Wednesday, November 17, 2010

Why Weaker Dollar Might Not Reduce Trade Deficit

Caroline Baum points out that by strengthening the incentives to borrow and weakening the incentives to save, quantitative easing could reduce net exports, or in other words increase the trade deficit. This effect could very well be stronger than the apparent opposite effect from a weaker dollar.

This is an observation that I've made before. The example of Japan is even more conspicous than it was then as the yen is now at 1.2 U.S. cents (which in the normal inverted terms means that a dollar costs 83 yen) compared to 0.28 U.S. cents in the 1970s (inverted terms, 360 yen per dollar), yet Japan still posted a $23.5 billion (¥1.96 trillion ) monthly current account surplus in September, which translates into an annual surplus of nearly $300 billion.

Thus, there are good reasons to believe that quantitative easing will not reduce the trade deficit despite weakening the dollar. It will raise nominal domestic demand, but it might not increase real domestic demand because prices will be higher.

And this also illustrates why there is an overbelief in how much yuan appreciation will really reduce the Chinese trade surplus, when the same hasn't achieved it for Japan.