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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