On exchange rates and trade deficits

International trade theory argues that trade deficits must eventually cause significant devaluation of a currency. Trade surpluses on the other hand work in the opposite direction. Your currency exchange value rises over time. The idea is that the stronger or weaker currency rectifies the imbalance in   much the same way as the old gold standard brought about in theory rebalancing by shrinking economic activity and therefore imports in the country having to ship or transfer gold which automaticaly contracted the money supply and slowed the economy. With the passing of the gold standard and the substitution of freely floating exchange rates it was thought the adjustments would continue but the results would be less painful. There is no doubt that this is true because so far we have avoided the disasterous circumstance of the Great Depression when automatic deflation because of trade imbalances and gold transfers led to a world depression. But does the new system work as planned? One would have to say no not really. Take the situation in Canada and the United States.

Canad is running a major trade surplus, as high as 10 bilion dollars last quarter. The Canadian dollar is rising heading toward the 90 cent barrier. Canadian manufacturing is slowing and eventually despite rising productivity Canadian exporters may be pricing themselves out of the US market.In manufacturing that is but not in raw materials and energy rich exports where buoyant world prices and demand continues to be strong.The Bank of Canada is taking a big risk in raising interest rates in this environment but no one knows precisely where the tipping point is.

Lets look at the US. The US is running a chronic trade imbalance. Asian central banks and savers are buying up US treasury issues and thereby helping to finance the US public sector debt.Analysts like Paul Krugman at the New York Times continue to predict doom in the near future once Asian finance officials suspect a collapse in the value of the US currency because of the trade deficit and the public sector deficit. But how realistic is this   Chinese bankers and businessmen buy US denominated debt instruments and dollar assets because they consider   the US economy a very safe place to park their money and recycle their profits from the low wage trade they engage in with the US. The Middle Eastern oil producers similarly buy up US assets including American ports for precisely the same reason. Where else that is equally safe are these interests likely to send their money . Canada, Europe, Asia, the Middle East? It is this lack of appropriate alternatives that permits the US to defy for the time being the economic laws of gravity. Eventually the American economy and its currency will cease to be the fiat currency of last resort,   the global reserve currency in effect. But when and if that happens we will need an international substitute, probably a currency based on a composite basket of global commodities and stocks. Bancor anyone ?