Below the Beltway: Whistling Past the Trade Deficit

Soon after he was nominated to be Secretary of Commerce,
Bill Daley called in several prominent trade experts to brief
him. What, he asked them, was the most important thing he should
know? Claude Barfield from the American Enterprise Institute was
quick to reply, "You should understand that the trade deficit
doesn't matter."

Barfield's advice appeared to defy common sense. The trade deficit
has been climbing steadily since 1991. Last year's total of $114.2
billion (including services as well as goods) is the highest since
1988. The merchandise trade deficit of $187.6 billion is the highest
ever. Yet Barfield's opinion is shared by top Clinton administration
officials and by most policy experts in Washington—from the Heritage
Foundation to the Brookings Institution. To find dissenters, you
have to call up smaller outfits like the Economic Policy Institute
and the Economic Strategy Institute, or maverick economists like
Charles McMillion of MBG Information Services.

The dissenters don't receive much attention in the press, nor
do they have much face time with high-ranking administration officials.
But this could be one of those cases where respectable opinion
is wrong, and commonsense opinion, represented in Washington by
the mavericks and dissenters, is substantially right.

The established policy experts invoke three different arguments
to show that the trade deficit doesn't matter. First, they say,
trade deficits are intrinsically positive. Writes Bryan T. Johnson,
the Heritage Foundation's venerable trade analyst, "Trade
deficits are not harmful to the economy. If they were, America
would not be the economic powerhouse it is today. For most of
its history, the U.S. has run a trade deficit."

That's simply nonsense. When the United States was regularly running
trade deficits during the nineteenth century, it was an economic
subordinate of Great Britain. When it began running surpluses
in 1893, that signaled its emergence as Britain's equal. The United
States did not run a trade deficit again until 1971, when it also
began to suffer slower growth and higher unemployment. It is true
that a country can run trade deficits and prosper. Great Britain
did so during the zenith of its prosperity in the nineteenth century.
But Britain's deficits, unlike ours, were based on raw material
and agricultural imports and were compensated by its dominance
of world shipping.

The trade establishment's second argument is that the trade deficit
is merely a reflection and product of an imbalance in domestic
savings. Says Barfield, "Most economists would argue that
the trade deficit is not very important. It may reflect underlying
problems but they are not related to trade itself. The best way
to deal with the trade deficit is to get your private and public
savings rates up." This theory, which imputes a particular
causal relationship to a general accounting rule, dates from the
early 1980s, when the Japanese used the dollars they accumulated
from U.S. trade deficits to buy T-bills, skyscrapers, and movie
companies. Previously, most economists would have argued that
trade deficits were a factor in reducing the American savings
rate—they increase consumption without increasing domestic income.
(In other words, when consumers here buy imported products, most
of the money goes abroad.) But in the Reagan era, economists began
to maintain that the budget deficits were unilaterally causing
the trade deficits.

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The older economists had it right. There are certainly circumstances
when budget deficits can increase trade deficits by increasing
consumption of foreign goods, but there are other factors that
can also increase trade deficits, including industrial backwardness,
foreign trade barriers, and a shortage of expensive natural resources.
The resulting trade deficit can, in turn, reduce domestic growth
and savings. Lowering budget deficits can also improve the trade
deficit, but here, too, there is not a one-way causal relationship.
Since 1992, for instance, the budget deficit has declined but
the trade deficit has risen.

The third, and most compelling, argument against taking
the trade deficit seriously actually comes from the Treasury Department.
Treasury Secretary Robert Rubin and Deputy Secretary Larry Summers
argue that the current trade deficit simply reflects the disparity
in national business cycles. With the U.S. economy running near
full employment, and with other countries mired in recession or
experiencing slower growth, increased American consumption of
imports is not being balanced by increased foreign consumption
of our products. Rubin says, "If you have a high unemployment
economy, then the trade deficit tends to reduce GDP, then you
worry about it. If you have a low unemployment economy, which
we have now, then that issue isn't on the table." There is
certainly some truth in this argument. Last year's trade deficits
with Germany ($15.5 billion), Italy ($9.4 billion), and France
($4.2 billion) primarily reflected faster growth rates in the
United States. Faster growth has helped sustain a rise in the
dollar against the yen and the German mark, which has further
contributed to the U.S. trade deficit. But the question is how
much of the current trade deficit can be explained away by these
cyclical factors. The answer is not that much.

