Tag: trade deficits

Econ 101: Trade Deficits, another Bite

Some years ago my friend Moritz Schularick and I were walking down a street in what is now called midtown Berlin (the former Eastern zone). Moritz asked me if I could explain why capital was flowing into the U.S. from developing countries when economic theory suggested it should flow in the other direction. At the time I didn’t have a very good answer. This note offers a better one.

We expect investors to put their money where the risk adjusted return is highest because that would maximize their profits. Wealthy countries like the United States have large capital stocks as a result of many decades of investment. Poor countries—especially the emerging economies—have much smaller capital stocks. Under those circumstances, the return to investing in more capital where it is relatively scarce is normally higher than where large investments have already been made. Economists call this the declining marginal return to capital. So the capital intensive, wealthier countries should have a lower return on investing in still more capital than would the poorer capital scarce countries. If the return to capital (interest rate) in emerging market economies is higher than in the U.S., capital should flow from the U.S. to promising developing countries.

I told Moritz that it must be that because of stronger institutions and property rights (rule of law) in the U.S. compared to many developing economies, investment in them was riskier to such an extent that the risk adjusted return was actually lower in developing economies. That may explain part of the reverse flow of capital into the U.S.

But two other factors might be even more important.

First we need to understand how capital flows from the U.S. to another economy. Consider American investments in Chile, a rapidly growing emerging economy with relatively good institutions and rule of law. American investors must buy Chilean pesos in the amounts to be invested. This will appreciate the peso some (one peso will be more dollars than before making American goods cheaper). Those pesos might be used to buy shares in a growing Chilean company. The purchase of these shares by an American might simply be a change in ownership (portfolio investment) or might finance new investment (Foreign direct investment—an actual increase in capital).

But what does the Chilean who sold her pesos for dollars do with those dollars? It simplifies without fundamentally changing the story to assume that the Chilean firm selling its share to an American acquired those dollars. The firm might buy U.S. treasury securities with these dollars (this is the simple swap of asset ownership of portfolio investments). But more likely it buys American machinery and equipment for its new investment. The U.S. “enjoys” a trade surplus as a result of these capital outflows. This is the traditional relationship assumed between the developed and undeveloped world. Capital flows from the U.S. to Chile.

Two additional very important factors have changed this story causing capital to flow backward from the Chiles of the world to the U.S. In my previous blog “Econ-101-trade-deficits” I explained the following relationship:

(M – X)   =   (I – S) +   (G – T),

which says that the trade deficit (imports-M- less exports-X) is equal to the savings deficit (investment-I- less saving-S) plus the government’s fiscal deficit (government spending-G- less its tax revenue-T). Uncle Sam has had a fiscal deficit every year since the Clinton administration surpluses (even currently when the economy is fully employed!) The rest of the world has helped finance our fiscal profligacy thus keeping US interest rates lower than they otherwise would have been and crowding out less of our private investment than such fiscal deficits would otherwise have caused. The rest of the world acquires the dollars to invest in the U.S. by selling more to us than they buy from us (i.e., via our trade deficit). So other things equal a smaller fiscal deficit or, god forbid, a fiscal surplus will reduce our trade deficit.

The other, often overlooked, cause of our trade deficits arises from the use of the U.S. dollar as the world’s primary reserve asset and thus the demand from foreign central banks to hold them in their foreign exchange reserves. They acquire these dollars via our trade deficit (and their trade surplus). Their demand for U.S. dollars appreciates the exchange rate of the dollar relative to foreign currencies making foreign goods cheaper in the U.S. and American exports more expensive abroad, thus creating our trade deficits and their surpluses (see my blog from last week linked above and/or this more extensive treatment; “Why the world needs a reserve asset with a hard anchor” Frontiers of Economics in China 2017, Vol 12 Issue 4, http://journal.hep.com.cn/fec/EN/10.3868/s060-006-017-0023-7).

