No correlation between deficit and dollar = weasel words

By bart
June 30, 2006

Not rocket science...

Of course, even the quickest glance at the charts of the US current account deficit and the dollar shows that they're not correlated well.

... until other deficits and a flow are added in

Let's change it around some and look at a combination of the US trade deficit, the US budget deficit and something called Treasury International Capital (TIC) flows:

And now we see a very good visual correlation and an "un-weasel-ing" of the relationship between deficits and the dollar. Yes, there really is a relationship between deficits and the dollar.

So what's this Treasury International Capital flow thing? Here is the home page at the US Treasury. Basically, its just a measure of the net investment flows into and out of the US and mostly contains stocks & bonds.

What's with the chart title - "The international dollar - income & expense"?

In order to value a business or company and see what it's worth and how it will do in the future, three of the most important factors are sales, expenses and profit. Profit is basically sales minus expenses. If we go way out there and assume the entire US is a company, and pretend that the US dollar is its stock, then we have another way to look at the international value of the dollar.

The black line on the chart is the monthly TIC flow from other countries (income), with both the trade and budget deficits (expenses) subtracted. So you say - "So what?"... well, by doing that we show an income and expense statement for the US dollar itself. Any numbers above zero on the left hand scale mean a profit and if the number comes in below zero then there has been a loss.

In other words, if we back way off from the dollar and look at it from a 30,000 foot level as the stock of the USA itself, we need to figure out what would represent sales and what would represent expenses. We pretend that TIC flows are income and that the combination of the trade and budget deficit are the expenses.

Then, TIC minus (trade + budget deficit) represents net profit or loss of the dollar itself. Well, what happens when a company has losses - their stock price goes down... and the same thing has happened with the international value of the dollar since early 2002. When there was a consistent net profit between 1997 and 2001, the dollar value rose.

Some may say that what we're doing is way too simple and there's some truth there... but the bottom line is that it does work and does track and has tracked the value of the dollar for almost 15 years.

Addendum - August 16, 2005 The chart has had some small modifications made in order to show a better correlation. The 3 month moving average was changed to the current 12 month moving average, and a 6 month lag was added. The correlation is now a lot clearer and stronger and, as a bonus, we now have a mildly predictive chart.

Addendum - August 19, 2005 - an additional view and chart interpretation from jk at the iTulip forum
TIC= net change in dollar based foreign portfolio investments. Let’s regroup TIC- (trade+budget deficits) = (TIC-trade deficit)-budget deficit.

TIC-trade deficit = net change in dollar based foreign portfolio investments – the number of dollars thrust into foreign hands via our trade deficit. In order for foreign entities to acquire dollar portfolio investments greater than the trade deficit, the foreign entities must borrow dollars from U.S. domestic lenders. So tic-trade deficit represents excess foreign demand for u.s. dollar loans.

The budget deficit represents excess domestic demand for u.s. dollar loans. This is a restatement of the “crowding out” description of the deficit.

If foreign demand for U.S. dollar loans exceeds domestic demand for U.S. dollar loans, the value of the dollar rises. If domestic demand exceeds foreign demand, the dollar index falls. Ta-da!

(update June 2007 - some good points about TIC data from Brad Setzer here.)

M3b update

It has been almost two months since the original "M3 is back" article was published here and our original here. Here's the current chart.

These and other charts are updated weekly on my key stats page.

Quote of the day
"So the question is, having very consciously and purposely tried to break the bubble and upset the markets in order to sort of break the cocoon of capital gains speculation, we are now in a position—having done that and in a sense succeeded perhaps more than we had intended—to try to restore some degree of confidence in the System."
-- Alan Greenspan, Chairman of the Federal Reserve.

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