The Trade Deficit and the Politics of Misdirection
The political class in Washington is becoming increasingly agitated about the U.S. trade deficit... again. The reaction is to blame Europe, Japan, and China. We have House of Representatives Speaker Nancy Pelosi and her team saying, "We ask you again to join us and develop a meaningful action plan that addresses the burgeoning deficit" in a letter to President Bush. We have blogs trolling through past episodes of U.S. deficit panic. We have been here before. Well, maybe not here, but in a frighteningly parallel universe version of here, with ballooning trade deficits, large budget deficits, and general panic in Washington. Yet past episodes usually involved a high dollar making imports cheaper and exports uncompetitive. Real U.S. exports are actually up 25 percent since 2001. As a percent of GDP, they are also up from 10.2 percent to 11.1 percent of GDP since 2001. In contrast, when the trade deficit surged between 1991 and 1994, the dollar was up 22 percent. At the moment it is down by a comparable amount between 2001 and 2006. While things are similar, superficially, to recent past deficit scares, they are also different in important ways.
The situation is at once deceptively simple, and yet quite complex. From national income identities, a growing deficit "squeezes" GDP. Throw in some mindless accounting, and you can argue that it costs jobs. Throw in a video camera as well, and some air time on CNN, and you have the Lou Dobbs show. (No I am not going to link to mind candy. Google it yourself). Yet things are not so simple. The U.S. has an unsustainably low national savings rate. The IMF projects that the U.S. may borrow 7 percent of GDP in 2007. In part, (and technically by definition) this is what drives the growth of the trade deficit. Congress should be asking itself if, as policy, the U.S. should feel comfortable borrowing 7 percent of GDP, given that it will need to borrow even more (publicly or privately) to fund surging retirement and health care benefits in the immediate future.
It is also informative to work the numbers a bit, and deconstruct the surging deficit. An obvious candidate is inflation. If we look at the deficit in constant dollars (you can download these from BEA in 2000 dollars), the trade deficit since the Bush White House took over in 2001 has grown by one-third. Another 10 percent of the nominal growth is due to a general increase in U.S. prices. So roughly one-quarter of the growth is simply inflation. Another force driving the nominal deficit growth is linked to the drop in the dollar. On a trade-weighted basis, the Federal Reserve's nominal broad dollar index has fallen by about 14 percent since 2001. This is despite the broad Asian peg to the U.S. dollar. Against the euro, the dollar has lost more than 35 percent. On this basis, in foreign currency terms, another third of the surge in the deficit is clearly linked to exchange rate changes. The same imports cost more. The ironic thing here is that the move in the dollar -- down -- should be helping the trade deficit, all other things being equal. However (and this is the proof that we have not really been here before despite the déjà vu) the currency is being driven this time by the same forces driving the trade deficit itself. The U.S. wants to borrow increasingly more money. There apparently is not sufficient growth in the supply of credit from our collective foreign bankers. So.... mathematically something has to budge. Since the U.S. borrowing spree has refused to budge, the solution in the market has been to drive down the dollar, so that the same foreign currency-denominated credit goes farther in dollar terms. You can borrow more dollars when they are worth less. The remaining growth in the deficit, about one-third of the total nominal growth, can be linked to rising oil prices and growing U.S. demand for foreign credit.
So, in a roundabout way, I agree with the Democratic leadership of the U.S. Congress. Something needs to be done. That something includes a more economically literate discussion of the issues. The American public does not need populist economic rhetoric. The growth in the deficit is large, but not as large as advertised in the current round of speeches, and not for the reasons cited. In real terms, most of the growth has been driven by the surge in U.S. collective borrowing, combined with high oil prices. Any real policy debate should therefore start with U.S. borrowing (federal, state and local, and private) and the reasons for rising oil import bills. Beating up on China, the EU, and Japan is a sideshow at best -- populist rhetoric. The Euro has appreciated by roughly 50 percent against the dollar (the flip side of the dollar falling by 35%) since 2001. What are they supposed to do exactly? The Asian peg is a problem, but the U.S. needs to be very careful how it unwraps that particularly complex web of excess global liquidity (from Japan's implicit support of the massive Yen carry trade) and U.S. need for more and more buyers in domestic bond markets. Discussion on budget (not trade) deficits and energy policy would be a constructive response to the deficit. Beating up on trading partners is not.
The situation is at once deceptively simple, and yet quite complex. From national income identities, a growing deficit "squeezes" GDP. Throw in some mindless accounting, and you can argue that it costs jobs. Throw in a video camera as well, and some air time on CNN, and you have the Lou Dobbs show. (No I am not going to link to mind candy. Google it yourself). Yet things are not so simple. The U.S. has an unsustainably low national savings rate. The IMF projects that the U.S. may borrow 7 percent of GDP in 2007. In part, (and technically by definition) this is what drives the growth of the trade deficit. Congress should be asking itself if, as policy, the U.S. should feel comfortable borrowing 7 percent of GDP, given that it will need to borrow even more (publicly or privately) to fund surging retirement and health care benefits in the immediate future.
It is also informative to work the numbers a bit, and deconstruct the surging deficit. An obvious candidate is inflation. If we look at the deficit in constant dollars (you can download these from BEA in 2000 dollars), the trade deficit since the Bush White House took over in 2001 has grown by one-third. Another 10 percent of the nominal growth is due to a general increase in U.S. prices. So roughly one-quarter of the growth is simply inflation. Another force driving the nominal deficit growth is linked to the drop in the dollar. On a trade-weighted basis, the Federal Reserve's nominal broad dollar index has fallen by about 14 percent since 2001. This is despite the broad Asian peg to the U.S. dollar. Against the euro, the dollar has lost more than 35 percent. On this basis, in foreign currency terms, another third of the surge in the deficit is clearly linked to exchange rate changes. The same imports cost more. The ironic thing here is that the move in the dollar -- down -- should be helping the trade deficit, all other things being equal. However (and this is the proof that we have not really been here before despite the déjà vu) the currency is being driven this time by the same forces driving the trade deficit itself. The U.S. wants to borrow increasingly more money. There apparently is not sufficient growth in the supply of credit from our collective foreign bankers. So.... mathematically something has to budge. Since the U.S. borrowing spree has refused to budge, the solution in the market has been to drive down the dollar, so that the same foreign currency-denominated credit goes farther in dollar terms. You can borrow more dollars when they are worth less. The remaining growth in the deficit, about one-third of the total nominal growth, can be linked to rising oil prices and growing U.S. demand for foreign credit.
So, in a roundabout way, I agree with the Democratic leadership of the U.S. Congress. Something needs to be done. That something includes a more economically literate discussion of the issues. The American public does not need populist economic rhetoric. The growth in the deficit is large, but not as large as advertised in the current round of speeches, and not for the reasons cited. In real terms, most of the growth has been driven by the surge in U.S. collective borrowing, combined with high oil prices. Any real policy debate should therefore start with U.S. borrowing (federal, state and local, and private) and the reasons for rising oil import bills. Beating up on China, the EU, and Japan is a sideshow at best -- populist rhetoric. The Euro has appreciated by roughly 50 percent against the dollar (the flip side of the dollar falling by 35%) since 2001. What are they supposed to do exactly? The Asian peg is a problem, but the U.S. needs to be very careful how it unwraps that particularly complex web of excess global liquidity (from Japan's implicit support of the massive Yen carry trade) and U.S. need for more and more buyers in domestic bond markets. Discussion on budget (not trade) deficits and energy policy would be a constructive response to the deficit. Beating up on trading partners is not.
Labels: budget deficit, china trade policy, euro exchange rate, oil import prices, trade deficit, trade policy, yen carry trade
