Global Policy Forum

By Eduardo Porter and Mark Landler

Jessica Heyman's recent breakfast in Paris provides an apt, if somewhat gut- wrenching illustration of how the weak dollar is supposed to help pare America's outsized trade deficit with the rest of the world.

On vacation from their jobs in New York, Heyman and her husband each had a modest repast of eggs, coffee and a side salad at the Café de Flore on Boulevard St.-Germain. It was nothing out of the ordinary, she said, except for the bill — €46, or about $60 at the current exchange rate. The stunning cost "almost made me want to keep the receipt," she said. Five years ago, when the euro was languishing around 90 cents, a similarly priced meal would have amounted to about $42. Instead, with each euro now worth about $1.30, Americans visiting Europe have a powerful incentive to remain on a frugal diet. "We ate a lot of bread," Heyman said.

Shocking tourists into counting every cent is one way that a weaker dollar helps prod Americans into buying less from foreigners while enabling relatively cheaper made-in- America products and services to conquer a bigger share in global markets, too. And to some extent it is working just as the economics textbooks say it should, with American exports growing faster and the rising cost of foreign goods and travel abroad slowing the growth of imports.

But the dollar's long and steep slide over the past five years against many of the world's major currencies — including the euro, the pound and the Canadian dollar — has not been anywhere near enough to right America's lopsided trade imbalance with the world, which hit $702 billion in the first 11 months of 2006, on track to easily outstrip the $717 billion of 2005 and hit a new record.

"My U.S. colleagues tend to believe that exchange rates alone can carry out this adjustment which I, looking from the outside, find hard to believe," said Thomas Mayer, chief European economist at Deutsche Bank in London. "You would need to have unrealistically large changes in exchange rates to overcome that gap."

There are several reasons why currency shifts alone are unlikely to do the trick. For one thing, many foreign suppliers are willing to absorb the impact of a declining dollar on their profit margins rather than passing it on to consumers as higher prices. That gives Americans less of an incentive to shift away from imports. Moreover, economists point out, the dollar has not fallen much against the currencies of some of America's biggest trading partners. In the last two years the dollar has actually risen against the Japanese yen.

"Both the yen and the dollar are weak currencies," said Tohru Sasaki, currency strategist in the Tokyo office of J.P. Morgan.

And then there is the yuan, whose value against the dollar is carefully managed by the Chinese government. Between January and November, China alone clocked up a $213 billion surplus in its trade of goods with the United States, but the yuan has risen 6.3 percent against the dollar since China scrapped a peg between the two currencies in July 2005.

Perhaps most importantly, for the United States to begin to balance its trade American consumers must spend less, while foreign consumers would have to buy a lot more.

"The intractability of consumer behavior is the key to the mystery," said Cliff Waldman, economist at the Manufacturers Alliance/MAPI, a research group for manufacturing companies. "About half of the United States' deficit problem with Europe is the difference between the behavior of the European consumer, which is moribund, and the behavior of the American consumer, who never stops."

Free-market economists argue that a growing trade deficit does not really matter — it is mostly a benign side effect of America's faster economic growth and its appeal as a destination for foreign investment. Trade imbalances reflect private transactions between consenting adults who just happen to live in different countries, these economists say, and should be ignored by policy makers. Yet with the deficit now exceeding 5 percent of the U.S. gross domestic product, many other economists worry that the foreign debt needed to finance the burgeoning imbalance is accumulating at an unsustainable pace.

To be sure, a weaker dollar has bolstered American exports to strong- currency nations a bit. America's deficit trading goods and services with the European Union declined by about 1 percent in the first three quarters of last year compared with the same period of 2005, after accounting for inflation, to about $84 billion.

California vintners have been making a mint in Canada, where sales have grown by double digits every year since 2002, when the dollar started its fall against the Canadian dollar.

"There's a real price threshold of 10 dollars Canadian a bottle," said Joseph Rollo, director of the International Department at the Wine Institute, the lobby group for California wineries. "A few years ago it was very difficult for California wineries to make that level. Now it's a lot easier."

The cheap dollar is also allowing some American companies to enter foreign markets for the first time. Bert Miller, president of Phoenix Closures, a manufacturer of bottle caps in Naperville, Illinois, said that freight costs and customs hassles pose a big obstacle to European buyers.

But a few months ago the company picked up a German client. "I was looking through our order book and discovered a little factory in Germany buying our caps," Miller said. "I assume these guys are getting a fairly large price reduction coming to us."

Martin Baily, former chief economic adviser to President Bill Clinton, remains optimistic that the decline in the dollar will gradually turn the United States' current account deficit around. "I think we are poised for a gradual reduction," Baily said. "We are at a point where exports are starting to grow faster than imports."

But new factors arising from the increased globalization of production seem to be making the trade adjustment particularly slow. For example, by moving more production out of Europe, into dollar-pegged regions like China and elsewhere in Asia, European companies have created natural hedges against a strong euro. Indeed, despite an 11 percent rise in the value of the euro versus the dollar in 2006, German exports rose an estimated 13 percent during the year — the fastest clip since the Internet boom year of 2000.

"With globalization, we now have a large network of plants all over the world," said Anton Bí¶rner, president of the BFA, the Berlin-based association of German wholesalers and exporters. "So we are not as affected by changes in a single currency." This pattern of far-flung production across Asian nations means that to significantly dent the large imbalance in America's trade with the world, the yuan and other Asian currencies would need to rise substantially against the dollar. But it also suggests that the scale of changes required would impose big costs on both sides.

The People's Bank of China is holding some $1.01 trillion in reserves, the vast majority in dollars, which it has amassed as part of its strategy to keep the yuan from appreciating against the American currency to ensure Chinese products remain competitive in the United States market.

The Chinese and other Asian central banks are beginning to diversify more into euros, which has helped fuel its recent appreciation. "That's really the main reason," said Ben Simpfendorfer, a currency strategist in the Hong Kong office of the Royal Bank of Scotland.

Such diversification, however, will have limited effect unless Asian countries buy a lot fewer Treasury bonds, slowing the flood of credit that has kept interest American interest rates low and supported consumer spending. And that would harm the Chinese as much, if not more, than it would Americans. "With China," said Waldman, the manufacturing economist, "the capacity for trade imbalances to adjust is minimal."

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