It would be in our interest to replace the dollar’s use in foreign reserves with an internationally issued reserve currency, something I have been advocating for many years. The details for what this might look like and how it could be done are provided here: “Real SDR Currency Board”

 

 

Econ 101: Trade deficits

Responding to critics of the administration’s proposed steel and aluminum tariffs, Commerce Secretary Wilbur Ross stated on CNBC: “I think this is scare tactics by the people who want the status quo, the people who have given away jobs in this country, who’ve left us with an enormous trade deficit and one that’s growing. [The trade deficit] grew again last year, and if we don’t do something, it will keep growing and keep destroying American jobs.” “Wilbur-Ross’s-star-rises-as-trump-imposes-tariffs”

Though the forces determining our trade deficits have many moving parts, it is not that complicated to explain why everything in the above statement is wrong. In this note I explain why:

  • Our trade deficits are caused more by U.S. government fiscal deficits than by the mercantilist export promotion policies of China, Japan, and Germany;
  • Mercantilist policies that subsidize exports and restrict imports don’t cost American jobs but rather reallocate workers and capital to less productive jobs that lower our standard of living; and
  • Challenging mercantilist policies using the tools and provisions of the WTO and other trade agreements better serves our long run interests than unilaterally imposing tariffs and inciting trade wars.

To understand the relationship between our fiscal deficit and trade balance, it is essential to understand the macro level relationship of our trade deficit to the other broad categories of our national income and expenditures. So take a deep breath as I explain the national income identities through which I will explore that relationship.

The economy’s total domestic output, known as Gross Domestic Product (GDP), can be broken into the broad components of our output/income that reflect how that income is spent. I understand how a little math can discourage some from reading further, but this is necessary and I hope you will indulge me. Starting with the components of expenditures:

GDP = C –M + I + G + X, or GDP = C + I + G + (X-M)

Where:
C = household consumption expenditures / personal consumption expenditures
I = gross private domestic investment
G = government consumption and gross investment expenditures
X = gross exports of goods and services
M = gross imports of goods and services

C-M is household consumption of domestically made goods and services, while M is household consumption of foreign made goods and services. If we subtract M from X (foreign expenditures on domestically made goods and services) we have the famous trade balance. When we buy more foreign goods and services than foreigners buy of our output, i.e., when X-M is negative, we have a trade deficit. As discussed further below, it is important to note that the trade balance (deficit or surplus) is between the U.S. and the rest of the world. Bilateral deficits or surpluses with individual countries are irrelevant.

But another way of breaking up total output (and thus income) is into how households allocate it:

GDP = C + T + S

Where:

T = household tax payments (personal and corporate income taxes plus sales taxes)

S = household saving

These two equations each provide definitions of the same quantity (GDP) and thus can be set equal to each other. This enables us to arrive at a useful formulation of the trade deficit:

C + I + G + (X-M) = C + T + S, or M-X = I-S + G-T;

The relationships in the identity can be described in several ways. Our fiscal deficit (G-T) must be financed by domestic net saving, i.e. a negative I-S, or by foreigners (M-X), i.e. a trade deficit or a mix of the two. Government finances its deficits by selling treasury securities domestically or abroad. If they are purchased domestically, residents must save more for that purpose or investors must borrow less from existing saving. If a fiscal deficit doesn’t crowd out private investment or increase private domestic saving (e.g., if I-S = 0) then it must be financed by foreigners who get the dollars with which to buy U.S. treasure securities by selling their goods and services to us in excess of what they buy from us, i.e., a trade deficit.

The above relationships are derived from definitions. They are tautologies. If the government’s spending exceeds its tax revenue it must borrow the difference from someone: a diversion of spending that would have financed investment (crowding out), a reduction in consumption (i.e., increase in saving), or an increase in the share of consumption spent abroad (increase in imports) giving foreigners the dollars they lend to the U.S. government. The interesting part—the underlying economics—is how markets bring about these results (usually a mix of all three).

