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What Does the Trade Deficit Mean, and How Does it Affect Us?

by Drew J Jones Sat Feb 11th, 2006 at 04:29:23 PM EST

It seems like Americans are bombarded with talk of our current-accounts deficit on an almost-twenty-four-hour basis.  One of the reasons -- China's artificially undervalued currency, the yuan -- is breeding a great deal of anger among workers, and it is being fueled by the television news media with all the talk of outsourcing and currency pegs and the like.  It has led many famous economists, including former Fed chairman Paul Volcker, to caution that a run on the dollar is increasingly becoming a danger to the American economy.

That may be true, but lost in all of this has been an understanding of the actual implications of this trade deficit at the household level.  Some of it -- a lot of it, actually -- is the result of Americans going on a spending binge, thanks to low interest rates and their nasty, little partner, the housing boom.  And, yes, the undervalued yuan allows countries, like China, to artificially stimulate their exports.  But, before we launch ourselves into another Cold War with another communist party, let's think about what the trade deficit actually means.


The road to prosperity is one that China will need to travel along for many more years before its GDP per capita will even begins to resemble those of America and Western Europe.  It's population is roughly four times the size of America's, and three times that of the EU.  Whereas poverty in America is found in the rural, inland West -- Idaho, Wyoming, and Montana, among others -- where citizens earn average incomes in the neighborhood of $10,000 per year, many in China's western provinces live on only about one dollar per day and suffer from issues like the hideous effects of truly-massive environmental pollution.

But in only thirty years, China has escaped the grip of arguably the most murderous totalitarian political figure of the 20th Century, Mao Zedong, and many of its citizens have found high-paying jobs in China's screaming urban economy.  It has been quite a sight to see.

That growing prosperity is limited, however, by the actions of the Chinese government.  The government, by propping up the dollar, is essentially holding down the purchasing power of the yuan, restricting the ability of the emerging middle- and upper-classes to buy goods and services produced elsewhere.  While this continues to push Chinese exports, these citizens are being penalyzed by their government's modern form of mercantilism -- a theory, attacked by both Adam Smith (in The Wealth of Nations) and David Ricardo, that saw trade as a zero-sum game, with the goal being the accumulation as much precious metal (e.g., gold) as possible by running a positive trade balance.

This is not without some benefit to America.  With artificially low purchasing power in the yuan, American citizens necessarily have artificially high purchasing power in the dollar, as it relates to Chinese goods and services.  In that way, a friend of mine commented, this could be considered almost a gift from the Chinese.  (Don't expect a Thank You card, President Hu.)  After all, he said, they're selling their goods to us at lower prices.  And while I would hardly call it a gift -- it's a trade, not a gift -- the basic argument holds.

Now it is possible that a run on the dollar is inevitable, at this point -- a harder landing than we would hope for.  The trade deficit is truly massive, now 5.8% of annual output ($726b in 2005), and the higher it climbs, the larger the adjustment will be.  The figure typically thrown around by economists is a 40% plunge in the dollar.  And as pressure builds on Washington to get tough with the Chinese government on currency policy the expected timeframe in which investors believe the dollar will fall will be moved closer.

The adjustment may well be quite painful for households that have grown accustomed to being able to buy cheap products made in Asia.  But it will also allow consumption to pick up in China, providing citizens with the ability to buy far more goods and services from other countries.  That will stimulate production elsewhere.

The media are wrong to use this issue to fuel hatred of the Chinese by painting trade as a zero-sum game, because many Americans have enjoyed great benefits from the current relationship.  But they are right to preach flexible exchange rates and incentives for Americans to save.  Painful though it may be to many, the current situation distorts the proper workings of the international economy, and I've got to believe that spells danger.

It's time to let the yuan float.  And it's time for Americans to put their wallets away.

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For a libertarian take on this try this article:

http://www.tcsdaily.com/article.aspx?id=021006G

He says not to worry, trade deficits are good for us...

Policies not Politics
---- Daily Landscape

by rdf (robert.feinman@gmail.com) on Sat Feb 11th, 2006 at 04:59:34 PM EST
He's, of course, wrong, as they tend to be.  The trade deficit, as I explained, has been good for some of us, but at the expense of other benefits.

Be nice to America. Or we'll bring democracy to your country.
by Drew J Jones (pedobear@pennstatefootball.com) on Sat Feb 11th, 2006 at 05:17:46 PM EST
[ Parent ]
What other profession do you know of where leaders in the field can come to exactly opposite conclusions from the same data besides economics?

