Why is the trade deficit, even taking out oil, so large when the dollar is so weak? Maybe some insights can be gleaned from productivity measures.
In Figure 1, net exports ex. oil is plotted against the real trade weighted exchange rate of the dollar (up is weaker).
Figure 1: Net exports ex.-oil to GDP ratio (blue), log real dollar exchange rate (Federal Reserve Major Currencies index) (red), and log real dollar exchange rate (IMF, unit labor cost deflated, against industrial countries) (teal). Exchange rates normalized to 0 in 2000, and lagged two years. NBER defined recession dates shaded gray. Source: BEA NIPA release of July 31, 2008; Federal Reserve Board; IMF International Financial Statistics; NBER.
As I’ve observed in the past, during the last adjustment episode during the 1980′s, the dollar lagged two years explained pretty well the path of the ex-oil trade balance. But in this episode, that adjustment has been delayed.
One possible explanation is the wrong currencies are included in basket (the plotted series is the Fed’s “major” index) (see , ). Another possibility is that the wrong type of index is used . In this post, I want to examine the implications of looking at a real exchange rate deflated using the cost of production. That is the unit labor cost (ULC) deflated dollar exchange rate. (Unit labor costs equal wage per hour divided by output per hour.) This series is plotted teal in Figure 1.
Clearly, the ULC deflated series exhibits even greater depreciation than the Fed’s major dollar index. So why hasn’t all this touted productivity yielded greater improvement in the trade balance; after all, the “weaker” the dollar in real terms, the more competitive American goods should be against foreign goods.
One possibility is that exactly because productivity growth in the US is very rapid, future prospects for America’s wealth (in the form of the present value of future net output) are very bright, and hence we should dis-save now, in order to smooth consumption (see this report for a discussion of this view. Figure 2 depicts the trajectory of output per hour in the business sector; growth has held up remarkably well even this late in the business cycle.
Figure 2: Log output per hour in business sector. NBER defined recession dates shaded gray. Source: FRED II; NBER.
Somehow that argument seems a little less convincing now than in 2000, and even in 2005. Let me propose two alternative explanations.
First, since the ULC deflated index is calculated only against other industrial countries, we are missing exactly the countries that are experiencing even more rapid growth — China comes to mind. In that light, the true ULC deflated series is probably less depreciated. (Fixing this problem is of course not straightforward — one would have to estimate Chinese unit labor costs… )
Second, productivity growth is overstated. As I’ve mentioned before, National Income and Product Accounts statistics are revised over time  (and indeed the 08Q2 numbers will be revised up due to the higher trade figures for June). Productivity will be too. And my guess is these productivity numbers will be revised down over time, if indeed we are at a turning point in the business cycle, resulting in a less depreciated dollar exchange rate.
The implication of both interpretations is that the dollar will have to decline further in order to effect a sustained (i.e., not just recession-induced) improvement in the trade balance ). Of course, there is no requirement that this depreciation will be against the euro — and in my view it is unlikely to be )