The goods and services trade deficit widened in September, reversing recent improvements. It was good news that both imports and exports increased after a shrinkage of trade resulting from the global contraction. The deficit increased because imports increased more than exports.

Exports or goods and services increased by $3.7 billion to $132.0 billion while imports increased by $9.3 billion to $168.4 billion. The deficit for September increased from $30.8 billion to $36.5 billion, an increase of 18 percent.

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The headline in today’s Wall Street Journal says “World Tries to Buck Up the Dollar.” The headline writer no doubt savored the opportunity to use “buck” for its double meaning even though it might have been more accurate to say “World Tries to Hold Down It’s Currencies.” That would have gotten closer to the world’s motivation.

The second paragraph acknowledges this implicitly when it says “Thailand, South Korea, Russia, and the Philippines have been snapping up dollars this week in order to hold down the value of their currencies.” It goes on to say that Brazil’s finance minister said the country’s currency remained too strong even after Brazil adopted some capital controls to weaken it.

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As now, the dollar was in general decline against some currencies during September 2007. The Euro was strong against the dollar; the British pound reached $2 per pound and the Canadian dollar reached 1 to 1 parity with the dollar.

I have always kept track of the U.S./Canadian dollars by comparing the two prices inside new book dust covers. I wrote about this here on October 4, 2007 in a post titled McTeer on Dollars and Books.

Chairman Greenspan’s book, The Age of Turbulence, was released on September 17, 2007, priced at U.S. $35.00 and Canada $43.50. That was a 24 percent difference despite the parity in the exchange markets that month. His publisher obviously didn’t think the parity would hold.

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Credits in the U.S. balance of payments give rise to a demand for dollars. Debits reflect the supply of dollars. Together, they determined the exchange rate for the dollar. So far, so good. Everybody knows that.

Then why is it that virtually all the commentary on the dollar on financial TV and in blogs fails to mention the balance of payments when discussing the dollar? The dollar is considered super-important these days while the balance of payments isn’t considered important enough to mention. That’s like saying the price is important, but supply and demand don’t matter.

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We continue to discuss the topics above as separate issues, without acknowledging their interdependence. They are mutually determined as in the solving of simultaneous equations. For example, our budget deficit indirectly, and our current account deficit more directly, affect the dollar exchange rate and the size of our trade deficit (and capital inflow). With China’s trade surplus being the main counterpart to our deficit, its inflow of dollars to China depends more on the size of that imbalance than their desire for dollars over other currencies.

Our national saving—made up of personal, business and government saving—is being supplemented by the foreign capital inflow that finances our current account deficit and helps support domestic investment. The floating dollar adjusts to help maintain the necessary relationships.

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Why can’t we learn even the most obvious lessons from the Great Depression? Many policy mistakes were made then, but perhaps the biggest and most destructive was the Smoot-Hawley tariff that contributed to a world-wide trade war and the reinforcement of the depression’s downward spiral. We’ve already dissed our Mexican neighbors by abrogating the trucking provisions of NAFTA. Do we really want to have a tire war with China to pander to domestic unions? The Chrysler bond holders would probably have an opinion on that.

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The talks by our Secretary of State and Secretary of the Treasury with the Chinese about U.S. borrowing have once again created some mushy commentary by the talking heads. They speak in terms of how much U.S. debt China will be willing to buy in the short-term and in the long-term.

No one has thought to mention that those amounts depend almost entirely on the volume and balance of trade between the two countries. If the U.S. trade deficit (and Chinese surplus) grows, it will be necessary to borrow more to finance it. If trade shrinks, less borrowing will take place.

If the willingness to borrow changes independently of the financing needs of trade, then the trade will have to adjust. Either way, the two are linked, and it is foolish to talk about them as if there is no relationship at all.

With The Illusion of Saving as background let me explore a very counterintuitive proposition: That the growth in the budget deficit might indirectly strengthen the dollar.

It might do so by requiring a larger capital inflow (and thus a larger current account deficit) to make up for the shrinkage in domestic saving relative to investment caused by the growing budget deficit.

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Undesirable and Unnecessary

Protectionism is creeping insidiously into the rhetoric of financial TV.  "Taxpayer money should be spent to stimulate the domestic economy, not foreign economies."  "We should be creating domestic jobs, not foreign jobs."

