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.
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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