Question:
In May 2003, at an otherwise tranquil
meeting of the Group of 8 at the seaside resort of Deauville,
France, Treasury Secretary John W. Snow said that the
Bush administration would no longer measure the dollar's
strength by its market value against other leading currencies.
Instead, he suggested it would be measured by its credibility
and its resistance to counterfeiting (and held up a
redesigned multi-colored $20 bill to demonstrate this
new policy.)
This announcement was interpreted by financial markets
as a signal that the White House wanted a weaker dollar
against other currencies to remedy a US trade deficit
that was approaching a record half-trillion dollars
a year.
Is there any reason to believe that a devalued currency
necessarily results in a more favorable trade balance?
Answer:
No. Nations cannot change the terms of trade with the
rest of the world merely by changing the numerical values
of their accounting units. And currencies (even redesigned
dollars) are nothing more than accounting units. If
countries could work such financial alchemy, Latin American
and African countries that periodically devalue their
currencies by adding zeroes to them, would have massive
trade surpluses. But, no matter how much they devalue
their currency, they still have massive trade deficits.
The American dollar is no exception. When its value
is reduced against the currencies of its foreign trading
partners, adjustments are made by everyone concerned
to compensate for the change in the accounting unit.
If the value of dollar was cut in half, for example,
Americans would have to spend twice as much to buy the
same amount of foreign goods, which would leave them
much poorer in terms of buying power. And foreigners
would have to spend half as much to buy the same amount
of American goods, which would leave them much richer
in terms of buying power. Presumably these new prices
would induce changes consumer behavior with Americans
discouraged from buying the same quantity of foreign
goods and foreigners encouraged to buy a greater volume
of American goods. The issue is the extent of these
changes.
Even if a devaluation increases the number of units
exports and decreases the number of units imported,
the trade deficit can still grow larger because the
dollar value is less for each unit sold abroad and,
conversely, the dollar value is more for each unit imported
into the US. There is no law of economics that say says
a decrease in price is compensated by an increase in
volume (or everyone would make money by cutting prices.)
Just as a price cut may or may
not increase profits, a devaluation may or may not improve
the trade balance. Consider, for example, the recent
record. When President Bush assumed office, the Federal
Reserve Bank's Major Currency Index, which measures
so-called trade weighted dollars, was 100.2, and the
trade deficit was running about $33 billion a month.
By January 2004, the dollar had fallen by over 15 percent
to 84.4. Meanwhile, the trade deficit had increased
by 30 percent to a record $42.4 billion a month. So
the decrease in the value of the dollar did not improve
America's trade deficit.
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