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Breaking Down the Trade Deficit

Today, the Commerce Department reported the May deficit on trade in goods and services was $59.8 billion. This was not much changed from the April deficit of $60.5 billion in April.

The trade deficit remains high because of surging prices for imported oil and refined products, continuously rising imports from China, and the shift to more fuel efficient imported vehicles. At about five percent of GDP, these pose a significant drag on the economy.

The trade deficit aggravates the pain caused by recession and surging unemployment.  Ben Bernanke’s recent comments about oil driven inflation only serve to distract attention from these issues and make matters worse.

Simply, money spent on Middle East oil, Japanese and Korean cars and Chinese televisions and coffee makers goods can’t be spent on U.S. made goods and services. The drag on aggregate demand, along with the credit crisis and resulting shutdown in new housing and commercial construction, are driving up unemployment. Since December, the U.S. economy has lost 438,000 jobs—235,000 jobs in manufacturing and 261,000 in construction.

At the same time, higher prices for imported oil, surging imports of cars and consumer goods from China, and the credit crunch have pushed the economy into recession, and high unemployment has put the skids on inflation on non-energy and non-food products. That is why core inflation, prices less food and energy, had been so modest, and the kind of inflation gripping China and Europe is not likely in the United States.

Federal Reserve Chairman Ben Bernanke in recent comments has emphasized that western central banks stand ready to resist oil induced recession, when in fact oil price increases are far beyond the control of the Federal Reserve and other central banks to affect.  The threat of higher interest rates have tanked the stock market and pushed down the dollar against the euro, and the latter has actually pushed up oil prices by giving the Europeans extra dollars to bid up Middle East petroleum prices.

China is subsidizing oil imports, without regard to spot prices in international markets, and controlling domestic gasoline prices with the dollars it purchases with yuan. It undertakes the latter purchases to keep the yuan undervalued against the dollar and boost exports. Hence, consumers in the country contributing most to growing demand for oil, China, are wholly insulated from rising oil prices. As oil prices rise, the Chinese drive prices even higher with their subsidies.

Bernanke should talk about U.S. options for combating Chinese manipulation of oil and currency markets, instead of punishing the U.S. economy with the threat of higher interest rates that would serve no positive purpose.

Instead, Bernanke’s words cause markets to believe the Fed may raise interest rates as we travel deeper into a recession, and this drives equity prices down, compounding the panic created by rising oil prices.

Raising interest rates now would be the kind of policy the Federal Reserve pursued in 1929. Is that the kind of signal a central banker and student of the Great Depression wants to send to fragile markets?

If Bernanke wants to do something about both the recession and inflation, he should focus on Chinese purchases of dollars with yuan, which boost exports to the United States, and Chinese subsidies on oil imports with those dollars, which drive up global oil prices.   Together, these are driving up the trade deficit, exacerbating the recession and driving up U.S. gas prices.

Were the Chinese yuan problem solved, the trade deficit could be cut by a third, and that would boost U.S. GDP by about $300 to $500 billion GDP.

Breaking Down the Deficit

Together, petroleum, China and automotive products account for nearly the entire U.S. trade deficit, and no solution to the overall trade imbalance is possible without addressing these segments.

Petroleum products accounted for $33.2 billion of the monthly trade gap, on a seasonally adjusted basis. Since December 2001, net petroleum imports have increased $27.7 billion, as the average price of a barrel of imported oil has risen from $15.46 to $106.28., and monthly imports oil and refined products have increased from 353 million to 373 million barrels.

Retuning conventional gasoline engines and transmissions, hybrid systems, lighter weight vehicles, and other alternative energy sources could substantially reduce U.S. dependence on foreign oil. These solutions require national leadership, but both Republican and Democratic Party leaders have failed to champion policies that would reduce dependence on Middle East oil.

In 2007, 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 the United States will be just as dependent on imported oil as before without stronger conservation and alternative fuel policies.  Factor in falling production from U.S. oil fields, the situation gets worse.

China accounted for $21.0 billion of the May trade deficit, up from $20.2 billion in April and $5.5 billion in December 2001. The bilateral deficit is rising, because China undervalues the yuan, and this makes Chinese exports artificially inexpensive and U.S. products too expensive in China. U.S. imports from China exceed exports to China by a ratio of 3.2 to 1.

China revalued the yuan from 8.28 to 8.11 in July 2005 and has permitted the yuan to rise less than 5 percent every twelve months. Modernization and productivity advances raise the implicit value of the yuan much more than 5 percent every 12 months, and the yuan remains undervalued against the dollar by at least 40 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 government purchased $462 billion in U.S. and other foreign currency and securities. This comes to about 14 percent of China’s GDP and about 35 percent of its exports of goods and services. These purchases provide foreign consumers with 3.5 trillion yuan to purchase Chinese exports, and create a 35 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 9.0 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 still carry significant cost disadvantages 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 at least $1000 per vehicle.

Also, the Bank of Japan has 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 and others from moving more auto assembly and sourcing more parts in the United States.

Deficits, Debt and 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 $6.5 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 3.8 million jobs since 2000. Following the pattern of past economic recoveries, the manufacturing sector should have regained more than 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 at least $300 billion a year or about $2000 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. That would raise the potential trend rate of growth from 3 percent to 4 percent, and the additional taxes raised would be enough to resolve critical issues like social security and health care for the 45 million uninsured Americans.

Lost growth is cumulative. Thanks to the record trade deficits accumulated over the last 10 years, the U.S. economy is about $1.5 trillion smaller.  This comes to about $10000 per worker.

The damage grows larger each month, as the Bush administration dallies and ignores the corrosive consequences of the trade deficit.

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

 

 

 

 

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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.

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