The fact that this fellow is the chairman of the economics department at his university tells you something about the reliability of our fiscal and monetary policies...

Policies not Politics
---- Daily Landscape

by rdf (robert.feinman@gmail.com) on Sun Feb 12th, 2006 at 09:52:19 AM EST
[ Parent ]
Don't read too much into the fact that he's a chairman of a department.  Plenty of departments are chaired by morons.  Plenty are chaired by brilliant people.  My old department's chairman was an excellent developmental economist.  (Most of his research deals with Africa.  He's not very involved in the traditional areas of the field, like business cycles and monetary theory.)  Unfortunately, becoming chairman of a department can sometimes be more of a political victory than an intellectual one.

Auburn University, for example, is a very Austrian-leaning department, even though Austrian economics is not followed by many economists, while Princeton was chaired by Ben Bernanke, a Keynesian, for a long time.  Bernanke also hired Krugman.  You'll find departments tend to become stacked with people of the same view, unfortunately.

As for coming to different conclusions, you can find the same problem among climate researchers, and God knows that statisticians love to tell all sorts of stories with data.  It's more a question of finding the economists who know what they're talking about.  That can be difficult, but it's certainly not impossible.

Be nice to America. Or we'll bring democracy to your country.

by Drew J Jones (pedobear@pennstatefootball.com) on Sun Feb 12th, 2006 at 10:12:41 AM EST
[ Parent ]
Just show me a physics department where the chairman says that gravity makes things fly apart instead of coming together...

Policies not Politics
---- Daily Landscape
by rdf (robert.feinman@gmail.com) on Sun Feb 12th, 2006 at 10:25:59 AM EST
[ Parent ]
Not sure about that.  Maybe among the Christian-Right-dominated schools.  Physicists also don't tend to have a problem with keeping professors apolitical.  Economics departments certainly do, in many cases -- hence my example of Auburn and ths stacking of staff who all agree with the same view.

That's politics, not economics.

Be nice to America. Or we'll bring democracy to your country.

by Drew J Jones (pedobear@pennstatefootball.com) on Sun Feb 12th, 2006 at 10:58:48 AM EST
[ Parent ]
It's hard to avoid the impression that much of what passes for economics is thinly conceiled politics.

A society committed to the notion that government is always bad will have bad government. And it doesn't have to be that way. — Paul Krugman
by Migeru (migeru at eurotrib dot com) on Sun Feb 12th, 2006 at 12:07:25 PM EST
[ Parent ]
You have obviously never been involved in a good Physics department fight.
by asdf on Mon Feb 13th, 2006 at 10:32:54 PM EST
[ Parent ]
A little perspective:

Not to imply NAFTA is the cause, it was just something I was looking at.

See Jobs In America Vol. III for a look at the imapct of the trade deficit.

by btower on Sat Feb 11th, 2006 at 07:23:26 PM EST
Thanks to you Drew, and rdf's suggested article, I have spent a number of hours rummaging around the internet on macro-economic issues.  My focus for many years has been on micro-economic/business issues, so this was fun, though draining.  I found a great article, Remarks by Governor Ben S. Bernanke, March 10, 2005, The Global Saving Glut and the U.S. Current Account Deficit that I found to be very heavy reading, for me, but very enlightening, to the extent that I could understand it.
The part that sticks out for me, is that he focuses some attention on the flip side of the current account, the capital account.  He seems to say you need to look at the issue from both perspectives--like two sides of the same coin.  The typical newspaper discussion talks only about current account oriented issues--spending, lack of savings, etc.  But what is minus on the current account is plus on the capital accounts--a tautology as he says.  And he points out that from 1996 to present, a somewhat surprising thing has happened--the developing countries have become net investors in the industrialized countries.  Seems kind of backwards, but he explains why, and also shows why the relationship needs to change.  But the Industrialized countries, particularly the US, have provided a great investment vehicle with their productive economies--and the developing countries have actually had great need for investment returns, gaining of $ based reserves.  And it is this investment side of the picture that has driven much of what we have seen over the past 10 years.  I know my imperfect summary totally lacks, and hope you will go through this--but I really found it helpful in understanding the situation today.

