US dollar affected by both trade deficit and inflation
The US dollar has been falling of late and the conventional wisdom is that the large US trade deficit causes the US dollar to be weak. However, Donald Luskin of Trend Macrolytics thinks that the reason for the fall in the US dollar is inflation rather than the trade deficit.
In an article for SmartMoney.com on 12 November titled "Buffett Is All Wrong on the Dollar", Luskin wrote:
In the chart that Luskin shows, there is indeed no apparent correlation. The problem is that the trade-weighted index that Luskin uses covers only the major currencies -- that is, the currencies that are widely circulated outside the country of issue. So it conveniently excludes the renminbi -- the currency of the Chinese economy with which the US has a large part of its deficit -- and the currencies of many other emerging economies.
A broader trade-weighted index would have shown that, after a relatively stable period in the 1970s for both the US dollar and the trade deficit, the US dollar has been on a rising trend for most of the period since the early 1980s, and the trade deficit has risen along with it for much of that period.
So Luskin is wrong in saying that the dollar and the trade deficit have nothing to do with each other.
That does not necessarily mean that he is wrong about the impact of inflation on the dollar.
Inflation in the US is largely the result of excessive money supply caused by low interest rates. When money supply increases faster than the amount of goods and services produced in the economy, the purchasing power of each unit of the currency declines. A lower purchasing power tends to lower the value of the currency, so its exchange rate tends to fall, unless holders of the currency find other uses for it -- for example, for investment or as a medium of international trade (both of which apply in the case of the US dollar, which helps offset its declining purchasing power).
Having said that, one of the indicators of inflation and purchasing power in a country is none other than the trade deficit.
By creating excess money supply, inflation tends to drive up prices. This tendency is mitigated in a globalised economy by some of that excess money going oversees to seek out cheaper imports. How much, and whether it leads to a trade deficit, depends, among other things, on whether and by how much local prices are higher than foreign ones at prevailing exchange rates. Obviously, the greater the inflation, the greater the excess money and the greater the differential in prices (assuming the exchange rate stays constant), hence the greater the likely trade deficit.
Therefore, whether you look at it as excess money seeking an outlet through imports or as rising local prices relative to foreign ones inducing substitution with imports, the trade deficit is an indication that the US is indeed experiencing inflation to a greater degree than other economies.
So whichever way Luskin chooses to look at the trade deficit, he should not advise investors to ignore it.
In an article for SmartMoney.com on 12 November titled "Buffett Is All Wrong on the Dollar", Luskin wrote:
The falling dollar is the one dark cloud on the market horizon right now, the one thing that has the power to threaten the post-election "Bush rally." But the reason you should be worried about the dollar is very different from the scare stories you're hearing in the media...
Warren Buffett...has shorted the dollar because he is worried about the impact of the U.S. trade deficit... [T]ake a look at the chart...which plots the value of the dollar vs. a trade-weighted basket of foreign currencies...compared with the U.S. trade deficit...all the way back to 1973... As far as I can see, the dollar and the trade deficit simply have nothing to do with each other...
So if Buffett is so terribly wrong, how come he's making money on his short position in the U.S. dollar? Why is the dollar falling?... It all comes down to...Fed chairman Alan Greenspan... Greenspan's mistake is that he has kept interest rates too low for too long, and now inflation is beginning to creep back into the U.S. economy... And that's why the dollar is falling. It buys less than it used to...
In the chart that Luskin shows, there is indeed no apparent correlation. The problem is that the trade-weighted index that Luskin uses covers only the major currencies -- that is, the currencies that are widely circulated outside the country of issue. So it conveniently excludes the renminbi -- the currency of the Chinese economy with which the US has a large part of its deficit -- and the currencies of many other emerging economies.
A broader trade-weighted index would have shown that, after a relatively stable period in the 1970s for both the US dollar and the trade deficit, the US dollar has been on a rising trend for most of the period since the early 1980s, and the trade deficit has risen along with it for much of that period.
So Luskin is wrong in saying that the dollar and the trade deficit have nothing to do with each other.
That does not necessarily mean that he is wrong about the impact of inflation on the dollar.
Inflation in the US is largely the result of excessive money supply caused by low interest rates. When money supply increases faster than the amount of goods and services produced in the economy, the purchasing power of each unit of the currency declines. A lower purchasing power tends to lower the value of the currency, so its exchange rate tends to fall, unless holders of the currency find other uses for it -- for example, for investment or as a medium of international trade (both of which apply in the case of the US dollar, which helps offset its declining purchasing power).
Having said that, one of the indicators of inflation and purchasing power in a country is none other than the trade deficit.
By creating excess money supply, inflation tends to drive up prices. This tendency is mitigated in a globalised economy by some of that excess money going oversees to seek out cheaper imports. How much, and whether it leads to a trade deficit, depends, among other things, on whether and by how much local prices are higher than foreign ones at prevailing exchange rates. Obviously, the greater the inflation, the greater the excess money and the greater the differential in prices (assuming the exchange rate stays constant), hence the greater the likely trade deficit.
Therefore, whether you look at it as excess money seeking an outlet through imports or as rising local prices relative to foreign ones inducing substitution with imports, the trade deficit is an indication that the US is indeed experiencing inflation to a greater degree than other economies.
So whichever way Luskin chooses to look at the trade deficit, he should not advise investors to ignore it.
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