When the government increases its need to borrow, other things equal, the increase in the supply of treasury securities relative to the existing demand for them increases the interest rate the government must pay. Higher interest rates generally encourage more saving and discourage investment. If we have no trade deficit (X-M = 0 so that G-T = S-T), the government’s deficit (G-T) must be financed by net saving (S-T). Depending on how much of the net saving comes from an increase in saving and how much from a decrease in investment, government deficits are bad for investment and economic growth in the long run (abstracting from countercyclical budget deficits and surpluses meant to offset cyclical swings in aggregate demand).

However, much of our fiscal deficits have been financed by foreigners (predominantly China and Germany) through their trade surpluses and our trade deficits. The market produces this result because the higher interest rates on U.S. treasury securities (and until now their perceived low risk of default) attracts foreign investors. The foreign demand for dollars in order to buy these treasury securities increases (appreciates) the exchange rate of the dollar for other currencies. An appreciated dollar makes American exports more expensive to foreigners and foreign imports cheaper for Americans. The resulting increase in imports and reduction in exports increases the trade deficit, which then finances our fiscal deficit.

As Alan Blinder put it: “Nations that invest more than they save must borrow the difference from abroad. Happily, the U.S. can do that because foreign countries have confidence in American securities. When we import more than we export, foreigners get IOUs in return for goods and services Americans want. That sounds more like winning than losing: We get German cars, French wines, and Chinese solar panels, while the Germans, French and Chinese get paper assets. America’s tremendous ability to export IOUs has been called our “exorbitant privilege.” Yes, privilege.” “This-is-exactly-how-trade-wars-begin”

If you have made it this far, you will be better able to understand the errors of Secretary Ross’s statement above: “if we don’t do something, it [the trade deficit] will keep growing and keep destroying American jobs.” If the United States government wants to reduce our trade deficit, it should reduce, rather than further increase, our fiscal deficit.

As noted above, however, our trade deficits reflect many moving parts. In the above example, foreigners want to increase their holdings of U.S. dollars (and dollar assets) in part because the dollar is a widely used international reserve asset. Our trade deficit is the primary way in which we supply our dollars to the rest of the world (and its central banks). However, what if our trading partners were manipulating their exchange rates in order to produce trade surpluses for themselves?

In the past, China followed such a mercantilist policy of promoting its exports over imports as part of its economic development strategy. In that case our trade deficit would result in foreign investments in the US with the net dollars accumulated abroad even without U.S. fiscal deficits. If they are not soaked up financing government debt they will be invested in private securities or other assets (such as Trump Hotels). Just to keep it complicated, these foreign investments would either add financing to increased domestic investment (if they lowered U.S. interest rates) or would buy existing American assets freeing up funds of the sellers to help finance government deficits or new investment. As I said, there are many moving parts, which adjust depending on prices (interest rates) and the public’s buying and investing propensities.

Tariffs don’t violate the above national income identities. Rather they potentially change the allocation of resources toward or away from traded goods. The Better Way tax reform proposals of Congressman Kevin Brady in 2016 included a so-called border adjustment tax, which taxed all imports equally and exempted all exports from the domestic expenditure tax. The tax on imports would have been, in effect, a tariff on all imports. Interestingly Brady’s border adjustment tax would not have affected our trade balance nor distorted resource allocation. The dollar’s exchange rate would have adjusted to nullify the impact of the tariff/tax on the prices we would pay domestically on imports.

Contrast this with the tariffs proposed by President Trump on steel and aluminum imports. These tariffs were meant to prop up inefficient American steel and aluminum firms by increasing the cost of their imported competition. As such it would reallocate our workers and capital to activities that are less productive than they would otherwise be used for (i.e., to the increased production of steel and aluminum). Once all of the adjustments were made we would be poorer, though still fully employed. “Econ-101-trade-in-very-simple-terms.”

