Currency Fluctuations and Trading Deficits
Drew asked me an interesting question about trade deficits. I thought this subject might of interest to many. I also would appreciate some comments from economists who may have a much different perspective than I.
If the US has a $40 Billion trade deficit (or whatever) and the dollar slides 50% in terms of goods and services (it has slidden (pluperfect subjunctive) from 0.80 to 1.20 vs the Euro) then the trade deficit "balloons to $60 Billion" without any change in the amount of Goods/services crossing the border. Yes the current accounts deficit measured in dollars, and the "flux" (motion across a barrier per unit time) of dollars is higher, but they are now little bitty dollars.

So "lowering the trade deficit" could occur by a) dollar goes up (ie fewer dollars for the same pile of goods/services) or b) the dollar goes down so exported goods/services are more desirable to everyone else.

This obviously is getting nonsensical.

What am I missing here? There is a "CPI adjusted for inflation". Shouldn't there be a "Current Accounts Deficit adjusted to PPP (Purchasing Power Parity) at some set date in the past" or something?

I expect you already know this, but just to ensure we are all the same page, let me define terms. A debt is how much we already owe. If our debt was in Euros, a weak dollar would make our debt bigger and a strong dollar would make our debt smaller. Since our national debt is in US dollars, the strength and weakness of the dollar doesn't make any difference to American bond holders. But it makes a huge difference to foreign investors. If the dollar continues to decline, foreign holders of US bonds are going to take a BIG bath. On the other hand, if the dollar resumes its normal strength, foreign bond holders will still be in good shape.

The deficit is a current summary of period of time (usually one month, one quarter, or one year). In terms of a trade deficit, it means we bought more than we sold in a period of time. As you observed, currency fluctuations can have large impacts on the current trade deficits. And it probably will not surprise you to know that some economists argue that a strong dollar is good for reducing the trade deficit while other economists argue that a weak dollar is better for reducing the trade deficit (despite their mild-mannered stereotype, economists can have quite heated differences in opinion even if they cannot express their argument in terms that are easily understood by the rest of us).

Before I try to sort this out, let me complicate the issue some more. Some countries (especially in the Asian Rim) link the value of their currency to the value of the US dollar. These countries obviously belong to the weaker monetary unit camp of thought. So if an Asian Tiger currency is valued at 10 stripes to the US dollar, and the dollar falls against the euro, the dollar is still valued at 10 stripes to this Asian Tiger. So a falling (or rising) dollar has no direct impact on our trading deficit (or surplus) with this Asian Tiger or other countries that peg their currency to ours. Now it may have an indirect effect. For example, if the dollar falls against the euro, the currencies of these countries also fall against the euro. So Europeans may decide to visit these countries since their euro buys more. Likewise, these countries may buy more goods from the USA since the cost of Europeans goods just went up. The reverse holds if the dollar (and pegged currencies) rise against the Euro.

This example leads to another point I wish to make. Too many people assume transactions are static. That is, some politicians foolishly (and incorrectly) believe that if they raise taxes from 50% to 60% they can calculate exactly how much more money they will raise. However, many taxpayers will quit working so hard if the government is going to keep more of their labor. So tax revenues sometimes decline in the face of tax increases. This is because people are not static, they are smart enough to react to change. International exchange is just as flexible. Let's say the US imported 3 million German cars last year at an average cost of $50,000 (I'm making up these numbers). If the dollar falls against the euro so that same cars now cost an average of $65,000, I can guarantee that the US would not be importing 3 million German cars this year. Some Americans would still buy them, but others would either buy American or buy a luxury import from Japan instead of paying the increased price for German car.

