Trading Down

While it is still unclear how large the trade problem will loom in the presidential election, there is surely plenty to be worried about. On several occasions under George W. Bush, the monthly trade deficit has exceeded the total annual deficit -- $41 billion -- in the entire last year of his father's administration. Of course, Bush Junior cannot be blamed entirely for the deterioration. In reality, most of it occurred under Bill Clinton. But even compared with the record trade deficit in Clinton's last year in office, last year's ran about 20 percent higher.

In fact, figures soon to be released are expected to show that in 2003 the U.S. account for the first time topped the psychologically important 5-percent level. This was the worst performance since American economic statistics were first compiled in the 19th century. By comparison, the notorious U.S. trade crisis of 1971-72 was a mere blip: The trade deficit in 1972, approximately 0.5 percent of the gross domestic product, was less than one-tenth of the current level. In truth, America's current trade position is a time bomb that sooner or later will explode -- with devastating political consequences for whichever luckless soul happens to occupy the Oval Office at the time.

Media interest in the trade story took a dive during the euphoria of the dot-com bubble. Although the media interest has yet to fully recover, several key economic observers are sounding the alarm. MIT economist Lester Thurow, for instance, has suggested that the trade deficits are setting the scene for an eventually devastating currency crisis. In a new book, Fortune Favors the Bold, he argues that without careful handling, the dollar could plunge by half, propelling the global economy into a 1930s-style depression. Also publicly fretting is billionaire investor Warren Buffett. In an article in Fortune last fall, he proposed a complicated import-control system in which importers would bid in at public auctions for special permits to buy from abroad. For all this system's free-market fancy dress, its impact on U.S. trade would be virtually indistinguishable from that of an across-the-board tariff.

Thurow and Buffett are, of course, liberals whose views the Bush White House can readily discount. But prominent conservatives are also joining the clamor. A standout in this regard has been CNN's Lou Dobbs. Once seemingly prepared to accept mass layoffs as a necessary price for the benefits of globalism, Dobbs has in recent months emerged as perhaps the most trenchant critic of what free trade has done to the American manufacturing sector. Even Henry Kissinger has obliquely criticized the worsening trade trend. In a comment last summer, he suggested that a nation that has lost its manufacturing base cannot long remain a world power.

"The question really is whether America can remain a great power or a dominant power if it becomes primarily a service economy, and I doubt that," Kissinger said in an India Financial Express article that appeared in July 2003. "I think that a country has to have a major industrial base in order to play a significant role in the world."

Sensing President Bush's vulnerability, the Democratic presidential contenders have also hardened their rhetoric on trade recently. In the words of veteran trade hawk Pat Buchanan, they are all "beginning to sound like Pat Buchanan now."

By all world standards, America's trade deficits are stunningly out of line. An analysis of six major economies -- the United States, Japan, Germany, France, Britain, and Italy -- shows that it is generally only during or immediately after a war that rich nations have incurred trade deficits even remotely comparable to America's recent performance. Indeed, history records only one previous case of a major nation running a trade deficit of more than 5 percent of the GDP. This was Italy in 1924 -- hardly an auspicious precedent. In recent years, the consensus both on Wall Street and in the media has been that the trade deficits "don't matter." Unfortunately, the economic thinking underlying this conclusion is as facile as the profits-don't-matter ethos that fostered the ill-fated dot-com bubble. All wishful thinking to the contrary, trade is still an important indicator of an economy's health.

For starters, a worsening trade trend has obvious implications for jobs. Indeed, the U.S. economy has lost more than 2.5 million manufacturing jobs just since Bush took office. Some observers argue that cuts in American manufacturing jobs are an inevitable, indeed welcome, reflection of rising productivity. They point out that other advanced economies, including Japan, have seen large declines in manufacturing employment over the last decade. But this comparison is highly misleading. In sharp contrast to the United States, none of the other nations usually mentioned in this context is running chronic trade deficits. (Japan, for instance, continues to run the world's largest surpluses -- about four times China's.) By contrast, America's vast trade deficits incontrovertibly testify to an unhealthy weakness in U.S. manufacturing output. What's more, even if most displaced manufacturing workers eventually do find work in services, they can rarely match their previous wage levels.

