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What Are We to Make of the Trade Deficit?
by Stefan M.I. Karlsson

[posted March 21, 2005]

Despite a falling dollar, the U.S. trade deficit has continued to increase to new record levels. The total current account deficit1 rose to a record 6.3 % of GDP during the 4thquarter of 2004, exceeding for the first time ever 6% of GDP. What are the implications of this for the U.S. economy? Is it good or bad? Or a little bit of both?

The answer to this question also reveals what, if anything, should be done about it.

The answer to this will be derived by refuting the two most common views of the implications of the trade deficit, the mercantilist and the supply-side view, who are strongly at odds with each other but still both manages to get it wrong, albeit in different ways. In this, the debate is akin to the marxist and neoclassical theories, which are strongly at odds with each other, but still manage to get it wrong.

The mercantilist view of the trade deficit is the one held by protectionists of various stripes, including paleoconservatives like Pat Buchanan and Paul Craig Roberts, CNN News anchor Lou Dobbs and the left-wing Economic Policy Institute. This view in effect holds that the trade deficit kills jobs. Paul Craig Roberts, Lou Dobbs and the Economic Policy Institute have all explicitly blamed the trade deficit for the--by American standards--slow job growth during recent years and Pat Buchanan used to repeat the calculation by a U.S. trade representitive that $1 billion in exports means 25000 jobs, which he then used to argue that this means that a trade deficit of $300 billion translated into 7.5 million lost jobs from trade. He has stopped using that calculation now presumably because even he realizes that it is absurd to try to argue that America with its current $700 billion trade deficit would have 17.5 million more jobs in the absence of trade.

The view that trade deficit reduces growth does not hold for either closer theoretical challenges or empirical "tests". Take for example the two European countries Germany and Estonia. During the last few years, Germany has had very sluggish growth, while Estonia has had among the fastest growth rates in Europe. Given the fact that Germany has very high labor costs and Estonia very low labor costs and given the labor cost theory of trade balances common among American protectionists, the mercantilists would then explain that the growth differential between Estonia and Germany is driven by rapidly rising trade surpluses for Estonia and rapidly rising trade deficits for Germany.

But the facts are just the opposite of what the mercantilists would predict. Germany has in fact a very large and growing trade- and current account surplus. In absolute numbers Germany's goods and services trade surplus is now the biggest in the world , although Japan's overall current account surplus is still larger because of Japan's high surplus in investment income. As late as 1998 Germany had a current account deficit but now it has a annual surplus of roughly $100 billion or roughly 3.5% of GDP. But "despite" this growing trade- and current account surplus which according to the mercantilist view means that Germany has been able to take more and more jobs from other countries, Germany has had the slowest growth among all western countries in recent years. Estonia , also contrary to the mercantilist prediction, has a large and rapidly growing current account deficit. Last year Estonia had a current account deficit of more than 12% of GDP, twice as high as in America and more than twice as high as it was in 2000 "Despite" this rapidly rising trade deficit which according to the mercantilists means that Estonia is losing more and more jobs overseas, Estonia has had an average growth rate of more than 6.5% during the latest 5 years as compared to an average of 0.5% in Germany.

Nor is this some kind of anomaly. While there are many exceptions, most notably the extremely thrifty East Asian countries whose savings rate is so high that they can both invest so much that they can have rapid growth and have trade surpluses, it is generally the case that fast growing countries have current account deficits and slow growing countries have current account surpluses. And a study by Dan Griswold shows that when trade deficits increases so does growth and when trade deficits decreases so does growth. In the 24 years since 1980, the current account deficit has grown rapidly 6 years, grown moderately ( less than half a percentage point of GDP ) in 10 years and declined in 8 years.

During the years of rapid increases in deficits, growth has been an average of 4.4%, during the years pf moderate increases growth in the deficit growth has been an average of 3% and during the years when the deficit was falling growth was an average of 1.9%, a pattern which is similar if you look at job growth. So generally the empirical pattern is the precise opposite of what the mercantilists predicts it will be.

Of course, empirical correlations do not prove causation, but there is good theoretical reasons to refute the mercantilist view and this empirical correlation does refute Paul Craig Roberts' frequent insistence that free trade theory is "Ivory Tower" and out of touch with the real world.

The error of the mercantilists is to take the GDP accounting approach of considering trade deficits to be a drag too literally and confusing it with the real world. When calculating GDP, you first add the money value of the different categories of domestic demand-private consumption, residential investments, business investments, inventory buildup and government consumption- and then you subtract the trade deficits (Or add a trade surplus for the countries that have that) to arrive at a measure of the money value of domestic production. While this approach may be valid as far as GDP accounting goes, taken literally it gives the misleading impression that trade deficits reduces domestic production.

What the mercantilists overlook namely is that domestic demand should in the real world certainly not be taken as a given, and that a trade deficits necessarily implies a net capital inflow which helps finance a higher level of domestic demand then would otherwise be possible. A good example of Henry Hazlitt's theme in Economics in One Lesson of what is seen and what is not seen. It is namely a fundamental economic truth that a current account deficit necessarily implies a equally large net capital inflow and that conversely a current account surplus necessarily implies a equally large net capital outflow.

If say Toyota sells a Japanese-manufactured car in the United States, then they have two options as to what they shall do with the money: either buy American goods and services, in case which the trade deficit does not increase, or they can buy Ameican assets which will increase the pool of funding for investments in America, or they can try to exchange the dollars earned into yen, which someone will have to sell to them and then use it for one of Toyota's two first options.

