Why the Trade Deficit Matters

On Friday, the Commerce Department will release data for the November 2007 trade deficit. The consensus estimate is $60 billion, up from $57.8 billion in October. It may be a bit larger or smaller, but either way, it comes to about 5 percent of GDP, That is an enormous drag on national income and growth, and has corrosive consequences for our children’s future..

Budget Deficit Sophistry

In the discussions about the trade deficit, a great deal has been made of the U.S. federal budget deficit; however, during the third quarter the current account deficit, which includes goods and services, net flows of foreign investment income and transfer payments, was $178.5 billion, but the federal deficit was only $57.3 billion. How can a $57.3 billion domestic financing requirement cause a $178.5 billion external deficit?

In 1991, the federal budget deficit was huge and the current account was in surplus. When Bill Clinton left office in 2001, the budget was in surplus and the current account was in deficit. That is the absolute opposite of what those who blame the trade deficit on the budget deficit would have us expect.

Of course the budget deficit matters but so do a lot of other factors. That said, it is hard to find good reasons for the rest of the problem in the competitive fitness of the U.S. economy and business.

Each year the World Economic Forum computes a growth potential index for 131 economies. It examines factors like public finances (e.g., budget deficits, efficacy of the tax system), the environment for the cultivation and commercialization of technology, and quality of civil institutions (e.g., the prevalence of corruption, evenhandedness of the judiciary and respect for law), and openness to international competition. In this assessment of national competitive potential, the United States ranks 1st-China and India rank 34th and 48th.

Our labor force is much stronger than education entrepreneurs in search of higher taxes would have us believe. Virtually our entire native born population finishes high school, two thirds receive some post secondary training, and our universities are among the nation’s most prolific export industries. The most important determinant of quality in the classroom is the student population, and if our universities are populated by dullards, why do so many foreign students want to pay our pricey tuition?

U.S. productivity is advancing briskly. Since 1997, private business productivity has increased 2.7 percent a year. In durable goods manufacturing, where technology matters as much as anywhere, productivity has been advancing at a 6.0 percent pace. Those are solid gains.

New products and methods continue to burst from our research labs. We would have to go back to electrification, the railroad and the opening of the West to find epic events that so transformed our economy and the global economy as contemporary American innovations in new materials, electronics and logistics.

So where are the problems? I suggest we look in three places.

Oil, China and Automobiles

Net imports of petroleum, products from China, and automobiles and parts total about 110 percent of the trade deficit, and no solution to the overall trade imbalance is possible without addressing these segments.

Petroleum accounted for $26.3 billion of the monthly trade gap in October 2007.

From December 20001, the cost of imported petroleum increased $20.8 billion, the average price of a barrel of imported oil rose from $15.46 to $72.49, and the volume of imports increased from 353 million to 406 million barrels.

In 2008, prices are higher, and the monthly oil import bill could easily exceed $35 billion. Yet, neither the Republicans nor the Democrats seem inclined to do what could be done to address our dependence on imported oil.

Last year, the Congress managed to push through the first increase in automobile mileage standards in 32 years but don’t cheer loudly. The 35 mile-per-gallon standard to be achieved by 2020 is far less than what is possible.

The bill also requires the production of about 2.4 million barrels a day of ethanol. Along with other conservation measures, the 2007 Energy Act could reduce U.S. petroleum consumption by 4 million barrels a day by 2030. Over the last 23 years, petroleum consumption has increased by about 5.5 million barrels a day, despite improvements in mileage standards, automobile and appliance technology, and conservation.

Being optimistic, in 2030 we will be just as dependent on imported oil as before. Factor in falling production from U.S. oil fields, the situation gets worse.

We could do a lot better. Retuning conventional engines and transmissions, more hybrids, electric vehicles, lighter vehicles, and more nuclear power are attainable. The Chinese are likely to turn in those directions in greater force than we do. Then we can buy our cars from the Middle Kingdom just like our coffee makers.

China accounted for $25.9 billion of the October trade deficit, up from $23.8 billion in September and $5.5 billion in December 2001. The bilateral deficit keeps rising, because China undervalues the yuan, and this makes Chinese exports artificially inexpensive and U.S. products too expensive in China.

China revalued the yuan from 8.28 to 8.11 in July 2005 and has since permitted the yuan to rise 3.6 percent every twelve months. Modernization and productivity advances raise the implicit value of the yuan about 7 percent every 12 months, and the yuan remains undervalued against the dollar by 50 percent.

China’s huge trade surplus creates an excess demand for yuan on global currency markets; however, to limit appreciation of the yuan against the dollar and drive its value down against the euro, the Peoples Bank of China sells yuan and buys dollars, euros and other currencies on foreign exchange markets.

