The U.S. Trade Deficit and the Dollar

For over three decades, the U.S. has consistently imported more than it has exported. That automatically increases foreign ownership of U.S. assets, both financial and real. Many view the trade deficit with alarm, and see it as diminishing the wealth of America. They also fear that some day the U.S. will be unable to pay off its indebtedness to foreign interests, or that the exchange value of the dollar will collapse. A closer look will show that these fears are unrealistic.

Investing in America

One nation invests in another by selling to it more than it buys. When an American buys a Japanese-made auto and pays in dollars, the Japanese auto company acquires a dollar balance in a U.S. bank. In so doing, it has invested in the American dollar. If the auto company wanted payment in yen rather than dollars, the buyer would first have to trade his dollars for yen. Then the seller of yen rather than the Japanese auto company would have invested in the America.

Trade Policies

Contrary to conventional wisdom, the U.S. does not seek to borrow from its trading partners to support its trade deficit. Rather the trade deficit reflects the desire of foreigners in the aggregate to increase their holdings of U.S. dollar assets. They willingly offer their goods and services in exchange for dollar credits. They vigorously compete in the U.S. market, selling at the lowest possible prices, while attempting to hold down their domestic wages to increase their competitiveness. When foreign goods are offered at attractive prices in an open economy like that of the U.S., they will be bought in preference to higher-priced U.S. goods of the same quality.

Another reason for the U.S. trade deficit is that its trading partners depend on exports to help support their own domestic employment. As long as other countries promote trade surpluses with tariffs, import restrictions, and interventions in the financial markets to support the U.S. dollar, they are helping foster the U.S. trade deficit. In a truly floating exchange rate system, free of trade restrictions, the U.S. trade deficit would tend towards zero over time.

How Foreigners Can Use Their Dollar Holdings

Foreigners can use their dollar holdings in several ways:

(1) They can buy U.S. goods and ship them home for their own use or resale, which will reduce the trade deficit and help support U.S. employment.

(2) They can invest them in dollar-denominated assets including new enterprise, which will help support U.S. employment and economic growth.

(3) They can trade them for their own or another currency in the forex market, in which case the dollars will simply change hands without affecting net investment in the U.S.

(4) They can sell the dollars to their central banks, which will invest them in U.S. Treasury securities and thereby help to hold down long term interest rates.

A Broader View

The U.S. economy comprises not only its domestic base but also the many foreigners who invest in the U.S. one way or another. The greater the fraction of their assets that foreigners hold in dollars, the more their financial well-being depends on a strong dollar. Ultimately they will become full members of the U.S. economy. That they may live overseas is no longer relevant.

Suppose an Italian decides to produce wine for sale in America. He hires workers, develops a vineyard, bottles the wine, and exports it to the U.S. for sale. If his wine sells, the U.S. trade deficit will have increased by the amount of dollars he acquires. Like any American citizen, he must pay U.S. taxes on the net income from his sales in America. One can think of him as an American who happens to work abroad. The wine is produced in Italy, but his earnings are in dollars and they remain a part of the dollar economy.

If his sales do well enough, he will become an integral part of the U.S. economy. His own financial well-being will depend on the strength of the dollar relative to the euro. The stronger the dollar, the more euros he can acquire to cover his employee costs, and therefore the greater his profits in euros. Because of the large market the U.S. presents and the status of the U.S. dollar as world’s primary reserve currency, in effect the U.S. trade deficit expands the dollar economy beyond America's geographic borders.

Why a Collapse of the Dollar is Unlikely

As long as foreigners run a net trade surplus. with the U.S, their dollar-denominated assets will increase. They can repatriate their dollar holdings individually, but not collectively. A wave of selling dollars could leave the same quantity of dollars in foreign hands, but at a lower value in terms of the foreign currencies. The trade deficit would be largely self-correcting if foreigners collectively tried to repatriate their dollars.

