NEW YORK (CNN/Money) -
A drop in the dollar seems like everybody's favorite answer to how to fix the United States' huge trade deficit with the rest of the world.
The notion that a weaker greenback will spur U.S. consumers to favor American goods while at the same time making U.S. wares more competitive in the global marketplace is so entrenched that it's become a guiding dynamic of U.S. economic policy. There's a reason the White House's stance on what a "strong dollar" means got so watered down and why Washington types of all creeds cry bloody murder over how China keeps its currency weak against the dollar?
So, um, how come we haven't seen any improvement yet?
The U.S. dollar has now been dropping for a solid two years, declining on a broad trade-weighted basis, according to the Federal Reserve, by 13.6 percent from its February 2002 peak. Against many of the world's major currencies the buck has buckled by even more: 25 percent against the British pound, 21 percent against the Japanese yen, 32 percent against the euro.
And what's happened to the U.S. trade deficit? It's got even worse, of course, jumping from $359 billion in 2001 to $418 billion in 2002 to $489 billion in 2003.
That the trade gap keeps on widening despite the weak dollar is a bit of a puzzle, but economists think the situation should reverse itself as time wears on.
Or at least the economists at the Fed think that. In his testimony before Congress last week, Alan Greenspan said he reckoned many firms were using financial instruments to hedge against their currency volatility, and that many foreign companies are eating their currency losses.
"[T]he currency depreciation that we have experienced of late should eventually help to contain our current account deficit as foreign producers export less to the United States," said Greenspan. "On the other side of the ledger, the current account should improve as U.S. firms find the export market more receptive."
But Greenspan's explanation for the trade gap's continued growth doesn't square entirely with the facts.
First off, although hedging may mute the effects of the dollar's decline for a while, in most cases it won't last very long. HSBC currency strategist Marc Chandler points out that currency hedges most companies use last three months, and rarely longer than six months, because the cost of putting on a longer hedge is prohibitive.
"I'd say hedging has nothing to do with what we've seen in the trade data," said Chandler.
And what of overseas manufacturers eating their losses? Though certainly something of a factor, it can't entirely explain away the trade deficit either. First off, you would think that U.S. companies, at least, would be reaping the benefits of a lower dollar, and so helping close the trade gap. And second, it appears that some overseas manufacturers actually are raising the U.S. prices of their goods.
Europe provides the best example. From the end of 2001 to the end of 2003 the U.S. trade deficit with the European Union swelled by 54 percent to $94.3 billion. During this period the U.S. prices of European goods didn't rise by nearly as much as the euro did -- but they did rise by 9 percent, outpacing the U.S. rate of inflation by more than 4 percent.
How could this happen? Goldman Sachs chief U.S. economist Bill Dudley points out that a lot of it probably has to do with the strength of the U.S. economy versus Europe -- the pace of demand has been growing far quicker here than on the other side of the Atlantic.
Morgan Stanley money market economist Bill Sullivan adds that a lot of the things Americans buy simply aren't made here any more, and that for others -- cars for instance -- quality perceptions mean that many consumers will continue to gravitate toward foreign-made brands.
He also points out that what's called the J-curve -- an economic theory that says a declining dollar will actually make the trade deficit worse, because higher prices on imports will more than make up for reduced volumes -- may be coming into play.
Finally, even if the dollar declines to the point where it really does damp import growth and rev up exports, the huge difference between the two means that the trade deficit could continue to swell, notes Lehman Brothers chief U.S. economist Ethan Harris.
It's a matter of math. Total U.S. imports last year came to around $1.5 trillion; exports equaled about $1 trillion. If imports grow by, say, 6 percent next year, they'd be up by $90 billion. For exports to add $90 billion, they'd have to grow by nearly 9 percent.
"This is why people talk about radical moves down in the dollar," said Harris. "They just can't see an improvement of the trade balance happening any other way."
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