Why Isn't the Weaker US Dollar Correcting the Trade Balance Deficit?

There is a well known function in economics that says that if trade imbalances exist between countries in a free market, currency differentials will adjust to normalize them back into an equilibrium balance. Some question this because they see 'a weaker dollar" but the Trade Deficit is not improving, and is actually becoming worse. Why is this? Is the function no longer valid?

The majority of market punters look at the familiar USDX Dollar Index, quite simply because this is what is traded if you are trading dollar futures.

The US Dollar Index® (USDX®) is a globally recognized benchmark for the performance of the US dollar. Futures contracts based on the USDX are offered exclusively by the New York Board of Trade, and are available for trading on the fully electronic platform of the Intercontinental Exchange (ICE) beginning on June 15, 2007

The U.S. Dollar Index® (USDX®) – the barometer of the U.S Dollar – has been around since 1973.

The New York Board of Trade is the designated futures market and exclusive global marketplace for U.S. Dollar Index® (USDX®) futures and options on futures contracts.

The USDX futures have traded exclusively in the NYBOT currency markets since 1985. USDX futures and options represent useful financial instruments for those who wish to hedge currency risk exposure or to take an investment position in the U.S. dollar without the exposure to a single currency pair.

The Federal Reserve maintains some indices that are 'trade weighted' meaning that the currencies included and the percentages by which they are weighted are based on the level of mutual trade that the countries conduct with the United States.

Let's take a look at the Fed's trade weighted indices, their components, and what they might be telling us.

From looking at this chart, the high and low lines, Other Important Trading Partners and Major Currencies answer two very important questions.

The Other Important Trading Partners is dominated by the Asian export countries, who have adopted a mercantilist industrial policy with regard to the US markets. China, for example, devalued the yuan by a about 40% in 1995, and has maintained currency controls and a dollar peg since then, with the agreement of first the Clintons and then the Bush Administrations. The oil exporters have been maintaining a de facto dollar peg as well.

The reason our trade deficit has not yet corrected is because the major imbalances (but not overall trade) are held with countries that have not yet allowed their currencies to decline significantly against the US dollar. The free market portion of that theory is not being applied. An imbalanced currency peg has a similar effect on trade as tariffs and import restrictions and export subsidies, and don't let anyone tell you otherwise because its fairly straightforward math. The fact that both Messrs. Bush and Clinton acquiesced to China without demanding a free market in their currencies, even on a schedule, represented a significant blow to US manufacturing base, but a significant windfall to the financial sector and Wall Street. The fact that economists defend this as benign shows how the financial system has corrupted the economics, regulatory, and accounting professions.

The second important index is Major Currencies. This is what we like to think of as the basket alternative for the US dollar as global reserve currency. For many years the US has been able to maintain a dollar hegemony which, backed up with over 700 military bases around the world, has allowed it to essentially print dollars as the most universally currency, tightly tied with the dollar oil peg with the Saudis, and to a great extent manipulate world finance and trade.

What the British navy was to the British Empire, the US dollar is to the American financial empire, maintained with military muscle.

Think about this a bit, and consider the implications, especially the British experience as they moved from the Victorian era through the 20th century and their colonial empire unraveled, in a surprisingly graceful manner as compared to several alternatives. In a subtle way the United States is in a similar position after the American Century. (cf. The Project for a New American Century of the neo-Cons)

Some believe that the American empire will never decline, and that the dollar can never be replaced as the currency of the world. Where then is the glory of Greece, the grandeur of Rome? Troy, Persia, Alexander of Macedon? The Ottomans, the Byzantines, the Egyptians? Austria-Hugary? Napoleon? the Shogunate? Third Reich? the Chin, Han, and Zhou? the Mayas and Incas? Mongols? Ubi sunt?

All gone. Cremated to ashes on the bonfire of the vanities. What remains are statues, some tools, broken monuments, literature, philosophy, sciences, and their gold and silver coins and adornments. Nothing else remains. The wheel of God's justice grinds slowly, but exceedingly fine.

I met a traveller from an antique land
Who said: Two vast and trunkless legs of stone
Stand in the desert. Near them on the sand,
Half sunk, a shatter'd visage lies, whose frown
And wrinkled lip and sneer of cold command
Tell that its sculptor well those passions read
Which yet survive, stamp'd on these lifeless things,
The hand that mock'd them and the heart that fed.
And on the pedestal these words appear:

"My name is Ozymandias, king of kings:
Look on my works, ye mighty, and despair!"

