From 1995 to 2001, the value of the dollar, measured by a weighted-average index of currencies of a broad group of U.S. trading partners, appreciated by 36 percent. With imports becoming commensurately cheaper and U.S. exports proportionately more expensive, the U.S. trade deficit for goods and services soared, rising from $96 billion in 1995 (1.3 percent of GDP) to $363 billion in 2001 (3.6 percent of GDP). As the trade deficit set record after record, many economists argued that the dollar would have to fall in value in order to return the yawning trade deficit to a level considered more sustainable over the long run.
The dollar, measured by the broad index, eventually reached its cyclical peak in early 2002, from which it depreciated 16 percent by the end of 2004. Against the euro and the Japanese yen, the dollar’s peak-to-trough depreciation was even greater, totaling 37 percent and 24 percent, respectively. Due to China’s policy of maintaining a fixed exchange rate, however, the dollar’s value against the yuan remained constant from the mid-1990s through 2004.
Despite the dollar’s broadly depreciating value from early 2002 through late 2004, the U.S. trade deficit nonetheless continued to soar, reaching $421 billion in 2002, $495 billion in 2003 and $618 billion in 2004 (5.3 percent of GDP), a level deemed even less sustainable. Countervailing forces contributed to the expanding deficit, including the short-term tendency for a trade deficit to increase following a currency’s initial depreciation (the so-called J-curve effect), rising prices and import levels of petroleum and a relatively faster-growing U.S. economy.
Considering the rising trade deficit (2002-04) in the face of a falling currency, many economists simply predicted that the value of the dollar would eventually fall even more in order for the U.S. trade position to begin rebalancing. However, contrary to expectations, the dollar reversed itself and staged an impressive rally this year. So far, the dollar has appreciated 13 percent against the euro and 17 percent against the yen, even as the U.S. trade deficit is on track to exceed $700 billion in 2005 (nearly 6 percent of GDP). Once again, countervailing forces (including petroleum and a faster U.S. economic growth rate) have been in action. Perhaps even more important, however, has been the rising interest-rate spreads offered by U.S. debt instruments, both public and private, compared to the bond rates on debt available elsewhere.
Absent a major policy reversal in Washington (such as finally exerting control over a fiscal situation that has become seriously unhinged over the short, medium and long terms) and absent a simultaneous return of household thrift (which has completely disappeared as the personal saving rate has turned negative), normally sober-minded economists are warning about severe financial consequences for both the United States and the global economy if the structurally unbalanced U.S. economy continues to rely on foreigners to lend it nearly three-quarters of a trillion dollars per year.