It turns out, however, that Trump’s tariff threats were probably a negotiating ploy (He has temporarily exempted Canada and Mexico from the tariffs and is making deals with other suppliers in exchange for suspending the tariff). China is already paying special tariffs on these products to counter Chinese government subsidies and only sells the U.S. 2% of its steel imports. Thus the tariff is largely irrelevant for China. The net short-term affect of Trump’s ploy may well result in almost no tariff revenue and no protection for U.S. steel and aluminum producers and some improvements in other trade deals with our trading partners (or at least what the President considers improvements). In short, Trump’s tariff threat could turn out to be helpful. However, given Trump’s generally negative and/or ill-informed views on trade, this may be an overly generous interpretation.

As The Economist magazine put it: “If this were the extent of Mr. Trump’s protectionism, it would simply be an act of senseless self-harm. In fact, it is a potential disaster—both for America and for the world economy.” “Trumps-tariffs-steel-and-aluminum-could undermine-rules-based-system” Why? Even if the tariffs are waved sufficiently to avoid the retaliatory trade war Europe and others are threatening, Trump’s use of the national security justification for his steel and aluminum tariffs can’t be taken seriously. “That excuse is self-evidently spurious. Most of America’s imports of steel come from Canada, the European Union, Mexico and South Korea, America’s allies.” The Economist My long time friend Jim Roumasset noted that “Wilber Ross did indeed make such a finding [of a national security threat], but then declared that the tariffs are “no big deal.” In other words, the tariffs won’t improve national security. Unfortunately, there is neither check nor balance against the ignorance of commerce secretaries.”

The large expansion of international trade made possible by removing trade barriers, including lowering tariffs, has enormously benefited us (the U.S. and the rest of the world). In 1980 60% of the world’s population earned less than $2.00 a day (inflation and purchasing power parity adjusted). Because of economic growth, significantly spurred by expanding world trade, this number as plummeted to 13% by 2012 (latest figure available). This incredible feat was made possible by the collective agreements of virtually all of the world’s countries to increasingly lower tariffs and other trade barriers and to agree on global rules for fair competition. These trade rules were developed under the General Agreement on Trade and Tariffs (GATT) created after WWII as one of the three Bretton Woods institutions (the International Monetary Fund, the World Bank, and the GATT), which became the World Trade Organization (WTO) in 1995.

With its large and diverse membership of 164 rich and poor countries, the GATT/WTO has not been able to conclude new global trade agreements since 1995. Thus attention shifted to regional, multilateral agreements such as the 11 country Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) successor to the Trans-Pacific Partnership (TPP) from which Trump very foolishly withdrew the U.S. last year. “The-shriveling-of-U.S.-influence”

When China was admitted to the WTO in 2001 we expected that it would continue to liberalize and privatize its economy in accordance with the requirements of the WTO’s rules. The expectation was that China’s membership in the WTO would draw it into the liberal international rule based trading system.

In 2002, the IMF sent me to China to discuss these requirements in the banking sector with the Peoples Bank of China. We had high expectations. Unfortunately, China’s liberalization has gone into reverse in recent years. While not a trade issue, China’s recent launch of its centralized rating of the good behavior of its citizens, drawing on its extensive surveillance capacities, and its just announced intension to bar people with low “social credit” scores from airplanes and trains is certainly not an example of the more bottom up civil liberties, human rights views and approaches of most other countries. “China-to-bar-people-with-bad-social-credit-from-planes-trains.”

China’s behavior has been a disappointment. From its accession into the WTO, China began flooding the world with its “cheap” exports while continuing to restrict its imports from the rest of the world. The normal market reaction and adjustment to the inflow of dollars to China from its resulting trade surplus would be an appreciation of the Chinese currency (renminbi), which would increase the cost of China’s exports to the rest of the world (and lower the cost of its foreign import). However, China intervened in foreign currency markets to prevent its currency from appreciating and as a result China accumulated huge foreign exchange reserves (peaking at 4 trillion U.S. dollars in 2014). Not only did China intervene to prevent the nominal appreciation of its currency, but it also sterilized the domestic increase in its money supply that would normally result from the currency intervention, thus preventing the domestic inflation that would also have increased the cost of its exports to the rest of the world.

