Summary
- For 2006 the US trade deficit reached $763 billion, a new record.
- Exports of goods and services totaled $1437 billion.
- Imports totaled $2201 billion.
The trade deficit with China totaled more than $220 billion, a new record, double the deficit typically run with Japan.
Continuing on this course, we will reach a trillion dollar deficit within a few years, even if we are highly successful at exporting. The simple dynamics of imports being almost twice exports insures that even rapid growth, well above the historical norm, in exports will not reduce the deficit.
Would David Ricardo use the argument for "free trade" to support the position of most business leaders that we are better off with an open economy, or is he turning over in his grave when he hears his simple, two country, two product, theory invoked to explain the benefits of trade to the simple minded and self interested business executives who profit from this over indulgence.
Analysis
Okay, lets talk realistically about trade. First of all there's nothing in David Ricardo's theory that suggests that a country trade all of one thing for what it needs for another. There's only the implication that you can gain by taking advantage of what you do best. Countries in the 1840's didn't have the leeway to buy 10% of their needs on credit year in and year out. This simple minded theory has been taken far out of context. First of all Ricardo was mainly interested in promoting business. To do that in the 1840's you needed to be pro cheap food. Cheap food meant imports from France or the Continent. If you had cheap food them you could pay lower wages to factory workers and profits would be greater. Of course the land owners didn't like this. Thus the corn laws and all that they entailed in terms of protection. Given the European Union's current outlook on the Common Agricultural Policy (CAP), things have not progressed much since then.
Once you get past the fairy tale that free trade is always right or that deficits don't matter because we can get the Chinese to buy our T-bills and the like forever, you come down to the hard realities of what is happening to the American manufacturing sector. The sector is being hollowed out. What does this mean? Lets look at what a company is today. It is less about direct manufacturing, and more about business process engineering, sales, marketing, and if we are lucky, research and development. These activities consume the lions' share of the wages paid. A company remains a manufacturing company so long as what it sells mainly are manufactured products, but if much of the inputs to these are imported or built in foreign plants and then repackaged or marketed under their brand, and if most of the sales revenues and profits are made here, then it may look like manufacturing is growing (which it is), while at the same time employment in manufacturing is falling as direct labor hours are replaced by foreign labor hours. Profits increase as costs go down. Sales are dependent on the growth in the consumer sector or even in sales of these imported inputs to other companies. In 1990 the import share of manufactured goods was just 17% and in 2006 the share is over 34%. Millions of manufacturing jobs have been lost, but according to the miscalculated productivity numbers, American workers are more efficient than ever before. It is surprising that no one in the financial community has tried to figure out this paradox. A failure to export sufficiently to cover our imports, but a surge in productivity.
Of course there's a simple explanation. If you replace US worker with foreign workers they don't show up in hours worked. Productivity growth is rarely measured correctly. Selling more with the same sales, marketing, management, but with fewer manufacturing workers, will yield higher productivity, but not necessarily demonstrate manufacturing prowess. The truth is that the private sector companies are abandoning production of real goods here and moving them overseas. This is, however, a shortsighted strategy that will, in the end, backfire on the country as a whole, if not on individual companies.
Okay, then what should be done about it? God forbid we try to increase prices for the average, underpaid American workers, or do anything to interfere with the free will of companies to buy from who they want to buy from what they want. Trade is a free rider problem in the grandest sense. Everyone wants to take advantage of the benefits of outsourcing production to the lowest cost producers, but at the same time they depend upon other companies to step up to the plate, employ the workers displaced, pay them decent wages, and thus insure that there is adequate final demand to buy the products they sell. If enough companies lay off enough workers then this will not work. Right now we have consumers buying more than they can afford given the stagnation in wages and the layoffs. We are, as a country, living well beyond our means. Of course we are supporting the growth and development of other countries by this consumption. Like good sailors, no one wants to rock the boat, thus the Asians dutifully buy our T-bills and recirculate the dollars. The Arabs do the same, but put more of their excess into real estate and hedge funds. And as American manufacturing is hollowed out , there are fewer products that are typically American. It is not surprising that agricultural products and raw materials or semi-processed intermediates, are often exported in lieu of finished manufactures.
Wage differentials are also quite wide. The Chinese wages are sometimes estimated to be 33 cents an hour in the export oriented manufacturing sector. The workers don't make enough to support the economy. At least 4% of the growth in China comes from trade. Higher wages in China might stimulate more domestic demand and less dependence on exports, but it wouldn't stop companies from doing both.