Interesting that his analysis does not lead him to believe in a crash of the American dollar, but rather a smoother longer term adjustment:

Finally, the large current account deficit of the United States, in particular, requires substantial flows of foreign financing. As I have discussed today, the underlying sources of the U.S. current account deficit appear to be medium-term or even long-term in nature, suggesting that the situation will eventually begin to improve, although a return to approximate balance may take some time. Fundamentally, I see no reason why the whole process should not proceed smoothly. However, the risk of a disorderly adjustment in financial markets always exists, and the appropriately conservative approach for policymakers is to be on guard for any such developments.
 Obviously his remarks take on particular meaning today in his new position at the Fed.  Also seems like a brilliant guy, and makes it clear why he was chosen and so easily approved.
by wchurchill on Sun Feb 12th, 2006 at 02:52:41 AM EST
Bernanke says:

"It follows that the country's current account deficit equals the excess of its investment over its saving."

Is he serious? This is just so wrong, it's hard to know where to start.

Doesn't he understand that just because money is spent doesn't mean it's spent as capital investment?

You could surely reality check this by assessing levels of capital investment and seeing how they've followed the deficit. Would anyone be silly enough to bet that there has been an explosion of capital investment to match the US trade deficit?

by ThatBritGuy (thatbritguy (at) googlemail.com) on Sun Feb 12th, 2006 at 08:09:58 AM EST
[ Parent ]
Especially at a time where we know the Fed has spent the last few years shoring up the economy by using policies encouraging individuals to mortgage themselves up to their eyebrows in order to fuel consumer spending...

A society committed to the notion that government is always bad will have bad government. And it doesn't have to be that way. — Paul Krugman
by Migeru (migeru at eurotrib dot com) on Sun Feb 12th, 2006 at 08:23:05 AM EST
[ Parent ]
This is "global savings glut" theory paper that was presented almost a year ago.

It is economically nonsensical because it effectively assumes that US spending is all related to capital expenditures to productive capital stock (which is not true). Actually US capital expenditures (in last few years) related to productive stock are roughly equal to amount needed to keep it in current level (i.e. to stay afloat). The US current account decifit is mostly due excessive spending to consumption and residential (effectively non-productive as far as import/export is concerned) construction.

It is also good to remember that US is not terribly good in attracting foreign portfolio investment (US investments are larger to abroad than foreign investment to US) and large current account decifit is due foreigners putting their money into US debt instruments.

Thus the trade decifits and current account decifits are not due any great surge of capital investment to US as engine of World economy.

by Nikita on Sun Feb 12th, 2006 at 09:30:44 AM EST
[ Parent ]
"the trade decifits and current account decifits are not due any great surge of capital investment to US"

Here is some data to illustrate it:

US FDI flows 1995-2004

Home made with data from UNCTAD FDI Database
Source: Bureau of Economic Analysis, U.S. Department of Commerce.

About the poor quality of the picture, please, be indulgent: it's the first time I use Photobucket to upload a graph I made...

"Dieu se rit des hommes qui se plaignent des conséquences alors qu'ils en chérissent les causes" Jacques-Bénigne Bossuet

by Melanchthon on Sun Feb 12th, 2006 at 12:46:30 PM EST
[ Parent ]
The graph is fine (if you want to be sure it fits, just add width="400" inside the < img > html, before or after the 'src="http://...' code

Thanks for the source on FDI. I've longed wanted such a source to build a graph with French inbound FDI compared to others, to show that despite its 'horrible' policies, it is an attractive place to invest in.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Sun Feb 12th, 2006 at 05:02:45 PM EST
[ Parent ]
Do you have a link to a paper, or discussion, by a professional economist that challenges Bernanke's view?  I would be very interested in reading it if you have one.

I've commented below to the effect that IMO your comment and others are defining the capital account in balance of payments as "capital expenditures to productive capital stock", in your words.  The capital account in fact includes the US debt instruments that you mention above, as well as investment in securities.

by wchurchill on Sun Feb 12th, 2006 at 02:14:39 PM EST
[ Parent ]
go through my diaries here or on dKos, and you'll find plenty of debunking of "Helicopter" Ben and "Bubbles" Greenspan.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Sun Feb 12th, 2006 at 04:42:43 PM EST
[ Parent ]
But what is minus on the current account is plus on the capital accounts--a tautology as he says.

I think this is only true in the aggregate -- meaning in the entire global economy.  If you were to add up every country's current-accounts deficit, it would be equal to their capital-accounts surpluses, I believe.

