Is the US Trade Deficit a Problem?


Is the U.S. Trade Deficit a Problem?

Trade deficits are nothing to fear, if they are temporary. During the course of continued trading, a country may experience a temporary trade deficit in one period, which is cancelled by a trade surplus in the next period.

However, if trade deficits are large and persists indefinitely, such chronic trade deficits may indicate a fundamental disequilibrium in the country’s balance of payments. Moreover, trade deficits often caused by high interest rates during boom periods, and hence distort factor prices and the trade patterns between countries.


The purpose of this note is to examine the causes of US trade deficits and examine traditional remedies and new arguments for protection.

1. US Trade Deficits
Figure 1. US Trade Deficits (Current Account Balance)

Source: http://www.economagic.com

Historically, in every recession during the post-war period interest rate was reduced. A rise in interest rate induces capital inflow and determines the amount of trade deficits, in the absence of exchange rate manipulation.

Since 1960s trade deficits were wiped out in every recession except that in 2001. Some economists have argued that recessions will cut trade deficits. We have a huge trade deficit now, despite the low interest rate during the current recession. Thus, there are other causes of trade deficits. China's pegging of yuan-dollar exchange rate is likely to be a major culprit for the US-China bilateral trade deficit.


Figure 2. U.S. Discount Rate

Source: http://www.economagic.com

Remark 1: In all recessions (1954, 1958, 19610, 1970, 1974, 1980, 1982, 1991, 2001) interest rate was lowered.
Remark 2: Until 1980s, trade was not important, i.e. the US was a relatively closed economy, and trade deficits were a small fraction of GDP. Trade deficits were relatively large during the mid 1980s, but again disappeared during the 1991 recession.

Remark 3: After the Great Inflation of 1980, interest rate skyrocketed and this hike was followed by a huge trade deficit during the 1980s. A high interest rate in the US causes capital inflow, which is used to pay for trade deficit. Trade deficits began to decline only after the interest rate reached its nadir in 1985. With another recession in 1991, trade deficits became negligible and almost disappeared.

Remark 4: High interest rate is not the only cause of US trade deficits. Continued decline in interest rate in 2001 and the recession did not eliminate trade deficits. Thus, these trade deficits are caused by other factors whose effects were not dissipated by the interest rate effect.

3. Two Schools of Thought
There are two schools of thought about trade deficits.

A. Classical Idea:

Trade deficits are not a problem. The government needs not do anything.

Daniel Griswold (June 1998)
First, there is no emergency. The trade deficit is not a sign of economic distress, but of rising domestic demand and investment. Second, the trade deficit is largely immune to changes in trade policy. Imposing new trade barriers will only make Americans worse off while leaving the trade deficit virtually unchanged.

These are classical ideas. Classical economists believed that all prices and wages are flexible and price flexibility will eliminate any deficits or disequilibrium in the market. In the classical world, there is no need for government intervention.

A1: Recession is a Deficit-cutter (so wait or engineer a recession)
Until 1980s trade accounted for a small fraction of GDP, and trade deficits were relatively small.
Some economists (e.g., Daniel Griswold, 1998) argue that recession is a proven trade-deficit cutter:
If the trade deficit really is one of our nation's most pressing problems, the surest and swiftest way to tackle it would be to engineer a deep recession.
Trade deficits are a sign that indicates robust economic health. During boom periods, trade deficits increase and disappear in recessions. There is nothing to worry about.

Griswold argues that capital inflow is the cause of trade deficits, using Germany’s experience in the early 1990s.
Germany in the early 1990s offers a case study of how this mechanism works. West Germans routinely ran large current account (and trade) surpluses in the 1980s, but between 1990 and 1991 Germany's current account flipped from a surplus of 3.2 percent of gross domestic product to a deficit of 1.0 percent.(20) The reason for the reversal was not that German manufacturers suddenly lost their legendary efficiency, or that Germany's trading partners imposed new and unfair trade barriers on the night of December 31, 1990. What caused the switch was the huge increase in domestic investment needed to rebuild formerly communist eastern Germany. An increase in domestic investment repatriated a huge amount of German savings that had been flowing abroad, thus reducing the amount of German marks in the foreign currency markets and raising their value relative to other currencies. The stronger mark, in turn, raised the price of German exports and lowered the price of imports, evaporating Germany's trade surplus.

Basically, this argument says that we do not face trade deficits during recession, and hence there is no role for government. However, this argument is faulty. If we have trade surplus during a recession and trade deficit during the growth period, then trade is balanced throughout a business cycle. However, that is not the case. During inflationary periods, we have trade deficits and balanced trade during a recession. Thus, throughout a business cycle, we have trade deficits.

