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Chart: Watch for This Drag on the GDP in 2014

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On trade, currencies, and competitive devaluation.

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The quote often is attributed to Mark Twain, and while some switch gears to Disraeli, the actual source is someone named Leonard Courtney: "There are three kinds of lies: Lies, damned lies, and statistics."

I often lie awake at night wondering why I am forced to choose between three such attractive alternatives.

Regardless, assorted politicians, protectionists, and misguided economists have been laying a whopper on all and sundry for years that a weaker currency leads to an improved current account balance. This conveniently ignores two realities -- that 90% of currency trade is unrelated to underlying physical flows, and that trade in large classes of goods such as petroleum, grain, high technology, and the military hardware so beloved by assorted thugs and warlords, is unaffected by exchange-rate variations. There is also something called the J-curve wherein the cost of imports rises after a currency declines and before trade flows adjust to the new price.

More than 40 years ago, when exchange rates began to float (freely in theory, but never freely in practice), no one contemplated what would happen if all major trade powers decided to devalue their currencies competitively. The answer, now, as it should have been contemplated then, is changes in currencies would have, at best, a trivial effect on the current account balance.

The Trade-Weighted Dollar

While the Marines are looking for a few good men, I am looking for a good dollar index. The standard for trading still remains the ICE US Dollar Index, which underlies futures and options as well as ETFs such as the PowerShares US Dollar Index Bullish Fund (NYSEARCA:UUP) and, you guessed it, the US Dollar Index Bearish Fund (NYSEARCA:UDN). The six currencies in this index have remained at fixed weights since 1973 even though trade patterns have changed dramatically over the past four decades. Explaining the Swedish krona's role in this index is about as rewarding as trying to justify daylight savings time.

Other indices are based on correlation-weighting schemes, financial-flow schemes, and in the case of at least one major business newspaper, hissy-fit schemes. The Federal Reserve, for its part, has a family of trade-weighted dollar indices, none of which are licensed for trading purposes; we would not want our central bank to lose its treasured independence, would we?

How has the US current account balance as a percentage of GDP changed as a function of the trade-weighted dollar since 1973? The answer is very little; as a 30-month lagging function of the trade-weighted dollar, the r squared, or percentage of variance explained, is a mere 0.21. Restated, we still need to account for the other 79% in factors such as changing global income levels, technological and other factor-endowment shifts, labor-force changes, and, yes, everyone else's currency shifts.



At least the effects in the chart above are directionally correct; a weaker trade-weighted dollar does lead to a contraction in the current account deficit, and vice versa. If this pattern holds, we should start to see an end of the current account deficit's shrinkage by mid-2014. That will be a drag on GDP and no doubt will lead to a clamor for that other macroeconomic fiction, more monetary incontinence.

Is this a great business or what? To finish with an actual Will Rogers quote, "I don't make jokes. I just watch the government and report the facts."
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No positions in stocks mentioned.

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