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.

Deficits and ... more deficits

The economics editorial debate in the U.S. has been focused lately on the Federal budget deficit. The U.S. now owes roughly $8.6 trillion in public debt. This continues to grow. In 2005, the Federal budget deficit was $319 billion. This dropped to $248 billion for the fiscal year ending September 2006. The projected deficit for 2007 is $423 billion. This is the apart from the additional accumulation of debt by state and local governments. (According to the Federal Reserve, state and local debt amounted to another $1.85 trillion in 2005). And of course, households also continue to accumulate debt. Much of this debt accumulation is funded by foreigners. Indeed, the exposure of foreign investors to U.S. debt and equity markets is now so large that they simply have to be getting nervous. A recent IMF working paper ('How Might a Disorderly Resolution of Global Imbalances Affect Global Wealth?' Francis E. Warnock; IMF Working Paper 06/170, July 1, 2006) examines just what this exposure means. By his estimates, a 10% decline in equity and bond markets, combined with a 10% drop in the dollar, would translate into a loss in foreign wealth equal to roughly 5% of foreign GDP. In the case of Canada, this is almost 6.25 percent of GDP. In contrast, in 1994 this would have been 2 percent. While attention in the U.S. has been focused on the budget deficit, tied to this debate is the ability of the U.S. to continue to finance its spending with foreign funds. Indeed, while the U.S. is borrowing more and more from abroad as a share of GDP, the prospects are not good. The bill for the retiring baby boomers has not yet come due. When social security payments and Medicaid and Medicare explode, things will get very interesting fiscally. Social security may be realtively well financed over the long term. Combined with the costs of Medicaid, Medicare, and the occasional optional war, however, the accounts are not so neat and tidy.

In retrospect, one gets the feeling that in the Clinton years, a (relatively) good faith effort was made by the baby boom generation to put the fiscal house in order for their looming retirement oblgations. This has all been squandered, of course, and there is no going back. Surprisingly, it looks like a number of editorial writers who have attacked Bush in the past for fiscal irresponsibility are now, for various reasons, instead rationalizing a shift in expenditures rather than restoring fiscal order. Paul Krugman ("Democrats and the Deficit," December 22 2006), for example, apparently does not now believe that the electorate is willing or able to support a fiscally responsible government. 'Rubinomics made sense in terms of pure economics, [but] it failed to take account of the ugly realities of contemporary American politics...'. If we are going to have deficits anyway, the logic runs, lets at least spend the money right.

The elephant in the room is the foreign lender. All of this hinges on the assumption that the Japanese will continue to print yen, the Chinese will continue to build up mountains of dollars, and the Europeans will continue to pour their pension savings into the U.S. debt and equities market. Can we really assume this will continue? If not, the budget pundits and apparatchiks are all in for a rude shock. We are in uncharted territory. According to the IMF, the U.S. current account deficit in 2006 was 6.6 percent of GDP. They project that this will be 6.9 percent of GDP in 2007. At this rate, foreign debt is accumulating faster than the underlying growth rate of the U.S. economy. By the standards of the last 100 years, these trends are simply unprecedented. Most likely, they are also unsustainable. They have implications for the dollar, U.S. asset prices, and "long-term" adjustments to the U.S. Fiscal balance that may not be so far away after all, if and when foreign investors change their collective mind. (See the CRS report 'Is the U.S. Current Account Deficit Sustainable?' for an overview of studies on how this might all play out.)

At the same time, with Krugman changing his tune, there has been a bit of bashing going on. Some examples can be found at the Marginal Revolution site. One post asserts that "Democrats resent me getting money that rightfully belongs to them..." Maybe Krugman is right that, in the current climate, serious discussion about fiscal responsibilty is not possible. To be honest, I resent everybody spending money that belongs to my kids (and grandkids for that matter...) Tax refunds in the face of continued borrowing does not mean no one will be paying the bill. I once tried to explain to my (then 12 year old) daughter how every American owes $28 thousand in public debt. She was not pleased.

© JFF & Intereconomics, LLC 2006