The Dollar and the Balance of Trade
Since January 2002 the U.S. dollar has fallen by 25.6% against the Euro and 13.2% against the yen.
Most experts are of the view that the sharp fall in the dollar is the result of the fact that American imports of goods by far exceed exports of goods. In March the trade gap stood at $43.5 billion, not far from the record deficit of $44.9 billion in December of last year. As a percentage of GDP the annualized trade deficit stood at 4.7% in Q1 against 4.5% in the previous quarter.
But is it true that the state of the trade account is what is behind the fall in the exchange rate of the U.S. dollar? Every participant in a market economy is a seller and a buyer of goods and services. In his capacity as a seller of goods he exports those goods to other individuals. While in his capacity as a buyer of goods he imports these goods from other individuals.
In other words, every participant in a market economy is both an exporter and an importer. For instance, a baker that produces 10 loaves of bread and consumes two loaves can now sell, i.e., export eight saved loaves of bread to a shoemaker for a pair of shoes. The pair of shoes that the baker secures for the eight loaves of bread is his import. Observe that he paid for the import with his export, i.e. eight loaves of bread is payment for the pair of shoes.
The introduction of money does not alter the essence of what we have said, i.e. that individuals pay for their imports by means of exports. A producer exchanges the goods he produces for money and then employs money to secure, i.e. to import, goods from other producers.
As with the price of goods, the supply and demand for money determines the price of money, or its purchasing power. For a given supply of money an increase in the production of goods implies that producers would demand more money since more goods must now be exchanged for money. As a result of this, the exchange value or the purchasing power of money will increase. Every dollar will now command more goods. If the supply of money increases for a given stock of real goods, the purchasing power of money falls since now there are fewer goods per dollar. In short, the prices of goods at any point in time are the manifestation of a given state of supply and demand for money.
Does the calculation of the balance of payments alter our conclusion that the purchasing power of money is determined by the supply and demand for money? For the balance of payments to influence the purchasing power of money, one needs to show that it can alter the supply and demand for money. Can the balance of payments, which is the difference between the monetary value of what was sold versus the monetary value of what was bought, alter the supply of money?
Obviously not, since the supply of money is determined by central bank monetary policies. Likewise, the balance of trade cannot determine the given stock of goods. The balance of payments only records the value of given goods bought and sold by an individual or a group of individuals.
We can thus conclude that balances of payments within a country do not cause the purchasing power of money in that country.
Now, if a given basket of goods is exchanged in the U.S. for one dollar and the same basket of goods is exchanged for two euros in Europe, the rate of exchange between the U.S. dollar and the Euro will be set as one dollar for two Euros. If money supply increases in Europe and as a result three euros are now exchanged for the same basket of goods, the rate of exchange between the U.S. dollar and the euro will be set as one dollar for three euros. Any deviation of the exchange rate from the level dictated by the purchasing power of currencies will set corrective forces in motion.
To put it simply, if in the U.S. the price of 1kg of potatoes is one dollar and in Europe two euros, then according to the purchasing power framework the currency rate of exchange should be one dollar for two euros. Now suppose that the rate of exchange was set in the market at one dollar for three euros. In other words, the dollar is now overvalued. It will pay to sell potatoes for dollars then exchange dollars for euros and then buy potatoes with euros—thus making a clear arbitrage gain.
For example, individuals will sell 1kg of potatoes for one dollar, exchange the one dollar for three euros, and then exchange three euros for 1.5 kg of potatoes, gaining 0.5 kg of potatoes. The fact that holders of dollars will increase their demand for euros in order to profit from the arbitrage will make euros more expensive in terms of dollars and this in turn will push the exchange rate in the direction of one dollar to two euros.
According to Rothbard, "the exchange rate between any two monies will tend to be at the purchasing power parity. Any deviation from the parity will tend to eliminate itself and re-establish the parity rate."
As with the balance of payments within a country, the balance of payments between countries does not cause the respective purchasing power of money and hence does not cause the currencies rate of exchange. Within a country when a baker imports shoes from a shoemaker he pays with the bread he produced. Things will not be different if an American baker has exchanged his produce with a Japanese shoemaker. Note that the respective import and export of goods doesn't alter the overall stock of goods. Hence for a given stock of money no change in the purchasing power of money emerges.