In the confused economic debate today, trade deficits are considered bad while capital inflow is considered good even though they are necessarily linked and similarly that trade surpluses is considered good while capital outflows are considered bad even though they are necessarily linked.

While Paul Craig Roberts have sometimes tried to give the impression that America suffers from the economic version of the appearance of squared triangles, the simultaneous occurence of a current account deficit and capital outflow, when pressed on the issue he has has admitted that this is impossible but contended that since capital inflow largely consists of Asian central bank purchases of U.S. government bonds rather than Foreign Direct Investments this somehow is less beneficial to the United States. While, as will be discussed more later, the Asian central bank purchases is unsound since it helps perpetuate and aggravate unsustainable conditions it is not bad for the reasons that the mercantilists claim, namely that this will in contrast to FDI not boost investments in America. Because of the inflow into U.S. government securities, the U.S. budget deficit has not had the "crowding out" on private investments that one would have expected which means that through these indirect means, Asian central bank purchases have helped boost investments in America.

Indeed, the situation which PCR so decries, a net outflow of FDIs combined with a large inflow of foreign capital into U.S. government securities is in fact a very good deal for America, since this means that Americans can get money very cheaply from the Asian central banks and invest them in high-yielding investments in Asia. This mechanism of foreigners pouring money at low-yielding investments in America and Americans investing in high-yielding investments offshore is the mechanism behind the fact that America despite the build-up of net foreign liabilities of more $3 trillion, still actually have had a surplus in net investment income of roughly $30 billion during 2004. The fact that foreigners have $11 trillion in U.S. assets versus U.S. holdings of only $8 trillion of assets outside America is thus more than compensated by the fact that U.S. investments offshore have a much higher average yield than foreign investments in America. It is not America who loses when the Asians lend money at low rates to Americans who can then invest it in high-yielding investments in Asia.

And the deal is even better for America if the money provided by the Asians is used by Americans to invest in high-yielding investments in America as this will not only mean high net profits for American investors but also a expanded productive capacity. And the reason why countries with trade deficits generally have stronger growth than countries with trade surpluses is that the capital inflow that trade deficits constitute helps increase investment and thereby expand the productive capacity.

Having seen the fallacy of the mercantilist "trade deficits kills jobs"-theory, does this mean that we should adhere to the supply-side view, taken by among others the aforementioned Dan Griswold, that trade deficits are a non-issue and never a problem? No, it doesn't mean that.

While the supply-side view is closer to the truth, it still neglects that the processes driving trade imbalances are sometimes unsound.

Current account deficits are simply a matter of people in one country on the aggregate borrowing more from foreigners than lending to them. And just as it is sometimes good, sometimes bad for individuals to borrow, so is it sometimes good, sometimes bad for countries to have current account deficits. If the money a individual borrow is going to be used for productive investments it is a good idea to borrow. But if on the other hand the money will be used for excessive consumption and/or bad investments it is a bad idea for the individual to borrow.

And what is true for the individual is also true for aggregates of individuals, like countries. If a country has a large current account deficits which reflects a large capital inflow to finance sound investments, then current account deficits are a very good thing, as we have seen in the case of rapidly growing Estonia. But if the capital inflow is used to finance excessive consumption and/or malinvestments then it is a unhealthy thing.

While the U.S. current account deficit does to some extent reflect the more flexible economic structure and accordingly bigger investment opportunities compared to Europe and Japan, it is also to a large extent driven by unhealthy factors created by the U.S. government. This includes of course the budget deficit which has driven down the national savings rate to dangerously low levels and it also includes the low interest rates policies of the Federal Reserve which has been fueling a housing bubble. The excess demand created by these policies have clearly been a factor in pushing up the trade deficit.

Some people may argue that the effects of these demand-boosting policies on the trade deficit will be negated by the downward pressure they put on the dollar. But this overlooks two things, firstly that Asian central banks have responded to this downward pressure by massive purchases of U.S. government bonds, which means that the effect on the dollar will be very limited. Secondly, even in the absence of foreign central bank intervention to prevent the dollar from falling, the dollar fall will only partially restore balance in the balance of payments by limiting the increase in the trade deficit. A falling dollar will also help to make U.S. assets more attractive since the lower the current dollar exchange rate is, the higher is the chanse that it will appreciate from current levels, something which will increase capital inflow to America, helping to finance the excess demand created by the U.S. government.

As the supply-side view of the trade deficit ignores the possibility that trade deficits may be the result of budget deficits and inflationary monetary policies (Which is probably related to the fact that supply-siders generally favor budget deficits and inflation) and accordingly goes to excessive consumption and malinvestments it too fails.

The lesson from the analysis of the failings of the mercantilist and supply-side view of the trade deficit is that trade deficits are in fact a good thing as long as it is not driven by excessive consumption and/or malinvestments.

And even then it is not really the trade deficit per se that is the underlying problem, it should rather be seen as a symptom of the effects of a loose fiscal and monetary policy as in the abscense of foreign capital inflow, the central bank could still hold down interest rates by a faster expansion of the money supply.

As excessive consumption and/or malinvestments is usually a result of a loose fiscal and/or monetary policy, the only way that trade deficits should be fought is by eliminating taxation on savings and by restoring balanced budgets and sound money.

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Stefan M.I. Karlsson is an economist currently working in Sweden.

http://www.mises.org/story/1762