The United States had reasonably balanced trade for about 70 years from the turn of the 20th century until the OPEC oil crisis in the 1970s when it began suffering increasingly regular trade deficits. These deficits have grown over the last 50 years to the point that, in recent years, America has sometimes accounted for up to 60-70 percent of all bilateral trade deficits in the world. Why did this happen?
By definition, trade deficits indicate that a country's exchange rate is overvalued. Yes, a trade or current account deficit of up to roughly 3% of GDP may be “sustainable” if the country is growing by 3% per year and debt service costs are not rising; in such cases, the outstanding debt will not rise as a share of GDP. However, for reasons that go well beyond the scope of this note, such trade deficits are rarely desirable. In any case, if there is a trade deficit, the currency is by definition overvalued with respect to the rate that, all other things being equal, would produce balanced trade. Thus, the question to be answered here is this: Why has the US currency been overvalued for about 50 years?
Changes in Exchange Rate Systems
The simple answer is that, because of the dramatic change in the early 1970s in the way exchange rates are determined, the dollar's exchange rates for the past 50 years have had little or no connection to the dollar exchange rates needed to balance American trade.
• As explained by the Scottish philosopher-economist David Hume in the late 1700s, with the gold standard, domestic prices adjusted automatically to maintain balanced trade. When a country ran a trade deficit and started running out of gold, the domestic money supply would shrink, a recession would be triggered, and domestic prices would fall. This would make the country's exports more price-competitive internationally and make its imports more expensive relative to domestic products. The country’s trade deficits would naturally shrink, and trade would rebalance.• Gold Standard: Until the 1970s, exchange rates were generally fixed in terms of currency units per ounce of gold. For example, an ounce of gold from 1934 to 1972 was priced at $35.• Floating Exchange Rates: After the gold standard was abandoned in the early-1970s, the world went from fixed to floating exchange rates. Since then, the dollar’s exchange rate has been determined by the global demand and supply for dollars in the world’s foreign exchange markets.
This means that, since the 1970s, exchange rates for the dollar have been set, not by the balance between imports and exports as in Hume’s time, but rather by the world’s for-profit, speculative forex markets.
Further evidence that exchange rates are now set by speculative currency trading is the relative size of the global markets for real goods and services compared to the size of global foreign exchange markets as shown in the chart below, which is based on data from the Bank for International Settlements (BIS). The change has been truly dramatic.
Less than 40 years ago, forex market turnover per year was “only” twenty times the size of foreign trade turnover in goods and services. Today, with the increasing financialization of world trade and the hourly speculation in currencies, the forex transaction volumes have been running eighty to ninety times real export/import transactions.
This demonstrates beyond doubt that the largest factor determining exchange rates today is transactions in private for-profit forex markets. The solution to our trade deficits thus lies in moderating the casino-like flood of money into America's forex markets.
Furthermore, the global demand for dollars and dollar-based assets is greatly increased because of the facts that the dollar is the world’s premier currency for (a) invoicing and settling international transactions, (b) providing an “intermediary” currency for forex transactions involving non-standard currency pairs, (c) accessing America’s exceptionally strong/deep/liquid/broad financial markets, and (d) holding financial reserves— especially in times of turmoil. These factors driving excess demand for the dollar means that the dollar's exchange rate set in forex markets is inevitably higher than the exchange rate that would balance real US imports and exports.
Thus, for many reasons, the dollar is almost always overvalued and, as a result, America almost always has major trade deficits that reflect lost opportunities for growth.
For example, if the trade deficit was three percent and we reduced it to zero from one year to the next by increasing exports and by replacing imports with globally competitive domestically-produced goods, GDP growth would increase by roughly three percentage points. In reality, the change would probably take several years so the annual boost to economic growth would be less, but the principle is the same. Regardless of what some people may say, trade deficit drags on growth are a reality.
Unfortunately, this is seen in America’s growth rates since the trade deficits began in the 1970s. Over the past 50 years, average economic growth in America has slowed by about half.
Even more important are the hidden costs of our trade imbalances such as lost jobs, lost family incomes and lives, lost communities, and lost lines of production due to offshoring. With our needless trade deficits and budget deficits caused to a significant degree by the overvalued dollar, we are literally living beyond our means and stealing from future generations in the process.
The MAC can fix these problems because it would restore balanced trade for America.
America Needs a Competitive Dollar - Now!
