Today's GDP revisions were delicious, especially the positive impact of trade responding to our more competitive dollar.

The earlier estimates of real GDP owed the 1.9 percent annual growth rate entirely to a 2.4 percent increase in net exports, with exports increasing and imports shrinking.  The substantial upward revision of the Real GDP estimate to a 3.3 percent growth rate included an even larger increase in exports and decrease in imports, although other revisions contributed as well.  In the current estimate, the increase in exports accounted for 1.65 percentage points and the reduction in imports accounted for 1.45 percentage points of the 3.3 percent increase in Real GDP.  In other words, net exports accounted for 3.1 of the 3.3 percentage point increase.

I've been arguing for some time that the weak dollar would play a crucial role in avoiding a negative GDP.  That has been happening.  I've also argued the "right" way for the dollar to strengthen is through an improved trade balance.  That also has now begun to happen.

If the dollar strengthens through magic, prayer, jaw boning, intervention, or some other form of levitation, its negative impact on trade would hurt GDP.  A dollar made stronger by growing export demand and import substitution can strengthen along with GDP.

I've been emphasizing the trade accounts because they've been ignored by most commentators.  Looking at the role of foreign investment and the capital accounts in influencing the dollar, expectations of future dollar movements are more important than the current level of the dollar.  What a foreign investor wants is for the dollar not to depreciate during his investment horizon so he can get out of the investment more favorably than he got in.  If the dollar appreciates during his investment horizon, so much the better.  For this reason, once the recent appreciation of the dollar comes to be viewed as a longer term trend, the appreciation would likely accelerate.  By the same token, it could weaken on opposite expectations.  Given the size of the trade deficit, and the outflow of dollars it represents, a more gradual appreciation of the dollar would allow continued improvement in the trade deficit while a precipitous increase might kill off that needed source of strength.

As I've said before, to take greater liberties with St. Augustine's famous prayer regarding chastity, I say give us a strong dollar, but not too strong too soon.

Trade is as Important as Capital Flows in Valuing the Dollar and Impacting the Economy

Background

In the mid-1960s, as the debate over fixed vs. flexible exchange rates was heating up, I did some research on one of the principle arguments for flexible exchange rates – that they help insulate a country from foreign economic conditions and cycles and thus provide independence for domestic monetary policy.  In addition to a review of the theoretical literature, I used the Canadian experience with flexible exchange rates in the 1950s as a case study.

Under fixed exchange rates a foreign expansion or inflation was transmitted to the domestic economy via an increase in foreign demand for home country exports.  With the exchange rate fixed, the resulting increase in net exports, other things equal, would stimulate the domestic economy, with the split between real growth and inflation determined primarily by the degree of slack in the labor market.  Foreign weakness would be imported via a slowing of home country exports and a reduction in net exports.

With exchange rates fixed, restoration of each country's external balance had to take place through changes in the internal economic variables – nominal prices, incomes, interest rates, etc.  Inflation contagion would come through domestic expansion triggered by an expansion of net exports.  Foreign weakness would be transmitted through the reduction in aggregate demand domestically triggered by a reduction in net exports.  In keeping with the practice of the early to mid-1960s, I just used Keynesian "aggregate demand" language to summarize the process.  The same outcome could be described by the classical language of monetary expansion or contraction.  This was done primarily in the context of the gold standard.

The adjustment mechanism acted as an automatic stabilizer for domestic shocks.  A domestic recession would increase a country's net exports by curbing import demand while a domestic inflation would reduce net exports by increasing import demand.  Those changes in net exports would reduce the domestic impact of a domestic shock, but, in doing so, it transmitted the domestic shock, at least in part, to foreign trading partners. 

The monetary authorities under a gold standard's "rules of the game" were supposed to allow or even reinforce the domestic adjustments needed for international balance.  Under other fixed-rate systems, such as the one established at Bretton Woods at the end of World War II, monetary authorities were supposed to achieve through policy what was supposed to occur automatically by the flow of gold.  Hence, the lack of monetary independence under fixed rates.

Proponents of flexible exchange rates argued that movements in the exchange rate would bring about the necessary international adjustments with less trauma to domestic economies.  If internal prices and wages were flexible in both directions, the domestic impact of adjustment would amount to the same under the two systems.  However, in reality, prices and wages were not very flexible in a downward direction; so a country undergoing what would have been disinflation or falling internal price and wages would experience unemployment and recession.  This in turn led the monetary authorities to break the "rules of the game" to support the domestic economy.

Flexible exchange rates would, in effect, make sticky domestic prices and wages flexible internationally.  Depreciation in the home currency would reduce real wages without the need to reduce nominal wages and suffer unemployment.  Workers' real incomes would decline to correct an external deficit, but the decline would be spread more broadly and the brunt of the adjustment wouldn't have to be borne by the newly unemployed.  Home currency appreciation would achieve external balance without the need for domestic inflation.  The higher prices would be seen abroad, but not at home.

