Continuing our series of examining the effect of exchange rate on the balance of trade between the U.S. and its major trading partners, we now turn our attention to Germany. Previously, we have seen that the effect of changes in the exchange rate on the balance of trade has been as economists would predict when the U.S. is dealing with countries roughly equal in population density or less densely populated – countries like Australia, Canada, Brazil and Colombia. When the dollar falls, our balance of trade improves, and vice versa. However, the predicted effect seems to break down when dealing with nations far more densely populated – nations like Japan and China. Changes in the currency exchange rate seem to have no effect whatsoever or, if anything, yield the opposite effect. That is, a decline in the dollar is more likely to result in a worsening of America’s balance of trade. Or more likely, a worsening trade deficit yields a decline in the dollar, as economists would predict, but that decline is powerless to offset the effects of population density disparity and reverse the deficit, contrary to what economists would predict.
So let’s see what happens in America’s trade with Germany, another nation far more densely populated than the U.S., by a factor of 7. Here’s a chart of the U.S. balance of trade with Germany vs. the exchange rate between the dollar and the Deutschmark (prior to 1998) and the dollar and Euro (following the adoption of the Euro in 1998).
In the case of Germany, there is no correlation, positive or negative, whatsoever. Exactly 50% of the time, the balance of trade responded as predicted by economists in response to changes in the exchange rate. But the other 50% of the time, changes in the exchange rate yielded the opposite result. And look at the changes over the full period of time for each currency. From 1990 to 1997, a small 7% rise in the dollar (from 1.61 DEMs to 1.73 DEMS) resulted in a 62% worse trade deficit – much worse than the small rise in the dollar would predict. But from 1998 through 2009, a 21% decline in the dollar from .92 EURs to .727 EURs yielded only a 7.6% improvement in the trade deficit. By far, most of that decline in the deficit was due to the global economic crisis that took hold in late 2008. If we take away 2009 trade results, a 21% decline in the dollar actually resulted in a 40% worse trade deficit with Germany. Were it not for the global economic crisis in 2009, we would conclude that the effect of a falling dollar is actually contrary to what economists predict.
Here’s an update of the correlation tracking mechanism, with these results for Germany now included:
As you can see, a trend is taking shape. When dealing with countries of similar population density, the correlation score tends to be greater than .5, indicating that changes in exchange rate produce the changes in trade balance that ecnomists predict. But, when the trading partner is more densely populated (and the break seems to occur at about 2.0, when nations are at least twice as densely populated as the U.S.), the effect breaks down, and a weakening dollar has virtually no effect on reversing trade deficits.
On the other hand, my theory of the effect of population density on per capita consumption and on trade imbalances has accurately predicted in all but one case so far (trade between the U.S. and Colombia) whether the trade imbalance would be a surplus or deficit.
Next up: Mexico.
Exchange rate data provided by http://www.oanda.com/