December 11, 2006
A FREE TRADER'S GUIDE TO THE TRADE DEFICIT
The U.S. trade deficit has grown sharply over the years, and now routinely exceeds $60 billion a month, according to the government. By some accounts, red ink's rise on the trade ledger portends trouble, if not calamity for the United States and perhaps the global economy when the trend reverses.
But while the trade deficit must eventually shrink, or at least stop growing, are the effects sure to be painful? Or could a reversal be relatively smooth and orderly?
Arguably, a disciplined descent in the red ink is not only possible but is now underway. The U.S. trade deficit in September, for instance, tumbled by $4.7 billion, which was the biggest monthly decline in five years. The primary driver of the fall: lower prices for imported oil.
Nonetheless, one dismal scientist warned against expecting too much from the trend. "There is little in this report to tell me that once we get past the petroleum effect, [that] there are any basic changes in the trade situation," Joel Naroff, chief economist at Naroff Economic Advisers, told CBC News last month after the September trade figures were released. "With the Congress changing hands, the political pressure on the administration to do something about China is likely to build."
Indeed, U.S. Treasury Secretary Henry Paulson warned a few days back that protectionism may be on the rise. "There's a growing protectionist sentiment,'' he said in an interview with CNBC television via Bloomberg News. "It's a paradox because the lesson of the last 25 years has been that those economies that have opened themselves to competition, reform, integration into the global economy have benefited, and the rest have been left behind."
The menacing history of the Smoot-Hawley Tariff Act of 1930 invariably hangs over any talk of protectionism. By sharply raising tariffs on thousands of imported products at the start of the thirties, the law is widely thought as one of the contributing factors that deepened the Great Depression.
Meanwhile, the high level global trade in the 21st is unprecedented, suggesting that the stakes are also high for what comes next. Is the trade deficit therefore something to worry about? For some thoughts, last week we talked with Daniel Griswold, director of the center for trade policy studies at the Cato Institute, a Washington, D.C. think tank that promotes free trade.
Clearly, there's a variety of thinking on what the trade deficit means and what should be done about it, if anything. Griswold, of course, brings a free trader's perspective to the debate, and so those who favor mercantilism or some other type of heavy handed government intervention may want to avert their eyes before the conversation below begins in earnest.
Q: Does the trade deficit matter?
A: The trade deficit's an important trade number, more for what it tells us about the rest of the economy than for any effect it's having on the economy. It's the result of the underlying factors than any kind of driver in the overall economic health. The trade deficit fundamentally reflects underlying levels of savings and investments in the United States. We run a big trade deficit because we don't save enough to finance all the investment opportunities. Foreign capital comes into the United States to fund those investments, and therefore we run a chronic trade deficit.
Q:. Is America's profligacy a concern? If so, how should the country deal with it?
A: If policy makers were determined to do something about the trade deficit, the only constructive option available would be to encourage more domestic U.S. savings. Politicians can do that directly by reducing the federal government's budget deficit, which eats into domestic savings and creates demand for foreign capital inflows. They could also reform the U.S. tax code to eliminate biases against savings and investment. If we were to move toward a consumption-based tax system, it would in theory encourage more companies and households to save more, which would increase the pool of domestic savings to finance our investment opportunities and reduce the inflow of foreign capital, and ultimately lower the trade deficit.
Q: How should an investor react to the trade deficit?
A: Economic and investment analysts have been crying wolf over the trade deficit for 20 years. If someone had taken their [bearish] advice back in the 1980s, when we had relatively large trade deficits, I think they would have lost a lot of money betting against the dollar, betting against the U.S. economy. The trade deficit is not a very meaningful figure in terms of determining investment decisions.
What the trade deficit does tell us is that foreign savings are important to the U.S. economy. Up until now anyway, the U.S. has been successful in attracting foreign investment. When the trade deficit starts shrinking precipitously, that's a warning sign that the economy's in a recession.
Q: Your point has some empirical support. Hasn't Japan's slump in past years been associated with a trade surplus?
A: Yes. Over the last 15 years, as the Japanese stock market was losing half to two-thirds of its value, as its economic growth ground to a halt, Japan was running trade surpluses. Ditto with Germany. As its growth was slowing and the unemployment rate was hitting double digits, Germany too was running a large trade surplus. So there's no connection between a healthy economy and a trade surplus.
Q: Nonetheless, a number of economists continue to forecast trouble for the United States as the red ink in trade keeps rising. Is the trade deficit something to worry about as it grows bigger?
A: Not in and of itself. The biggest worry I have is that it brings a negative direction in U.S. policy with rising protectionism and hostility to foreign investment. If that happens, it'll not only hurt domestic investors, but it will discourage foreign investors, which would drive away foreign capital to other markets, causing a weakening of the dollar. That typically leads to a smaller trade deficit.
Investors should keep their eyes on the fundamentals, the same fundamentals that determine the trade deficit. That is, the overall investment climate, economic growth, and the vitality of the U.S. market overall.
Q: So, in your view, a shrinking trade deficit wouldn't be inherently be positive for America. Trade deficits and surpluses can rise and fall for different reasons. Ergo, context is everything.
A: Yes. I've looked at the ebbs and flows of the trade deficit over the last 30 years and some startling patterns jump out. Our smallest trade deficits--in fact, our rare surpluses--have occurred in the middle of recessions. That's because the ability of consumers to buy imports declines; the appetite of foreign investors to put their money into the U.S. declines. This all contributes to smaller trade deficits.