Trade Deficits and Outsourcing of Manufactures
This school ignores the effects of trade deficits on technology and innovation in the domestic economy. Technology and innovation occur mostly in the manufacturing sector, rather than in the service sector. The Unite States is gradually turning into a service economy, rather than an industrial economy.
Bronfenbrenner et al (2001) report that between 1992 and 2000 approximately 760,000 jobs were lost due to production shifted to China. They report that among the 15 major industries, the US had trade deficits in all industries except in aerospace. That is, the US has a comparative advantage only in aerospace at the current exchange rate. This is not to say that all job losses due to production shift to China are bad. If production shifts that would occur under balanced trade condition improves efficiency and enhance domestic income. Production shifts beyond those under balanced trade would deplete US industrial base.

Trade deficits are most pronounced in the manufacturing sector. Learning by doing occurs mostly in the manufacturing. Innovations and new products are produced in the manufacturing sector. Also, our military depends crucially on technology in the heavy industries and manufacturing. When manufactured goods are all imported, the very basis of engineering and military technology disappears. We need not be self sufficient in all sectors of manufacturing, but the US needs to maintain overall trade balance in manufacturing. Multinational firms are moving production to other countries and transferring technology to Asian countries. The fact that China is becoming an industrial giant indicates that we have lost much of manufacturing basis to China.

The US has fewer engineers than Japan, although its population is twice that of Japan. It is difficult to maintain adequate manufacturing sector when the US lacks engineers. This also shows the underlying problem in our science education. Without scientists and engineers, the US is bound to import manufactured goods, regardless of protectionist policies.

B. Protectionism: Trade deficits hurt the US economy. The government should adopt protectionist policy.

Temporary trade deficits do not necessarily hurt the US economy. Even chronic deficits will not hurt the US market if they are the results of investment to enhance US production in the future. It will hurt the US economy if borrowed funds are used to finance excessive consumption habits. Protection targeted to bolster US manufacturing may be a solution. Other countries may retaliate, but that is an acceptable risk.

C: Other Myths
1. Trade Deficits reduce Domestic Wage (FPE effect)
This may be called the factor price equalization effect. Trade between a high wage country and a low wage country tends to reduce the wage gap.
Robert Scott (1997) “The US Trade Deficit: Are We Trading Away our Future?” Economic Policy Institute.

Robert Scott claims that there is a negative relationship between trade deficits and the real wage rate. Do trade deficits cause domestic wage to decline? Perhaps increased trade reduces the real wage of unskilled workers through the factor price equalization effect. How important is the FPE effect? This is an empirical question. Do trade deficits cause a decline in the wage rate? Not directly.
Figure 3 shows the trend of wages and salaries of blue-collar workers. Trade is supposed to affect the wages of unskilled workers, rather than skilled workers. Does it show the FPE effect? No. The wage for blue-collar workers were rising, whether the economy was in recession or not.

Sources of US Trade deficit

A. Japan: difference in interest rate, protection. The real yen-dollar exchange rate is highly correlated with the US real interest rate.

When dollar was worth 250 yen or more in the late 1970s to mid 1980s, the US ran a large trade deficit with Japan. This trade deficit is due to undervalued yen. After yen realignment at around 120 yen per dollar after 1985, US trade deficit disappeared.

What is the cure for US trade deficit with Japan?
Scott and Blecker (1998) state that lowering U.S. interest rate results in a capital outflow and a depreciation of dollar, which corrects trade imbalance. Griswold (1998) show that yen-dollar real exchange rate is closely tied to the domestic interest rate.


B. China: exchange rate manipulation, protectionist policy
The genesis of the Asian crisis might have been China’s currency devaluation. The official exchange rate of Chinese yuan (RMB) to US$ (5.8 yuan/$1) was abandoned in January 1994, while the market-clearing rate (8.7 yuan/$1) took over. Because it has a large economy, China may have felt the pressure of terms of trade deterioration at that time. Even other labor abundant countries in Asia could not compete with China. Thus, China’s currency devaluation in 1994 may have been the origin of the Asian financial crisis, and US trade deficit with China.

The US trade deficit which started to develop from the mid 1990s had its origin in China’s devaluation in 1994, which resulted in the Asian Financial Crisis of 1997. Asian countries could not compete with China, and quickly developed huge trade deficits, and their currencies collapsed shortly thereafter. Ever expanding US trade deficits is a tell-tale sign that the United States is now feeling the impact of China’s devaluation in 1994. Instead of waiting until the last minute, the US need to adjust the yuan-dollar exchange rate. Otherwise, the US will be forced to devalue dollar relative to yuan drastically, from the current rate (about 8 yuan to the dollar to about 1 or 2 to the dollar).

