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The Deficit and the Damage Done

by PETER MORICI

The Commerce Department reported the August deficit on trade in goods and services was $59.1 billion. This was not much changed from the July deficit of $61.3 billion.

Still, the trade deficit remains high because of high prices for imported crude oil and refined products, subsidized imports from China, and the continuing woes of the Detroit automakers. At nearly five percent of GDP, those pose a significant drag on the economy and combine to destroy millions of high paying U.S. jobs.

Simply, money spent on Middle East oil, Chinese televisions and coffee markers, Japanese and Korean cars can’t be spent on U.S. made goods and services, unless offset by a comparable amount of exports. Since U.S. imports exceed exports by about five percent of GDP, the trade deficit creates an enormous drag on demand for U.S.-made goods and services. Along with the credit crisis and resulting slowdown in new housing and commercial construction, the trade deficit is driving up unemployment.

Since 2001, the trade deficit has increased about $350 billion, and 3.9 million manufacturing jobs have been lost. China and other major Asian exporters of manufacturers subsidize their sales in U.S. markets by suppressing the exchange rates for their currencies against the dollar by intervening in foreign exchange markets. Were this problem resolved, the trade deficit could likely be cut in half, GDP would rise by $300 billion and about 2 million manufacturing jobs could be restored.

The Bush Administration characterizes critics of China’s mercantilism as protectionists. Democratic leaders in the Senate and House talk tough, but can never seem to bring a bill to a vote in either chamber that would bring substantive action.

Presidential candidate John McCain appears aligned with President Bush on trade with China. Senator Barack Obama’s positions are in line with those of leading Congressional Democrats, who express angst but take no action.

Meanwhile, workers across Middle America suffer, and U.S. automakers abandon their communities for the Middle Kingdom. Wall Street bankers open new branches in China and lavish campaign contributions on both political parties for their compliance in America’s policy of appeasement.

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 $35.6 billion of the monthly trade gap, on a seasonally adjusted basis. Since December 2001, net petroleum imports have increased $30.1 billion, as the average price of a barrel of imported oil has risen from $15.46 to $119.99, and monthly imports of oil and refined products have increased from 353 million to 389 million barrels.

Retuning conventional gasoline engines and transmissions, hybrid systems, lighter weight vehicles, nuclear power, 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 million barrels a day, despite improvements in mileage standards, automobile and appliance technology, and conservation.

Unless U.S. economic growth permanently stagnates, 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 $25.3 billion of the August trade deficit, up from $24.9 billion in July and $5.5 billion in December 2001. The bilateral deficit is huge, 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 4.9 to 1.

China revalued the yuan from 8.28 to 8.11 in July 2005 and since 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 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, and in 2008, it is on track to purchase about $685 billion in foreign currencies. This comes to about 18 percent of China’s GDP and about 46 percent of its exports of goods and services. These purchases provide foreign consumers with 4.7 trillion yuan to purchase Chinese exports, and create a 46 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.

In recent weeks, China has begun pushing down the value of the yuan, and if this continues, this will likely have major repercussions for global trade and financial stability in the months ahead.

Automotive products account for about 7.6 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.

Recently negotiated contracts improve the Detroit Three’s cost position but do not wholly close the labor cost gap with Toyota and other Asian transplants. 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.

Moreover, the Detroit Three do not have a wide enough selection of relevant, fuel efficient vehicles to respond to $3.00 a gallon plus gasoline. Even with federal assistance, the Detroit Three do not have enough designs on the shelf or that they can import from operations abroad to adequately change their vehicle line ups within the next few years.

Recently approved federal loans to the Detroit Three will not solve their basic structural problems. When pleading for federal money, Detroit’s executives offered nothing new. These loans will only put off the inevitable restructuring that will come when they run out of cash.

It may actually be better for one or all of the Detroit Three to go through Chapter 11 now than down the road, after the Japanese and Korean automakers have captured more market share. They would likely emerge from bankruptcy court much more efficient and competitive. Better to do it now than later.

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 3.9 million jobs since 2000. Following the pattern of past business cycles, 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 and Democratic Congress dally and ignore 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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