Ref. No.

: MEBE0026

Trade Deficits, Current Account Deficits and

Exchange Rates in US: The Policy Implications

A fall in the value of the US dollar questions its endurance as the most popular reserve currency
of the world. It happened for the first time in 1977–1979, when the high rate of inflation in US
economy weakened the dollar. But US thwarted the crisis, when the Treasury sold Deutsch
Marks (DM) – denominated ‘Carter bonds’ worth $6.4 billion to raise funds – and defended the
dollar.1 The US dollar was again threatened in 1985 and 1995, due to the soaring gold price, and
these two were also managed. But since 2002 through 2007, the US dollar is falling continuously
(2005 being the exception) and this has become chronic, because of the weak economic
fundamentals mainly caused by a huge trade deficit. With recession looming large on the US
economy, the Federal Reserve (Fed) has to adjust the interest rate to bring the economy back on
track. But the central bank is in a tight spot about the direction of adjustment of interest rate, in the
face of depreciating dollar and weakening economy.

US Trade Balance: From Surplus to Deficit

During 1950s and 1960s, the US possessed a sizeable trade surplus. It helped war-ravaged
countries like Japan and Europe through the Marshall plan2 of 1947. This plan was evolved to
reconstruct the countries devastated by World War II. The Marshall plan was funded by the US
dollar, which in turn boosted the demand for US exports. During the four years from its implementation
in 1947, around $13 billion were used up for providing the necessary economic and technical assistance
for the war-torn countries. Consequently, US was regarded the world’s leading export powerhouse.
Increase in export demand helped its industrial sector grow up rapidly and the manufacturing sector
took a large chunk of this benefit.

1
“Losing faith in the greenback”, http://www.economist.com/opinion/displaystory.cfm?story_id=10208445, November 29 th
2007
2
US proposed for the Marshall plan, in July 1947, for rebuilding and laying a strong foundation for the future growth for the allied
countries of Europe which were devastated in World War II. This plan was named after the Secretary of State George Marshall.

This case study was written by Pretimaya Samanta under the direction of Saradhi Kumar Gonela, IBSCDC. It is intended to be used
as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case
was compiled from published sources.

© 2007, IBSCDC.
No part of this publication may be copied, stored, transmitted, reproduced or distributed in any form or medium whatsoever
without the permission of the copyright owner.

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 Trade Deficits, Current Account Deficits and Exchange Rates in US...

During the late 1950s and the first half of 1960s, the US trade surplus was estimated to be around
1% of its GDP (Gross Domestic Product).3 But the Marshall plan did have serious repercussions on
the US economy in the late 1990s, with Japan and Europe started to compete with the US in a range
of industries. This affected the demand for US exports which transformed to a trade deficit, a
situation which was largely unknown to the US economy. So from a trade surplus of 1% of GDP in
the beginning of 1960s, it reached a trade deficit of 6% of GDP in 20064 (Exhibit I). The increased
trade deficit deteriorated trade balances; the manufacturing sector was the worst hit. The reduced
demand for US exports compelled the employers to cut millions of jobs in the manufacturing sector.
The increasing trade deficit in US has also affected wage rates. Since the late 1970s, the wage rate
has been declining in US. And this rate cut in wages has severely affected non-college-educated
workers, who make up around three quarters of the total US labour force. 5 Most economists
acknowledge that the trade deficit has also augmented income inequality in the US.

Exhibit I
US Trade Balance with China
2.5 2.5
0.0 0.0
-2.5 -2.5
-5.0 -5.0
-7.5 -7.5
USD (billions)

-10.0 -10.0

billions
-12.5 -12.5
-15.0 -15.0
-17.5 -17.5
-20.0 -20.0
-22.5 -22.5
-25.0 -25.0
’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07

Source: “Where next for the US Economy?”, http://www.tutor2u.net/newsmanager/articlefiles/2559-

US_Economy_070907.pdf

However, this soaring trade deficit in US is because of many reasons. First, in the 1980s, as
global trade grew and manufacturing migrated from the US to lower-cost nations, increasing deficits
started to increase. Imports from emerging low-cost export nations such as Mexico, Malaysia and
China steadily widened the US trade gap. Secondly, a number of key foreign markets put non-tariff
barriers on US exports, contributing to an increase in the US trade deficit. Thirdly, these countries

3
Scott E. Robert, “The US Trade Deficit: Are We Trading Away Our Future?”, http://www.epinet.org/content.cfm/
webfeatures_viewpoints_tradetestimony
4
“Loosing Faith in the Greenback”, op.cit.
5
“The US Trade Deficit: Are We Trading Away Our Future?”, op.cit.