This slippery slope to protectionism is undesirable. It won't work. It will invite retaliation.

However, it's not only undesirable, it's unnecessary.  Listen carefully.

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A Primer

The balance of payments always balances. That's why they call it the balance of payments.

Constant balance (not to be confused with equilibrium) results from double entry accounting where total debits always equals total credits. Each international transaction results in a new debit and a matching new credit; an equal reduction in debits and credits; or offsetting debits (one plus; one minus) or offsetting credits (one plus; one minus). This in itself is no great revelation, but it does impose a useful discipline in thinking about international transactions. It keeps you honest, so to speak.

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The Good, the Bad, and the Ugly

The Good:  The Trade Deficit is shrinking.
The Bad:    Trade is shrinking.
The Ugly:   Protectionism is growing.

The deficit in U.S. trade in goods and services shrank to $26 billion in February, from a revised $36.2 billion in January. This is good news. On the other hand, the total value of imports and exports has been shrinking for several months because of reduced aggregate demand at home and abroad. In February, our exports rose slightly, by $2 billion, while our imports declined $8.2 billion. Other things equal, our small uptick in exports in February along with a more substantial decline in imports, suggests that our trading partners are experiencing more demand weakness than we are.

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In my last blog for the New York Times, I reviewed the effect of our trade balance on GDP. We've had a deficit (imports>exports) for several years, which is a net minus, or drag, on GDP. However, in recent quarters, in part because of the decline in the dollar until lately, the deficit has shrunk, exerting a positive influence on the change in GDP. (A minus times a minus equals a plus.) In some quarters, including the 2^nd and 3^rd of 2008, the positive change in the trade balance has been greater than the change in GDP itself.

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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.

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.

Don't Do Right at the Wrong Time

Originally appeared in July 5th edition of:

Shortly after coming to the Lone Star State, I bought the classic book of Texas wisdom, "Don't Squat with Your Spurs On!" One of its many useful pearls was "No matter who says what, don't believe it if it don't make sense."

That's easier said than done, of course, when everyone seems to agree on something I'm still trying to make sense of. Many examples arise from the tendency of lawmakers and regulators to do during a crisis what should have been done earlier to prevent the crisis. Too-late smart may not be smart at all. Fixing the barn door after the horses escape doesn't do much good, and it may keep the horses from returning.

Example: The argument that we should raise gasoline taxes to help wean drivers from too much driving in their gas guzzlers. If that was ever a good idea, it was before the recent rise in gasoline prices. Now it would just make a bad situation worse. Suspending gasoline taxes this summer is probably not a good idea either, but it makes more sense than raising them, and is more consistent with the common sense of making hay while the sun shines.

In another example, the Fed and others have argued for years for reforms of Fannie Mae and Freddie Mac – including clarifying that their debt is not backed by the full faith and credit of the U.S. government, and capping their growth to limit the distortions caused by their artificially low borrowing costs and thin capital. The current reforms under way, including raising their capital, may have been needed. But they should be expedited to facilitate, rather than inhibit, the important role Fannie and Freddie can play in resolving the credit crisis. Let's postpone our hand wringing over their government-sponsored credit ratings and cost advantages, and take opportunistic advantage of them in the current crisis. We need them, as well as the Federal Housing Administration, to do more of what they do, not less.

To me, the most serious example of doing the right thing at the wrong time is overly strict adherence to "mark to market" accounting rules. Most of the write-downs of securities that are creating capital shortages in financial institutions don't result from actual losses, or even expected losses. They result from having to mark down assets, many or most of which could easily be held to maturity and redeemed at par. This includes securities issued or guaranteed by Fannie and Freddie and other investment-grade securities, especially those graded triple A.

Holders of mortgage-backed securities point out that marking them to market is currently impossible because there is no market. Moreover, identifying those that can easily be held to maturity, and classifying them as such, makes more sense than marking them down to levels that never need to be realized. Book losses if and when they are realized – not before. Eliminating unnecessary mark-to-market losses would go far toward resolving the current crisis.

