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By Dirk van Dijk

In my earlier post today about the trade deficit (see "Trade Deficit Falls Again"), I argued that one essential step in curing the Trade Deficit is for the dollar to get weaker. (The other essential step is to once and for all start to cure our addiction to imported oil.)

A weaker dollar would make imported goods more expensive, and thus consumers would buy less of them. In some cases people would do without the goods, in others, the imports would be replaced with goods produced here in the good old U.S. of A. It would also make our goods more competitive abroad.

It is not just a case of the bilateral exchange rate -- for example, if the dollar were to fall against the Yen, the effect would not just be in our trade balance with Japan (a deficit of $5.8 billion in November). It would also show up in the trade balance with third countries. In sales to say, Mexico, Caterpillar’s (NYSE:CAT) tractors would automatically “go on sale” relative to the price of tractors made by Komatsu, thus boosting Caterpillar’s sales and thereby employment in Peoria, IL.

In the first 11 months of 2010, the U.S. ran up a total trade deficit of $458.66 billion. That means that we either went into debt to the rest of the world, or sold off capital assets (or a combination of the two) to the tune of $458.66 billion in just 11 months. Assuming that the December trade deficit matches the November one, and that the bottom-up consensus estimates for the S&P 500 are correct, the trade deficit for the year will be equal to 63.8% of the total net income, world wide, of the 500 firms that make up the S&P 500 in 2010.

Each dollar of the trade deficit lowers GDP, dollar for dollar (and by extension, each dollar the trade deficit changes is reflected in the GDP growth numbers). The U.S. is already the world’s largest debtor, by a very wide margin.

An Unsustainable System

Going further into hock to the rest of the world is simply not sustainable. If left unchecked it is the path to national bankruptcy. It is the trade deficit that would be responsible for that, not the budget deficit. That, folks, is not an opinion -- it is an accounting identity. It is every bit as true as the fact that a company’s assets have to equal the sum of its liabilities and equity.

(The budget deficit does contribute indirectly by lowering the overall national savings rate, but the national savings rate has actually been increasing lately even with the big budget deficits, as households have saved more and strengthened their very weak balance sheets).

An expanding trade deficit shrinks the economy, while and expanding budget deficit stimulates the economy (at least short term). Thus, at least in the short term, I see the trade deficit as being a far bigger economic problem than the budget deficit.

I simply do not see a path back to a balanced trade deficit (and preferably a trade surplus, so we can start to pay down some of the huge external debt) that does not involve a weaker dollar. Even if we could totally eliminate our dependence on imported oil, we would only solve about half of the problem.

I am all for doing everything we can to cut our oil imports, more efficient cars, increased use of natural gas as a transportation fuel, greatly expanded use of wind and solar to generate electricity and then having lots of plug in hybrids, etc. Still, that is only part of the solution even if my utopian wish for zero oil imports were to be fulfilled.

Yes, a strong currency is a point of national pride, but it is not for nothing that Pride is the first of the Seven Deadly Sins. King Dollar is a tyrant and needs to be overthrown and beheaded (I hope that does not count as coarsening of the political rhetoric, or people thinking I am inciting violence -- I’m not).

The European Dilemma

There is just one huge problem with the dollar getting weak enough to put a big dent in the trade deficit. That is Europe. While Europe as a whole runs a pretty balanced trade book (Germany runs big surpluses, the PIIGS run big deficits) overall its economy is as messed up as ours is, and there is a very real danger that the currency will actually collapse and we go back to a world of Marks, Francs and Lira. That is not the most likely scenario, but neither is it a super-low probability event either. It is hard to quantify the odds, but I would put that risk at about 10% over the next five years.

It is looking more and more like the Maastricht Treaty which created the Euro was a mistake, or at the very least should have been limited to the central core of Europe, Germany, France and the Low Countries). However, unscrambling that egg may well prove to be impossible. For an excellent analysis of the European situation, see this article from the New Your Times Magazine by Paul Krugman. It’s on the long side, but well worth your time to read.

If the Euro does not fall apart, then the countries on the European periphery, the famous PIIGS (Portugal, Ireland, Italy, Greece and Spain) are going to have to go through what is known as internal devaluation. That is basically years and years of economic pain of deflation, high unemployment and depression. Or the PIIGS could simply default on their debts, but in that case we are back to another global banking crisis, one that would be at least as big, if not bigger, than the 2008 fiasco.

The only other alternative would be for much greater fiscal integration in Europe, making Europe much more like the U.S. That is unlikely to happen since that would mean that the richer countries in Europe (mostly Germany, but countries like the Netherlands and France, to a lesser extent) would have to explicitly subsidize the poorer PIIGS, just the way that the richer states in the U.S. like Connecticut subsidize the poorer states like Mississippi. It doesn’t seem likely to me that the politics in Europe will allow the citizens of Leipzig to be bailing out the citizens of Lisbon any time soon.

Euro = The Anti-Dollar


The Euro is sort of the anti-dollar: when it strengthens the dollar weakens, and vice versa. In the graph below, look at the extremely strong inverse correlation between the broad trade-weighted index of the Dollar and the Dollar’s relationship with the Euro. The correlation with just the major currency index would be even stronger, since the Euro makes up a much bigger part of it.

Currencies are always expressed relative to each other not to a common benchmark (well, some people use gold as a common benchmark but even if it is Ron Paul’s greatest wish, the chances of the U.S. or any other major currency going back to the gold standard is vanishingly small and for good reasons).

I’m not sure how we resolve this problem, but it is imperative that we do so. A weaker dollar is one of the paths through which the Fed’s QE2 program is most likely to work, but I’m not sure if it will be enough to make a big impact on the dollar especially in light of the problems across the pond.

One other thing to keep in mind is that a weaker dollar will not have any effect on the oil side of the problem. While oil is priced in dollars, there is no reason that people in other countries would pay less to fill up their tanks just because the dollar is weak. The U.S. currency does not have an effect on the supply or the demand for oil.

Thus when the dollar is weak, the price of oil tends to rise, thus offsetting the effect of the weaker dollar on that part of the trade deficit. Over long periods of time there might be some effect as it would raise the relative price of oil here in the U.S., thus encouraging more energy efficiency and substitution for other fuels, but that is a very slow process. We need both a weaker dollar, and strong action to reduce our oil consumption, independent of any currency related effects on oil prices if we are going to cure this cancer that is slowly killing the country.

Source: Trade Deficit Falls Again, Part II