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Trade Deficits and Weakening Dollars Essay

Economist Frank Shostak offers an unpopular view of the United States’ trade deficit and its effect on the country’s economy. The view is widely held that an increasing trade deficit ultimately leads to the unwillingness of other nationals to hold the American currency. The effect of such a development would be an ultimate decline in the United States’ dollar exchange rate.

When United States nationals converts its dollars to that of another country, say the Japanese Yen, in order to procure their goods, this might be considered as the existence of a demand for Japanese money. This demand arises as a result of a demand for goods produced in Japan. If such demand is no reciprocated—that is, if this American demand for Japanese products is not answered by an equal demand by Japan for American products—then this could lead to a trade deficit.

The important aspect of this trade deficit lies in the fact that the demand for American goods is not as great as American demand for foreign goods. On some level, money can be considered as a commodity—especially for the purposes of investment where interest becomes the price of money. When the demand for American money decreases, the price of money also decreases.

Interest rates are an important part of economic growth as it denotes (in the most simplified sense) the worth of such strictly monetary transactions as investments, lending, savings, etc. It would appear that when the price of money decreases, the worth of money would also decrease, and this leads to a disparity between the worth of the U.S. currency and that of the Yen—in favor of the Yen.

Shostak argues otherwise. Though he concedes that the trade deficit is related to the exchange rate of the U.S. currency, he does not consider the trade deficit to be the deciding factor of that exchange rate. Rather, he considers the deficit an unfortunate result of that decline in the exchange rate. The U.S. monetary policy is what he blames. He considers a wanton increase in the money supply as having precisely the same effect as counterfeiting.

Below is a table showing the changes in money supply, interest rates, trade deficit and GDP between 1987 and 2005. Here it can be seen that a fall in GDP does occur in relation to a fall in interest rates. Though the decrease appears small, the comparison should not be exaggerated, as many fluctuations occurred in between the given time period. It does show an overall decrease in the net deficit, but this is shown as a percentage of GDP. The effect of one on the other is therefore not clear from this table.

Money Supply (1987 = baseline)Interest Rates
1987200519872005
100%273%6.5%1%
Net Deficit (as % of GDP)Gross Domestic Product
1987200519872005
~8%6.3%~3.4%~3.3%

(Naito, Norrington & Yamaguchi; Elwell, 8).

However, according to Shostak, when the U.S. money supply increases in relation to that of another country (say Japan), yet all else remains the same, the amount of money competing for essentially the same amount of output rises. This scenario mimics a rise in demand, which leads to a rise in prices according to the price elasticity theory of demand. When this occurs, the comparison between the prices of two similar products in the United States and Japan yields an elevated price in U.S. dollars and therefore a deflated U.S. currency.

This comes from the principle of purchasing power parity. However, it might be argued that the fall in the U.S. exchange rate could have the effect of reducing the trade deficit when the amount becomes expressed in terms of other nations’ currencies. The final analysis is that Shostak’s theory appears convincing especially in light of the rise in the U.S. monetary supply that seems to exceed GDP growth (see table) and the current weakening of U.S. dollar on the global market. The U.S. exchange rate in comparison with the Eurodollar fell 40% between 2001 and 2004 (Evans, 2).

Works Cited

Elwell, Craig K. The U.S. Trade Deficit: Causes, Consequences, and Cures. Congressional Research Services, 2006. http://www.usembassy.it/pdf/other/RL31032.pdf

Evans, Edward A. Understanding Exchange Rates: A Weakening U.S. Dollar—Good, Bad, or Indifferent for Florida Farmers and Agrobusinesses? Gainesville: University of Florida IFAS. 2005 http://edis.ifas.ufl.edu/pdffiles/FE/FE54600.pdf

Naito, Yuki, Robert C. Norrington, & Keiko Yamaguchi. “The United States.” A Multi-country Evaluation of Trade Imbalances. Ed. Steven Suranovic. Washington DC: George Washington Universtiy. 1999. http://internationalecon.com/tradeimbalance/US.html

Shostak, Frank. “Does the widening U.S. trade deficit pose a threat to the economy?” The Daily Reckoning. 2006 http://www.dailyreckoning.com/Featured/ShostakDeficit.html

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