China’s currency manipulation was not seriously challenged at that time. Economic conditions in China have more recently changed and since 2014 market forces have tended to depreciate the renminbi, which China resisted by drawing down its large FX reserves (all the way to 3 trillion USD by the end of 2016—they have risen modestly since then). China is no longer a currency manipulator as part of an export promotion (mercantilist) policy.

But China does continue to violate other WTO rules with many state subsidies to export industries and limits and conditions for imports and foreign investment (such as requiring U.S. companies to share their patents as a condition for investing in or operating in China). A government subsidy of exports distorts resource allocation and thus lowers overall output in the same way but in the opposite direction as do tariffs. Both reduce the benefits and gains from trade and are to be resisted. The WTO exists to help remove such barriers and distortions in mutually agreed, rule based ways. A tariff that balances a state subsidy helps restore the efficient allocation of resources upon which maximum economic growth depends. These are allowed by WTO rules when it is established that a country’s exports violate WTO rules. President Trump is considering such targeted tariffs (his steel and aluminum are certainly not an example of this type of tariff) and hopefully they will conform to WTO requirements. “Trump-eyes-tariffs-on-up-to-60-billion-chinese-goods-tech-telecoms-apparel-targeted”

Trump’s bypass of WTO rules for his steel and aluminum tariffs, undermine the WTO and the international standards that have contributed so much to lifting the standard of living around the world. Despite its many weaknesses and shortcomings our interests are better serviced by strengthening the WTO rather than weakening it. “Trumps-tariffs-aren’t-killing-the-world-trade-organ”

“Whatever the WTO’s problems, it would be a tragedy to undermine it. If America pursues a mercantilist trade policy in defiance of the global trading system, other countries are bound to follow. That might not lead to an immediate collapse of the WTO, but it would gradually erode one of the foundations of the globalised economy. Everyone would suffer.” The Economist

As an aside, our bilateral trade deficits (e.g., with China) and surpluses (e.g., with Canada) are totally irrelevant and any policy designed to achieve trade balance country by country would damage the extent and efficiency of our international trade and thus lower our standard of living. See my earlier discussion of this issue in: “The-balance-of-trade”

“Even though trade policies are unlikely to change the long-run trade balance, they are not unimportant. Americans will be better off if the United States can use trade negotiations to open foreign markets for its exports, not because more exports will increase the US trade surplus, but rather because US incomes will be higher if more US workers can be employed in the most efficient US firms that pay high wages, and if those firms can sell more exports at higher prices. Similarly, US living standards will be higher if the United States reduces its trade barriers at home because this will give consumers access to cheaper imports and make the economy more efficient. Ultimately, therefore, the goal of US trade policies should not be focused on trade balances but instead on eliminating trade barriers at home and abroad.” This is quoted from the excellent and more detailed discussion of many of these issues that can be found here: “Five reasons why the focus on trade deficits is misleading”

There is another, very important negative byproduct of Trump’s transactional, confrontational, zero sum approach to getting better trade agreements. Mutually beneficial trade relations strengthen political and security relations and cooperation. These have been important non-economic benefits, for example, of NAFTA. Trump’s confrontational approach undermines these benefits. Pew Research Center surveys in 37 countries found that: “In the closing years of the Obama presidency, a median of 64% had a positive view of the U.S. Today, just 49% are favorably inclined toward America. Again, some of the steepest declines in U.S. image are found among long-standing allies.” Senator Ben Sasse delivered an exceptional speech on this subject followed by an outstanding panel discussion of the NAFTA negotiations at the Heritage Foundation. I urge you to watch the following video of that event: “The-national-security-implications-of withdrawing from-NAFTA”

The Balance of Trade

President Trump has regularly called for bilateral trade balances with our trading partners. Though he prudently gave up his campaign promise to declare China a currency manipulator on his first day in office because of China’s large trade surpluses with the U.S., he more recently criticized Germany’s even larger surplus. The Trump administration’s objectives in renegotiating the North American Free Trade Agreement (NAFTA) published July 17th also call for reducing U.S. bilateral trade deficits with Mexico and Canada. Economists recognize these objectives as nonsensical, but it might be worthwhile to spell out to the broader public (if not to Trump’s protectionist White House wing) why that is so.