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 Trade Deficits, Current Account Deficits and Exchange Rates in US...

adopted export-led growth strategies with an aim of affecting the American markets, because they
are well known for their large size and openness. Fourthly, the countries whose currencies are
pegged against US dollar, continued to overvalue it, thereby gaining competitive edge over US
manufacturers. Fifthly, it was also claimed that the American industrial structure was not given the
required emphasis by the federal government. This transpired at a time when US’ industrial sector,
especially the manufacturing sector, was struggling against the increasing trade deficit. Sixthly, the
slow growth rate of the traditional trading partners (in sectors like heavy engineering, which booked
huge export volumes) such as western European nations affected the demand for US exports. This
reduction in the volume of US exports affected its trade deficits adversely.

US Trade Deficits & Strong Dollar: The Conundrum

In the last quarter of the 20th century, the US economy continued to suffer from trade deficits. In
the late 1990s, the situation turned grim as deficits increased by around $100 billion almost every
year from 1998 onwards and they reached a phenomenal $758 billion by 2006 (Annexure I). Looking
at this huge trade deficit, economists predicted a sharp decline in the value of dollar. But in contrast,
the dollar held its ground in the global currency market till 2002. This theoretical paradox, between
the trade deficits and the depleting US dollar, shows signs of an unbalanced US economy that is
excessively dependent on the strong demand from consumers and the government sector.
Several reasons explain this peculiar situation in the US economy. First, the strong dollar is largely
because of the surge in demand for US dollars in foreign countries. This surge in demand is driven by
the fact that most transactions in the international trade are carried out by the dollar denomination, as
it is the world’s most popular reserve currency. The recent hike in the oil prices has been largely
responsible for the increasing demand for US dollars. Secondly, there have been huge capital inflows
into the US markets. Fed’s tightened monetary policy has lured investors and currency speculators,
to invest in the US. Fed raised the interest rate 13 times, from 1% in June 2004 to 4.25% in November
2005 (Exhibit II), to contain inflation; but that has further lured the investors.

Exhibit II
US Base Rates
7 7
US Base
6 6
Rates
5 5
Percent

4 4
3 3
2 2
1 1
0 0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Source: “Where next for the US Economy?”, http://www.tutor2u.net/newsmanager/articlefiles/2559-

US_Economy_070907.pdf

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 Trade Deficits, Current Account Deficits and Exchange Rates in US...

Currency arbitrageurs took the benefit of this interest rate differential between the US and some
of its trading partners like the Japan. They borrowed money from the Japanese market, where the
interest rates are close to zero, and then put their money in the US markets to get better returns.
Strong growth in the economy (Exhibit III) and a better than expected performance of the US stock
market, for almost all the three decades through 2005, attracted huge inflows into its economy. Thus,
by the end of 2005, the US economy was largely ignoring the huge trade deficits – by standing on the
shoulders of a fast growing economy, rising interest rates and strong asset prices. However, this
trend is not likely to continue – in the face of a mammoth trade deficit and concerns over the possible
downward movement of the dollar.

Exhibit III
GDP Growth of US
Percentage rate of growth year on year at constant prices
5.0 5.0
4.0 4.0
3.0
Percent

3.0
Economic Growth
2.0 2.0
1.0 1.0
0.0 0.0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: “Where next for the US Economy?”, http://www.tutor2u.net/newsmanager/articlefiles/2559-
US_Economy_070907.pdf

The Mystery behind the Weakening Dollar

The dollar’s value has experienced a sharp fall in its value, vis-à-vis all the major currencies of
the global forex market since the late 2001. Except a few months in 2005, the value of the US dollar
continued to tumble against all other major currencies through to the end of 2007 (Exhibit IV). From
2002 to 2007, the US dollar depreciated by around 53.1% against euro, 36.5% against the Swiss
Franc and 31% against the Canadian dollar.6
Massive deficit in the US trade balances can be singled out as the most important reason for the
weakening US dollar. In 1998–1999, the US trade deficit started to show its first sign of a cosmic
increase – through an increment of around $100 billion, from a deficit of $166 billion in 1998 to a
deficit of $265 billion in 1999. And it stood at $758 billion at the end of 2006.7 The rate of increase in
the value of imports has been more than that of exports since 2002 through 2007. Oil imports, the
largest item in the US imports, have been growing continuously.Also, US imports have been augmented
by the consumers’ crave for Japanese automobiles, German machinery, Finnish mobile phones and
Chinese clothing – to mention a few.

