Tuesday, March 18, 2008

The Myth About the U.S. Dollar and the Trade Deficit

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

One of the most widespread pieces of misinformation that is believed in and broadcast by the financial community is that as the U.S. dollar falls, the trade deficit will improve and by implication even disappear. It is almost impossible to view financial TV or read the press without seeing this incorrect piece of information being cited with great certainty and authority by the 'experts'. While this idea was indeed true when the U.S. was on the gold standard, it is not true in a monetary regime where where the dollar floats instead of having a fixed value.

It is only necessary to look at two charts to see that the generally accepted relationship between the U.S. dollar and the trade deficit is false. Those charts are the value of the trade-weight dollar (the value of the U.S. dollar based on the currencies of its major trading partners) and the trade deficit itself. It becomes immediately obvious when examining these charts the declining dollar has had less and less positive impact on the trade deficit over time and seems to have actually made the trade deficit worse since 2000. New York Investing meetup thought this issue was so important that we made one of our first videos about it (please see: "The U.S. Dollar Relationship to Inflation and the Economy" at: http://www.youtube.com/watch?v=3amH-T1B9pQ).

The U.S. went off the gold standard in 1971. There has been a continual trade deficit since 1977 and the amount of the deficit has gotten bigger and bigger over time. Classical economics would infer from this that the value of the dollar has been steadily rising. Instead the value of the dollar has been in a long-term downtrend since 1984. The trade-weighted dollar in fact lost around half its value between 1984 and 1992 and while the trade deficit decreased at the end of this period, at no point did it disappear. The dollar has been in a sharp decline since 2002 and the trade deficit, in total contradiction to classical economic theory, has skyrocketed during that time.

A hint as to how the U.S. trade deficit has managed to grow while the dollar was in sharp decline appeared in the report on the January 2008 trade deficit. Even though the U.S. dollar had been almost in free fall for the preceding several months because of Federal Reserve easy money policy, the trade deficit once again defied classical economic thought and increased instead of decreasing. An explanation in the report mentioned that the price of oil had gone up so much (and the U.S. is a major oil importer and has imported an increasing amount of oil since the early 1970s), that it had more than wiped out any benefits from the falling dollar elsewhere. Since the falling dollar itself makes the price of oil go up, a possible destructive feedback mechanism could be at work. In this scenario a falling dollar causes oil prices to rise and overwhelm the benefits elsewhere of the falling dollar, so the trade deficit goes up. In turn, the rising trade deficit damages the U.S. dollar (since the U.S. has to borrow money from foreigners to fund the trade deficit) and the dollar goes down further. The cycle then repeats itself over and over again.

Next: Housing Market Collapses, but the Statistics Hold Up

Daryl Montgomery
Organizer, New York Investing meetup

For more about us, please go to our web site: http://investing.meetup.com/21

1 comment:


The dollar is not real money.