Deficits and the Dollar
Contrary to what many people seem to believe, a simple, straightforward relationship does not exist between a nation’s current-account balance and movements in its trade-weighted exchange rate. A current-account deficit need not produce a currency depreciation, and an exchange-rate appreciation need not cause a current-account deficit. A nation’s current-account balance and the value of its exchange rates result from the consumption and savings choices of individuals across the globe—all 6.6 billion of them. Many patterns of current-account balance and currency movement are possible, depending on the underlying factors that drive them.
Imagine, for example, that holding everything else in the world constant, aggregate demand in the United States increases, and as a consequence, U.S. citizens increase their imports from abroad. Any existing current-account deficit will then widen. Since U.S. residents need foreign currencies to buy foreign goods, their demands for imports will drive up the value of foreign currencies relative to the dollar. The dollar will depreciate.
This scenario needs one more element to be complete. As we previously explained, an inflow of foreign savings must match any current-account deficit. The dollar’s depreciation will also make our financial assets look more attractive to foreigners, who now are consuming less than they produce (otherwise they could not ship goods to the United States) and saving the difference. The inflow of foreign savings will exactly match the current-account deficit.
A second example, however, shows just the opposite relationship between the current-account balance and the exchange rate. Again holding everything else in the world constant, allow that foreigners—for whatever reason—decide to save more of their income and to channel that savings into U.S. financial assets. In the process of buying U.S. financial assets, they will drive up the value of the dollar relative to their own currencies. The dollar’s appreciation will also raise the foreign-currency prices of our goods, lower the dollar price of foreign goods, and shift worldwide demand away from U.S. products. The resulting current-account deficit will be associated with a dollar appreciation.
From the relationships described in these scenarios, we can often infer the source of U.S. current-account deficits. Between the end of 1995 and early 2002, for example, the dollar appreciated 28 percent on a real trade-weighted basis, and the trade deficit increased from 1 percent of GDP to 4 percent of GDP. At the time, the United States was experiencing strong productivity growth. The resulting high yields on investment attracted an inflow of foreign savings, which helped to finance an investment boom in the United States. The inflow of foreign savings fostered a dollar appreciation that led to larger U.S. current-account deficits. This pattern closely fits Chairman Bernanke’s “savings glut” description of the U.S. current-account shortfall.
More recently, however, the pattern has been somewhat different. Since early in 2002, the U.S. dollar has depreciated nearly 17 percent, and the trade deficit has expanded from 4 percent of GDP to roughly 6 percent of GDP. Unlike the previous period, this pattern of deficit and exchange-rate movement is not consistent with a pure savings-glut scenario. In recent years, as aggregate demand in the United States has grown, we have consumed more of the world’s resources. In the process, the current-account deficit has expanded, and the dollar has generally depreciated. The dollar’s depreciation has made our financial assets more attractive to foreign savers and induced an inflow of foreign savings commensurate with a growing trade deficit.
In 17 of the past 26 years (65 percent), the correspondence between changes in the U.S. current account and movements in the real trade-weighted dollar suggest that decisions about where to place savings have driven the adjustments. Of course, myriad factors can affect those decisions.