China's Trade Deficit

A funny thing happened happened early this week while Washington was focused on the budget -- China ran a quarterly trade deficit. Yes, that's right, the currency manipulating export-mad engine of growth whose rapid advances have dominated coverage of the global economy is now a net importer. Given the amount of huffing and puffing that Americans have done about trade with China over the past several years, you might think this is excellent news. In fact, it's a sign that oil scarcity poses a severe risk to the world economy -- America's most of all.

What happened?

Well China didn't stop selling stuff to foreigners. It's still the world's manufacturing hub. And Chinese people didn't suddenly start gobbling up tons of American manufactured goods. That's too bad. A spike in Chinese demand for American-produced goods would put Americans to work and help push our domestic economy into a pattern of self-sustaining growth. But even though Americans are often a bit solipsistic, we're not the only country China trades with. And the main factor driving the Chinese into deficit is oil. Specifically, they started paying much more money for the same old oil they'd been importing all along.

That's because oil is a rather special kind of good in a way that's a problem for both our countries.

If the price of Diet Coke skyrockets, people will start drinking more Diet Pepsi. If the price of soda skyrockets, people will drink more fruit juice or coffee or water. And over the long term, oil is no different. If you look at European countries with much higher gasoline taxes, you see much lower per capita consumption of gasoline. There's more mass transit, more walkable neighborhoods, more bicycle commuting, and most banal of all, the cars are smaller, lighter, and more fuel efficient.

But this only works over the long term. If gas gets more expensive, people can't all suddenly run out and buy new cars or start riding subway lines that nobody's built. What happens instead is that American households do what China as a whole did -- buy roughly the same amount of stuff but pay more money for it.

Mark Doms, the chief economist at the Commerce Department, recently drew up some charts that illustrate the point well. In 2008, the average American household spent $281 per month on gasoline. In 2009, that was down to $204. What happened? Did we all give up on driving? Not really. The price of a gallon of gas dropped from $3.25 to $2.35. When it went back up to $2.78 in 2010, monthly expenditures went back up to $240.

That means spending on all goods and services that aren't oil needs to fall proportionately. And that means fewer jobs and slower economic growth.

Of course, it would be different if the folks who sell us the oil turned around and bought stuff with the money. And to an extent this happens. The Persian Gulf is a major market for both military equipment and civilian aircraft, both of which are important American export industries. But most countries realize that they have a limited stock of oil to sell and that therefore it's imprudent to spend all your earnings. Countries from Norway to the United Arab Emirates save a hefty share of their oil money on sovereign wealth funds.

The upshot is that higher oil prices cause a reduction in aggregate demand globally, which is bad news for an American economy that continues to suffer from high unemployment and massive excess capacity.

Given that there's no sign the upward trend of oil prices is going to halt, this is a big problem to which policy-makers should be responding with demand-stimulating policies. Unfortunately, they thus far seem to be doing the reverse. Not only is austerity fiscal policy the order of the day, but last week, the European Central Bank raised interest rates to curb inflation. There's some risk that the Federal Reserve will do the same. After all, when oil gets more expensive, that does push prices up. But it's a huge mistake to see this as inflation, a monetary phenomenon caused by excessively loose money and curable by tighter money. Raising interest rates won't magically create extra supply of oil, nor will it magically conjure up a new transportation infrastructure for people to use. All it will do is exacerbate the already intense problem of unemployment and weak wage growth.

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