Let us assume that the rate of exchange between the U.S. dollar and the Yen is 1:1, i.e., one dollar for one yen, and it is also in line with the respective purchasing power parity of the U.S. and Japan. Now let us further assume that money is created out of "thin air" in the U.S. American importers employ the new money to buy Yen. In the process, the exchange rate of Yen against the dollar appreciates to $2:1Yen. With Yen, Americans now buy Japanese goods. The trade balance of the U.S. with Japan moves into deficit.
Observe that what we have here is an exchange of nothing for something. Americans exchange unbacked by production money for goods. Japanese would have difficulty to secure real goods from Americans for dollars they have received since these dollars are unbacked by production. This will be manifested by an increase in prices in the U.S. In short, by means of empty dollars Americans have diverted real Japanese savings.
Consequently, what we have here is a fall in U.S. money purchasing power, a fall in the U.S. dollar rate of exchange against the Yen and the U.S. trade deficit with Japan.
So while the trade balance doesn't cause the currency rate of exchange, it does provide an indication of the extent of monetary abuses by the central bank. In short, it provides an indication regarding the diversion of foreigners' real savings to the country that is engaged in reckless monetary policy.
Since the U.S. dollar is the most acceptable medium of exchange, the U.S. central bank's monetary policy is an important means in the diversion of foreigners' real savings. Can this diversion continue without consequences?
Now, within the framework of a fixed exchange rate excessive monetary pumping by a country's central bank will lead to a run on the currency of the country and put a halt to loose monetary policy. However, in the framework of a floating exchange rate system the adjustments in rates of exchange are smooth and it takes a long time before the crisis point emerges.
Moreover, if all central banks are coordinating their monetary policies, as is the case at present, the crisis can be averted for a long period of time. Only if central banks stop coordinating their policies can a currency plunge and an economic crisis emerge–following one central bank's having pushed its monetary pumping more aggressively. It remains to be seen whether the U.S. central bank has decided to go its own way and accelerate its monetary pumping relative to other central banks. If this is the case then the dollar could fall sharply and a possible financial crisis could emerge.
As a rough guide, looking at changes in the supply of money relative to its demand can do much to explain movements in the purchasing power of money and the exchange rate. A comparison of money supply growth versus the rate of growth of a country's economic activity gives the "excess money supply rate of growth". (An increase in economic activity implies more goods are produced and hence a greater demand for money).
The relative excess money supply rate of growth provides an important clue for the likely direction of a currency's rate of exchange. Thus, if over time the excess money supply rate of growth in the U.S. exceeds the excess money supply rate of growth in Europe, the U.S. dollar will depreciate against the Euro. The converse will happen if over time the excess money growth will fall in the U.S. versus Europe.
In this regard, the excess money growth of the EMU in relation to U.S., or the excess money growth differential between the EMU and the U.S., after falling to -4.3% year-on-year in September 2001 jumped to 5.5% in March this year. In short, Europeans print money at a faster pace now than Americans. Given the fact that the effect from changes in money supply operates with a lag, this means that the strong rebound in the excess money growth differential between the EMU and the U.S. raises the likelihood that in the months ahead the U.S. dollar should strengthen against the Euro.
After falling to 0% in February 2001, the excess money growth differential between Japan and the U.S. climbed to 27.6% by April last year. From then onward the excess money growth has been on a decline falling to 7.8% by March this year. Given the lag, we suggest that the effect from the acceleration in the differential between February 2001 and April 2002 is likely to assert itself in the months ahead. In short, the U.S. dollar is still likely to strengthen against the Yen before the effect of the falling differential between April 2002 and present asserts itself.
Contrary to popular thinking, it is the purchasing power parity, and not the state of the trade account, that sets the exchange rate between any two monies. The latest fall in the US$ is not so much a crisis of the US currency in response to the trade deficit as it is a crisis of the present floating exchange rate system, which permits unchecked loose monetary policies by central banks. These unchecked policies create the conditions for severe distortions.
In the floating exchange rate framework by means of monetary policies coordination, central banks can create the illusion of currency stability. But this approach can undermine real economies over a prolonged period of time. The longer the current floating exchange rate regime is allowed to function, the more damage is inflicted on wealth producers. The only way out of this mess is to seal off all loopholes to monetary pumping.
Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. Send him MAIL and see his outstanding Mises.org Daily Articles Archive. Special thanks to Michael Ryan for his comments. Follow the dollar and the markets at Mises.org.
 Murray N. Rothbard.  1970. Man , Economy and State Nash Publishing. P. 726.