Those who don't want to rock the boat, including most economists, tend to worry that any form of protection will lead to Harley Smoot tariffs and a collapse of the world economy. They ignore the experience of steel and autos, both benefiting from some form of protection to avoid complete collapse. The American steel industry remains alive where it would have been driven into the tank by cheap foreign made products without the trigger prices. The limited, voluntary protection, in autos incentivized the Japanese to open factories here. My own opinion it was probably the best move they could make as it centered them on the key market and made them more efficient and effective as global competitors. Nor will changing exchange rates cut it. There is no exchange rate that will make Chinese exports of low value products more expensive than American substitutes. Nor will selective tariffs imposed through the cumbersome process of anti-dumping duties.
Then what can be done and why should we do it? First of all the WTO rules are flawed. Countries are admonished from imposing new tariffs or subsidizing home production. There is no consideration of the size of the deficit with the world. Nor is there any penalty for countries that run ever larger surpluses with the world. International trade is a two way street. Thus the first thing I would do would be to demand before reauthorizing the WTO membership to force a rule change that demands mandatory, across the board, tariffs to be applied to reduce the deficit if it is declared to be chronic. Increasing prices by say 10% or 20% on imports to reduce the deficit will definitely do the trick. Alternatively countries running chronic surpluses would be forced to impose a similar export tax on their exports with the world. In this way the trade would, in time, become more balanced.
Of course this is only one of many possible solutions. If you don't want to impose higher tariffs, then penalize companies that depend upon selling in the American market for their business, but buy most of the products they sell from abroad. For large, multinationals, there might be an adjustment in the corporate tax rate based on a formula that measures the ratio of their US market sales to their total sales (the upper part of the ratio) against their Purchases in the US against their total purchases of goods, services, and wages. For example a company that earns 70% of their revenues in the United States but purchases only 35% of their product and services here has a ratio of 2. If the corporate tax rate is 45% then they would multiply this by this ratio to get their new tax rate. Such a program would force companies to weigh the benefits and costs of outsourcing production and services.
There's a third alternative. I suggested this about two years before Warren Buffett got his ass in the ringer for suggesting the same thing in Fortune. Lets say we wanted to reduce the trade deficit by about $100 billion a year. The government would issue or sell in the open market say $2 trillion dollars worth of import rights. Importers would have to buy one of these rights before they could import their products. If they purchased $100,000 worth of imports they would have to have, in hand, $100,000 rights. Third parties would buy and sell these rights. Next year the government might issue only $1.8 trillion and so on until the deficit were reduced. If the rights are issued at an original cost of say 5 cents per right, this would raise $100 billion for the treasury and go a long way to funding new research and development programs or reducing the size the deficit. Third parties would snap these up and buy them like any other financial instrument. If imports fall faster then they would lose value, if demand is greater then they would increase in value. But at the end of the year imports would be limited to the initial offering of rights.
Free trade is not a panacea for all that is wrong with the world. It benefits only a few countries and distorts the natural growth in manufacturing in most emerging and developing markets. Integration with the world economy is a double edged sword. It holds down wages at home and it makes raw materials and intermediates valuable at international prices that are consistent with wages in rich, industrialized countries. Thus it artificially increases the prices of manufactures in developing countries and limits market growth to only those workers who make enough to buy these more expensive finished products. To see this make a graph relating the purchasing power parity index (US = 1.0) for developing economies against their manufacturing wages relative to US wages in an XY graph. If wages were consistent with PPP prices then the points should group close to the 45 degree line. Instead they cluster above that line as PPP prices are higher than relative wages.
There are no easy answers to the question what should be done about the US trade deficit, but the first step is to stop believing that free trade is the only solution to global growth and development. It is not. Trade is important, specialization critical, but trade that is chronically imbalanced, that reduces the ability of countries to feed themselves or make products using the range of human capital available in all countries, is not. Everyday low prices are not worth, lower wages and stifled technologies. Workers are better off with a growing, vibrant manufacturing sector at home, than with cheap goods from China or outsourced software from India.
