Exchange Rates & Trade Balances
One interesting pattern is that the trade deficit climbs after a period of dollar weakness, and furthermore that the big drop in the deficit late last year and earlier this year came after a dollar rally. How could this be true?
Jim Jelter at Marketwatch explains it with oil, and that would indeed explain a lot since the drop in the deficit followed a drop in oil prices and the increase in the deficit.
However, the non-petroleum deficit also fell sharply late last year and early this year (from $37 billion in September 2008 to $20 billion in June 2009) and has since then increased again (to $26 billion in September 2009). So it is not simply oil.
There are in fact three explanations for this. One is the J curve effect. In the long run, a lower real exchange rate will, other things being equal, increase net exports, which in the case of the United States mean a smaller trade deficit. However, in the short run, it could actually lower net exports (the initial downward slope of J). The reason for that is that a weaker dollar will raise import price, and usually raise them more than export prices while at the same time much of the contracts have already been signed, meaning that volumes will in the short term not be affected very much. And as the price of imported goods rise while volumes in the short run is basically unchanged, this means that in the short run the cost of imports will rise, increasing the trade deficit. In the long run, when volumes have adjusted to the price changes, the deficit will fall, but in the short run it could actually increase.
Oil is one example of this, as the dollar price of oil is very sensitive to dollar movements, but it is not the only one.
Another explanation is that things need not be equal. And things like the "cash for clunkers scheme" and other parts of the stimulus package have helped increase the deficit.
And the third explanation is that while an "autonomous" (caused by other factors than the trade deficit) weakening of the dollar will at least in the long run cause the deficit to decline, an "autonomous" (caused by other factors than the dollar) increase in the trade deficit will cause the dollar to drop. If for American due to "cash for clunkers" demand more Japanese and Korean cars, this will increase demand for foreign currencies and therefore lower the dollar's exchange rate.
Because of the latest factor, there is actually no necessary empirical correlation between the dollar's exchange rate and the trade deficit. The positive causal relationship that the dollar's exchange rate has on the trade deficit is counteracted by the negative causal relationship that the trade deficit has on the dollar's exchange rate. In some cases the former will have a greater influence than the latter and in other cases the latter will have a greater influence than the former, but none of them will always have a greater influence. Which will have greater influence depends on the circumstances. And usually (including now) they will to some extent cancel each other out, limiting the empirical net effect.