Getting Closer to the Point

Note that my over simplified discussion above, which, nevertheless, captures the essence of the exchange rate debate prior to the mid-1960s, all the focus is on international trade while capital flows weren't mentioned.  The reason is that the capital account transactions were viewed primarily as financing trade.  If trade balances, so does the capital account.  A trade deficit would be financed by a net capital inflow of the same amount.  A trade surplus would be matched by a net capital outflow.  Capital flows responded to trade imbalances.

When I evaluated the argument for economic independence and insulation through flexible exchange rates using the Canadian flexible-rate experience of the 1950's, the theoretical expectations were only partially confirmed.  The problem was that there were "independently motivated" capital transactions over and above those that were passively financing trade.  I assume that had always been the case, but it was rarely mentioned in the literature up to that time.  In the real world, however, flexible rates – while better than fixed rates in my opinion – don't fully deliver on the promise of insulation and independence because of complicating capital flows.

Over the years, independently motivated capital flows have grown so much that one might even make the counter intuitive argument that trade finances capital flows as much as capital flows finance trade.  The accounting balance remains intact (double entry accounting), but the automatic equilibrating mechanism is not allowed to work.  As I've written before, the balance in our balance of payments is a balance of imbalances.  There is nothing sacred about any given "equilibrium" exchange rate, meaning the rate that prevails during external "balance."

The Point

All the above is really background and context to my main point, which is that just as capital flows used to be ignored while all the focus was on trade, it has gotten to the point where the opposite is now happening.  Commentators today routinely discuss the dollar exchange rate while ignoring trade or even dismissing it as a significant factor.  If cause and effect are mentioned at all, interest rate differentials are seen to influence capital flows.  But most recent calls for a stronger dollar don't even mention interest rate differentials as a way of attaining the desired exchange rate.  They mostly just want the dollar to be "talked up" by the President, the Treasury Secretary, or the Chairman of the Fed.  Dollar "levitation" is the word that comes to mind.

Focus on the dollar without including imports and exports can lead to some strange conclusions and recommendations.  For one thing, just about everyone on financial television these days says a strong dollar and a strong domestic economy go together, and more often than not they treat a strong dollar as the cause and the strong economy as the effect.  However, other things equal, a levitated dollar will weaken the domestic economy by increasing import demand.  A dollar pulled up by growing export demand or import substitution at home, on the other hand, is consistent with a strong domestic economy, but they are still not cause and effect.  The stronger dollar and the stronger economy are both are the result of a third cause – an increase in export demand.

While a strong economy doesn't lead to a strong dollar and a strong dollar doesn't lead to a strong economy, anticipation of a better investment climate domestically probably will strengthen the dollar. To be even more precise, an expectation that your economy is becoming a more attractive location for foreign investment will attract capital and, other things equal, strengthen the dollar.

I have argued for some time that the recent dollar weakness will be self reversing when investors decide it has reached bottom and the next move is more likely to be up than down.  Unlike international trade, where the level of the dollar matters; with foreign investors, the level doesn't matter nearly as much as its anticipated change during their investment horizon.  They want to get out at an exchange rate higher than when they got in, or at least no lower.  The shift in expectations appears to have begun recently and the dollar is on the rise.  In addition, the fall in the price of oil and other imported commodities is reducing our net export deficit and boosting the dollar through a shrinking trade deficit.

It isn't clear yet whether the recent rise in the dollar is explained more by trade changes or capital flows.  Net exports, which have been a very large negative for a long time, have recently become less negative, and have therefore been a positive for GDP growth.  But net export changes can be affected by capital flows as well as trade flows, although, in the end, the balance remains.  

Exports have been responding well to the more competitive dollar for some time now, but in the second quarter of this year, the reduction in imports provided an even bigger boost to GDP than did the increase in exports.  As indicated in my previous posting, preliminary estimates indicate that the trade in goods and services contributed 2.4 percentage points to the 1.9 percentage point increase in real GDP.  In other words, net export improvement accounted for more than the entire increase.

The timing of the recent reduction in oil prices and the more recent strengthening of the dollar is the opposite of what most pundits have been telling us.  Their emphasis has been on getting the dollar up to get the oil price down.  That may have worked, but what we know worked is that lower oil prices contributed to the rise in the dollar.  Exports have been doing well for some time, but imports have kept pace in large part because of the effect of higher oil prices on import values.  If oil prices go lower, or even not rise, the prospects for further stimulus from the trade sector are excellent.

Don't Fall Into the All or Nothing Trap

A few weeks ago I posted a partial list of "bad thinking habits" with the intention of discussing several of them in the context of contemporary economic issues.  The one I started with was "All or Nothing Thinking."  I applied it to varied views of the Laffer Curve.  See "The Laffer Curve and Tax Policy" posted on June 26, 2008.  I find that I keep coming back to the same bad habit, all or nothing thinking, which, I suppose, is one of my bad habits.

I won't belabor the point on this one, but I want to remind people not to fall into all or nothing thinking when it comes to our energy policy, or lack thereof.

Most of us agree that we rely too heavily on imports for energy, mainly oil and gas.  Most of us agree that we should increase domestic energy supplies.  We have been foolish in tying our own hands with excessive restrictions on drilling for oil and gas, building nuclear plans, cleaning up coal, and so forth.  We need to move in the direction of energy independence. 