I am not going to spend much time discussing how individual firms handle this since you are interested in the bigger picture, but do want to mention a few things. International companies have become fairly sophisticated about currency risks. If a company is spread out over enough countries, it may choose to accept all the risks (and benefits) of currency fluctuations themselves. However, many companies hedge their risks on the money market. They buy and sell future dollars (or euros, or yen, etc.) on the market and let international traders take the risk. For example, let's say I signed a 3 year contract with a German company to sell them one high-end widget a month for thirty-six months. They will pay me 10,000 euros per widget plus actual shipping costs. If I think the euro is going to rise or stay the same against the dollar (and want to gamble on this), I would be happy with this arrangement. If I thought the euro was going to fall against the dollar (or I just didn't want to gamble), I could sell an agreement to turn over 10,000 euros at the appropriate time on the futures market. In exchange I would receive a discounted amount that would reflect both the going interest rates and the presumed market risk of holding euros. Assuming I went this route (and many companies do so), any fluctuations in exchange rates would not affect me at all until my contract ended. Then I would negotiate a new contract based upon the current exchange rate.

While I was composing this, I received a follow-up email from Drew

I guess the real issue is "How is the Capital Accounts Deficit most accurately measured" and "realizing that, for example a fall in the Dollar makes US Exports more attractive (and contrariwise for a rise in the Dollar) how do you figure out if a change in the currency is making the Current Accounts Deficit closer to Zero or Larger"
I don't know the answer the first question. Hopefully one of our readers can help. From my perspective (which may horrify some economists), I don't think this is that important because I don't think a trade deficit is a bad thing. If country A creates (not redistributes, but creates) more new wealth than countries B, C, D, and E put together, I would expect country A to run a trade deficit. After all, each year it has more new wealth than the other countries, so you would expect them to have more money for imports. Trade deficits are only a bad thing if you borrow to pay for your imports or even if you are paying for imports out of savings without replenishing the savings. However, if your savings are growing and you have a trade deficit, this is fine.

However, if the US dollar remains lower than the euro for an extended period of time, I expect this to have a big impact on the trading patterns of many nations. There are many exceptions to what I am about to say, but in general American companies sell high-quality high-priced goods to the rest of the world. In general, Asian companies sell decent quality, low-priced goods to the rest of the world. In general, European companies aim somewhere in between. If the euro continues to climb against the dollar (and against the Asian currencies), this will eventually have an impact, especially when multi-year contracts expire and companies look at the costs of renewal. Higher-quality American goods could easily cost less than competitive products from Europe. And Asian goods will be significantly less expensive than those from Europe. In such a situation, European manufacturers will be squeezed on both the high-end (America) and low-end (Asia). However, from a European perspective there are a few advantages to a strong euro. It is much easier to buy foreign companies with a strong euro (and the smart play for European companies in such a situation). It is also a good time to buy machine tools and other capital equipment from foreign suppliers.

I've probably raised as many questions as I've answered, but I'll end this post here and look forward to the comments.

 
 
Comments

Admiral, surely trade deficits are historic. In plain words they are what they were when you settled the paperwork. So doing your accounts on Dec 31, the $6 million you paid the PRC for those MP3 players on April 20 is still $6 million.
You can do purchasing power parity adjustments like you can do inflation adjustments. But most official stats are done on an historic basis to make the sums easier. As you note, you can get wildly unstuck this way if your central bank is asleep!

Posted by: Cobden | 04/17/2004 - 06:20 AM

Cobden,
I'm not sure your example applies to trading deficits, but I would call your example an example of a firm's debt - which is indeed fixed.

I looked up the definition of a trade deficit. It is simply when The value of a nations imports exceeds the value of its exports.

I am not 100% certain how the US measures trade deficits. I believe it simply tracks the stated dollar value of imports vs. the stated dollar value of exports for each month. So trading deficits (and demand) will change dramatically with currency fluctuations unless firms have long-term commitments at set prices.

Does this make sense?

Posted by: Don Quixote | 04/17/2004 - 08:25 AM

Don, your month by month example is indeed what I meant by settlement period. As the currencies change, if you settle monthly, then the annual defecit in dollars would surely be the sum of the sub-totals?
One would not adjust it again for accountancy purposes.
Now what would be difficult would be a journalist re-stating the defecit in a 3rd currency. Which rate would he use? Stick to dollars (you will..) and you should be OK.

Posted by: Cobden | 04/18/2004 - 10:03 AM
 
 
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