Larry Chimerine of the Economic Strategy Institute argues, "The
bulk of America's merchandise deficit is structural rather than
the result of disparate growth rates. . . . America's overall
merchandise import rate was high and rising rapidly even during
our latest period of stagnation and recession—the late '80s and
early '90s." Well, that's not quite true. The trade deficit
fell from 1987 to 1991, but it did persist even during the slowdown.
And there are reasons for the continued deficit that don't bear
directly on the U.S. savings rate or rate of growth.

The continued deficit with Japan and China, for instance, is largely
the result of their mercantilist trade strategies. Inspired by
Japan's success, other Asian countries have also sought to create
an export surplus through restricting imports—either through formal
or informal barriers—and subsidizing exports. In 1996, for instance,
our merchandise trade deficit with Japan ($47.7 billion) and China
($39.5 billion) made up 46 percent of our total. Our trade deficit
with Pacific Rim nations as a whole was $102 billion, or 54 percent
of the total. These deficits have persisted in the face of changing
exchange rates, rising and falling federal deficits, and rising
and falling economic growth.

Some of our trade deficit has also been due to American multinational
corporations that have moved their production to foreign countries
and have then imported more goods back into the U.S. than they
have exported to their overseas affiliates. In 1994, imports from
U.S. multinationals made up 38 percent of American imports. The
rising trade deficit between the United States and Mexico—$16.2
billion in 1996—is partly due to American firms importing from
Mexico. According to economist Charles McMillion, Mexican affiliates
of foreign companies now export more autos to the United States
than the U.S.-based auto companies export to the entire world.

If the trade deficit is partly structural, should we—and
Bill Daley—worry about it after all? Barfield and other policy
experts can still argue that as long as countries clamor to invest
in the United States, persistent trade deficits will not have
the same effect on the American economy that they would have on,
say, Italy or Indonesia. The U.S. currency won't come under attack,
and the U.S. won't have to raise interest rates to recession levels.
But these experts are ignoring less dramatic, but still significant
drawbacks to persistent trade deficits.

The sheer size of the trade deficit regularly reduces the rate
of growth. Last year, it reduced the rate of growth from 4.2 to
2.5 percent (given the trade deficit's relationship to gross domestic
productand figures from the Commerce Department). A higher growth
rate would have meant more jobs, a tighter labor market, and increases
in wages. Of course, at a 5.4 percent rate of unemployment, some
Washington economists insist we are already at full employment,
but even in the midst of a slowdown, Japan boasts 3.3 percent
unemployment and little inflation. And much of America's full
employment consists of what economist Joan Robinson used to call
"disguised unemployment"—low-wage, low-productivity
service jobs that wouldn't exist in a booming economy.

The composition of the trade deficit reinforces the trend toward
greater wage inequality. The trade deficit is no longer concentrated
in petroleum imports, but in manufacturing goods. In 1974, petroleum
imports accounted for 35 percent of American imports; in 1994,
they made up 8.3 percent. The deficit is also not concentrated
in traditionally labor-intensive, low-wage industries like shoes
and textiles, but in automobiles and electronic equipment. The
leading contributor to our trade deficit with China is electrical
machinery and equipment. The leading contributor to our deficit
with Japan and Mexico is automobiles and auto parts. These are
industries that could sustain middle-class communities in the
United States. Without them, many American workers are being forced
to take low-paying jobs in the service sector. This contributes
to a decline in the savings rate.

Specific, ongoing trade deficits have also contributed to the
decline of American manufacturing industries. By winning market
share in the U.S. through relentless price cutting while keeping
American goods out of their market, Japanese firms were able to
gain an edge over American consumer electronics, steel, and semiconductor
firms in the 1970s and early 1980s. The consumer electronics industry
was decimated; deprived of expected rates of return, American
firms simply abandoned the field. The steel industry was reduced
to a shadow of itself, and the semiconductor industry has only
partially recovered—American firms make the world's most sophisticated
processors, but have not regained their place in the production
of memory chips. It seems remote now, but continuing trade deficits
in autos and auto parts could kill off one of the Big Three auto
companies and many of the domestic parts companies that supply
the Big Three.

Finally, persistent trade deficits also create a growing obligation
to foreign holders of American bonds and assets. McMillion notes
that the cumulative trade deficit during Clinton's first term
of $667 billion far surpassed that of the first and second Reagan
administrations and of the Bush administration. These obligations
confer a certain power over American finance and in the long run
can pose a threat to the dollar itself, the strength of which
rests ultimately on the ability of American industries to produce
goods that Americans and the rest of the world want to buy. In
the midst of a business upturn, it is easy to ignore these dangers.
But once the bloom is off—and that could happen before the end
of the second Clinton administration—respectable opinion in Washington
may once again prove to have been shortsighted.

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