6
Hodges Michael, “Grand Father Foreign Exchange Report”, July 2007, http://mwhodges.home.att.net/exchange_rate_a.htm
7
“The US Trade Deficit: Are We Trading Away Our Future?”, op.cit.

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 Trade Deficits, Current Account Deficits and Exchange Rates in US...

Exhibit IV
Weakening US Dollar
160 US Dollar Trade-weighted Exchange Rate
(Major Currencies Index: March 1973 – 100)
150
Plaza Accord 22 Sep. 1985 to
Strengthen JPY. weaken USD
140

130

120
Louvre Accord 22 Feb
110
1987 to stem USD decline
100

90
Sadomonctarism in US
80 and UK, US tax cuts
and Reagan defence
The Great Millennarian
70 build up
Boom begins 1996–2000
60
1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

Source: “The dollar’s slide: 1/3 down and falling faster”, http://ftalphaville.ft.com/blog/2007/11/07/8713/the-dollars-slide-
13-down-and-falling-faster

Besides the trade deficit, there are several other reasons for the weakening US dollar. Accounting
scandals at Enron (2001), WorldCom (2002), Tyco (2004), and many other companies revealed
serious loopholes in the US reporting and regulatory system. It put apprehensions regarding the US
stocks, bonds and other investments – leading to massive investment losses. All these shook the
confidence of the foreign investors and inflows into the US markets declined; instead, outflow
increased as investors liquidated their portfolios. Secondly, the US government budget deficits increased
from $158 billion in 2002 to $413 billion in 2004.8 Thirdly, US households have increased their total
debt to a level of $12,817 billion – of which around three-fourths is accounted for home mortgage.
This triggered the subprime crisis, which pulled down banks and other mortgage lenders. Net private
capital inflows into the US appear to have evaporated since the credit turmoil began. Fourthly, US’
far-flung military operations introduced enough uncertainty.
If the economic fundamentals of the US are weak, it will be difficult to maintain its status as
global superpower. Many believe that the US dollar may be on its way out as an international reserve
currency. Plausible parallels can be drawn between dollar’s recent fall and the decline of pound
sterling as a reserve currency 50 years back. Britain’s two hundred years of global supremacy was
based on a strong currency, a large trade surplus and growing foreign investments. A decline in
Britain’s trade balances foretold its Empire’s collapse in the late 19th and early 20th century. Given
what the US economy has gone through at the end of 2007 – like trade deficits, current account
deficits and the falling US dollar – the forecast is that it may lose its supremacy.
8
“US Government Budget Surpluses and Deficits: 1970–2006”, http://www.globalpolicy.org/socecon/crisis/tradedeficit/tables/
budgetdeficit.htm

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 Trade Deficits, Current Account Deficits and Exchange Rates in US...

Annexure I
US Trade in Goods and Services – Balance of Payments (BOP) Basis
($ millions)
Balance Exports Imports
Goods Goods Goods
Period Total BOP Services Total BOP Services Total BOP Services