Bush and his advisers can continue to brush aside the concerns of American industrial workers, but they won't be able to ignore a more powerful constituency: the world's financial markets. Why? Trade deficits have to be financed. For every $1 of current account deficit the United States incurs, it has to sell $1 of American assets abroad. Much of the financing comes in the form of foreigners' purchases of American stocks and real estate, plus an ever rising share of U.S. Treasury bonds that is being bought by foreigners, particularly the governments of Japan, China, and other nations in the region. The question is how long foreigners will continue to finance a U.S. trade trend that they know is recklessly unsustainable.

In the meantime, foreign asset purchases are becoming an increasingly intrusive feature of the American economic landscape. In particular, foreigners are buying many of America's largest corporations outright. Such erstwhile pillars of U.S. industry as Amoco and Chrysler were bought in the late 1990s by British Petroleum and Daimler-Benz, respectively. In 2002, Lucent, heir to the fabled technological riches of Bell Labs, sold its optical-fiber business to Furukawa of Japan. Meanwhile, IBM announced the sale of its disk-drive business, a crucial high-tech operation that has played a historic role in the development of the global computer industry. Again the buyer was Japanese, in this case Hitachi. In effect, the United States is selling the family silver. Within the space of a single generation, it is disposing of much of its industrial and commercial base -- a base that was built by many earlier generations of Americans.

Large parts of Wall Street have also come under foreign control. Names like Scudder Investments, Bankers Trust, First Boston, Alliance Capital, Republic Bank, Kemper Corporation, Alex Brown, and Dillon Read may still sound American, but these former pillars of the U.S. financial establishment are now controlled from places like Zurich, Frankfurt, Paris, and London. Even the American book-publishing industry is now largely foreign-owned. According to one estimate, German companies alone now account for more than half the industry. American publishers that are now German-owned include Random House; St. Martin's Press; Doubleday; Crown; and Farrar, Straus & Giroux. Even Clinton's memoirs are to be published by a foreign-owned publisher -- the Knopf imprint of Random House. (Random House was taken over by the German Bertelsmann group in 1998.)

All these sales have already undermined the United States' economic standing on the world stage. While this may not be obvious to the American public, it is shockingly clear in national asset and liability figures compiled by the International Monetary Fund. These show that between 1989 and 2000, America's net foreign liabilities ballooned from $47 billion to nearly $2.2 trillion. Lester Thurow's figures predict that the current trade deficit could run between 7 percent and 8 percent of the GDP by 2010, while Washington-based economist Pat Choate has suggested that the deficit could reach 10 percent of the GDP by 2013.

One key factor sustaining the upward trend is outsourcing: Given that wages in even the most advanced regions of China run less than one-quarter of American levels, no likely revaluation of the Chinese yuan is going to dissuade corporate America from shifting jobs to China. Perhaps more worryingly, the trend to outsource service jobs such as the writing of software and the designing of computer chips to places like India, the Philippines, and Malaysia is just beginning. The effects are apparent in America's traditional service surpluses, which have been in free fall since 1997. Assuming unchanged exchange rates, they could well disappear within a decade.

Another exacerbating factor is oil. Given America's ever increasing dependence on foreign supplies, oil import costs are bound to rise even without any further increases in oil prices. Add in a 1970s-style oil shock (which could be triggered by China's rapidly growing oil imports) and the trade deficits could easily increase by between $50 billion and $100 billion a year.