Let’s start with the U.S. trade balance with the rest of the world. As we pay for what we import with what we export, we would generally expect a balance between imports and exports over time, just as we expect a rough balance between our income and expenditures over time. But uniquely in the case of the U.S., we need to have a deficit (imports exceeding exports) paid for with U.S. dollars, because the rest of the world holds and uses our dollars to finance many international transactions. The dollar is the world’s primary international reserve currency and our trade deficit is the primary means by which we supply them to the rest of the world.

This is an over simplification, however, because dollars are also supplied to the rest of the world via our capital account, i.e. Americans investing abroad. At the end of 2016 Americans had invested about $24 trillion USD equivalent. However, the rest of the world had invested over $32 trillion USD in the U.S. Roughly $5 trillion of this net investment in the U.S. of $8 trillion represented official foreign exchange reserves held by foreign governments in U.S. dollars out of total foreign exchange reserves of about $8 trillion.

Something also needs to be said about the relationship between foreign holdings of dollars and changes in those holdings. Any increase in the demand for foreign exchange reserves by foreign governments, something that tends to happen naturally as economies grow, must be met by the balance of payments deficits of the countries supplying those reserves. Thus the U.S. trade deficit last year (2016) of about $500 billion USD more or less reflects the addition to the dollar reserves of foreign governments.

So the use of the U.S. dollar in foreign exchange reserves implies that the U.S. will have, and need to have, a balance of trade deficit of a similar amount. But let’s simplify and assume that U.S. trade with the rest of the world is balanced (zero trade balance as well as zero current and capital account balances), perhaps because the U.S. dollar is replaced in international reserves by the SDR as I have long recommended. See my: Real SDR Currency Board What about the trade balance with Mexico and Canada? Should we want and expect each bilateral trade relationship to be balanced?

The error of such thinking can be easily illustrated with a simple, hypothetical example. Assume that within NAFTA the U.S.’s comparative advantage is in manufacturing all the pieces that make up an automobile and growing wheat, Mexico’s comparative advantage is using its “cheap” labor to assemble those pieces into cars, and Canada’s is growing and milling lumber. Assume that that is all they do that crosses their borders. The U.S. sells its car parts to Mexico, which puts them together and sells the cars to the U.S. and Canada. The value of the parts sold to Mexico is less than the value of the cars (which incorporates the parts from the U.S.) Mexico sells to the U.S. so that on net the U.S. has a trade deficit with Mexico. The U.S. sells wheat to Canadians buying a lesser value of lumber in return and Canada sells its lumber to the U.S. and to Mexico buying a few cars but of less value. Looking at bilateral trade balances, Mexico has a surplus vs. the U.S. and a deficit vs. Canada. Canada has a surplus vs. Mexico just sufficient to cover its deficit vs. the U.S. These bilateral deficits and surpluses are not a problem because the U.S. has a trade balance vs. Mexico and Canada combined and indeed with all of the rest of the world. The same is true for Mexico and Canada. What really matters is whether the value of a country’s exports to the rest of the world match and thus pay for the value of its imports from the rest of the world. As someone noted, no one worries that you have a large trade deficit with the grocery store as long as your total spending everywhere is covered by your income (the sale of your labor to your employer).

Being the eternal optimist, I trust that there are enough people in the Trump administration that understand that seeking bilateral trade balances with each and every country would be a terrible mistake to keep him from trying to do so.