rise continued from $19 billion in 1980 to $93 billion in 1989. Between 1996 and 2001 (years of impressive dollar strength) the trade deficit rose 250 percent. The dollar strengthened throughout the 1980s, yet the trade deficit's rise continued from $19 billion in 1980 to $93 billion in 1989. Between 1996 and 2001 (years of impressive dollar strength) the trade deficit rose 250 percent. Since 2001 the dollar has fallen pretty substantially against the pound, euro, and yen, yet Feldstein's own statistics show that the current account deficit rose to $668 billion in 2004 and will rise above its current level of $790 billion in 2006.

Looking period January 1970 to December 1979 we find that M1 rose by a very impressive 85 per cent. From January 1980 to December 1988 M1 rose by an even more impressive 104 per cent. During Bush 41's presidency M1 grew by about 30 per cent. Under the Clinton administration M1 expanded by a more modest 25 per cent. Since his inauguration until last September MI had grown by about 24 per cent. It ought to be plain to see that the course of trade deficits follow the same course as M1. Whenever spending slows because M1 has slowed the deficit shrinks and vice versa.

Now there is absolutely nothing new in this aspect of monetary theory. Writing in 1553 the Dominican Domingo de Soto, a prominent Spanish Scholastic, applied supply-and-demand analysis to exchange rates and trade deficit, explaining that

the more plentiful money is in Medina the more unfavourable are the terms of exchange and the higher the price must be paid by whoever wishes to send money from Spain to Flanders....And the scarcer the money is in Medina [i.e., the greater its purchasing power] the less he need pay there, because more people want money there than are sending it to Flanders.

In other words, de Soto was using the theory of purchasing power parity to explain exchange rates in terms of the relative purchasing power of other moneys. Mises made the same point when said that "[e]xchange rates are determined by the relative purchasing power per unit of each kind of money". The link between exchange rates and trade deficits was discussed in great detail during the bullion controversy in early nineteenth century England. What sparked this debate was the price of bullion rising relative to pounds while the trade deficit grew.

In 1797 England suspended gold payments. In response the issue of bank credit and notes expanded resulting in a growing trade deficit and a depreciating currency. (The story is far more complicated than this). Today, however, this process is obscured by the fact that the world is on a fiat standard and that relative money stocks are continuously changing. What happens here is that all currencies are experiencing a downward trend in relative purchasing power. Nevertheless that is no excuse for ignoring the fundamental role of money and denying the validity of the purchasing power parity theory.

Moreover, economists and a whole range of media wannabes are continually express opinions on the trade deficit without making any references to nominal incomes, something that was discussed long ago. (Gottried von Haberler's Theory of International Trade, William Hodge and Company Limited, 1950, ch. 7, section 3. Also Ludwig von Mises' On the Manipulation of Money and Credit, Free Market Books, 1978, Appendix). As the money supply increases nominal incomes rise which then raises the demand for imports and creates a trade deficit. This process occurs before any rise in general prices appear. This is exactly what Mr J. J. Polak's 1957 study found. Polak, an economist with the IMF, discovered that credit expansion generated current account deficits.

One very important matter that is entirely overlooked by our economic commentariat is that "international imbalances" also include real factors. US current account deficits have had the perverse effect of misdirecting foreign companies into serving American consumers. The effect of a devaluation could therefore disrupt some foreign countries' manufacturing processes. To what extent this could happen would be determined by the extent to which they have become dependent on the US market and are able to respond to swift changes in demand for their products.

It has been pointed out to me that between 1985 and 1987 the dollar fell against the German Mark and the Japanese yen by about 50 per cent. Nerveless, all three countries still rapidly grew while US exports surged. What is missing here is the fact that Germany, Japan, etc., also accelerated monetary growth.

We can therefore conclude that the US has been exporting its inflation. In doing so it has run massive trade deficits. However, trends clearly indicate that the dollar is undergoing a necessary adjustment. When the dollar falls the cry will go up that devaluation will worsen inflation. Talk about carts and horses. It should be clear that any devaluation will be the result of the Fed's inflationary monetary policy. Moreover, such critics overlook that a devaluation should stimulate US exports.

Note: The Austrian definition of the US money supply is currency outside Treasury, Federal Reserve Banks and the vaults of depository institutions.

Demand deposits at commercial banks and foreign-related institutions other than those due to depository institutions, the U.S. government and foreign banks and official institutions, less cash items in the process of collection and Federal Reserve float.

NOW (negotiable order of withdrawal) and ATS (automatic transfer service) balances at commercial banks, U.S. branches and agencies of foreign banks, and Edge Act corporations. NOW balances at thrifts, credit union share draft balances, and demand deposits at thrifts.

AMS definition therefore equals cash plus demand deposits with commercial banks and thrift institutions plus saving deposits plus government deposits with banks and the central bank.