One year ago, the chorus of the consensus told America that the dollar's exchange rate was due to fall in 2005. Under relentless assault from cheap Chinese imports and facing a record trade deficit, the dollar had nowhere to go but down. The influential Economist magazine went so far as to say, "[t]he deficit is unsustainable: sooner or later it will need to shrink, and that will involve a cheaper dollar." Politicians and pundits predicted economic trauma at the hands of outsourcing. Time has proven them wrong. What the U.S. needed then and needs now is to stick to the reliable keys to growth: low tax rates, deregulation, limited government, and especially free trade.

A Dollar - Deficit Link?

The U.S. economy did set two records last year. First, 2005 saw a new record trade gap. Imports to the U.S. exceeded exports by $724 billion, or 5.8 percent of GDP. Second, more Americans were employed than ever before in history, arguing against those who preached doom and gloom.

The data continue to support our contention of last May that the trade deficit is not the signal to watch: "This is all wrong... Many economists and the weight of history suggest that the trade deficit, a symptom of investment capital inflows, is a sign of national economic strength."[1]  Additionally, two papers published last spring pointed out the lack of a historical relationship between currency values and trade deficits.[2] Indeed, despite the widening trade gap, the dollar gained value against other currencies.

The January 5, 2006, Economist admits that the dollar pessimists "were all wrong." Yet the conventional wisdom of "trade hawks" is again resurgent, arguing that trade deficits are unsustainable and the dollar cannot hold. Last week, the government reported the third deepest trade gap on record, with imports outweighing exports by $65.7 billion. Current exchange rates, however, appear normal compared with exchange rates over the last few decades.

Unless Congress moves from protectionist rhetoric to protectionist legislation, there is no reason to expect the dollar to slide significantly.  Trade flows are the "tail of the dog," as Fed Chairman Ben Bernanke once explained. From time to time the dollar does fall when the world's investors lose confidence in the superiority of America's institutions and markets. Sadly, congressional hostility to the U.A.E. port deal was a bipartisan embarrassment and isn't likely to reassure the world that America is as free and fair as it proclaims. Equally troubling is the Schumer-Graham proposal in the U.S. Senate to place trade barriers on imports from China.

The Chinese Invasion

According to the last week's data from the Department of Commerce, the U.S. trade deficit with China was $13.8 billion in February. In 2005, the U.S. trade deficit with China grew by 25 percent to $202 billion. That amounts to nearly twice the $103 billion bilateral deficit in 2002. The ratio of imports to exports with China is now 5 to 1, perfect for the "Chinese invasion" storyline. The U.S.-China deficit's growth probably won't continue, but not because it can't. Consider these points:

• Mathematically, trade flows are balanced by investment flows. The bigger the trade deficit, the more capital flowing into the U.S. Chinese and other foreign investors prefer to trade their goods for America's equity and debt. America is seen as the safest, surest investment bet in the world. That's bad news?

• Realistically, trade represents voluntary exchange. Any "imbalance" is voluntary. As with trade between a consumer and a retailer at the local mall, the two consenting parties each benefit from the voluntary trade of goods for currency.

• Empirically, record trade deficits have coincided with positive economic news in the U.S.: record levels of employment, low unemployment rates, rising pay, and fast GDP growth. The argument that this is a debt-driven party is far less credible than the argument that imports are as economically valuable as exports.

• Pragmatically, much of the trade deficit with China represents re-importation by U.S. firms with factories overseas, such as General Motors, Motorola, and Boeing. Parts leave the U.S. and come back as more valuable assembled products. A 2005 National Bureau of Economic Research study[3]  reported that 90 percent of U.S. exports and imports flow through U.S. multi-national companies, with 50 percent flowing within a single firm. The lesson for Congress is that American companies, not just China, will be injured by protectionism.

We should cheer the triumph of capitalism and its alleviation of poverty within China, as well as its benefits for American consumers and shareholders. The only point of debate is whether American workers' wages are suffering due to trade with China, but there is no clear evidence of wages "racing to the bottom." Instead, China is experiencing a severe labor shortage that is driving wages up rapidly in a "race to the top"-the level of free-market workers.

The real dangers to America are not free trade or China's currency. That's not to say there aren't smart policies that should be taken to curb abuses of fair trade, rather that protectionism and currency haggling aren't part of the smart mix. The real danger is that Congress will try to fix what is not broken and adopt a mercantilist policy of import limitation. Congress would do well to stick to the reliable keys to growth spelled out in The Heritage Foundation's Index of Economic Freedom: strong property rights, low tax rates, low regulation, limited government, and especially free trade.

Tim Kane, Ph.D., is Director of, Marc Miles, Ph.D., is Senior Fellow in, and Anthony Kim is Research Associate in, the Center for International Trade and Economics at The Heritage Foundation.