In 2007, the Chinese central bank purchased about $450 billion in U.S. and other foreign currency and securities. This comes to about 15 percent of China’s GDP and about 45 percent of its exports. These purchases provide foreign consumers with 3.6 trillion yuan to purchase Chinese exports, and create a 45 percent “off budget” subsidy on foreign sales of Chinese products, and an even larger implicit tariff on Chinese imports.

In addition, China provides numerous tax incentives and rebates, and low interest loans, to encourage exports and replace imports with domestic products. These practices clearly violate China’s obligations in the WTO, and it agreed to remove those when it joined the trade body.

Automotive products account for about $11.2 billion of the monthly trade deficit. Japanese and Korean manufacturers have captured a larger market and are expanding their U.S. production. However, Asian manufacturers tend to use more imported components than domestic companies, and GM and Ford are pushing their parts suppliers to move to China.

GM, Ford and Chrysler carry a significant cost disadvantage against Toyota plants located in the United States, thanks to clumsy management and unrealistic wages, excessive fringe benefits and arcane work rules imposed by United Autoworker contracts. Recent negotiations have improved the Detroit Three’s cost position but did not wholly close the labor cost gap with Toyota and other Asian transplants.

Recently negotiated labor agreements should reduce, but not eliminate, these cost disadvantages. Even with retiree health care benefits moved off the books and a two tier wage structure, the cost disadvantage will remain well above $1000 per vehicle.

Also, the central banks of Japan and Korea have aggressively stepped up sales of yen and won for U.S. dollars and other securities to keep their currencies cheap against the dollar. This discourages Toyota, Hyundai and others from moving more auto assembly and sourcing more parts in the United States.

More Debt and Slower Growth

Apologists for Chinese currency and trade policies point out that U.S. consumers benefit from less expensive products at Wal-Mart and other purveyors of subsidized imports. But these bargains come at high cost: we are saddling our children with debt to foreigners and slashing economic growth.

Trade deficits must be financed by foreigners investing in the U.S. economy or Americans borrowing money abroad. Direct investments in the United States provide only about a tenth of the needed funds, and Americans borrow about $50 billion each month. The total debt is about $6 trillion, and at five percent interest, the debt service comes to about $2000 per U.S. worker each year.

High and rising trade deficits tax economic growth. Each dollar spent on imports, not matched by a dollar of exports, shifts workers into activities in non-trade competing industries like department stores and restaurants.

Manufacturers are particularly hard hit by this subsidized competition. Through recession and recovery, the manufacturing sector has lost 3.3 million jobs since 2000. Following the pattern of past economic recoveries, the manufacturing sector should have regained about 2 million of those jobs, especially given the very strong productivity growth accomplished in technology-intensive durable goods industries.

Productivity is at least 50 percent higher in industries that export and compete with imports. By reducing the demand for high-skill and technology-intensive products, and U.S. made goods and services, the deficit reduces GDP by about $250 billion a year or about $1750 for each worker.

Longer-term, persistent U.S. trade deficits are a substantial drag on growth. U.S. import-competing and export industries spend at least three-times the national average on industrial R&D, and encourage more investments in skills and education than other sectors of the economy. By shifting employment away from trade-competing industries, the trade deficit reduces U.S. investments in new methods and products, and skilled labor.

Cutting the trade deficit in half would boost U.S. GDP growth by one percentage point a year, and the trade deficits of the last two decades have reduced U.S. growth by one percentage point a year.

Lost growth is cumulative. Thanks to the record trade deficits accumulated over the last 20 years, the U.S. economy is about $3.0 trillion smaller. This comes to about $1000 per worker.

Our Legacy

As a consequence of decades of trade deficits, our children will be less productive, poorer and saddled with huge interest payments to foreign creditors.

No surprise these costs are overlooked by advocates of the status quo. Many work for private equity firms, hedge funds, and large commercial and investment banks on Wall Street. They champion outsourcing, as it offers the opportunities to finance big deals that move Midwestern factories to Asia and to enter Chinese financial markets. We would do well to remember they are the same bunch that gave us the subprime crisis, the collapse and foreign rescues at Merrill Lynch and Citigroup, the melt-down in the mortgage and housing markets, and the pending recession.

Meanwhile, the Bush Administration lectures China but ignores the corrosive consequences of the trade deficit. Leaders in Congress talk tough but have not acted.

Our children will be poorer, much poorer for this sophistry.

PETER MORICI is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.





PETER MORICI is a professor at the Smith School of Business, University of Maryland School, and the former Chief Economist at the U.S. International Trade Commission.