Trade is as Important as Capital Flows in Valuing the Dollar and Impacting the Economy

Background

In the mid-1960s, as the debate over fixed vs. flexible exchange rates was heating up, I did some research on one of the principle arguments for flexible exchange rates - that they help insulate a country from foreign economic conditions and cycles and thus provide independence for domestic monetary policy.  In addition to a review of the theoretical literature, I used the Canadian experience with flexible exchange rates in the 1950s as a case study.

Under fixed exchange rates a foreign expansion or inflation was transmitted to the domestic economy via an increase in foreign demand for home country exports.  With the exchange rate fixed, the resulting increase in net exports, other things equal, would stimulate the domestic economy, with the split between real growth and inflation determined primarily by the degree of slack in the labor market.  Foreign weakness would be imported via a slowing of home country exports and a reduction in net exports.

With exchange rates fixed, restoration of each country's external balance had to take place through changes in the internal economic variables - nominal prices, incomes, interest rates, etc.  Inflation contagion would come through domestic expansion triggered by an expansion of net exports.  Foreign weakness would be transmitted through the reduction in aggregate demand domestically triggered by a reduction in net exports.  In keeping with the practice of the early to mid-1960s, I just used Keynesian "aggregate demand" language to summarize the process.  The same outcome could be described by the classical language of monetary expansion or contraction.  This was done primarily in the context of the gold standard.

The adjustment mechanism acted as an automatic stabilizer for domestic shocks.  A domestic recession would increase a country's net exports by curbing import demand while a domestic inflation would reduce net exports by increasing import demand.  Those changes in net exports would reduce the domestic impact of a domestic shock, but, in doing so, it transmitted the domestic shock, at least in part, to foreign trading partners. 

The monetary authorities under a gold standard's "rules of the game" were supposed to allow or even reinforce the domestic adjustments needed for international balance.  Under other fixed-rate systems, such as the one established at Bretton Woods at the end of World War II, monetary authorities were supposed to achieve through policy what was supposed to occur automatically by the flow of gold.  Hence, the lack of monetary independence under fixed rates.

Proponents of flexible exchange rates argued that movements in the exchange rate would bring about the necessary international adjustments with less trauma to domestic economies.  If internal prices and wages were flexible in both directions, the domestic impact of adjustment would amount to the same under the two systems.  However, in reality, prices and wages were not very flexible in a downward direction; so a country undergoing what would have been disinflation or falling internal price and wages would experience unemployment and recession.  This in turn led the monetary authorities to break the "rules of the game" to support the domestic economy.

Flexible exchange rates would, in effect, make sticky domestic prices and wages flexible internationally.  Depreciation in the home currency would reduce real wages without the need to reduce nominal wages and suffer unemployment.  Workers' real incomes would decline to correct an external deficit, but the decline would be spread more broadly and the brunt of the adjustment wouldn't have to be borne by the newly unemployed.  Home currency appreciation would achieve external balance without the need for domestic inflation.  The higher prices would be seen abroad, but not at home.

Getting Closer to the Point

Note that my over simplified discussion above, which, nevertheless, captures the essence of the exchange rate debate prior to the mid-1960s, all the focus is on international trade while capital flows weren't mentioned.  The reason is that the capital account transactions were viewed primarily as financing trade.  If trade balances, so does the capital account.  A trade deficit would be financed by a net capital inflow of the same amount.  A trade surplus would be matched by a net capital outflow.  Capital flows responded to trade imbalances.

When I evaluated the argument for economic independence and insulation through flexible exchange rates using the Canadian flexible-rate experience of the 1950's, the theoretical expectations were only partially confirmed.  The problem was that there were "independently motivated" capital transactions over and above those that were passively financing trade.  I assume that had always been the case, but it was rarely mentioned in the literature up to that time.  In the real world, however, flexible rates - while better than fixed rates in my opinion - don't fully deliver on the promise of insulation and independence because of complicating capital flows.

Over the years, independently motivated capital flows have grown so much that one might even make the counter intuitive argument that trade finances capital flows as much as capital flows finance trade.  The accounting balance remains intact (double entry accounting), but the automatic equilibrating mechanism is not allowed to work.  As I've written before, the balance in our balance of payments is a balance of imbalances.  There is nothing sacred about any given "equilibrium" exchange rate, meaning the rate that prevails during external "balance."

The Point

All the above is really background and context to my main point, which is that just as capital flows used to be ignored while all the focus was on trade, it has gotten to the point where the opposite is now happening.  Commentators today routinely discuss the dollar exchange rate while ignoring trade or even dismissing it as a significant factor.  If cause and effect are mentioned at all, interest rate differentials are seen to influence capital flows.  But most recent calls for a stronger dollar don't even mention interest rate differentials as a way of attaining the desired exchange rate.  They mostly just want the dollar to be "talked up" by the President, the Treasury Secretary, or the Chairman of the Fed.  Dollar "levitation" is the word that comes to mind.

Focus on the dollar without including imports and exports can lead to some strange conclusions and recommendations.  For one thing, just about everyone on financial television these days says a strong dollar and a strong domestic economy go together, and more often than not they treat a strong dollar as the cause and the strong economy as the effect.  However, other things equal, a levitated dollar will weaken the domestic economy by increasing import demand.  A dollar pulled up by growing export demand or import substitution at home, on the other hand, is consistent with a strong domestic economy, but they are still not cause and effect.  The stronger dollar and the stronger economy are both are the result of a third cause - an increase in export demand.

While a strong economy doesn't lead to a strong dollar and a strong dollar doesn't lead to a strong economy, anticipation of a better investment climate domestically probably will strengthen the dollar. To be even more precise, an expectation that your economy is becoming a more attractive location for foreign investment will attract capital and, other things equal, strengthen the dollar.

I have argued for some time that the recent dollar weakness will be self reversing when investors decide it has reached bottom and the next move is more likely to be up than down.  Unlike international trade, where the level of the dollar matters; with foreign investors, the level doesn't matter nearly as much as its anticipated change during their investment horizon.  They want to get out at an exchange rate higher than when they got in, or at least no lower.  The shift in expectations appears to have begun recently and the dollar is on the rise.  In addition, the fall in the price of oil and other imported commodities is reducing our net export deficit and boosting the dollar through a shrinking trade deficit.

It isn't clear yet whether the recent rise in the dollar is explained more by trade changes or capital flows.  Net exports, which have been a very large negative for a long time, have recently become less negative, and have therefore been a positive for GDP growth.  But net export changes can be affected by capital flows as well as trade flows, although, in the end, the balance remains.  

Exports have been responding well to the more competitive dollar for some time now, but in the second quarter of this year, the reduction in imports provided an even bigger boost to GDP than did the increase in exports.  As indicated in my previous posting, preliminary estimates indicate that the trade in goods and services contributed 2.4 percentage points to the 1.9 percentage point increase in real GDP.  In other words, net export improvement accounted for more than the entire increase.

The timing of the recent reduction in oil prices and the more recent strengthening of the dollar is the opposite of what most pundits have been telling us.  Their emphasis has been on getting the dollar up to get the oil price down.  That may have worked, but what we know worked is that lower oil prices contributed to the rise in the dollar.  Exports have been doing well for some time, but imports have kept pace in large part because of the effect of higher oil prices on import values.  If oil prices go lower, or even not rise, the prospects for further stimulus from the trade sector are excellent.