Nothing beside remains: round the decay
Of that colossal wreck, boundless and bare,
The lone and level sands stretch far away.

Ozymandias, Percy Bysshe Shelley

Quis Custodiet ipsos Argentarii?

Who will watch the Money Lenders?

G7 discussed joint action if market moves irrational

BRUSSELS, Feb 11 (Reuters) - Finance ministers and central bankers from the Group of Seven industrialised nations discussed collective action to calm markets if price moves become irrational, Eurogroup Chairman Jean-Claude Juncker was quoted as saying on Monday.

Juncker, who chairs the Eurogroup -- the monthly meetings of the ministers and the European Central Bank, told the Luxemburger Wort newspaper in an interview that turbulence on financial markets could continue for months.

"We are not yet at the end of the market crisis," Juncker was quoted as saying.
"The corrections will drag on for a few weeks, months. We have agreed in Tokyo that if there are irrational price movements in the markets, we will collectively take suitable measures to calm the financial markets," he said.

Asked what form such collective action may take, he said:

"Whoever has a strategy, should not set it out. Otherwise it will lost its effect if it is explained."

Oui, Monsieur Junckers. And we, the populus, should have a plan for dealing with willfully irrational financial systems as well.

Political Circuses, but Where's the Bread?

For those of us who enjoy a voyeuristic fascination with the US political process, the 2008 presidential election continues to satisfy beyond all expectation, even for an election that will likely choose a leader who, for better or worse, will be inheriting a mantle similar in many ways to that of Franklin Delano Roosevelt.

The flip flops have been breathtaking.

The Republicans

Not all that long ago, Rudy Guiliani was among the emotional and poll tested frontrunners for the Republicans, whereas John McCain was floundering in terms of money and momentum, with Mitt Romney clearly the annointed choice of the powerful conservative wing of the party.

Mike Huckabee was appealing for his personality and no apology backwoods persona, with Fred Thompson a polished version of the same with a faux-Reaganesque patina. Remember when Fred announced his candidacy on late night television to breathless anticipation? And of course, Mike Bloomberg stood ready to come in to a possibly brokered convention to save the day. Ron Paul always had the mark of a third party candidate in this party of ultimate insiders.

Cut to February 2008, with Mike Huckabee having morphed into the evangelical alternative to the front running John McCain who is anathema to the conservative and religious base of the Republicans, excepting his pronounced hawkishness for war. Thompson turned out to be asleep on the porch, and Romney and Guiliani folded their cards faster than a three card monty game when the police come round the corner. The Guiliani collapse was breath-taking, possibly setting a record for the most money spent to obtain one delegate. Rudy may find a life as the designated Homeland Security Chief, but he would probably prefer attorney general. Romney's fold was most likely a deal of sorts, with some big backing having shifted to McCain behind the scenes.


The Democrats

What started out as the most motley collection of candidates in recent memory has sorted itself out to two frontrunners, and now appears headed for a brokered convention with the opportunity for controversy on the level of the 2000 US elections, hanging chads and all. A brokered convention is one is which the candidate is not chosen by the primary votes, but in back room deal-making by the party politicos.

Barack Obama came seemingly out of nowhere, and having gathered significant backing from key elements of the Democratic party (celebrities and Kennedys), has nudged the Lady Hillary sufficiently to make her weep quietly (although we would view those tears with the same caution as we would the rattles from a desert viper).

In primary election delegates Hillary and Obama are running neck and neck, with Obama having pulled ahead in the donations area. This is a remarkable turn of events given the Clinton reputation for pulling in the big donation bucks. And the 'first black president' Bill Clinton turned into a pale comparison of his former self when his condescending remarks sounded presumptuous. There is an obvious Clinton fatigue in the country which the Democrats would do well to observe.

This election is remniscent of the 1976 elections that catapulted the relatively unknown Jimmy Carter into the Presidency, as the after shocks and weariness of the Nixon presidency drove the public to cast their votes for CHANGE. After Bush, we're there again.

Time to start keeping a close eye now on the Democratic delegate counts. And be aware that no matter how the actual primary elections turn out, the democratic contender may very well be chosen at the convention by party regulars who are unelected and not obligated by any of these pre-election votes. Won't it be something if Obama goes into the convention with the delegates, and the Clintons manage to deal for the actual nomination behind closed doors? After all, Slick Willy himself is a super delegate. McCain could ask for no better break.



Let the games begin!

US Dollar Long Term Chart

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