While mine is no doubt a minority view, it is supported by William Isaac, former chairman of the Federal Deposit Insurance Corporation. He says that mark to market is overdone and is pro-cyclical, since regulators limit the ability of banks to reserve during good times, but insist on increased reserves during bad times. Even some supporters of mark to market acknowledge that it was not intended for over-the-counter, hard-to-value assets.

Accounting purists would call this forbearance and frown. But forbearance in shooting the sick and wounded with good recovery prospects is no sin in my book. The greater sin would be to let a "rules is rules" mentality continue to make a bad situation worse.

I don't intend here today to try to prove the case for free trade all over again.  It's been done many times before, but it doesn't seem to stick.  For academic types, I simply refer you to the absolute advantage arguments of Adam Smith, and their refinement into comparative advantage by David Ricardo. Somewhere in there we should place Frederic Bastiat, whose arguments for free trade were not only correct, but fun to read.  If he were alive today, he would be a frequent guest on Kudlow and Company.

Briefly and simply, absolute advantage says we benefit if we do what we do best and trade for the rest.  Smith said the cause of the wealth of nations was the division and specialization of labor, which is limited by the extent of the market.  International trade extends the market enhances the benefits of specialization.

Comparative advantage carries the argument a step further and says that it pays to specialize and trade even if one party can produce everything more cheaply than the other.  My favorite example from school was the executive and his secretary (showing my age with that word).  Even if he can type faster and more accurately than she can, it probably still pays for him to leave the typing to her since his advantage over her as a typist is not likely as great as his advantage as an executive.  Comparative advantage is a most-best or least-worst phenomenon.

Notice I haven't mentioned jobs or trade balances.  The benefits of opening up trade are indicated more by the increased volume of trade than which party develops a surplus or deficit.  It's hard to predict the net impact on jobs initially, but over time it will tend to even out since more imports tend to stimulate exports and more exports tend to stimulate imports.  The net number will tend to end up the same, but presumably they will be in areas of comparative advantage instead of areas protected by barriers to trade.

Bastiat's Petition on behalf of the candle makers to the French Parliament is the classic defense of free trade.  He points out how unfair it is for the French candle makers to have to compete with the sun for the provision of light and argues for a law requiring the shutting of blinds and shutters to level the playing field.  He goes into great detail about the secondary benefits that spread from the candle makers to other related industries and create a general prosperity.  (See Why Bastiat is my Hero in 2001 speeches at http://www.bobmcteer.com/.)

While Bastiat's arguments for free trade are more fun, a more succinct statement was provided by Henry George, who pointed out that protectionists want to do to their country during peacetime (close its borders to imports) what the country's enemy would want to do to it during wartime.   

Most educated people understand the benefits of free trade, and that probably includes educated politicians.  However, many who understand are only too willing to pander to the many more that don't.  The reason many don't is that the benefits of free trade are widely dispersed while the costs are more concentrated.  Free trade helps almost everyone a little bit, but hurts a few a lot.  Furthermore, the higher standard of living associated with, and attributable to, free trade is not easily identified — while a job lost at a plant moving to China is easily associated with it.

Theoretically, those benefited could use a portion of those benefits to help those harmed get trained for the new jobs created by trade.  But, alas, it's easier for politicians to feed the ignorance than to try to educate their constituents, and that seems true for two-thirds of our presidential candidates.

*Originally appeared as an NCPA Brief Analysis

Economists often refer to the U.S. trade deficit and the federal budget deficit as problems of inadequate domestic saving.  They speak of these deficits "crowding out" domestic investment.  They allude to unspecified relationships between these deficits but seldom explain them, confusing everyone.

What is often left unsaid is that the trade deficit (when more goods and services are imported than exported), the budget deficit (when government spends more than its tax revenues), and the balance between domestic saving and investment are related to each other.  In fact, their sum must equal zero.  A change in any of them affects all of them.  For example, tax incentives to encourage saving would likely stimulate investment, lower both the budget and trade deficits, and also reduce reliance on foreign capital.  Think of three fat men filling up a telephone booth.  When one inhales, the other(s) must exhale.