C. Germany: will not be a problem due to single currency.
Now that Germany has adopted euro, trade deficit with Germany will no longer be a problem, as long as euro-dollar exchange rate is in equilibrium.

2. Do Trade Deficits Hurt Domestic Manufacturing?
Griswold: By any definition, the ability of American industry to compete in the world has not suffered because of a rising trade deficit. The experience of the 1980s and 1990s points in quite the opposite direction.


In every recession, interest rate was low and industrial production declined. During recession, trade deficits also declined or vanished. Trade deficits were positive when the US economy was not in recession. This shows that trade deficits did not cause US industrial production to decline.

3. Do Trade Deficits Cause a Rise in Unemployment?
Unemployment was high always during recession. During a recession, interest rate was almost always low and trade deficits became negligible. If there is any correlation between the two, unemployment rate was high when trade deficits were close to zero. Thus, there is a negative correlation between trade deficits and unemployment.

However, if trade deficits are caused by the undervalued yuan, this trade imbalance may cause outsourcing and jobs may be shifted to China.

Policy Options
1. Exchange Rate Intervention
Some attention should be paid to exchange rate manipulation by two countries that maintain large trade surplus with not only the US but also with Europe and other countries: Japan and China.

2. Manage yuan-dollar exchange rate
Ministers of G7 or G8 countries should now include China. Aggressive exchange rate policies of China will not leave other industries unaffected. China’s devaluation in 1994 was the origin of the Asian financial crisis of 1997 and the expanding US trade deficits. If the yuan-dollar exchange rate is not adjusted, a similar collapse of US dollar is likely to occur. Also, the Asian Crisis of 1997 was the result of development in Pearl Delta surrounding Hong Kong only. Increased mobilization of other regions of China will exert pressure on other Asian currencies and US trade deficit unless yuan-dollar exchange rate finds a realistic value. While the US and Europe had become beneficiaries of drastic downward realignment of Asian currencies in 1997, the US also began to experience large trade deficit since the crisis. Most Asian currencies were devalued to counter China’s aggressive exchange rate policies and export promotion, but the US has not responded to these changes. Hence, the accumulation of a large trade deficit. Interest rate should be kept at low level for extended period and a prolonged recession will cure trade deficit.
It is time for the US to peg dollar to Chinese yuan.

3. Protection of Essential Manufacturing Sectors
An Italian proverb states that a rolling stone does not gather moss. Batra (1993, 1996) emphasize the need to protect US manufacturing industries. While creative ideas and innovations may occur from time to time in the service sector, the vast majority of technological innovations occur in agriculture and manufacturing industries. Thus, itt is important for the US to maintain adequate manufacturing industries. While non-essential manufacturing activities may be outsourced to foreign countries, industries that develop frontier knowledge and innovations should be nurtured in the United States.
While US industrial production does not seem to have declined, it is clear that China is turning into an industrial giant, and the US is importing a large volume of manufactured goods from China. Slowly, the manufacturing base of the US is being depleted in this process.
Today the US has military superiority to Middle Eastern countries and can adequately respond to military threats. However, without developing sound industrial base, the US cannot maintain its military superiority. Technological superiority cannot be maintained when the US produces fewer engineers than Japan with half the US population. The government should nurture engineers and R&D activities to ensure technological superiority in these industries.

REFERENCES

Batra, Ravi, The Myth of Free Trade, New York: C. Scribner’s Sons, 1993.

Batra, Ravi, The Great American Deception, John Wiley & Sons, 1996.
Choi, E. Kwan, “The Neighbor-Immiserizing Growth: The Asian Crisis,” Japanese Economic Review 2001

Bronfenbrenner, Kate, James Burke, Stephanie Luce, Robert Hickey, Tom Juravich, Elissa Braunstein, and Jerry Epstein, “Impact of US-China Trade Relations on Workers, Wage and Employment,” June 2001.

Scott, Robert E. and Robert A. Blecker, “Cut U.S. Interest Rates Now: How to support the yen and save U.S. jobs at the same time.” Issue Brief #126, June 29, 1998.

Griswold, Daniel T., The Causes and Consequences of the U.S. Trade Deficit, Testimony before the Senate Finance Committee, Washington, DC, June 11, 1998.

Griswold, Daniel T., America’s Maligned and Misunderstood Trade Deficit, Trade Policy Analysis No 2, April 20, 1998.