Perhaps the most alarming news of all is that America's foreign-debt problem is now feeding on itself. In the words of the prominent British fund manager and financial commentator Marshall Auerback, America has entered a banana republic-style "debt trap." The nub of the problem is in the vast and ever rising flow of dividends and interest payments that the United States must remit to foreign owners of U.S. assets. In a paper published in June 2003 by Chalmers Johnson's Japan Policy Research Institute, Auerback sketched out this truly alarming prognosis:

[T]he U.S. is a country with a trade deficit and must also borrow [abroad] to pay the interest on its debt. Because the interest rate on that debt exceeds the U.S.'s growth rate, the compounding of capitalized interest payments alone will tend to raise the nation's relative indebtedness. I expect that the chronic U.S. current account deficit and mounting external debt will ultimately raise long-term U.S. interest rates. And this, in turn will speed up the compounding of the interest due on the U.S. external debt and will make the debt trap dynamics even more vicious. At that point, what author Charles Kindleberger calls a "credit revulsion" might ensue, producing a catastrophic outcome for the U.S. economy.

Auerback is not alone in fearing the worst. Even the U.S. government's own Trade Deficit Review Commission has strongly hinted that America's current account imbalances are spiraling out of control. In a November 2000 report, it suggested that, even assuming the deficit in goods and services did does not deteriorate further, the current account deficit could reach 7.5 percent of the GDP by 2010. Implicit in the commission's devastating analysis, which was discreetly published during the interregnum period after the last presidential election, was that the increase would be driven by rising debt-service costs, as America's foreign debt was likely to reach nearly 60 percent of annual the GDP in 2010 (up from 16 percent in 2000).

As if all this were not enough, the picture looks even bleaker when you consider the likely denouement. As people like Auerback and Thurow have suggested, a dollar devaluation seems unavoidable in the long run. But it will be a devaluation from hell. Already in the last year the dollar has fallen considerably against the euro. But even at today's rates, many American manufacturers know that they are still desperately noncompetitive. On paper, devaluation would seem like the right solution. After all, it immediately makes American goods cheaper to foreign consumers, and it thus should powerfully stimulate America's exports. Similarly, a devaluation at home should enable American producers to win back much of the domestic market share previously lost to imports.

All this, however, is dependent on the assumption that U.S. manufacturing industries have plenty of unused capacities available to capitalize on post-devaluation opportunities. This assumption has long since ceased to be valid: After 30 years of rising merchandise trade deficits, much of America's once formidable manufacturing capacity has been wiped out. Thus, in the short to medium term, devaluation would actually prove counterproductive. This is because import volumes would hardly decrease while import costs would rise considerably. The backfire effect would be particularly marked in the case of imports from advanced manufacturing nations like Japan and Germany. These nations now increasingly specialize in producing goods that Americans can no longer make (or in some cases never have made), including advanced materials (such as the super-strong composites used in planes), key components (such as the more advanced components in cell phones), and sophisticated capital goods (everything from the semiconductor industry's "steppers" to television broadcasting equipment).

A key reason why all this is not better understood is that U.S. trade figures have tended to hide the true extent of the rot in American manufacturing. Because America's goods exports have shown a cumulative increase of more than 40 percent in the last decade, countless ivory-tower economists have blithely assumed that large swathes of American manufacturing remain reasonably competitive. In reality, much of the export growth in manufactured goods consists merely of the re-export of imported content. Virtually every American-manufactured product these days is heavily dependent on imported content. Indeed, America's most advanced manufacturers have led the trend to outsource the most difficult to make components and materials from former rivals in Japan and Germany. A classic in this regard is Boeing, which is relying on Japanese partners for much of the serious manufacturing in its forthcoming 7E7 jet.

Moreover, distribution patterns have changed in ways that tend to exaggerate American export strength. Take, for instance, how Asian manufacturers ship components to Mexican maquiladoras. They often airfreight the more valuable components to Los Angeles International Airport before shipping them south by truck. At the border, the Asian material is logged as high-tech American "exports" to Mexico. Similar distortions are at work in the recording of overland trade between Canada and Mexico.

So when can we expect a reckoning? Given that Asian nations remain eager to promote their export industries, the balance of probability is that the Bush administration can stagger through 2004 without suffering a truly devastating devaluation. Nonetheless, there is no gainsaying the fact that the United States is hurtling toward the tipping point in its trade with the rest of the world. And the longer the reckoning is postponed, the more painful and disruptive it will be.