An Economy without Government or International Trade. To understand the interdependence of these three imbalances, first consider saving and investment in an economy with no external trade and no government.  All saving (income minus consumption) and investment (output not consumed) are domestic.  With different people doing the saving and investing, plans for each are likely to differ.  If so, market forces – such as interest rates, prices and nominal income – will adjust until actual saving and investment balance.  In this closed economy, if planned saving exceeds investment, incentives for saving (that is, interest rates) will tend to fall until saving and investment balance.  Likewise, if planned investment is greater than saving, they will be brought into balance by market forces, if the economy is at or near full employment.

Think of saving as a leakage from the income stream which, other things equal, tends to shrink income.  Think of investment as an injection into the income stream (in addition to consumption); other things equal, it tends to increase income.  Income and other variables will adjust until the leakage of saving matches the injection of investment (I = S), as shown in the top half of Box 1 in Figure I.

An Economy with Government.  Introducing government into the equation creates another leakage similar to saving in its impact; that leakage is taxes (T).  There is also another injection into the income stream in addition to investment:  government spending (G).  If taxes and government spending balance – that is, if the budget is balanced (G = T) – the net impact of government on income is neutral, and private saving and investment will also balance.

The leakages balance the injections, but the individual components aren't necessarily equal.  If government runs a budget deficit (Box 2), it will be matched by an equal surplus of private savings compared to investment (S >I).  This is how a budget deficit crowds out private investment, by competing with private borrowers for savings.  A budget surplus (Box 3) will be matched by an equal deficit in saving compared to investment (S < I).

An Economy with Government and International Trade.  Now, add international trade to the analysis.  When we do, payments for imports become a third leakage from the domestic income stream while income from exports become a third injection.  An imbalance in any of the three pairs will be matched by an opposite imbalance in the other two taken together.  The principle is the same as in previous examples, but the interactions become more complex.

As shown in Box 4 (Figure II), any excess of investment over saving (I > S) is matched by a combination of budget and export surpluses (G < T and X > M).  The budget surplus is positive government saving, and capital flows out to be invested abroad.  This economy is sacrificing some consumption today for greater prosperity tomorrow.

The U.S. Deficits.  Box 5 (not drawn to scale), depicts the current situation in the United States:  The shortage of private savings (I > S) to finance domestic investment is exacerbated by negative government saving (the budget deficit, G > T).  However, both these shortfalls are met by the trade deficit – or, more precisely, the inflow of foreign investment that finances the trade deficit.  In other words, the United States is relying on foreign savings to supplement domestic savings.  The U.S. economy consumes more goods and services than it produces thanks to foreign credit.  One result is that each year's external deficit adds that amount to net foreign holdings of U.S. dollar assets.  This is not necessarily a bad thing.  Foreign investment has historically played an integral part in U.S. economic growth and shows that America is attractive to investors.  In addition, external investment mitigates the crowd-out effect of government borrowing by expanding the pool of available credit.

The situation can become unsustainable, however, because foreign investment is funding increasing government budget deficits (government dissaving) and inadequate private saving.  The growth in foreign claims on the U.S. dollar relative to U.S. claims abroad makes the U.S. economy vulnerable to the actions of foreign central banks and, possibly, sovereign wealth funds.  Better to reduce that vulnerability sooner rather than have to go cold turkey later.

Reducing the Deficits.  What are the policy implications of these interdependent imbalances?  Here are three:

-Tax incentives to encourage saving would likely also stimulate investment and lower both the budget deficit and the trade deficit.

-Reducing the budget deficit would reduce the vulnerability of the U.S. economy to foreign creditors; rising deficits could lead to foreigners dumping dollar assets, causing equities to decline, interest rates to spike and the dollar to plunge.

-Reducing the budget deficit doesn't necessarily mean higher tax rates; marginal rate cuts reinforced by slower government spending growth would be ideal incentives.

Unfortunately, the recent tax "rebates" designed to stimulate the economy dealt a setback to budget discipline.  Most people probably understand that.  What they probably don't understand is that the increased budget deficit will also tend to worsen our international balance of payments and weaken the dollar.  The hip bone is connected to the thigh bone; so policymakers need to study these interconnected deficits.  They need to borrow my boxes.

Who is harmed by the decline in the dollar?

As consumers, we are all harmed by the decline in our purchasing power.  Import prices go up directly, as everybody knows, but there is also an indirect increase in the prices of domestic goods and services that are also exported or potentially exported.  In addition, some of us are hurt as producers or workers:  people in the import business (foreign car dealerships for example).

