About That Trade Deficit
The United States and the Hard Currency Services Export Business
(written by Lancelot Finn, Dec. 12, 2004)
If there were no money, there would be no trade deficit.
Think about it. If we couldn't pay for Japanese cars, Chinese T-shirts, Saudi Arabian oil, Singaporean radios and Chilean wine with dollars, we would have to pay for them with exports. We would give, say, beef to the Japanese, computers to the Chileans, foodstuffs to the Singaporeans, movies to the French, everything to the Saudis.
Every import would be paid for with an export. No trade deficit.
What changes when we bring money into the equation? First, we pay for imports with dollars instead of exports. We sell exports for dollars and earn some of those dollars back, but not necessarily all of them. Second, dollars are not counted as an export good. The trade balance equals what we send abroad, other than dollars, minus what we bring in from abroad, other than dollars.
But what if we count dollars as just another traded good?
In that case, there is, again, no trade deficit. We pay for each import with an export. Dollars then become one of our main export commodities.
The dollar is valued by foreigners because it is a form of hard currency, along with the euro, the pound and the yen. The United States is in the hard currency export business—or, to put it more subtly, the export of hard currency services.
Hard currency is a physical good—banknotes and coins—but as a physical good per se it is unimportant and worthless. The currency-holders benefits from a number of services provided by the issuer of the currency, the US government.
The US government maintains the value of the dollar against consumer goods in the US (generally speaking) by monitoring the price level, manipulating interest rates, regulating the financial industry, maintaining tax authority throughout the US economy, and acting to punish counterfeiters. The dollar’s stability (with a little help from the huge size of the US economy) makes it useful to foreigners as 1) a unit of account, 2) a medium of exchange, and 3) a store of value. Local currencies, of course, also perform these functions. But in international transactions, in very small economies, and in countries that suffer from inflation, hard currencies perform them better. Many people who live thousands of miles from America, in Latin America, Russia or Africa, save, trade, and even do their mental accounting in dollars.
Lately there's been a lot of angst—though more in foreign than in American publications, and especially at The Economist—about the falling value of the dollar in international currency markets. There have been rumors of a potential dollar crash, and its disastrous consequences. How likely is a dollar crash? If the dollar doesn't crash, will it continue to depreciate? Should we be worried about dollar depreciation? Is this a good thing or a bad thing for the US? For the world?
The answers to these questions lie in an analysis of the global currency services industry.
In any market (and there is a market for hard currency as for other goods), prices result from an interaction of supply and demand.
On the demand side, the future of the currency services market looks good. Developing countries are likely to grow fast. New technologies like cell phones and internet are in some cases more accessible to poor countries than older technologies like cars and planes. Birth rates are declining in many developing countries, which will lead to a "demographic transition," a generational phenomenon during which the ratio of working to dependent people will be unusually high, creating an opportunity for a surge of economic growth. Meanwhile, China's continuing boom is raising commodity prices, boosting the fortunes of many countries that rely on commodity exports, and which suffered from worsening terms of trade throughout the 1980s and 1990s. India has also grown strongly in recent years. If this strong growth in developing countries is sustained and spreads, developing countries will demand more of everything, including hard currency, as they engage in more international trade, and have more savings.
On the supply side, the dollar faces at least one major new competitor: the euro. As developing countries grow, and as some of them improve their economic policies, local currencies may displace the dollar—although, on the other hand, some economists have argued that the world has "too many currencies," in which case more prosperous developing countries may opt for increasing dollarization. The dollar may face unorthodox new competitors such as an "index currency," a currency pegged to a basket of Third World currencies, proposed by economists Barry Eichengreen and Ricardo Hausmann as a way to relieve poor countries of the handicap that comes from being unable to borrow in their own currency. It is even possible that the private sector (the Visa Corporation, for example) will develop new quasi-currencies that will weaken the dollar's pre-eminence.
Whither the dollar, then? Demand for hard currency services will probably continue to increase. But the dollar will probably lose at least some market share to the euro. It may also lose market share to developing countries' currencies (though it could gain it). We can probably keep exporting hard currency services, i.e. running a trade deficit, but it is somewhat likely that our hard currency exports will diminish in the future.
It is fairly ordinary for us to foresee the decline of a particular export industry. The textile industry, for example, has long been decimated by international competition, but economists don't seem to mind. Why, then, are economists so worried about the hard currency export industry? There are two good reasons and a bad one.
The first good reason is that the currency services industry is a government-run natural monopoly—only advocates of "free banking" dispute this, and they're a fringe group—and it plays a key role in public financing. When a country's currency is held in high esteem, its government can borrow easily, for purposes of war or counter-cyclical macroeconomic policy. Historian Niall Ferguson likes to emphasize that "deep pockets" are a key element of world power. Still, this argument has become self-parody of late: The Economist often seems to be arguing that having the dollar as the world's reserve currency is useful to America because it enables to run huge trade deficits indefinitely; so America should stop running trade deficits, to avoid jeopardizing this privilege. Come again?
The second good reason (even better) is that the currency services industry has huge externalities. Stable money is good for the business climate and good for individuals' happiness. Inflation creates a whole array of perverse incentives. We all use money every day, so currency fluctuations directly affect us all. Worse, much of our property is dollar-denominated, so changes in the value of the currency create an invisible process of silent, unplanned confiscation and redistribution. The externalities that come from a stable currency affect the world, not just the US, economy; and if it is the exchange rate (as opposed to the domestic price level) which is unstable, foreigners are affected more than Americans. This explains why foreign publications (like The Economist) tend to be more worried about the sliding dollar than American publications are: a stable dollar exchange rate is more in their interests than ours. Shrewdly enough, The Economist makes arguments (albeit unpersuasive ones) for why it is in America's interest to steady the dollar, since American voters, consumers and policymakers have the power to influence it; but they really have the world economy on their minds. That said, the Fed has good reason to worry that a weak dollar will feed into domestic inflation.
The bad reason that economists are so worried about the sliding dollar is that they won't rethink the question: why do foreigners want dollars? Economists will often state in front of a class: "Foreigners want dollars in order to buy American goods." Why so? The statement doesn't seem to describe the real world, where people have been acquiring more and more dollars, while purchasing relatively fewer American goods, for three decades. Nor is it especially logical, since foreigners could just as well want dollars because they serve the traditional roles of money better than local currencies do. As a result of this rather stubborn mindset, economists have seen the US trade deficit and mechanically predicted, year after year, a decline or possible crash of the dollar. When the dollar defies their predictions and soars, they express a bit of embarrassment, then go predict the same thing.
If the US does get squeezed, or pushed, or stampeded out of the hard currency services export business—as The Economist would say, "if foreigners stop financing the trade deficit"—that's not necessarily a bad thing. Whether it is or not depends on the resilience of the American economy. If the American economy proves highly resilient, the decline of the hard currency export industry will hurt us no more than the decline of the textile industry did. Or rather, it could be beneficial. A weak dollar will make our exports more competitive; foreigners will demand more of them; we will respond to increased demand by increasing productivity faster and creating more jobs; and the "disappearing dollar" will make us richer.
I for one think the American economy is resilient enough to do just that.