Monday, March 10, 2008

Exchange Rates and the Trade Deficit

Fellow blogger Mike Fladlien made a request in my previous post. It seems some of his students don’t see the weakening dollar reducing the trade deficit. My best advice is to look at this publication produced by the Federal Reserve Bank of St. Louis. In each issue, they summarize the component parts of Gross Domestic Product (GDP) and how they contribute or detract from the overall number. Since early 2006, the quarterly trade data has been predominantly positive – exports larger than imports – resulting in positive contributions to GDP. If memory serves, this is about the time that the dollar began weakening against many other currencies.

But I think the main question his students have been asking is why there still is a trade deficit if we’re seeing exports outpacing imports. The response I would give is that a handful of quarters of positive trade flows does not equal all the quarters of negative trade flows over the past decade. The parallel I would use is the years of budget surplus at the end of the Clinton administration. While they were nice, the surpluses weren’t large enough to cancel out the accumulated annual deficits (the national debt). Likewise, these trade surpluses were not large enough to counterbalance the previous deficits.

I would also remind students of something from their American History classes. I believe, the United States has been a net trade deficit nation most of its history. The other side of the trade deficit was a positive capital flow – nations investing in the United States. That helped build the capital base that supported economic growth.

I look forward to additional comments.

**Correction**
Thanks to a sharp-eyed colleague for pointing out an error in my post. I was focusing on absolute amounts when I should have been focusing on growth rates. Here's how my colleague correctly explains the issue:

"I think this explanation mixes together two related but different concepts: absolute amounts and growth in absolute amounts. The confusion comes from the wording "exports outpacing imports" -- which implies that the dollar value of exports currently exceeds the dollar value of imports (which it does not). A better phrase to use might be "growth in exports outpacing growth in imports." The current trade deficit overall is still highly negative. As an example, suppose exports are currently $200 billion and imports are currently $400 billion. The trade balance is -$200 billion.

If exports are growing by 10% a year, however, exports will be $266 billion after 4 years. If imports are falling by 10% a year, imports will be $292 billion after 4 years. Hence, this change in exports and imports contributes to faster U.S. growth, even though the trade balance itself is still in deficit (-$25 billion) after 4 years. So, it is not exports that are outpacing imports. It is the growth in exports that is outpacing the growth of imports."

My thanks to my colleague, and my apologies to my readers.

1 comment:

Mike Fladlien said...

thank you for a nice explanation that i can take into class...