The time will come when some nations have acquired more dollar-denominated assets than they wish to hold. However they cannot arbitrarily cut their exports to the U.S. without increasing their unemployment levels, unless their domestic market can take up the slack. Nations that have accumulated large dollar reserves must also be careful in diversifying into other currencies lest they hurt the dollar's exchange value and shoot themselves in the foot. A collapse of the dollar is highly unlikely short of an environmental catastrophe or runaway inflation that ruins the U.S. economy.

The U.S. trade deficit will likely diminish in relative terms as the economies of its major trading partners grow. But the deficit will continue until they are capable of buying most of their own production. Until then, foreign investment in the U.S. will grow, and further expand the dollar economy and dollar's role as the world's primary reserve currency, a role once played by the British pound sterling.

Disclosure: Long

Comments

[da'zman:]

The relationships you write of are generally correct but the assertion that dollar hegemony will continue and even strengthen is naive at best.

2008 Dec 22 09:05 AM

[socrateazz:]

Those explanations are very good as to why the dollar has held up so well. The value of anything is an arbitrary number based on how many think an item is worth more or less than the current value. and the supply and demand of that item. Those who continue to think any one way will not effect the market. The people who change their opinion on any value are the folk who will effect the market direction. If the majority believe the dollar is a good value, and more net value goes toward such , then the dollar will increase in value. If belief is the opposite then the dollar will decrease in value. Most extreme moves in any commodities follow extended moves in one direction. example stock market....2002-2007, 1992-2007, 1974-2007, and 1932-2007 are examples. notice the time frames vary but all are extended moves upward. Now the dollar has had extended moves upward over 50 years. the correction will come. The fact is it will only appear drastic on a long term chart with a few quick drastic moves. Since values are belief based the movements are subject to mostly human foilbles and needs the real movements in markets can not be predicted. In the 1980's I kept hearing Gold was ready to explode upwards in price. That continued into the early 1990's. The real movement began after most everybody seemed to discount gold as a good buy. Now folk are often saying how good of buy gold is. I do not see a long term explosion in price because too many folk think it will act that way. I do admit many people think it is over valued. The price will go the direction of greatest change in belief.

2008 Dec 22 09:49 AM

[RSAAKS:]

How about the hypothetical scenario- let us say this trade deficit continues till 2050, by then the non-US citizens or countries have accumulated 200 trillion dollars via trade imbalance, and the value of all US property (companies, real estate, crop land) is also $200T. They decide to just buy all and split the whole shbang into pieces, say the Japanese take CA, Chinese take NY, and so on...could that happen?? or will everyone start polishing their guns instead of bullions?

2008 Dec 22 10:03 AM

[jtareen:]

I agree with the assessment provided in the article above. The US economy is the most dependable, efficient, and believe it or not, most accountable compared to the rest of the world. We are still a nation of relative justice and economic transparency although some of our so called business leaders and Wall street crooks do everything they can to take advantage of the system. Our govt has not been so cleaned either for the last 16 years. Nevertheless the rich people of the world and large multinational corporations will in my opinion continue to look towards the US for relative financial stability. Our infrastructure as it may be today still the world's best and our political system as corrupt as it may be today still the most changeable. Evidence: After Bush, we chose Obama.

2008 Dec 22 11:14 AM

[Asbytec:]

Imagine that. We run trade deficits and they buy us out with our own money. I wonder what ever happened to the days when trade deficits were settled in gold.

Good argument for the decoupling myth. China could not buy it's own products, it's middle class is just not big enough. A rough guess, it would have to be as large as the American and European middle class combined (roughly) and about as wealthy.

In any case, I like to hear arguments in favor of a strong dollar. Thanks for the insight.

2008 Dec 23 10:00 AM

[Kunst:]

55065 and Asbytec get it.

We are hiring people in other countries to work for us. We pay them in dollars. Over time, they use the dollars they earn to buy assets in the US, such as property, companies, and land. Over time, the percent of US productive assets owned by foreigners increases. The returns (profits) of those assets go to the overseas owners too.

Eventually, we have sold the entire farm, and we wind up working for what used to be the hired help.

2008 Dec 25 12:22 AM

[flow5:]

"the world's primary reserve currency, a role once played by the British pound sterling"

and? what lead to the pound's demis?

2008 Dec 26 12:14 PM