November 1, 2005

Why the Trade Deficit Is So Large and Why It Matters

In August, the U.S. deficit for trade in goods and services was $59 billion, about 5.5% of the Gross Domestic Product (GDP). In the months ahead, it likely will rise even further.

Blame for the trade deficit often falls on the federal budget deficit. However, during the second quarter, the current account deficit, which includes goods, services, investment income and transfer payments, was $196 billion but the budget deficit was only $70 billion. The budget deficit, and the foreign borrowing to finance it, is less than half the problem.

In 1991, the federal budget deficit was huge and the current account was in surplus. When Bill Clinton left office in 2001, the budget was in surplus and the current account was in deficit. That is the absolute opposite of what those who blame the trade deficit on the budget deficit would have us expect.

Perhaps the trade deficit is due to a lack of competitive fitness among U.S. businesses.

However, each year the World Economic Forum computes a growth potential index for 117 economies. It examines factors like public finances, technology, the quality of civil institutions and openness to international competition. In this assessment, the United States ranks second after Finland- China and India rank 49th and 50th. The WEC also ranks the fitness of businesses, and on that score the United States ranks first, India ranks 31st and China 57th.

Since 1999, productivity in the United States has increased 3.2% a year. In durable goods manufacturing, productivity has been advancing at a 5.4% pace.

Competitive fitness is, then, not the problem. So what is? I suggest we look in three places.

Despite the generally good U.S. policy environment, certain industry policies place undue burdens on the growth of export and import sectors and push capital and labor into other industries. Many of these policies weigh heavily on manufacturing, in particular durable goods manufacturing where so much competitive potential seems unfulfilled.

Higher healthcare costs, the cost of America's environmental policies and legislative costs, most specifically tort costs, place a heavy burden on U.S. companies. (See ForwardJuly/August 2005.)

Overall, the National Association of Manufacturers has estimated higher benefits costs, regulatory compliance costs and lawsuits add nearly 13% to U.S costs that foreign competitors do not bear. These bias growth toward non-goods producing activities, and we import more and export less in the bargain.

U.S. trade deficits have been driven up by the ineffective negotiation and implementation of trade agreements. These have permitted, for example, China to subsidize manufacturing with zero interest loans and pirate intellectual property, and EU governments to underwrite Airbus with risk-free capital from government treasuries. Many governments require U.S. investors to give away technology, source components locally that might be more cost-effectively made here or hit export goals. (See ForwardSeptember/October 2005.)

The United States is much more dependent on personal and corporate income taxes to finance government than the EU and other countries that levy substantial value-added taxes. The standard value-added tax in the EU averages about 19%, and when rebated on exports and applied to imports, these adjustments provide a 19% subsidy on European products sold here and a 19% tax on U.S. products sold there. An arbitrary interpretation of WTO rules prohibits the United States from making similar border tax adjustments on its exports and imports.

The United States has acceded to special and differential treatment in the WTO which permits developing countries to maintain much higher tariffs on manufactured products, and affords them weaker enforcement on a whole range of issues from subsidies to intellectual property to conditions imposed on U.S. investors. As a consequence, U.S. firms move production to developing countries to scale tariff barriers—consider Brazilian and Chinese auto tariffs.

The Bush administration seems bent on repeating the mistakes of the past. It is not making parity in tariffs a bottom line requirement for negotiations of the Doha trade round.

Foreign governments' latitude to lay on subsidies will likely emerge substantially intact. Rules for foreign investment and exchange rate manipulation are not on the table. U.S. dumping and subsidy/countervailing duty laws, which provide the only real defense against these subventions and abuses of free and open trade, are under assault with only tepid defense from U.S. negotiators.

Perhaps the largest single cause of the trade deficit is the almost complete absence of meaningful disciplines for exchange rates, which the Bush administration has chosen not to address effectively. Since January 2002, the dollar is down an average of 14% against all currencies. The dollar has fallen an average of 24% against the euro and other industrialized country's currencies, but it is up an average of about 1% against the Chinese yuan and other developing country currencies.

The Chinese 2.1% revaluation announced July 21 was too small to significantly affect the value of the dollar or have a measurable effect on trade. The Chinese yuan remains fixed at about 8.1 per dollar thanks to substantial Chinese government purchases of dollars. Other Asian central banks continue similar currency policies lest they lose export markets in the United States and elsewhere to China.

Chinese government purchases of dollars and other securities easily exceed $200 billion per year and 12% of China's GDP. Chinese government purchases of dollars and other securities create a 33% subsidy on China's exports.

Overall, China and other foreign governments purchased more than $82 billion in the second quarter of 2004, creating a 17% subsidy on the sale of foreign goods and services to Americans.


Apologists for the trade deficit argue that it indicates the strength of the U.S. economy, because it is financed by productive investments in U.S. industry. That is less than half true. Most of the capital we import to finance our nearly $800 billion current account deficit goes into foreign holdings of U.S. securities—U.S. government bonds, bank deposits, corporate bonds and the like. These now total about $5 trillion dollars and are growing at a pace of about $500 billion a year-that's more than half the trade deficit. And not all of these are private investors seeking haven from the uncertainties of foreign capital markets. Remember about $395 billion of those $500 billion in paper assets purchased in 2004 went into the coffers of foreign central banks.

At 5% a year, the debt service comes to $250 billion, increasing at about $25 billion a year. This size debt will not be paid off for generations.

Further, persistent U.S. trade deficits undermine U.S. growth. They shift employment away from export and import industries, which enjoy higher productivity and pay higher wages. Trade deficits are a key reason that wages for workers with only high school diplomas have barely kept pace with inflation during the recent economic recovery.

U.S. import and export industries spend at least 50% more on R&D and encourage more investments in skills development and education than other sectors of the economy. By shifting employment away from these competitive industries, the trade deficit reduces U.S. investments in knowledgebased industries and skills and handicaps U.S. growth

U.S. manufacturers are particularly hard hit. Cutting the trade deficit in half would create nearly 2 million more manufacturing jobs. Highly competitive U.S. durable goods manufacturers, such as producers of machine tools, industrial and construction machinery, auto parts and electronic equipment, would benefit substantially.

Slashing the trade deficit in half would add more than one percentage point to U.S. productivity growth and potential GDP growth each year.