The Dollar and the Trade Deficit: How Does Productivity Fit In?

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).


defprod1.gif

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 [1], [2]). Another possibility is that the wrong type of index is used [3]. 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.


defprod2.gif

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… [4])


Second, productivity growth is overstated. As I’ve mentioned before, National Income and Product Accounts statistics are revised over time [5] (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 [6]). Of course, there is no requirement that this depreciation will be against the euro — and in my view it is unlikely to be [7])

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17 thoughts on “The Dollar and the Trade Deficit: How Does Productivity Fit In?

  1. The Market Traders

    The Dollar and Trade Deficit: How Does Productivity Fit In?

    Menzie Chinn submits: 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

  2. anon

    What would be the intuition for preferring unit labor costs as the inflation component for the real exchange rate?

  3. flow5

    Your supposition is wrong: “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”
    The problem is that further depreciation of the dollar will not correct our foreign trade deficit
    A weak currency is not a cause; rather it is a symptom of a weak, non-competitive economy. In time, of course, a declining dollar will eliminate the deficit in our balance-of-trade. But the price exacted will be a sharp decline in imports, principally oil, and the purchase of foreign services, reflecting our relative poverty and inability to compete in the international economy. The rising cost and diminishing volume of imports will contribute to an increase in inflation, and the expectation of further inflation will also push up interest rates. This spells stagflation.
    No country has become and remained a world power if it is a world debtor and has a weak currency. From these unwanted events we can expect a vicious level of stagflation that will become an enduring feature of our economic landscape. And the United States will be forced into a high degree of economic isolation, and perhaps an increasingly totalitarian mold.
    Even if we eliminated the trade deficit and ran a surplus sufficient to service our foreign debt, the dollar would still decline because of the war/containment/terrorist deficit. Since actions sufficient to eliminate these deficits are highly improbable, the dollar will eventually decline to a level which will eliminate them.
    At that level our standard of living, for this and other reasons including financing the federal debt, will be much lower than at present, and the capacity of the Pentagon to project conventional military power abroad will be severely circumscribed.
    We can help terminate these deficits by (1) the U.S. government drastically reducing its overseas military expenditures or by transferring most of the cost of maintaining bases and personnel to foreign governments; (2) revitalizing a large segment of U.S. industry so that it will be able to compete in foreign markets; (3) sharply reducing our dependence on foreign energy sources; and, (4) increasing the attractiveness of foreign long-term investment in the U.S.
    But PPP is a false doctrine. Obviously comparison of identical commodities with identical weights is not being made. ( international adjustments are more difficult than domestic hedonic adjustments).
    The only way to correct the dollars imbalance will be to sell higher quality, lower cost, goods & services, sufficient to push the trade deficit into a surplus.

  4. KevinM

    “No country has become and remained a world power if it is a world debtor and has a weak currency.”
    Drivel. Too vague to properly attack, but obviously drivel. (Russia, Germany, Japan post WW2).

  5. Buzzcut

    Kevin beat me to it.
    A weak dollar solves a lot of ills. So do higher interest rates. A cheap dollar and higher interest rates will increase savings, increase exports, cause us to use less foreign oil, etc.
    But we don’t have a weak dollar. At 109 yen to the dollar, it’s not extremely strong, but it isn’t weak.
    People are much too focused on the Euro exchange rate. Probably because our media likes to spend so much time in Europe. ;)
    The yen is where it’s at.

  6. Menzie Chinn

    anon: One would want to use unit labor costs because it’s the closest measure to the domestic economy idea of cost-competitiveness. Of course, if markets were perfectly competitive, then the two would be equivalent (or if markups were constant and equal across countries). For more, see the link [4] in the post.

