years, exporters, not only in europe but in many other trading partners of the united states as well, have tended to increasingly absorb declines in prices denominated in their own currencies when their currencies rose and to fatten profit margins when their currencies fell. unit labor costs in euros and sterling, for example, increased nearly 2 percent between the first quarter of 2002 and the first quarter of 2004. so, given the average fall in euro and sterling prices of european exports to the united states, gross operating profit margins on those sales must have declined more than 20 percentage points. 3 the margin squeeze, in effect, absorbed about three - quarters of the decline in the dollar's exchange rate relative to the euro and the pound, on average, over the two years. export margins, as i indicated earlier, had apparently risen to high levels by early 2002, following the roughly 40 percent increase in the value of the dollar in terms of euro and sterling from 1995 to 2002. hence, margins in early 2004 might still have exceeded their levels of 1995. however, with the strengthening of sterling and the euro that resumed in the last three quarters of 2004, exporters to the united states exhibited significant resistance to further lowering of euro and sterling prices. accordingly, dollar prices of imports from europe picked up a bit. this pickup suggests that profit margins were minimal at best a year ago and hence that exporters were willing to lose some u. s. market share rather than compress margins still further. a noticeable downtrend in the share of european exports in u. s. imports has been apparent over the past year. * * * gains from increased currency hedging against the dollar since early 20024 may have enabled european exporters to tolerate a fall in operating profit margins beyond what they otherwise would have been able to tolerate. hedging, however, can only partially and temporarily alter the impact of exchange rates on export prices. to be sure, very long - dated contracts can transcend short - run fluctuations in currencies. but, long - term hedging is expensive, and therefore, most currency futures contracts are short - term. once hedges expire, export revenues are no longer protected from past and future changes in exchange rates, and any new hedges must reflect the new exchange rates. thus, successful currency hedges can at best delay but cannot prevent the ultimate effects of changes in exchange rates on trade. many other exporters to the united states have exhibited

characteristics special to the united states that have permitted our current account deficit to be driven ever higher, in an environment of greater international capital mobility. in particular, the dramatic increase in underlying growth of u. s. productivity over the past decade lifted real rates of return on dollar investments. these higher rates, in turn, appeared to be the principal cause of the notable rise in the exchange rate of the u. s. dollar in the late 1990s. as the dollar rose, gross operating profit margins of exporters to the united states increased even as trade and current account deficits in the united states widened markedly. 2 but these deficits have continued to grow over the past three years despite a decline in the dollar, whose broadly weighted real index is now much of the way back to its previous low in 1995. although the dollar's exchange rate has been declining since early 2002, increasingly tight competitive conditions in the united states, as elsewhere, in 2002 and 2003 apparently induced exporters to the united states to hold dollar prices to competitive levels to ensure their market share and foothold in the seminal work on this issue by martin feldstein and charles horioka a quarter - century ago ( " domestic savings and international capital flows, " economic journal, vol. 90 [ 1980 ], pp. 314 - 29 ) implied that global savings are inefficiently distributed to investment, meaning that savers are bearing too much risk for the returns they achieve and that countries with high - potential investment projects are getting less financing than they could productively employ. savers tend, to their own detriment, to over - discount foreign returns. such suboptimal allocation of capital lowers living standards everywhere. data on profits and profit margins for export sales to the united states are generally not available for our major trading partners. however, indirect evidence of levels and trends can be gleaned from u. s. import prices converted to exporters'currencies and foreign unit labor costs. the world's largest economy. for example, from early 2002 to early 2004, the dollar's exchange rate against the euro and sterling, on average, declined about 30 percent, yet dollar prices of imported manufactured goods from the european union rose by only 9 percent, slightly more than dollar prices of u. s. manufactured goods during the same two years. the consequence of the relatively small rise in the dollar price was a significant compression of gross operating profit margins on european exports to the united states. in recent