Be nice to America. Or we'll bring democracy to your country.

by Drew J Jones (pedobear@pennstatefootball.com) on Sun Feb 12th, 2006 at 10:19:15 AM EST
[ Parent ]
The comments above criticizing Bernanke's paper focus on the fact that direct physical investment in assets in the United States do not offset the current account deficit.  But that is not what Bernanke says.  He says that the current account deficit must be offset by a capital account surplus.  But the capital account includes much more than capital expenditures to productive capital stock.  There are many spots on the Web, including Wikipedia which define the makeup of the capital account, but here is one I was recently reading from tutor2uTM
Supporting Teachers: Inspiring Students
Economics Revision Focus: 2004
AS Economics
Trade Deficit and Current Account
The capital account is one of two primary components of the balance of payments. It tracks the movement of funds for investments and loans into and out of a country.
The capital account is the net result of public and private international investment flowing in and out of a country. This includes foreign direct investment, plus changes in holdings of stocks, bonds, loans, bank accounts, and currencies.
The capital account only keeps track of the money being transferred (i.e., the worth of stocks is not taken into account as money when calculating figures for the capital account). Hence, a surplus in the capital account amounts to debtor status.
Along with transactions pertaining to non-financial and non-produced assets, the capital account may also include debt forgiveness, the transfer of goods and financial assets by migrants leaving or entering a country, the transfer of ownership on fixed assets, the transfer of funds received to the sale or acquisition of fixed assets, gift and inheritance taxes, death levies, patents, copyrights, royalties, and uninsured damage to fixed assets.
In fact note from the Bernanke article that I referenced, his own comment on one aspect of other countries investing in US Treasury Bonds:
In practice, these countries increased reserves through the expedient of issuing debt to their citizens, thereby mobilizing domestic saving, and then using the proceeds to buy U.S. Treasury securities and other assets.

I think this misunderstanding is leading many to miss Bernanke's point, which I have found to be a very insightful one.  It's not just the spending side of International trade flows that determines the entire picuture.  Decisions are being made on the investment side as well, and these decisions are just as influential as the spending side, perhaps moreso in today's worldwide financial situation.  Ignoring that will lead to an incomplete understanding of the world financial picture, and perhaps to less than satisfactory investment decisions.

I would be interested if anyone has seen a professional economist challenge Bernanke's views presented in this paper from May of 2005.  I have not found such a criticism, and am in fact under the impression that most leading economists agree with his views.  But of course I could be wrong, and would love to see such a paper.

by wchurchill on Sun Feb 12th, 2006 at 02:36:49 PM EST
I think you could find comments of Bernanke's views, as well as broader comments on deficits and trade imbalance on Nouriel Roubini and Brad Setser's site: RGE Monitor

"Dieu se rit des hommes qui se plaignent des conséquences alors qu'ils en chérissent les causes" Jacques-Bénigne Bossuet
by Melanchthon on Sun Feb 12th, 2006 at 03:08:02 PM EST
[ Parent ]
thanks for this site.  it looks great.  i'm afraid it might be pretty expensive.  as I clicked on articles to read, it put me in the registration section, and i did fill that out,,,,but they take some data about you and say they'll get back to you regarding price.  Was that also your experience?  I'll see what they come back with.
by wchurchill on Sun Feb 12th, 2006 at 04:26:10 PM EST
[ Parent ]
We're not the ones who are getting the Capital Account confused with capital investment. Bernanke is. To give the full quote:

"We saw earlier that the current account deficit equals the net amount that the United States borrows abroad in each period, and I have just shown that U.S. net foreign borrowing equals the excess of U.S. capital investment over U.S. national saving. It follows that the country's current account deficit equals the excess of its investment over its saving."

Are the words 'capital investment' ambiguous there?

Also, where is the evidence for a savings glut? According to Bernanke the world is swimming in liquidity, funded by a mature population with money to burn.

What evidence can anyone point to that this is really the case?

by ThatBritGuy (thatbritguy (at) googlemail.com) on Sun Feb 12th, 2006 at 04:56:32 PM EST
[ Parent ]
The world is indeed swimming in liquidity - kindly provided by the Fed's outrageously low interest rates for several years!

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Sun Feb 12th, 2006 at 05:00:07 PM EST
[ Parent ]
How much of that is corporate, and how much of it is personal?

I'm suspicious of any argument that seems to be trying to conflate personal, corporate and national debt and investment - as Bernanke seems to be trying to do.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Mon Feb 13th, 2006 at 05:20:27 AM EST
[ Parent ]


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