Deficit Difficulty

An old student emailed asking for clarification on an Economist article he read that is about the trade deficit. Here’s what the article is saying, in essence:

  1. The PPP predicts that the dollar should rise now, in terms of the Euro ($1.16/Euro by PPP, $1.55/Euro in nominal terms) – eventually, arbitrageurs should drive that difference away. That is, more French and German tourists buying dollars should drive the price of the dollar up (i.e., appreciation).
  2. Dollar speculators also feel that things have bottomed out (the dollar bears – people who bet against the dollar’s fall, not Cal students! – are despondent).
  3. The FEER model, on the other hand, is saying exchange rates should actually *increase* (devaluation of the dollar) given full-employment, sustainable deficit values of 3% of GDP (a flexible-price model-type analysis). According to the FEER, a rule-of-thumb is for each percent increase in the deficit more than 3%, the dollar should devalue by 10%. At the time of writing, the deficit was ~6%.
  4. Yet another study by Richard Cooper shows that the deficit is actually going to *increase* (imports will increase) when compared with the share of assets owned by foreigners in other “rich” countries. That is, the share of assets owned by foreigners in the US is less than those owned by foreigners in other comparable economies (because of secure property rights, speedy dispute settlement, etc.).

So is the deficit going to increase or decrease? Well, that is the million-dollar question. But I digress. Beau was asking, specifically,

I understand that a cheaper dollar makes exports cheaper, which in turn reduces the current account deficit.  I also understand that in terms of a relatively low PPP, it may be a good time to invest in the dollar, as the dollar may strengthen to increase PPP.  Finally, I know that foreign savings is negative net exports.  But if net exports are increasing, then foreign savings are decreasing, not increasing.  What do the foreign and domestic financial markets have to do with a persistent and large trade deficit?

I suspect Beau’s confusion stems from #4. But he answered his own question: Foreign savings equal negative net exports, so an increase in foreign savings coming in should increase the deficit by decreasing NX.  Or at least, that’s what Cooper thinks.

There are two main ways in which the financial markets affect the trade balance. Firstly, there are instances where a US company will exchange shares of stock in return for goods from a foreign country, thus decreasing the trade deficit. Secondly, capital inflows put upward pressure on the dollar – when foreigners buy assets in the US outright, they need to buy dollars first, and this results in appreciation, which, in turn, raises the dollar value of exports. And this, once again, raises the trade deficit.

What I found interesting was the percent of the deficit that oil constitutes. It looks like it’s over 50% now. Is anyone panicking yet? Anyone? Anyone?

Oil and the US Trade Deficit

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