Trade Deficits vs.Trade Surpluses

Despite a sharply falling dollar, the U.S. Trade Deficit has continued to confound the experts by steadily increasing to new record levels of 6.3 % of GDP. What are the implications of this for the U.S. economy and what, if anything, should be done about it? Let us begin by first examining the two most common views, the a) mercantilist and the b) supply-side views, who while strongly at odds with each other, yet both still manages to get it wrong. This debate is akin to the Marxist and Neoclassical theories, which are also at odds with each other, and both still manage to get it wrong.

The mercantilist view of the trade deficit is the one held by protectionists of various stripes, including Neoconservatives like Pat Buchanan and Paul Craig Roberts, CNN News anchor Lou Dobbs as well as the left-wing, Economic Policy Institute. This view in effect holds that the trade deficit kills jobs. They have all explicitly blamed the trade deficit for the slow job growth during recent years. Pat Buchanan used to repeat the calculation that $1 billion in exports means 25,000 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 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. 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. 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 should mean that Germany has been able to take more and more jobs from other countries, Germany has a 11.5% and rising unemployment rate. While Estonia , also contrary to the mercantilist prediction, has a large and rapidly growing current account deficit of more than 12% of GDP, almost twice as high as in America and more than twice as high as it was in 2000 "Despite" this rapidly rising trade deficit, 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 some 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 jet have trade surpluses because of their extraordinarily high personal saving rates (ashight as 40%0. It is generally the case that when trade deficits increases so does growth and when trade deficits decreases so does growth. 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 the free trade theory is "Ivory Tower" and out of touch with the real world.

What the mercantilists overlook 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 of capital 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.

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

Capital inflow that largely consists of Asian central bank purchases of U.S. government bonds are no less valuable than Foreign Direct Investments. While it can be argued that the Asian central bank purchases of U.S. Treasuries 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 many would have expected which means that through these indirect means, Asian central bank purchases have helped boost investments in America.

Indeed, 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 elsewhere. This mechanism of foreigners pouring money at low-yielding investments into 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 has 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. 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 an expanded productive capacity.

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 not just increased consumption and thereby expand the productive capacity of the country.

Having seen the fallacy of the mercantilist "trade deficits kills jobs"-theory, does this mean that we should adhere to the supply-side view, 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 the fact, 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 for individuals to sometimes good and sometimes bad to borrow, so is it for countries that have current account deficits. If the money an individual borrows is going to be used for productive investments it is a good idea but if on the other hand the money will be used for excessive consumption and/or bad investments it is a bad idea .And what is true for the individual is also true for 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, But if the capital inflow is used to finance excessive consumption and/or malinvestments then it is a very 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 both a housing and stock market bubbles as well as excess consumption.. 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's fall will only partially restore balance by limiting imports but 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 chance 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.

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 and accordingly goes to excessive consumption and malinvestments and not directly related to trade so 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 CONFUSING CAUSE AND EFFECT.

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 the FED still holds down interest rates by a faster expansion of the money supply.

As excessive consumption and/or malinvestments is always the result of loose fiscal and/or loose 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.

The best and only way to reduce trade deficits, without creating a trade war is to increase our National savings rate.


Aubie Baltin CFA, CTA, CFP, Phd. (retired)
Palm Beach Gardens, FL


4 August 2005

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