By Frances Coppola
Economist Brad Setser at the independent, nonpartisan Council on Foreign Relations suggests, instead, that the combined dynamics of international financial flows and trade imbalances could have led to the dollar's weakness in January. "The amount of funding the U.S. needed to cover its trade deficit rose just as investors concluded that Europe was growing as fast as the U.S. and the private outflow of capital from China faded," he wrote.5
Businesses planning international exchange rate hedging strategies may wish to consider Setser's analysis.
Economic theory says international exchange rates that don't float freely can cause trade imbalances. In other words, a persistently overvalued dollar can raise the price in foreign currency of U.S. exports, while depressing the dollar price of imports from other countries. This makes U.S. exports less competitive overseas, and encourages U.S. consumers to buy imports. Conversely, a consistently undervalued currency – perhaps due to a fixed exchange rate – can effectively subsidize that country's exports, therefore discouraging imports. Thus, an overvalued currency may result in a trade deficit, and an undervalued currency a trade surplus.
Because of USD's dominance in the global financial system, international demand for the dollar and for dollar-denominated assets tends to outstrip the world's supply of dollars. While this enables the U.S. government to borrow at lower interest rates than any other government, it also means a strong dollar exchange rate. As a result, the U.S. has run a large trade deficit for many years.6
But Setser appears to imply that the causation suggested by traditional economic theory may actually be the other way around. Rather than overvalued currency resulting in a trade deficit, the trade deficit itself might actually cause movement in the currency exchange rate. So, the dollar's exchange rate decline in January may have been caused by a sudden widening in the trade deficit. And the U.S.'s trade deficit did indeed widen abruptly one month prior.7
The phenomenon that the U.S. dollar's global pre-eminence inevitably results in a trade deficit – and often a fiscal deficit – is known as the "Triffin Dilemma."8 It was the Triffin Dilemma that forced President Nixon to completely abandon the gold standard in 1971. And running a persistent trade deficit when a currency is fixed, to gold for example, could eventually lead to losing all gold reserves, as Britain discovered in 1931.9
Now, in today's "fiat" currency system, the U.S. can simply create (or allow international banks to create) all the dollars needed for international trade and finance. But producing the sufficient amount of currency for global trade and finance to run efficiently means that either international banks must lend copious quantities of dollars, or U.S. consumers must purchase an abundance of foreign goods and services. The dollars created then recycle back to the U.S. through foreign purchases of U.S. dollar-denominated assets, especially government debt but also foreign purchases of U.S. goods and services. Thus, the Triffin Dilemma still holds today. The U.S's persistent trade deficit and historically strong dollar exchange rate both reflect the U.S.'s so-called "exorbitant privilege."
Notably, Setser's argument is not that the trade deficit determines the international exchange rate. Rather, his analysis suggests that the U.S.'s trade deficit and the dollar exchange rate are both driven by the circular flow of dollars around the world's financial system. For example, the U.S. bought more goods and services in December, causing its trade deficit to widen (in this case, due to an increase in imports, rather than decrease in exports, according to statistics).10 That widening of the deficit increased the flow of dollars out from the U.S. to the world. If this were matched – or driven – by international demand for dollars, the dollar exchange rate would be unaffected.
But in January, international demand for the dollar weakened as investors switched to the Euro and the Euro's trade-weighted exchange rate rose on average in January 201811 while capital outflows from China fell.12 Consequently, by increasing purchases of imports, the U.S. was sending more dollars out into the world just as the international demand for those dollars was falling. The resulting fall in the dollar exchange rate showed the Triffin Dilemma in action – only reversed from the usual direction!
With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Why is the U.S. dollar so weak?,” World First; https://www.worldfirst.com/uk/blog/economic-updates/us-dollar-weak/
2. U.S Dollar Trade Weighted Exchange Rate, Major Currencies,” FRED Economic Data; https://fred.stlouisfed.org/series/DTWEXM
4. “Probability of three interest rate rises in 2018 rises over 50 percent,” Financial Times; https://www.ft.com/content/39b6f65d-82b5-3633-8cb9-0898aca1d5c8
5. “Do Not Overlook The December Trade Data,” Council on Foreign Relations; https://www.cfr.org/blog/do-not-overlook-december-trade-data
6. “U.S. Balance of Trade,” FRED; https://fred.stlouisfed.org/series/BOPGSTB
7. “US International Trade Data – Foreign Trade,” U.S. Census Bureau; https://www.census.gov/foreign-trade/data/index.html
8. “Triffin Dilemma,” FT Lexicon; http://lexicon.ft.com/Term?term=Triffin-dilemma
9. “How the Bank of England abandoned the Gold Standard,” Telegraph; https://www.telegraph.co.uk/finance/commodities/11330611/How-the-Bank-of-England-abandoned-the-gold-standard.html
10. “US International Trade Data – Foreign Trade,” U.S. Census Bureau; https://www.census.gov/foreign-trade/data/index.html
11. “Euro daily nominal effective exchange rate,” European Central Bank; https://www.ecb.europa.eu/stats/balance_of_payments_and_external/eer/html/index.en.html
12. “UPDATE 1-China Jan FX reserves rise for 12th month as yuan rallies,” Reuters; https://www.reuters.com/article/china-economy-forex-reserves/update-1-china-jan-fx-reserves-rise-for-12th-month-as-yuan-rallies-idUSL4N1PX46D
13. “Devotions on Emergent Occasions,” John Donne; https://web.cs.dal.ca/~johnston/poetry/island.html
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