Hobson's Choice

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Short Posts on Trade & Currency

Trade and the Dollar

July 28, 2003

There have been several strange theories floating about regarding the US dollar (USD). Since its peak in early 2002, the US dollar has declined against the euro and some other important currencies, and when that happens there's usually a tendency for many to remark that this is the natural turn of events-this is what is natural. So, for example, the late invasion of Iraq is said to have been motivated by Saddam Hussein's intention to begin demanding euros in exchange for Iraqi oil, rather than US dollars. But if OPEC thought it could absorb other currencies and roll them over as efficiently as dollars, it would have made the switch before 1973. If OPEC did start demanding euros instead of dollars, it would have to face permanently reduced revenue from both investments and direct sales of oil - by a lot.

There are many good reasons why other nations opposed the invasion of Iraq; but hopes of a run on the USD were not among them. This week's briefing paper from the Economic Policy Institute furnishes this readable explanation of the issues associated with the USD and international trade. A little bit of detail has been sacrificed for ease in explanation, which I'd like to address below. But first, this helpful chart of the US trade deficit and net international investment position:

The article implies, but does not spell out, that the US current account deficit is financed by two things. One is the capital account balance (i.e.the net inflow of investment capital into the US economy from foreign sources); the other is the increase of foreign holdings of USD-denominated assets. The current account balance is dominated by a huge trade deficit; other transactions in the current account are comparatively small. Here is a chart I prepared of the Current Account Balance, Capital Account Balance, and Balance of payments (BoP) since 1960.

As you can see, the BoP has been negative for decades-actually, since the time of the Korean War-and much national policy has been directed at trying to make it "less so." Ironically, the period when the BoP shrank to a historic minimum was in the period of the '70's oil crises-when OPEC was rolling over its vast oil wealth in US markets.

On the basis of national income accounting, we say that the trade balance reflects the difference between savings and investment within a national economy. According to this idea, investment is institutionally given and household savings is culturally given; the one endogenous variable is the fiscal balance.

For heuristic purposes, we might treat the entire economy as if it were centrally planned, with separate accounts for government (G), consumption (C) and investment (I). In the very first instant of a hypothetical production cycle, we can see a fourth pile appearing, which is production allocated for allies and associates abroad. Of course, if we are running a trade deficit then, instead of a fourth pile of goods for (net) export abroad, we are borrowing some output from somebody else’s pile. The same is true for running a fiscal deficit: our planners, by allocating stuff for G, diverted it away from C and I; we regard this diversion as “taxes” (T). Yet our stash of stuff for G is somehow bigger than T, and it logically follows that the difference between T and G (or “fiscal deficit” DF) had to come from abroad. This is very compelling logic, and it seems reasonable to suppose that there should therefore be a very strong correlation between DF and the amount of stuff borrowed from abroad (the trade deficit, or DT). The chart of real (1982-84 US dollars) capital and current account balances displays a distinct butterfly pattern. In fact, a regression of the two confirms a close correlation, even though, in recent years, the CA has surged relative to its conjoined twin, the KA balance. Recall that the gross savings plus all forms of net income from abroad (S + CA + KA) will balance out investment and the fiscal balance (I + (G - T)). This means we can imagine BOP & SAVE as a crucial component of national accounts, and economic investment/ dissavings as the other. This should not be very surprising: most savings and investment is done through banks, whose creation of credit has several degrees of freedom with respect to deposits.

In the future, I'll be posting about how this mechanism influences the ability of national governments like ours to undertake social policies... and why, when that's not on the program, nations can turn to war.

Trade and the Dollar-Graphic

July 29, 2003

Here is a handy chart I prepared from Federal Reserve Data. It shows the trade-weighted value of the US dollar against other major world currencies.

The chart has an editorial cutoff date of 11/2002. For the most up-to date picture, here is a chart furnished by the Federal Reserve. As you can see, the actual exchange rate can be confusing. Much of American trade is with the less-developed world, where inflation can greatly skew exchange rate trends. But it's currencies such as the euro and the yen which are grabbing all the ink.

In Which I Pound My Head Against the Wall

November 04, 2003

Or, What's the Deal with International Reserve Currencies, Eh?

Here's a short blurb in the Moscow Times (10 Oct; English) about an alleged plan for the Russians to start demanding payment in euros for their oil; here's a more detailed account from Reuters, reprinted in the MT. And here is an article in the Guardian about earlier versions of the story. The rumor was that the US government was invading Iraq in order to prevent the government from changing its policy and demanding euros instead of US dollars for its oil.

All the clippings are very short and written for non-students of economics. But the provocative question I want to ask here is this: what would be the consequences if several countries began selling their petroleum for euros rather than dollars?

Evidently, an awful lot of people suppose it would bring about the utter collapse of American hegemony. The reasoning goes that people need reserves of dollars in order to buy oil. Because of this, the American economy is allowed to run a deficit in its current account and thereby expropriate huge amounts of goods and services. This, in turn, is alleged to have led to a host of other problems, such as the massive liquidity shocks experienced by the economies of Russia, Brazil, and East Asia in the late 1990's. (There are a large number of other examples).