1960 3,508 4,892 -1,384 25,940 19,650 6,290 22,432 14,758 7,674

1961 4,195 5,571 -1,376 26,403 20,108 6,295 22,208 14,537 7,671

1962 3,370 4,521 -1,151 27,722 20,781 6,941 24,352 16,260 8,092

1963 4,210 5,224 -1,014 29,620 22,272 7,348 25,410 17,048 8,362

1964 6,022 6,801 -779 33,341 25,501 7,840 27,319 18,700 8,619

1965 4,664 4,951 -287 35,285 26,461 8,824 30,621 21,510 9,111

1966 2,939 3,817 -878 38,926 29,310 9,616 35,987 25,493 10,494

1967 2,604 3,800 -1,196 41,333 30,666 10,667 38,729 26,866 11,863

1968 250 635 -385 45,543 33,626 11,917 45,293 32,991 12,302

1969 91 607 -516 49,220 36,414 12,806 49,129 35,807 13,322

1970 2,254 2,603 -349 56,640 42,469 14,171 54,386 39,866 14,520

1971 -1,302 -2,260 958 59,677 43,319 16,358 60,979 45,579 15,400

1972 -5,443 -6,416 973 67,222 49,381 17,841 72,665 55,797 16,868

1973 1,900 911 989 91,242 71,410 19,832 89,342 70,499 18,843

1974 -4,293 -5,505 1,212 120,897 98,306 22,591 125,190 103,811 21,379

1975 12,404 8,903 3,501 132,585 107,088 25,497 120,181 98,185 21,996

1976 -6,082 -9,483 3,401 142,716 114,745 27,971 148,798 124,228 24,570

1977 -27,246 -31,091 3,845 152,301 120,816 31,485 179,547 151,907 27,640

1978 -29,763 -33,927 4,164 178,428 142,075 36,353 208,191 176,002 32,189

1979 -24,565 -27,568 3,003 224,131 184,439 39,692 248,696 212,007 36,689

1980 -19,407 -25,500 6,093 271,834 224,250 47,584 291,241 249,750 41,491

1981 -16,172 -28,023 11,851 294,398 237,044 57,354 310,570 265,067 45,503

1982 -24,156 -36,485 12,329 275,236 211,157 64,079 299,391 247,642 51,749

1983 -57,767 -67,102 9,335 266,106 201,799 64,307 323,874 268,901 54,973

1984 -109,072 -112,492 3,420 291,094 219,926 71,168 400,166 332,418 67,748

Contd...

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 Trade Deficits, Current Account Deficits and Exchange Rates in US...

1985 -121,880 -122,173 294 289,070 215,915 73,155 410,950 338,088 72,862

1986 -138,538 -145,081 6,543 310,033 223,344 86,689 448,572 368,425 80,147

1987 -151,684 -159,557 7,874 348,869 250,208 98,661 500,552 409,765 90,787

1988 -114,566 -126,959 12,393 431,149 320,230 110,919 545,715 447,189 98,526

1989 -93,141 -117,749 24,607 487,003 359,916 127,087 580,144 477,665 102,479

1990 -80,864 -111,037 30,173 535,233 387,401 147,832 616,097 498,438 117,659

1991 -31,135 -76,937 45,802 578,344 414,083 164,261 609,479 491,020 118,459

1992 -39,212 -96,897 57,685 616,882 439,631 177,251 656,094 536,528 119,566

1993 -70,311 -132,451 62,141 642,863 456,943 185,920 713,174 589,394 123,780

1994 -98,493 -165,831 67,338 703,254 502,859 200,395 801,747 668,690 133,057

1995 -96,384 -174,170 77,786 794,387 575,204 219,183 890,771 749,374 141,397

1996 -104,065 -191,000 86,935 851,602 612,113 239,489 955,667 803,113 152,554

1997 -108,273 -198,428 90,155 934,453 678,366 256,087 1,042,726 876,794 165,932

1998 -166,140 -248,221 82,081 933,174 670,416 262,758 1,099,314 918,637 180,677

1999 -265,090 -347,819 82,729 965,884 683,965 281,919 1,230,974 1,031,784 199,190

2000 -379,835 -454,690 74,855 1,070,597 771,994 298,603 1,450,432 1,226,684 223,748

2001 -365,126 -429,519 64,393 1,004,896 718,712 286,184 1,370,022 1,148,231 221,791

2002 -423,725 -484,955 61,230 974,721 682,422 292,299 1,398,446 1,167,377 231,069

2003 -496,915 -550,892 53,977 1,017,757 713,415 304,342 1,514,672 1,264,307 250,365

2004 -612,092 -669,579 57,487 1,157,250 807,516 349,734 1,769,341 1,477,094 292,247

2005 -714,371 -787,149 72,778 1,283,070 894,631 388,439 1,997,441 1,681,780 315,661

2006 -758,522 -838,271 79,749 1,445,703 1,023,109 422,594 2,204,225 1,861,380 342,845

2007 -711,612 -815,582 103,970 1,621,808 1,149,340 472,468 2,333,420 1,964,922 368,498

U.S. Census Bureau, Foreign Trade Division.

NOTE: (1) Data presented on a Balance of Payment (BOP) basis. Information on data sources and methodology are
available at www.census.gov/foreign-trade/www/press.html

Source: www.census.gov/foreign-trade/statistics/historical/gands.pdf

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