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Some Gain From The Dollar's Pain


The dollar has lost a lot of buying power in the past five years, as any American who travels to Europe can attest. That's bad for tourists, but there's an upside. A cheaper dollar is finally chipping away at the huge U.S. trade deficit, and there's emerging evidence that the improvements will accelerate in coming years without further huge declines in the dollar.

A falling dollar narrows the trade gap by making imports more expensive and exports cheaper. Until recently, the improving outlook had been obscured by the surge in spending on oil imports and by the relative strength of the U.S. economy, which has sucked in goods, services, and investments from other parts of the world. From now on, the trade deficit should shrink even more quickly. Bolstering that idea is a forecast of the International Monetary Fund released on Apr. 5. It concludes that the U.S. trade deficit may be far more responsive to currency depreciation than economists have traditionally assumed.

The improvement in the trade balance between the U.S. and some trading partners is impressive. In February, the U.S. posted a surplus with Britain for the first time since 2001. For the first two months of 2007, the deficit with the European Union was less than $13 billion, down 28% from a year earlier. With Canada, the deficit fell to below $12 billion from more than $16 billion.

Those gains areconsistent with the IMF's new analysis. Economists for the IMF speculate that globalization may have increased the responsiveness of trade to currency movements. More trade leaves companies more exposed to price changes by foreign rivals, so imports and exports are more immediately affected by the dollar's fall.

Another point in the dollar's favor is that the gap in the U.S. current account doesn't need to shrink to zero. It only has to get small enough so that America's debts aren't piling up at an unsustainable pace. A current-account deficit equal to perhaps 2% or 3% of gross domestic product would be small enough to prevent external liabilities from climbing faster than the growth of the U.S. economy. Daniel Waldman, senior foreign exchange economist at Barclays Capital (BCS), argues that the deficit was swollen by cyclical differences in growth between trading partners. Stripping those out, he estimates the "structural" deficit last year was about 4.6% of GDP and getting it down to 3.1% would be enough.

HOW FAR IS DOWN?

Bears on the dollar aren't persuaded that the gap will be so easy to close without an enormous depreciation of the dollar. They note that the deficit in the current account—the broadest measure of trade and investment income—hit a record $857 billion last year. "The best-case scenario is that the dollar loses only half its value in the next few years," says Peter Schiff, president of Euro Pacific Capital Inc., a Darien (Conn.) brokerage.

Even those who are optimistic about the outlook for the deficit acknowledge that there are still big problems with some key trading partners. The dollar remains strong against the Japanese and Chinese currencies. No surprise, then, that the trade deficit with Japan hasn't fallen and the deficit with China has ballooned.

The unbalanced nature of the currency moves makes it hard to say how much more the dollar needs to fall. Would the deficit react to a further decline against the euro and the pound? Or does the yuan need to rise faster to stem the flood of imports from China?

Whatever the answer, it looks as if the U.S. is well on the way to depreciating its way out of its trade deficit without disaster. U.S. inflation hasn't heated up, and the Federal Reserve hasn't had to raise rates to defend the currency. "It sells better to say we're up for some catastrophic explosion" in currency markets, says Menzie Chinn, a University of Wisconsin economist. A harmless fizzle may be more likely.

By Peter Coy


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