There's a raft of books out, one of which was very highly recommended to me (The Global Gamble, by Peter Gowan). My policy is to not review books without reading them, and so I won't. I'll merely point out that I've read a large number of favorable reviews of the book, most of which address modalities of imperialism, and this posting is about something more discrete: national income and product accounting.

But I do find these conspiracy theories a bit disturbing. Part of the appeal is consensual reality; but it's also true that there's a craving for a single, simple conclusion to explain the badness in the world. In another post I shall attempt to explain these attitudes but for now I want to explain the problems with the whole notion. First, why is the US dollar an international reserve currency? Part of the reason is that, after the Second World War the USA and other nations met at Bretton Woods (a resort in New Hampshire) and set up some institutions. These included the World Bank and the International Monetary Fund. At the time of their inception, the Fund was intended to serve as a lender to central banks, enabling them to maintain exchange rates by lending short-run reserves. A part of the World Bank [Group] was also created, known as the International Bank of Reconstruction and Development (IBRD). Of the two, the IMF is the more heavily capitalized; it is best known for its structural adjustment programs (SAP) that typically strangle social programs in bankrupt countries.

Another key component was the gold-exchange standard, in which the US dollar was pegged to gold and other currencies had a statutory exchange rate to the dollar. This was well suited to the state-enhanced, or state-dominated capital markets of postwar Europe and Asia; but by the late 1960's the dollar was clearly overvalued. Since the end of the Korean War the USA had been exporting more capital (net) than it took in as a net exporter of goods and services; so of course there was a worrisome balance of payments (BoP) deficit. Congress attempted to stem the flow, none of which redressed the fact that the US dollar was so overvalued that equities abroad were cheap, the new economies in Europe were hot and growing, and American exports were losing their luster. When a country runs a trade deficit, its partners can either run a trade deficit of comparable size in the next period, or else buy assets like shares of stock or factories. Conversely, a country might run a trade surplus, and then buy assets abroad that are worth much more than the original surplus. We did both; and in most years since 1953 the USA has run a BoP deficit. The chart below illustrates this. Notice the explosive increase in the imbalances since the end of the 1980-83 recession, when the US government began running unprecedentedly high peacetime deficits during an economic expansion.

This, coupled with a vast array of business interests and the freewheeling nature of American business enterprise, ensured a huge accumulation of dollar-denominated accounts abroad. Then, too, there was the legacy of Bretton Woods, in which easy-to-acquire dollars were sucked up by Central Banks. National governments tended to retain a large measure of export revenue as currency reserves, creating more hot money and stimulating faster economic growth. When the US Treasury delinked the dollar from gold, it was already in the midst of an oil price shock. Not only that, the US government made repeated (and doomed) efforts to stimulate the growth of exports to Latin America. Hence, the money supply grew rapidly in the 3rd World.

What were the consequences? Well, the negative balance of payments was a major worry of most US congresses and most administrations. But measures to prevent it by altering the macroeconomic fundamentals were not politically tenable; instead, efforts were made to do this by applying pressure on foreign governments. Today we are in the unenviable position that our exports are regarded by other nations as a sort of assault on their sovereignty, and we run a trade deficit. If our trade agreements were redrawn to the approval of our European and Latin American partners, we would export almost nothing. But our efforts to restrict imports have caused profound opposition. And our trade deficit has caused considerable alarm in financial circles.

Actually what this proves is that, in economics, bad planning by one country hurts others. On the one hand, cabinets in EU member states have an obligation to look after the needs of their commercial interests; at the same time, the financial ministers of other rich countries (the OECD) are alarmed at the ballooning trade deficit and concomitant deficit in American current accounts. Most of the time this is offset by the investment opportunities that our markets afford to investors. If not, then either dollar-denominated accounts grow. And if that doesn't happen, then the dollar loses value. When the dollar loses value against major trading currencies, the current accounts of countries whose currencies are pegged to the dollar—e.g., China's renminbi—tends to grow.

Now, we have a few remaining questions:

So what if the international community decides it prefers using euros to US dollars as the international trading currency?

In that event, the dollar's value will decline. People holding dollars will either attempt to buy American products, or exchange them for euros. But the international supply of euros is extremely small because the EU member states run trade surpluses on a regular basis. Even a national government outraged by US policy—such as Iraq's pre-2003—is not going to give away purchasing power to its partners by swapping dollars for euros at an excessive rate. For example, you might decide you absolutely hated Mel Gibson with a purple passion. But if you have a big inventory of his movies, you're not going to burn them in your backyard. If you do, Mr. Gibson thanks you because you took them off the market! If you stand on a street corner and give them away at a penny apiece, you'll hurt yourself, while lots of people will take the [almost] free video home and perhaps became fans. Sure, it'll hurt sales over the short run, but obviously not for long.

