My Nonchalance About the Trade Deficit

by Don Boudreaux on March 25, 2005

in Trade

I’ve received 32 e-mails so far in response to my posts (here, here, and here) in which I argue that Warren Buffett misunderstands the trade deficit.  I continue not to worry about the trade deficit.

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One correspondent asks about dollars in the hands of foreigners: “doesn’t the supply of dollars to be changed in foreign currency lower the exchange rate of the dollar?  If so, the trade deficit really is something to worry about for the U.S., isn’t it?”

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No.  The trade deficit is nothing to worry about.

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First, a growing trade deficit for the United States can cause the dollar’s exchange rate to fall, but it doesn’t necessarily do so.  Let’s assume for the moment, however, that the price of the dollar in foreign currencies does indeed fall.  Good or bad for Americans?

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In a myopic sense, it’s bad, for each dollar now buys fewer imports.  But in a fuller, longer-run sense it is neither bad nor good in and of itself.  The price of the dollar, like all prices, reflects underlying realities.  The ‘right’ exchange rate is the one that reflects as accurately as possible these underlying realities.

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If foreigners find themselves holding too many dollars relative to their demand for dollar-denominated goods, services, and assets, the dollar’s exchange rate will fall.  The lower exchange rate will decrease American imports and increase American exports, reducing America’s current-account deficit.

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I view such an occurrence as being neither good nor bad.  Of course, it might reflect deeper problems with the American economy (such as an inflationary monetary policy), but it might also reflect nothing more awful than changing tastes and circumstances abroad.  Either way, there’s nothing suspect about the open trade that led foreigners to hold so many dollars that the dollar’s exchange rate falls.

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But as mentioned above, a U.S. current-account deficit will not necessarily lead to dollar devaluation.  It could well be that the American current-account deficit is itself the result of high foreign demand for dollars.

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Take the simplest example.  Suppose that (for whatever reason) foreigners conclude that holding dollars is now a better investment than they’d previously thought.  So they seek more dollars to hold.  How do they get these additional dollars?  By selling more things to Americans.  When foreigners increase their sales of goods and services to Americans and then hold on to the dollars they earn from these sales (rather than spend these dollars on American goods and services), the U.S. current-account deficit increases.  But there’s no downward pressure on the price of the dollar.  The very reason the current-account deficit rose is because the dollar is now in higher demand abroad.

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Or suppose that foreigners’ demand for American real-estate increases.  Needing dollars to buy this real-estate, foreigners sell more goods and services to Americans and spend their extra dollar earnings on American real-estate.  In consequence, The U.S. current-account deficit rises, but the extra dollars earned by foreigners are not flooding foreign-exchange markets.  They’re back in the U.S., having purchased American real-estate rather than goods and services.

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