One of the areas of surprising (to me) strength in the U.S. economy thus far this year has been the improvement in the trade deficit. Strong growth in exports coupled, with sharply slower growth in imports, has offset some of the impact of the housing crash. For this reason, I was struck by an article in the Financial Times this morning telling readers that the declining dollar had done almost nothing to redress international trade imbalances. The FT supports its case with a chart that shows the U.S. trade deficit hovering near $800 billion since early 2005. The problem with the FT chart is that it is showing imbalances in nominal dollars. The U.S. trade balance has been increased by the sharp rise in oil prices over the last two years. In real terms it has fallen substantially since its peaks last year. For 2007 to date, the trade deficit in real terms is down by more than 6 percent, and a year over year comparison of the last quarter shows a drop of 11.7 percent. It is hard to believe that anyone could have expected a more rapid decline. The FT charts conceal large changes in trade flows because they only look at nominal flows. Since the rising price paid for oil has largely offset the change in trade flows, it appears that little has changed. (Actually, even here the FT is not really conveying the information on its chart well. The deficit had been rapidly growing until 2005, at which point it leveled off. This is an important change, with the deficit shrinking as a share of GDP over the last two years, as opposed to growing.) The article also asserts that China is prevented from raising the value of the yuan relative to the dollar because it would mean that they would lose money on their holdings of dollar reserves. The Chinese central bank surely knew that it would lose money on these reserve holdings when it first acquired them. It is hard to believe that this could be a major concern in their decision to set the value of the yuan. It is also worth mentioning that a higher-valued yuan would do much to address the major problem for China cited in the article, an overheated economy and rising inflation. Raising the value of the yuan would reduce the price of imports, thereby dampening inflation. It would also reduce China's trade surplus, or at least slow the increase, thereby slowing economic growth.
--Dean Baker