Wednesday, May 11, 2011

Weaker Dollar Causes Short Term Trade Deficit Increase

The U.S. trade deficit rose to $48.2 billion in March-the highest since late 2008. Note that this happens after a dramatic weakening of the U.S. dollar's exchange rate.

This may be surprising to some as we hear all the time from various pundits that a weaker dollar will "solve" the trade deficit. The truth is that this only happens under special conditions and even then only in the long-term.

The special conditions I am referring to is that the currency weakness can't be the result of inflationary monetary policies. Inflationary monetary policy discourages savings while encouraging investments, two effects which will both increase the trade deficit and which will cancel out the exchange rate's deficit reducing effect.

Furthermore, even when the exchange rate falls for some reason unrelated to monetary policy the deficit will be reduced only in the long tern. In the short term, the effect of a weaker currency is usually to increase the deficit because import prices jump faster than export prices while volumes haven't yet been affected in a significant way. The increase in the trade deficit in the last few months is a good example of this as it is almost entirely the result of oil becoming more expensive (Though for the latest month, Libya was the key factopr driving this).

Because of the effect on the incentives for savings and investments and because of the short-term price effect, it seems certain that the increase in the trade deficit is in fact the result of the Fed's weak dollar policy. Later during the year, as the effects of the exchange rate on volumes begin to kick in, this net increase effect will largely dissipate.

UPDATE: A reader points out that I overlooked that there was a temporary spike in the trade deficit in June 2010 to $49.9 billion. Especially considering that it was only a temporary spike (it fell back to $42.2 billion the next month) , this doesn't however really affect the point of this post.