The U.S. Economic Contraction and Trade Deficit: Quantifying Exchange Rate Fluctuations’ Impact on International Trade Flows
June 10, 2015
The United States economy’s first quarter statistics are out, and the results are not great. Despite forecasts of a 0.2% seasonally adjusted growth rate, US Gross Domestic Product actually contracted by a potentially worrying 0.7%. A number of factors are likely to blame for this decline: an unusually harsh winter that depressed consumer spending, the government potentially not fully accounting for seasonal adjustments, and declining business investments – especially in the energy sector which is still reeling from precipitously low oil prices. Arguably the single most significant factor, however, is bad news from the international trade sector, as a steep decline in net exports slashed nearly two full percentage points from GDP – the largest magnitude in 31 years. The reasoning behind this decline is clear: the value of the US dollar is rising. But why would a rising dollar be bad for the US economy? Read on for Wonk Tank’s analysis.
No Reason to Panic, But…
First, it’s important to temper the bad economic news with a clarification: it’s not time to panic about a failing economic recovery. This is because the economy’s first quarter decline is largely due to cyclical, rather than structural, factors. Heavy snow, statistical quirks, and energy price shocks induced by oil-producing countries ramping up supply are not permanent features of the economy. And parts of the economy which are less variable and arguably more indicative of long-term economic health – corporate profits, unemployment, inflation, and consumer spending – are either holding relatively constant or moving in a positive direction, albeit slowly.
Of course, there is still significant slack in the economy, and recovery from the recent recession is best characterized as “tepid,” but it would still be inaccurate to say that a first quarter economic contraction is evidence of significant structural drags.
All that said…
The US Trade Balance is a Real, Long-Term Problem
(Image: United States net exports since 1960. Source: Federal Reserve Economic Data)
Our figures for the measurement of GDP depend on the US Trade Balance: the value of GDP increases (or as has been the case, decreases) by the exact amount of US net exports – calculated simply as total exports minus total imports.
Whether a trade deficit is inherently a bad thing is not necessarily clear cut. It certainly makes the United States more dependent on the willingness of foreign countries to sell their products to us – but given the United States’ status as a politically stable and economically hegemonic world power, it’s unlikely that in our particular case we face a risk of countries ceasing to do business with America. Sustained trade deficits, however, do have the potential to depress national savings as capital flows overseas, and cause job losses because if demand for foreign-produced goods is higher, companies may move their operations overseas. And of course there are political arguments along mercantilist lines, the theory being that political power flows from economic power and the United States’ influence on the world stage is greater if countries rely on our exports but we do not have the same reliance on theirs.
What is clear, however, is that at least in an accounting sense, trade deficits are a fiscal drag that at least nominally decrease domestic product. As the figure above shows, net exports have cratered in recent decades as the US imports far more than it exports, with the first quarter 2015 numbers showing no sign of this trend abating.
We can break this trend into basically two components, one cyclical and one structural. Let us first focus on the cyclical factor, as it has more immediate relevance to the problem at hand.
Currency Valuation and Export Flows
The biggest reason for the decline in exports in the first quarter of 2015 was a stronger US dollar. The dollar rose in value in the first quarter at its fastest pace in 40 years, largely thanks to the US economy’s stronger recovery – “stronger,” of course, in only a relative sense compared to economies in Europe and Japan. This stimulated demand for US currency assets, which of course raises the price according to traditional supply and demand mechanics. Europe and Japan are also embarking on new monetary stimulus programs which consequently devalue their currency, consistent with exchange rate policy choices Wonk Tank examined in our monetary policy primer, as well as currency manipulation issues I discussed in the context of the Trans-Pacific partnership.
A stronger dollar may seem like a good sign for the US economy, but it is actually pretty terrible for net exports. Economic data shows a very direct and statistically robust correlation between historical trends in dollar valuation (modeled by the Trade Weighted US Dollar Index, a statistic which measures the value of the US dollar relative to a broad basket of international currencies) and US export levels:
(Image: Value of US Dollar versus American Exports as a Percentage of GDP. Source: Federal Reserve Economic Data. Note: Variables are indexed, expressed relative to their value in 1973, the first year for which the government publishes the dollar index, so they can be represented visually on the same graph. Indexing does not affect statistical components such as the correlation or R-squared value.)
The data shows a strongly negative relationship between dollar index and exports (expressed as a percentage of total GDP to control for overall growth in trade). Specifically, we would expect a 10 percentage point increase in the value of a dollar relative to its 1973 level to correspond with a 15-23 percentage point decrease in exports relative to their 1973 levels – a dramatic decrease showing exports to be highly sensitive to currency fluctuations.
That said, we can make our model more accurate. While a correlation of -0.58 is very statistically robust, it is not necessarily indicative of a high level of accuracy in our predictions, and our R-squared value indicates that only 34% of the variation in export levels can be explained by the model.
We can refine our model by returning to what was alluded to above: the structural component driving changes in export levels.
Put simply, the answer is globalization and trade liberalization. Since the collapse of the Bretton Woods system in the early 1970’s, the world’s major economies have been increasingly globalizing, opening up their borders, easing tariffs, and increasing their international trade flows – both exports and imports. Thus, exports have been steadily rising over time as a consequence of these policy decisions, even after controlling for natural economic growth by scaling export levels to GDP.