But what if OPEC countries start demanding euros for oil?
*sigh* There's a lot of urban legends about oil. Middle East oil is special partly because there's so much of it, but mainly because it's so inexpensive to recover. In other industries, the most efficient producer gradually loses its edge as its advantages dissipate (really good managers get jobs elsewhere, the business model gets imitated, or the efficiency rents get absorbed by firm stakeholders). But in the oil industry, they don't. However, that doesn't give OPEC members extra control over currencies. "Petrodollars" have to be recycled, and oil ministers will do that in the most efficient way they can.

Doesn't the US enjoy the unique privilege of running deficits without consequences?
No. Our internal (public) deficits were far surpassed—relative to GDP—by those of Canada, Italy, France, or Japan, and all during either the Carter or the Clinton administrations. The statement makes somewhat more sense if you're talking about external deficits. Much mention is made of seigniorage, which is supposed to arise from our ability to get others to accept our worthless bits of paper in exchange for their valuable products. Again, on an annual basis this would be equal to our BoP deficit—would, except that those eurodollar accounts are American liabilities, whereas seigniorage is revenue. Conversely, one could argue that the ability to finance our debts cheaply is the seigniorage. The problem with this reasoning is that if our currency were not a reserve currency at all, then (by definition) all of our trade deficits would be used to buy future American goods and services, or else equities. In other words, either our import-export flows reflect the international community maximizing gains from trade; or, as is really the case, US exports are deflected downward, and imports upward, reducing efficiency and reducing demand for US-value addition. So, for example, it would be the same if a gigantic world tax were imposed on American exports (pushing down price and quantity sold), but Americans are able to borrow the difference.

Isn't this all a US plot to control the world and cripple other economies?
Hardly. The biggest difference between American society and European society is the lack of cohesion. European states can levy high taxes because Europeans anticipate high levels of state service. The same European can immigrate to the US, and vote Republican every time (they nearly always do!) because of a lack of institutional cohesion. It is true that the US government, unable to manage trade through domestic policies, applies the screws to other countries; anyone observing our trade relationships with Japan or, more recently, Europe, knows that invariably fails. Steel tariffs, for example, failed to accomplish anything at all beyond infuriating entire national populations.
So the evidence suggests that not only are Americans far too divided to approve of such an agenda (including amongst the elites), we can't make it work and all our efforts have been in the opposite direction. In terms of trade policy, the US government tries to combat deficits (and fails miserably), and to stimulate foreign investment in the USA (which increases the current account deficit). If you want evidence of a successful, cohesive American plot to suck up investment capital, there it is; because investors are treated like manifestations of Jesus here. But of course that would be incompatible with the whole BoP deficit scheme, so...

What are you, some kind of apologist for American policy?
That was a joke, but I'll answer it a little more seriously: if you really want to believe Americans are a secular demon, you shouldn't be reading this. I'm a student of economics, and also history. And the problem with a lot of radical ideology is that, stripped of pro forma protestations to the contrary, it invites despair because at its core it rests on the assumption that Americans are cohesive and collectively benefit from our awful foreign policies. In my experience, Europeans tend to be very receptive to this argument because they assume other societies are as cohesive as theirs; the concept of extreme social division and alienation is not one that comes naturally to them. The other problem is that, as I mentioned, Europe's wonderful social contract was achieved by centuries of state agency. On the continent, dirigisme goes back to the 17th century, and it intensified after the 1880's. In my essays on falangism, I tried to address this—that while a surfeit of state power can lead to oppressive fascist regimes, in the Western Hemisphere the risk to freedom has consistently come from elites destroying state agency and acting outside the [attenuated] legal framework. If you want to work for progressive change, look at other societies you admire and ask how they did it.

ADDENDA: Please note this story, also in the Moscow Times, 20th October. The article discusses the matter of euros versus US$ rather more soberly than the first MT article linked in this entry.

TRADE STATISTICS: The Census Bureau offers this PDFexplanation of NIPA terminology; I prefer this one at the Digital Economist. It includes this elegant summary:

Stage III: the U.S. is a young creditor nation (1920-1945)—There is a huge surplus in the current account due to large volume of postwar (WWI) exports. The capital account is now in deficit due to a great deal of U.S. investment in Europe for postwar reconstruction.
Stage IV: The U.S. is a mature creditor nation (1945-1980)—The current account has a merchandise deficit — exports < imports but an investment income surplus with a slight net surplus overall. -The capital account is in deficit largely due to postwar (WW II) reconstruction in Europe and Japan.

Stage V: (1980- )—There is a large (and growing) deficit in the merchandise accounts (The Trade Deficit) and a slight surplus in the investment income accounts. -There is a large surplus in the capital account partially to finance the above merchandise deficit (foreign individuals and banks lending money to individuals in the U.S.) Additionally, since the U.S. has had a low inflation rate since 1982 and consistent economic growth, the U.S. has been a good place to invest relative to the rest of the world. However the current inflow of capital investment could eventually lead to large investment income payments in the near future. The investment income surplus we now enjoy may soon be eroded thus worsening the current account deficit.

Here is the 10 October release of trade statistics from the US Commerce Dept. Here is a superb quick reference page from the US-DoC Bureau of Economic Analysis, with the international investment position.