Who is helped by the decline in the dollar?

Producers who are exporters or potential exporters at the more favorable exchange rate will experience an increased demand for their products.  Also helped are domestic producers who compete with imports, which will become more expensive.

Why is the dollar declining?  What is the problem?

The dollar is declining because of pressures on our balance of payments.  Some combination of our current account deficit being too big and creating an excess supply of dollars on the world market and our capital inflow (and demand for dollars) becoming inadequate to offset the deficit.

So, what is the relationship between our balance of payments and the market for dollars?

I'm glad you asked that since the connection between the two is key to understanding either one of them.  When we import goods and services or purchase foreign stocks or bonds, or real estate, those transactions are debits in our balance of payments.  When foreigners do those things, they are credits in our balance of payments.  Debits give rise to a supply of dollars and demand for foreign currencies.  Credits give rise to a supply of foreign currencies and a demand for dollars.  To a great extent these debits and credits balance out and so does the demand and supply of dollars and foreign exchange.  So, essentially we pay for our imports with our exports as do our trading partners.  However, it is unlikely that the balance will be perfect; so, there will likely be a small imbalance in trade that will be "financed" or offset by an equal imbalance in capital flows.  I just lost you with that last sentence; so, let me elaborate.

How is it that net trade balances and capital flows are exact mirror images of each other?

When I buy a BMW, I give the company a check on my bank.  If they deposit my check in their U.S. bank and leave the proceeds there, they have "loaned" money to a U.S. bank, which will be recorded as a capital inflow. Their increased bank balance is a capital inflow (credit in our B/P) that just matched my import purchase (debit in our B/P).  They may sell their U.S. dollar balances in the foreign exchange market for a Euro balance in a German bank in which case our dollar obligation is to a foreign bank instead of a foreign company, but the capital inflow remains the same and equal to the BMW import. You don't have to follow all that; just remember this basic point:  Every increase in our debits (from imports) is matched either by an increase in credits elsewhere in the B/P or by an offsetting reduction in debits elsewhere.  Double-entry bookkeeping keeps total debits and credits in balance as well as the dollars bought and dollars sold in the foreign exchange markets.  The balance of payments always balances.  Thus any net deficit or surplus in the trade portion of the B/P is always precisely matched by the opposite in the capital portion of the B/P.

So, what was the background to the recent decline in the dollar?

For several years we have had a large and growing deficit in our trade (goods) balance and our current account (goods, services, unilateral transfers) balance. It grew to more than 6 percent of our GDP, a very large imbalance in trade.  By itself this was supplying excess dollars in the foreign exchange markets.  By "excess" I mean more dollars that were being used to buy U.S. goods and services.  The current account deficit and the associated excess dollars were offset by an equally large capital inflow (surplus) which "mopped up" the excess dollars.

For years a huge trade deficit seemed unsustainable to most U.S. economists and for years they forecasted a decline in the dollar to correct the trade imbalance.  Another way of saying that is to say they didn't think the outside world (especially Europe) would continue lending us large amounts of money to finance our huge trade imbalance.  But year after year those forecasts never came true.  Finally, economists threw in the towel and stopped talking much about it.  (A watched pot never boils.)

Over the past year the U.S. growth has slowed largely in response to the housing situation while the world economy, even including Europe, became more robust.  As we ceased, at least temporarily, being the engine of world growth and as prospects here dimmed relative to prospects abroad, the capital inflow in combination with what was going on in trade became inadequate to sustain the dollar at past high levels.  Theoretically, the dollar will continue adjusting to bring our balance of payments into an internal balance consistent with world economic realities.  That doesn't necessarily mean until our trade becomes balanced, but it probably does mean that the deficit will be reduced.  That process has already begun modestly as our monthly trade statistics have improved of late.

What is the big picture of what's going on with our B/P and the dollar?

