by Calculated Risk on 9/20/2007 03:07:00 PM

The following graph shows the U.S. trade deficit as a percent of GDP compared to the Fed Nominal Major Currencies Dollar Index.

NOTE: The trade deficit as a percent of GDP is presented as a positive number (for easier comparison to the dollar index). The 2007 trade deficit is estimated at 5.1% of GDP. The 2007 currency index is set to the Sept value.

Click on graph for larger image.

The common pattern is a currency strengthens and the trade deficit increases. Some time after the currency peaks, the trade deficit peaks. And that is followed by a bottom in the currency. There are other factors, but that is the common pattern.

The recent increase, and extraordinary size of the U.S. trade deficit, was probably related to the housing bubble and mortgage equity withdrawal (MEW). Now that MEW is generally declining, and the U.S. economy weakening, the U.S. trade deficit will probably continue to decline.

If the trade deficit has peaked, the dollar is probably much closer to the bottom than the top. I know this may seem like heresy, especially given recent events.

The biggest short term concern is that MEW will collapse, and the trade imbalance will unwind faster than expected. A "Wile E. Coyote moment"! (see Krugman: Will There be a Dollar Crisis? )

Also, from the WSJ: World Economy in Flux As America Downshifts

"We're definitely poised to have some significant rebalancing" of trade, says Harvard University economist Kenneth Rogoff, a former chief economist for the International Monetary Fund. He had been expecting the account deficit to shrink "by maybe half a percentage point of GDP over the next twelve months. Now it seems likely it will go down by 1.5 percentage points." And, he adds, "We could see something more rapid."

Something "more rapid" could be painful. Since Americans have financed their prosperity with borrowed money, reversing that habit means a period of living less opulently.

If foreign money turns scarce and the trade deficit narrows suddenly, Americans could face a tumbling dollar, soaring interest rates and an economic downturn. That could send shock waves back through Europe and Asia if their own consumers don't make up for lost demand from the U.S., the world's largest national economy.

If it happens more gradually, the recent run of American prosperity may continue, in a more subdued way.