Conversely, the trade deficit tends to grow when the U.S. economy is experiencing its strongest growth. That's when we're attracting savings from around the world and U.S. consumers and businesses are hungry for imports. Meanwhile, the dollar's typically stronger, and that tends to drive up the trade deficit. So, investors should be looking at 20 other indicators before considering the trade deficit to be some kind of indicator of where they should be investing their money.
Q: Why do you think there's so much worry about the trade deficit?
A: The expanding trade deficit does reflect the growing integration of the U.S. capital market in the global economy. We could not run such a large trade deficit--or a large surplus, for that matter--if there wasn't significant freedom to flow in and out of the United States. That freedom has some inherent risks--capital that flows in can also flow out.
But of course the benefits of that far outweigh any risk. For example, we can tap into foreign capital markets, and foreign direct investment brings technology and management expertise and opens up trade opportunities. The bottom line: we just don't save enough in the United States to finance all our investment.
If we wanted to reduce the trade deficit to zero, we'd basically have to close our economy to significant capital flows and that would deprive our economy of investment dollars. A recent study by the National Bureau of Economic Research determined that foreign capital coming into the United States was holding down long-term interest rates [in the U.S.] by about 100 basis points.
Q: But the trade deficit can't keep growing indefinitely.
A: It's a truism that the trade deficit can't go on growing at the pace it has indefinitely. Everybody recognizes that, from Alan Greenspan on down the line. The question is, How's the unwinding going to occur? Is it going to be sharp and disruptive--the so-called hard landing that's been predicted for 20 years? Or is it going to be incremental?
Q: And your forecast….
A: I think the odds are that it will be incremental, and I'm not the only one who expects that. Our capital markets and foreign currency markets are extremely flexible. The dollar floats every day on global markets. The most likely scenario: foreign investors will say, "I have enough American investments in my portfolio; I'm not going to accumulate so many." Demand for the dollar will slack off, and that will eventually turn into a moderated trade deficit. A weaker dollar means imports cost somewhat more and imports are somewhat more competitive on global markets.
The Chinese, as they develop social safety nets and as they're able to afford more consumer items, will save less. There'll be less of their savings out there in the global capital markets looking for a home. That too would contribute to a weaker dollar and a moderated U.S. trade deficit.
Another way to look at it: every year the world saves something like $5 or $6 trillion. If $800 billion of that is finding its way to the United States, is that a fundamentally unsustainable scenario? We're 25% of global GDP; we're 50% of global stock capitalization. The United States is going to attract large amounts of foreign capital and there's nothing wrong with that.
Q: Is there any precedent for a country building up a large deficit that eventually unwinds relatively smoothly? Or are we in uncharted territory with a large U.S. trade deficit?
A: We're certainly in uncharted territory in terms of the size of the U.S. trade deficit. But of course we're the biggest economy the world's ever seen. Australia's run current account deficits of a magnitude comparable to U.S. deficits in terms of the size of its economy for 20 years or more. And Australia's been one of the better-performing economies with no sign of a hard landing. The U.S. economy itself ran trade deficits for most of our history up until World War One, and those deficits unwound without a hard landing. There have been studies of developed countries around the world that have witnessed their trade deficits fall and many have done it without a hard landing. In that sense, we're not in uncharted territory.
The key to a softer, more incremental adjustment is to have flexible institutions. A flexible exchange rate, flexible labor and capital markets so that the economy can make the internal adjustments. Those are the key issues.
A: A free market approach as opposed to trade barriers and other interventions in the marketplace.
A: Yes, trade barriers bring the perverse effect of chasing away foreign investment. My biggest worry about the trade deficit is not the deficit is itself, but what politicians may do in the name of curing it. It's a bit like falling sick in the hands of medieval physicians who believe in bloodletting.
Q: Of course, one could argue that in the generation after World War Two, trade was managed and everything seemed to work out fine. At least for a while.
A: Up until the mid-1970s, capital wasn't free to flow; no country had a very big deficit or surplus. That was the Bretton Woods arrangement, that included fixed-exchange rates and pretty severe capital controls. Large trade deficits or surpluses are only possible if you have capital mobility, which we have. And that's strengthened the global economy. So, [the rise of free trade] has been a positive development.
Posted by jp at December 11, 2006 12:53 AM
How can Americans help to correct the imbalance?
The government cannot do everything for this country, we citizens need to take action as well.
Posted by: TJP at December 15, 2006 9:38 AM
A lot of the problems are caused by Americans and their anti-saving beliefs.
Just think, the CHinese has over $2 billion stashed away in banks, while Americans had a negative savings rate this year for the first time since the Great Depression.
If we stopped borrowing so much and instead saved, our defecit would shrink.
Posted by: TJP at December 14, 2006 6:35 PM
Our need for foreign capital is a result of the US governement and foreign competitors creating a liquidity generated credit bubble to stimulate the domestic economy in response to... give-the-store away trade policies.
Australia found religion in fiscal discipline, a strong $A, and the beneficiary of commodity inflation caused by the liquidity bubble.
The US position has changed dramatically since 2001. The surplus credit capacity that existed then has been used up. Development of a sensible trade policy, before the world credit bubble, would have been much easier than now.
Griswald gives passing acknowlegement to the "rebalancing" of the twisted, maniplated mess of the US and world economies caused by our failed trade policies.
The US has proven itself open to free trade. The politicians have allowed and encouraged lopsided trade agreements to threaten the financial stability of the country. The cost of the current brand of free trade has become prohibitive, which in itself refutes Griswald's argument. Unfortuneately, it will require a systemic meltdown before the fantasies of our current trade policies are extinguished.
Posted by: zinc at December 11, 2006 8:24 AM