Like a family during the process of running up their credit card balances, our large current account deficit means we have been living beyond our means as a country.  We have been absorbing (consuming, investing, etc.) more goods and services than we have been producing. This isn't necessarily bad — you can use a credit card for worthy purposes — but it probably was unsustainable and it is the opposite of what one would expect of the world's richest large economy.  The "normal" pattern is for capital to flow from rich countries to poor countries, where presumably its return is greater.  The reverse has been happening.  Capital has moved to the richest country from poorer countries, presumably because our institutions and policies compared to our trading partners more than offset other factors.

What has to happen for "equilibrium" to be reached?

Our exports need to rise relative to our imports.  Resources will need to move from other industries into export industries.  The declining dollar will provide the needed price incentives by making our imports more expensive at home and our exports less expensive in foreign currencies.  Another way of saying that is that the exchange rate will raise the price of traded goods relative to the price of non-traded goods.

Is there an alternative to a declining dollar?

Yes, but they probably would involve more friction and more pain.  If the dollar is somehow prevented from falling, the needed adjustments would be the same in terms of exports needing to grow relative to imports, or imports needing to shrink relative to exports.  But with no change in the exchange rate, downward pressure on domestic income would push down domestic goods prices relative to international traded goods.  Our imports would have to shrink not because of higher import prices, but because of lower domestic incomes. If internal prices and wages were as flexible as the exchange rate, it would make little difference which is used.  But internal prices, and especially wages, tend to be sticky in a downward direction, so unemployment would be the likely result.  In effect a recession would be needed.

With inflexible exchange rates the temptation would be very strong to avoid the internal adjustments by restricting trade.  Our free trade policy would be in jeopardy.

So, McTeer, are you "dissing the dollar?"

I'm saying that, if adjustment is necessary, a decline in the dollar is probably the least-worst way of achieving it — less worse than domestic recession and less worse than trade restrictions.

Of course, an alternative might be to prolong the status quo ante by reinforcing the factors that made us a strong magnet for foreign capital despite being the most developed of the developed countries.  We could become more business friendly and attract capital keeping the tax cuts we already have and cutting capital gains and dividends taxes to zero, drastically reducing business taxes, etc.  This would postpone painful adjustments, but probably not forever.  However, those policies are needed on purely domestic grounds as well.

Aren't policymakers, especially the Federal Reserve, charged with protecting the value of the dollar?

Yes, but that commitment has always been understood to mean protecting its purchasing power over goods and services not over foreign currencies.  Even with the higher import prices coming from dollar depreciation, overall price indexes can be held down.  Of course, to the extent that a stronger dollar could limit the pressure on import prices, the rest of the job would be easier.

What do you expect our policymakers to do about the dollar?

They will continue to pay lip service to a strong-dollar policy, but deep down they will be grateful that the market is taking care of a potentially more difficult problem for them.  They know they will be criticized later for presiding over a shameful dollar decline, but they are less likely to be criticized for a prolonged recession or a reversal of our free trade policy.  And they will console themselves with the fact that if Congress would just listen to them we could have greater prosperity today and for years to come and leave correction of the trade deficit for a future generation of policymakers.

Naturally I bought the Maestro's book, Alan Greenspan, The Age of Turbulence, early on September 17, the day it came out.  I wanted to see if he said anything about me.  There was just one sentence on page 212.  Whew!  What a relief!

The price on its dust jacket was $35 in the U.S. and $43.50 in Canada, the 24 percent difference presumably reflecting the exchange rate between the U.S. and Canadian dollars.  The Prince of Darkness by Robert Novak had come out a little earlier with a 27 percent difference.  My other September book purchases had similar differentials, the lowest being 21 percent near the end of the month.  I buy a lot of books. I don't necessarily read them.  But I buy them.

Since book purchases are the main way I keep track of the U.S./Canadian dollar exchange rate, you can imagine my surprise to learn that before September ended, the Canadian dollar had climbed to parity with the U.S. dollar.  Or, perhaps I should say the U.S. dollar had declined to parity with the Canadian dollar.

Isn't it interesting that when the two dollars trade one-to-one, the U.S. dollar is called weak and the Canadian dollar is called strong. I guess what have you done for me lately is a question for currencies as well as for people.

If you don't hear from me for a while, don't worry. I'll be somewhere up north buying books with U.S. dollars and selling them across the border for Canadian dollars, which I will use to buy back U.S. dollars. Or, is it the other way around?  I hope I don't get confused.