Trade Deficits Matter
Over the last several years the U.S. trade deficit has persistently set new records, hitting $717 billion in 2005, equal to almost 6 percent of GDP. China, in particular has contributed to the deficit, and now accounts for just shy of one-third of the total. By any historical standard, the economic warning lights are flashing red.
Interestingly, both the economic right and left sometimes give comfort to the status quo with claims that trade deficits do not matter. From the right comes the argument that trade deficits donâ€™t matter because they simply reflect the actions of consenting adults doing what they choose through markets. Indeed, deficits are good, being the way that consenting adults obtain their utility maximizing lifetime consumption outcomes.
From the left comes the argument that the massive U.S. trade deficit with China benefits both countries. U.S. consumers get lots of cheap goods in return for which they give over paper I.O.U.s that are costless to print. Meanwhile, China creates millions of jobs and builds modern factories that are transforming it into an industrial superpower, and it also accumulates billions of dollars in financial claims against the United States. From this perspective, trade deficits donâ€™t matter because there are no limits or consequences to either government or private borrowing, and because manufacturing does not matter either.
According to the logic of left and right, the U.S. would benefit even further if China devalued its exchange rate and ran a larger trade surplus. If the Chinese want to give away their production at artificially low prices, more fool them and we should willingly accept the gift. When something sounds too good to be true, thatâ€™s usually because it is not true. Both left and right are wrong. Large persistent trade deficits do matter.
Before turning to why trade deficits matter, it is necessary to dispel a straw man argument. Trade deficit deniers often begin by rhetorically speculating what if the deficit were to disappear over night, and they rightly observe that U.S. inflation would immediately rise owing to lack of industrial capacity. This would force the Federal Reserve to raise interest rates, and might also compel higher taxes and government spending cuts.
However, this is a straw man. No one is arguing for going â€œcold turkeyâ€ on trade. Instead, there is need to begin a process of adjustment whereby the U.S. trade deficit is gradually reduced over the next few years. This adjustment will be difficult, but the longer it is delayed the more difficult and dangerous it will be. If you are unfit and wish to get fit, it is unwise to go out and immediately run a marathon. Likewise, continuing to smoke and generally over-indulge makes getting fit more difficult and dangerous. These analogies hold for the U.S. economy and its trade deficit.
Why then do persistent large trade deficits matter? The first reason concerns jobs. The current U.S. economic recovery has been the weakest since World War II, and this is significantly due to the trade deficit. In past recoveries, consumer spending created hundreds of thousands of domestic manufacturing jobs. This time round it has leached out of the economy in the form of spending on imports and created jobs in China and elsewhere.
For trade deficit deniers from the right the failure to create jobs is because Americans donâ€™t want to work. If they did they would lower their wage demands and job creation would follow. This glibness ignores the fact that lowering wages would quickly bankrupt most households who would be unable to pay their mortgages. That in turn would cause the financial system to collapse, giving rise to another Great Depression.
For deficit deniers on the left, the job shortage can be remedied by larger budget deficits and more private borrowing. The reasoning is budget deficits have no consequences and there is no limit to the amount of money banks can create or consumers can borrow. That reasoning is false. There are significant adverse consequences to both excessive budget deficits and excessive private sector indebtedness, and the U.S.â€™s extraordinary trade deficits have resulted in both being higher than would have otherwise been needed to restore U.S. full employment.
Regarding budget deficits, these can pose problems for the future because interest must be paid, which means reduced revenues available for other purposes. With regard to foreign-held U.S government debt, when foreigners spend the interest that will be good for U.S. jobs and incomes. However paying interest will consume available tax revenues so that maintaining government services could require higher taxes that may be politically difficult to accomplish. Moreover, unlike domestic bondholders, interest payments to foreign holders are not taxed, which amplifies their future budget impact.
Regarding private sector debts, accumulated debt burdens promise to be a drag on future U.S. demand growth and economic activity. Individual households have credit limits. Accumulated debts are deflationary because interest must be paid and because they constrain future borrowing. The problem is that U.S. household debts have grown far faster than income, in part due to the trade deficit that has resulted in job creation offshore rather than onshore.
Not only has the trade deficit burdened the demand-side of the U.S. economy, it has also burdened the supply-side. First, the undervalued exchange rate has resulted in many U.S. manufacturing companies closing factories because they cannot compete. Some companies have simply gone out of business, while others have re-located or sub-contracted production to East Asia. Second, many companies have re-directed investment to China rather than building new modern capacity in the United States. This has weakened the U.S. industrial base, and also made the task of trade deficit adjustment more difficult.
To trade deficit deniers on both right and left these effects apparently do not matter because manufacturing jobs can be replaced without consequence by service sector jobs. Boeing is one of the crown jewels of Americaâ€™s industrial base. According to such reasoning, Boeing could close shop, move to China, and then export aircraft to the United States. Boeing workers could be re-employed as service sector street sweepers with the same pay and America would be better off because it would have cleaner streets.
This is false. Manufacturing is key to prosperity, being a major center of productivity growth and innovation. When manufacturing moves offshore, associated research and development activities often go too. Additionally, international trade remains concentrated in goods, which means that over the long haul countries need goods to sell to finance imports. Behind the arguments of the trade deficit deniers is a tacit assumption that should the U.S. ever exhaust its international credit, it can quickly and simply reconstruct its industrial base. Unfortunately, that is not how real world manufacturing operates. Individual manufacturing firms are clusters of knowledge, skills, and capital, themselves clustered in industries. Once firms and industries are destroyed it is costly and difficult to reassemble them.
Lastly, both left and right also ignore the fact that persistent trade deficits raise financial stability and strategic concerns, which are particularly acute regarding China given uncertainty about whether it will become a geo-political friend or rival. The concern is that countries could start selling their holdings of U.S. financial assets, triggering financial disruption and higher interest rates. However, this concern should not be overstated, and xenophobic appeals of right-wing nationalists and left-wing populists should be resisted. The history of capital flight episodes shows that it is domestic investors who have tended to trigger panics, as they are better informed and therefore head for the exits first. That suggests Wall Street rather than foreigners will trigger any run on the dollar.
A modified version of this article first appeared at: http://commentisfree.guardian.co.uk/thomas_palley/2006/04/trade_piece_by_thomas_palley.html
Copyright Thomas I. Palley