(By the way, my friend T. Boone Pickens is providing great leadership in showing us the way.  Politicians should listen to him; the voters are.)

We need to move substantially in the direction of energy independence.  However, that does not mean we should go all the way to self-sufficiency even if we could.

There are two ways we can obtain the goods we need.  We can produce them ourselves.  Or, we can produce something that we have a greater comparative advantage in and trade for the goods we have a comparative disadvantage in.  I'm not talking about barter — one good for the other.  I'm talking about selling on the world market and buying on the world market taking advantage of specialization — paying for imports with exports.

I'm suspicious of national defense arguments for protecting certain industries, but I accept that there probably should be some limit to how dependent we become on others for oil.  We need to be less dependent, but not totally independent.  The reason for this –and it doesn't just apply to oil or energy — is  simple: diminishing returns to production.  The more we produce domestically the harder and more expensive it is likely to become.  We should remove the barriers and drill, drill, drill as Larry Kudlow puts it.  But somewhere down the road — and we aren't even close yet — the cost of the next barrel or ton of whatever gets prohibitively expensive relative to the cost of producing other goods that are tradable for energy.

Adam Smith concluded that the Wealth of Nations is based on the division and specialization of labor, and that it is limited by the extent of the market.  The relevant market is the world market.  Let's just keep that in mind as we hear politicians talk nonsense about total energy independence, or total independence of anything.

The preliminary estimate of second quarter Real GDP increased at a 1.9 percent rate.  This increased was more than accounted for by the change in the balance of trade.

Real exports of goods and services increased 9.2 percent in the second quarter, up from an increase of 5.1 percent in the first quarter.  Real imports of goods and services decreased 6.6 percent, compared with a decrease of 0.8 percent in the first quarter.  A decrease in imports is a positive in GDP accounting, just like an increase in exports.

Combining the two, net exports (exports minus imports) increased 14.3 percent and subtracted that much from the deficit in goods and services.

In terms of their contribution to the second quarter Real GDP estimate, exports of goods and services added 1.16 percentage points while import reduction added 1.26 percent. (Imports have a much larger base than exports.)  Together, net exports added 2.42 percentage points, considerably greater than the 1.9 percent increase in Real GDP.  Without the improvement in net exports, Real GDP would have been negative by half a percentage point.

Of all the individual spending components making up Real GDP identified by the Bureau of Economic Analysis, import reduction made the largest contribution and export increases made the second largest.  It is curious to me that export growth gets lots of media attention while import reduction is rarely, if ever, mentioned.

The reason that imports are subtracted from the GDP calculation is not that they are somehow "bad" or negative for the economy.  It's because there is an import component embedded in the other categories of spending, and subtracting imports from the total is easier that trying to do it component by component.  The subtraction is based on the fact that imports generate income for our trading partners rather than for the domestic economy.  The recent reduction in imports means that spending has shifted toward domestic production.

The second quarter's boost from the shrinking trade deficit is the largest in recent years. Here are the positive quarters since the beginning of 2005

Positive net export of goods and services:

I-2005     +0.28
II-2005    +0.79
I- 2006    +0.09
II- 2006   +0.59
IV-2006    +1.33
II-2007    +1.66
III-2007   +2.03
IV-2007    +0.94
I-2008      +0.77

Net exports were net negative (subtracted from Real GDP) in the years 2004, 2005, and 2006.  It was a small positive in 2007 and a more substantial positive so far in 2008.

The improvement has resulted from a combination of dollar depreciation and a slowing of the U.S. economy relative to our trading partners.  Since the improvement began before the U.S. slowdown, I assume that dollar depreciation was the dominant factor. However, the substantial benefit is only now beginning.

"Lord, give us a strong dollar, but not just yet."

The dollar is keeping us from having negative GDP numbers recently.  If the dollar strengthens because of continued improvement in net exports, the dollar and the U.S. economy will become stronger together.

If the dollar is "talked up" or otherwise pushed up by "levitation" without the pull of an improving trade balance, the stronger dollar will weaken the economy by increasing our negative trade balance (by increasing our imports relative to our exports).

A useful footnote:  Our entire deficit in trade in goods and services is in the goods portion; we actually have a surplus in services.  Therefore, it is accurate to refer to the trade balance in the context above since the "trade" balance traditionally refers to trade in goods only.

Another useful footnote: Traditionally such discussions have referred to the current account balance rather than the balance on goods and services.  Since the current account includes investment income received and paid and unilateral transfers (gifts, etc.), the new focus on goods and services is more focused on what adds or subtracts from U.S. Real GDP.

But lest these trees obscure your view of the forest, the main point of this posting is that the "weak" or, more accurately, "competitive" dollar has been playing a helpful role in supporting the domestic economy and keeping us out of negative GDP territory.

I would say it's, for sure, keeping us out of recession if the two consecutive quarters of Real GDP rule determined the recession.  However, I expect that in several months, the Business Cycle Dating Committee of the National Bureau of Economic Research will probably decide we were in a recession based on its own criteria, even if we don't meet the two quarter test.

I was on the Jim Blasingame Show this morning talking about the Federal Reserve and inflation, slow economic growth and a possible commodity bubble.  To listen to the interview, click here.