More accurately modeling the impact of the dollar’s value on international trade would require controlling for the overall increase in economic globalization – and luckily there are summary statistics that seek to do just that. In this case, we will use the KOF Index of Economic Globalization, which assigns countries an annual score between 0 and 100 measuring the extent to which their trade markets have been liberalized and globalized. Additionally, we can use inflation-adjusted (denoted as “Real”) figures for exports as a percentage of GDP to control for domestic currency valuation changes, and in this case we can use the actual values of exports as a percentage of GDP, rather than indexing them to their 1973 levels.
(Image: Summary Output of a Multivariable Regression of US Exports as a Function of Economic Globalization and the Trade Weighted US Dollar Index, followed by a visualization of the accuracy of the prediction model. Source: Compiled from Federal Reserve Economic Data and KOF Index Query site.)
Here we see a better estimation of the impact of the value of the dollar on exports. According to the data above, a 10% increase in the value of a dollar relative to its 1973 level would lead to a 0.7 to 1.1 percentage point decrease in exports – or, to convert to the scales used in our previous model, a 16-24% decrease in exports as a percentage of GDP relative to its 1973 level – assuming trade policy is unchanged.
This 16-24% figure is essentially unchanged from the result of our previous model. Thus, the data shows that even accounting for the structural economic effects of massive globalization and trade liberalization, as well as domestic currency changes in the form of inflation, export demand is still extremely elastic with respect to fluctuations in currency valuation.
While this data is not as easy to visualize in chart form, it is far more accurate. The multivariable correlation is approximately 0.897, which is extremely robust, and over 80% of the entire variance in exports as a percentage of GDP is explained by the model.
The result of all these econometrics is really quite simple. Demand for US exports is extremely responsive to the value of the US dollar (which we can think of as a proxy for the relative price of exports). And the dollar’s rising value is creating a substantial economic drag on domestic production levels, even as America’s economy continues to improve, relative to other advanced nations.
In the short run, the most sensible solution is arguably more expansionary monetary policy. Inflation in the US is at record lows; the Consumer Price and Personal Consumption Expenditure indices show year-over-year inflation figures of 0.1% and -0.2%, respectively. Factoring out food and energy prices increases those figures to 1.2% and 1.8%, respectively, but all of these numbers are still below the Federal Reserve’s 2% annual target. What this means is that the Fed has plenty of flexibility to expand the money supply and spur hiring and production – and plenty of options for doing so. While US interest rates are already at essentially zero in order to spur investment, other countries have experimented with cutting them to negative levels. Additionally, the Fed recently ended its Quantitative Easing program (despite its success in keeping the economy afloat during times of relative fiscal austerity), but such a program could easily be revived. Lastly, the Fed has more unorthodox policy options at its disposal, including just giving money directly to its citizens. Each of these policies would, aside from being beneficial in terms of direct monetary stimulus, increase the quantity of dollars available and thus decrease their international exchange rate value – benefitting both the domestic economy and American companies’ positions in international markets.
Regardless of one’s preference for the particular manner by which the Fed conducts monetary expansion, it is easy to see that the American economy is being hurt by unnecessarily tight monetary policy, especially relative to our peer countries. More stimulative monetary policy would serve as a course correction for the currently over-valued dollar, as well as give a jump start to the still languidly recovering domestic economy.
In the long term, the US still faces a massive currency problem, related largely to foreign governments and currency manipulation. Given America’s status as a dominant economic power, as well as the dollar’s former (and many would say current) status as the world’s reserve currency, countries – China is often cited as an example – stockpile US currency assets in order to drive up demand for the US dollar and thus artificially pump up its value and devalue their own currencies to make their exports more attractive.
(Image: China’s exports as a percentage of its total GDP, indexed to 1981=100, plotted alongside the yuan/US dollar exchange rate, also indexed to 1981=100. Notice how the yuan is massively devalued over the course of the 1980’s and 1990’s, losing nearly six times its exchange value relative to the dollar. Source: Federal Reserve Economic Data)
While some have argued that currency manipulation is not as great a threat as it is made out to be, because US consumers benefit from cheaper foreign goods, that view ignores the extent to which it hurts US producers and American jobs, and the extent to which it creates a fiscal drag on economic growth by negatively impacting the trade deficit.
In the long-term, the solution rests largely on the shoulders of the Fed, as well as the Office of the US Trade Representative. From the Federal Reserve’s perspective, the US central bank has to be more willing to directly combat currency manipulation: if the Chinese government engages in a massive purchase of US currency assets, the Fed must be willing to ignore its inflation hawks and print enough additional dollars to offset these actions. And from the perspective of international trade policy, Washington should demand restrictions on currency manipulation as a precondition of any free trade agreement, and use its power as an economic and political hegemon to influence trade policy writ large to reflect these objectives.
In short, America’s worrying first quarter economic contraction is not a reason to panic – but it should not be laughed off as a statistical quirk or chalked up to short term economic fluctuations either. A more comprehensive, coherent, and stimulative monetary policy is desperately needed in the short run as the US continues to struggle with its economic recovery, and more aggressive monetary and trade policy will be crucial to America’s long term economic health.
Here is a link to the Excel file with all of the data points, graphs, and econometrics used in this piece.
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