  7. GK

    “Why is the trade deficit, even taking out oil, so large when the dollar is so weak? ”
    One word : China.
    Almost all of the ex-oil deficit growth since 2000 has been China. Their artificially pegged currency continues this.
    If you do an ex-oil + ex-China deficit, it is flat, and is possibly even a trade surplus.
    However, even this deficit with China may be peaking. Their wages are rising, the cost of oil in dollars is even more painful for them than for us, and their economy is now too big for NET exports to be such a high percentage of their GDP for much longer – the rest of the world just can’t absorb that much.

  8. GK

    “Even if we eliminated the trade deficit and ran a surplus sufficient to service our foreign debt, the dollar would still decline because of the war/containment/terrorist deficit. ”
    Drivel. Is America the only country that is at risk of terrorism?
    On the contrary, Europe is far more vulnerable than America, particularly since Europe has had 2 major attacks in the last 5 years (London, Madrid), while America has had none.

  9. KevinM

    Continuing the pile-on of “flow5″…
    The wars in Iraq and Afganistan consume roughly 1% GDP and 4% US budget.
    Much has been made of the financial cost of the wars, working under conjoined-twin assumptions:
    1) 100% of the funding is from debt.
    2) The debt would not have been issued ex-war.
    When 50% of the budget is Medicare/Medicade, you can’t blame the 4% spent on war for all of the cost overruns. Thats like blaming the price of Starbucks for your mortgage foreclosure.

  10. KevinM

    Menzie, sorry to participate in a hijck of your thread. I’m afraid I didn’t understand the thesis well enough, and so was lead astray by trollish politics.
    You seem to be saying that without recession exchange rates would have adjusted less, and so ex-oil trade imbalance would have improved less? Seems obvious. I need more words to say why that idea would be important.

  11. don

    Buzzcut says “But we don’t have a weak dollar. At 109 yen to the dollar, it’s not extremely strong, but it isn’t weak.”
    Exactly. Those who speak of the dollar value as a single metric are only half right. It is undervalued against the euro, but it is certainly overvalued against the yen and the yuan.

  12. DickF

    Because so much work on inflation is done through econometrics often the faith or lack of faith of people is discounted. This article makes the point that our current low inflation rate is mostly due to the faith of the people that the FED will control inflation, but will they. I have heard economists who understand this talk abou the fact that the American government is the most corrupt in the world not criminals stealing for themselves, though we have enough of that, but because they are lying to the world and creating situations that will be out of control, i.e. Fannie and Freddie.
    http://online.wsj.com/article/SB121936581501662161.html?mod=opinion_main_commentaries

  13. anon

    Prof. Chinn,
    Thanks for pointing me to your paper on REER. I’m grinding my way through it very slowly. It looks like “assuming that markups are constant” is a fairly critical point in the answer to my question.
    If I may, as a non-economist, ask another naive, perhaps stupid question:
    Why is the terminology “deflator” used as in CPI deflator, WPI deflator, ULC deflator, etc.? It sounds good, but it seems directionally counterintuitive to me. If I’m interested in the dollar REER, am I not looking at how the chosen dollar based inflation measure effectively will inflate (rather than deflate) the nominal dollar exchange rate (i.e. relative to foreign inflation rates)?

  14. Menzie Chinn

    KevinM: Well, I think there’s been a lot of talk that the deficit has shrunk sufficiently so that we need not worry any further about further realignment of consumption/output mix and dollar strength. I just wanted to highlight the point that there’s insufficient evidence that sufficient adjustment has been made. And further that just because measured productivity growth has been rapid does not mean that we don’t need to worry.

    DickF: Output per hour is real, deflated by the price index for the business sector. See this post for details.

    anon: A reasonable question. It’s because we observe nominal magnitudes that need to be converted to real terms by taking out inflation, i.e., deflated.

  15. Brian Pearson

    The only way to correct the dollars imbalance will be to sell higher quality, lower cost, goods & services, sufficient to push the trade deficit into a surplus.
    The FairTax would bring in more revenue, increase jobs and productivity, stabilize SS and MC, and ultimately strengthen the dollar.

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