capital flows

You all know that the dollar is steadily declining in value. It has been in a slow motion decline for years, but since March it has lost value at a slightly faster pace and has devalued about 16% since then. If this keeps up we will be headed into a full blown currency storm which could well foul up the Fed’s ability to keep rates steady in order to stimulate the economy.

That’s for another day.

Today I want to make a quick mention of the dollar’s decline on our trade balance.

According to the standard text book a drop in the dollar should allow US exporters to lower their prices, win more business, and thus increase trade. This would both stimulate domestic production and add jobs, but it would reduce the trade deficit. The impact of a cheaper dollar is the opposite on the import side: as the dollar slides import prices are driven higher and, in theory at least, Americans would buy fewer foreign made goods and services by switching to cheaper US made stuff.

That’s the theory.

So what went wrong?

Today’s news is that the trade deficit grew rapidly to $36.5 billion in September, up from $30.8 in August. This deterioration will hamper GDP growth since a larger trade deficit reduces domestic wealth. And the textbook says it’s not supposed top happen this way.

The answer is straightforward: oil.

America suffers from an addiction to oil as we all know. We import about half of our consumption. And oil is priced and traded in dollars. So as the value of the dollar depreciates each barrel of oil costs more. A quick look at the details of the trade balance confirm this: petroleum imports of various kinds make up about two thirds of the increased trade gap.

So we are stuck. Our manufacturers may well be able to sell more stuff abroad and thus add jobs here. That will help the economy enormously. It will certainly boost GDP. But all that good work is being undone – more than undone – by our complete inability to get an energy policy that is not oil-centric. Our addiction is steadily corroding the economy.

Which is why all that talk from the administration about alternative energy and so on is not silly left wing eco-chatter. It is sensible economic policy. We need to reduce oil consumption any way we can. That way the fall in the dollar will have the beneficial effects we need.

Further, and on a deeper level, one of the big economic problems in the world today is the persistence of the American trade deficit. That deficit – accounting being what it is – is balanced by an opposite surplus on our capital account. Think of it this way: we import the cash [surplus on capital] to pay for the goods we buy [deficit on trade]. This flow is huge. It also means that the US economy is awash with money that tends to be recycled into cheap loans. More to the point: it allows loans to be cheaper than they otherwise would be. This massive imbalance is a worldwide problem – some people call it a savings glut in the exporting countries. Until the world savings and investment flows are in better balance we will continue to suffer periodic consequences such as over-lending in certain areas … American real estate was the last big example of this phenomenon. And we know how that worked out.

So getting the trade balance under control needs us to cut oil consumption, radically over the medium term, and by any amount we can in the near term. It also needs us to save more and spend less. That produces a knock-on effect: it will require big exporting nations like Germany, Japan, and China to spend more rather than save.

Interconnectedness is not just a banking problem. Our trade balance is also part of a global set of imbalances that need international cooperation to sort out.

Meanwhile our trade balance is getting worse just when it should be getting better.

What a mess we’ve made for ourselves by not confronting the tough issues for the last three decades.