The ever-growing deficit in America's international trade is a bomb waiting to explode, but one with a very long fuse. That's why for years economists and policymakers put the deficit low on their list of worries. The lack of urgency stemmed from the glacial pace of the gap -- it has been widening for 13 years with no problems -- and from the fact that the U.S. remains the most attractive destination for foreign funds.
Recently, however, the fuse seems to be burning a lot more quickly. Currency markets, increasingly edgy about the deficit, are pushing down the dollar. Overseas officials and international trade organizations have called on the U.S. to deal with the problem before it inflicts global pain. And policymakers at the Federal Reserve took time at their Sept. 21 policy meeting to discuss the "worrisome further widening of the U.S. trade and current-account balances." At the same time, growing economic tensions, especially in Europe, and contradictory statements from the White House about the dollar suggest that correcting the current-account deficit will be risky.
Indeed, no easy solutions lie on the horizon. Stronger global demand could help U.S. exports, but prospects abroad are not encouraging. Third-quarter growth in both the euro zone and Japan undershot expectations, and China's efforts to cool off its economy are hurting much of Asia. Boosting U.S. savings would lessen America's dependency on foreign funds, but Washington seems uninterested for now in reducing the main drain on savings, the federal deficit. Rising federal red ink only intensifies the U.S. need for foreign capital and worsens the trade gap as it stimulates U.S. demand.
Even a slow decline in the dollar may not be much of an elixir, because the drop is concentrated against a limited number of currencies, and thus a limited volume of U.S. trade. Worse still, given that currency markets often lurch instead of stroll, a strategy that relies largely on a weaker dollar could backfire. A sharply lower dollar would feed inflation pressures, boost long-term interest rates, and severely complicate the Fed's efforts to foster maximum sustainable growth. The October producer and consumer price indexes suggest at least a small dollar-related pickup in inflation outside of energy and food.
HOW DID THE DEFICIT GET SO BAD? For more than a decade, the global economy has become increasingly dependent on U.S. growth, while the U.S. has become more dependent on foreign capital to finance its demand. This cycle snowballed the deficit in the U.S. current account -- the broadest measure of international trade and financial flows -- to a record 5.7% of gross domestic product, a level exceeded only by the emerging nations Hungary, Bulgaria, and the Czech Republic. Foreign money now finances three-fourths of U.S. net investment.
Restoring some balance in global trade is potentially explosive because a successful adjustment requires so many pieces to fall into place at the right time. The U.S. trade deficit has to shrink without the dollar crashing. And trade flows have to shift, but without doing serious harm to global growth and financial markets.
Plus, accomplishing all this will require coordinated monetary and fiscal policies. The U.S. will have to tighten either monetary or fiscal policy -- preferably both. The European Central Bank must cut interest rates, and Japan must solve its long-running banking problems. China and many Asian governments have to loosen their grip on their currencies. And all countries must restrain themselves from protectionist urges.
IT'S A TALL ORDER, especially given the Bush Administration's penchant for acting unilaterally rather than in conjunction with other governments. Choosing to go it alone on this effort risks unleashing the wrath of the currency markets. Given the dollar's slide, they may already be losing their patience with current efforts.
In particular, forex markets seem dismayed by the prospect of large U.S. budget deficits. And traders are paying less attention to the Bush Administration's dollar mantra, most recently chanted by Treasury Secretary John W. Snow, that "a strong dollar is in America's interest." Instead, traders are focusing on the White House's other -- and opposite -- message that "currency values are best set in open and competitive exchange markets." Since current fundamentals strongly argue for a weaker dollar, forex markets seem willing to give the Administration what it is not so subtly asking for.
In the past, that would not be a bad thing. A weaker dollar was a major weapon for bringing down the trade deficit. For example, the 1985 Plaza Accord among major nations brought down the dollar, and the U.S. current account shrank from 3.5% of GDP to near balance by 1990. But relying on a dollar remedy will be a lot trickier this time because trading patterns have changed so dramatically and many key trading partners closely manage their currencies.
According to Fed data, the dollar is down 13% against a broad range of currencies since its peak in February, 2002. But that number doesn't tell the whole story. To gauge the U.S.'s global competitiveness, the Fed also calculates two subindexes of the trade-weighted dollar. The first compares the dollar to seven major currencies: the euro, pound sterling, Japanese yen, Swedish krona, Swiss franc, and Australian and Canadian dollars. The second index measures the dollar vs. the currencies of 19 other countries, which the Fed labels "Other Important Trading Partners". Together, these 26 regions account for about 85% of U.S. trade flows.
THE DATA REVEAL that the dollar's decline has been concentrated in a 25% drop against the major currencies of countries that account for 46% of the volume of U.S. trade. However, against the OITP currencies, the dollar is actually up 5%, and these countries make up 40% of U.S. trade volume. Not surprisingly, the U.S. merchandise trade deficit has deteriorated more against the OITP group. On a 12-month moving average, that gap has widened 56% since February, 2002. The U.S. goods deficit with the major nations is 34.6% bigger.
The problem isn't just China. Excluding China, the U.S. deficit with the OITPs is still 41% bigger than it was in February, 2002. And in the past year, the U.S. gap with the seven major trading regions has worsened just as much as the gap with China has, even though the dollar is down 5% vs. the major currencies and not at all vs. the yuan.
Why hasn't the dollar narrowed the trade deficit, even in areas with strengthening currencies? Strong U.S. demand, compared to that in other regions, has overwhelmed the constraints of the dollar's weakening. In effect, hefty stimulus from U.S. tax cuts and low interest rates has skewed global growth and helped out foreign producers.
In the coming year, economic tensions are bound to rise, as the global trade imbalance gets worse before it gets better. The onus will fall on the Bush Administration to take the lead in achieving a benign resolution. But if government policy fails, the currency markets will step in. And their remedy could be much more painful.
By James C. Cooper & Kathleen Madigan