Once you get past the fairy tale that free trade is always right or that deficits don't matter because we can get the Chinese to buy our T-bills and the like forever, you come down to the hard realities of what is happening to the American manufacturing sector. The sector is being hollowed out. What does this mean? Lets look at what a company is today. It is less about direct manufacturing, and more about business process engineering, sales, marketing, and if we are lucky, research and development. These activities consume the lions' share of the wages paid. A company remains a manufacturing company so long as what it sells mainly are manufactured products, but if much of the inputs to these are imported or built in foreign plants and then repackaged or marketed under their brand, and if most of the sales revenues and profits are made here, then it may look like manufacturing is growing (which it is), while at the same time employment in manufacturing is falling as direct labor hours are replaced by foreign labor hours. Profits increase as costs go down. Sales are dependent on the growth in the consumer sector or even in sales of these imported inputs to other companies. In 1990 the import share of manufactured goods was just 17% and in 2006 the share is over 34%. Millions of manufacturing jobs have been lost, but according to the miscalculated productivity numbers, American workers are more efficient than ever before. It is surprising that no one in the financial community has tried to figure out this paradox. A failure to export sufficiently to cover our imports, but a surge in productivity.
Of course there's a simple explanation. If you replace US worker with foreign workers they don't show up in hours worked. Productivity growth is rarely measured correctly. Selling more with the same sales, marketing, management, but with fewer manufacturing workers, will yield higher productivity, but not necessarily demonstrate manufacturing prowess. The truth is that the private sector companies are abandoning production of real goods here and moving them overseas. This is, however, a shortsighted strategy that will, in the end, backfire on the country as a whole, if not on individual companies.
Okay, then what should be done about it? God forbid we try to increase prices for the average, underpaid American workers, or do anything to interfere with the free will of companies to buy from who they want to buy from what they want. Trade is a free rider problem in the grandest sense. Everyone wants to take advantage of the benefits of outsourcing production to the lowest cost producers, but at the same time they depend upon other companies to step up to the plate, employ the workers displaced, pay them decent wages, and thus insure that there is adequate final demand to buy the products they sell. If enough companies lay off enough workers then this will not work. Right now we have consumers buying more than they can afford given the stagnation in wages and the layoffs. We are, as a country, living well beyond our means. Of course we are supporting the growth and development of other countries by this consumption. Like good sailors, no one wants to rock the boat, thus the Asians dutifully buy our T-bills and recirculate the dollars. The Arabs do the same, but put more of their excess into real estate and hedge funds. And as American manufacturing is hollowed out , there are fewer products that are typically American. It is not surprising that agricultural products and raw materials or semi-processed intermediates, are often exported in lieu of finished manufactures.
Wage differentials are also quite wide. The Chinese wages are sometimes estimated to be 33 cents an hour in the export oriented manufacturing sector. The workers don't make enough to support the economy. At least 4% of the growth in China comes from trade. Higher wages in China might stimulate more domestic demand and less dependence on exports, but it wouldn't stop companies from doing both.
Those who don't want to rock the boat, including most economists, tend to worry that any form of protection will lead to Harley Smoot tariffs and a collapse of the world economy. They ignore the experience of steel and autos, both benefiting from some form of protection to avoid complete collapse. The American steel industry remains alive where it would have been driven into the tank by cheap foreign made products without the trigger prices. The limited, voluntary protection, in autos incentivized the Japanese to open factories here. My own opinion it was probably the best move they could make as it centered them on the key market and made them more efficient and effective as global competitors. Nor will changing exchange rates cut it. There is no exchange rate that will make Chinese exports of low value products more expensive than American substitutes. Nor will selective tariffs imposed through the cumbersome process of anti-dumping duties.
Then what can be done and why should we do it? First of all the WTO rules are flawed. Countries are admonished from imposing new tariffs or subsidizing home production. There is no consideration of the size of the deficit with the world. Nor is there any penalty for countries that run ever larger surpluses with the world. International trade is a two way street. Thus the first thing I would do would be to demand before reauthorizing the WTO membership to force a rule change that demands mandatory, across the board, tariffs to be applied to reduce the deficit if it is declared to be chronic. Increasing prices by say 10% or 20% on imports to reduce the deficit will definitely do the trick. Alternatively countries running chronic surpluses would be forced to impose a similar export tax on their exports with the world. In this way the trade would, in time, become more balanced.
Of course this is only one of many possible solutions. If you don't want to impose higher tariffs, then penalize companies that depend upon selling in the American market for their business, but buy most of the products they sell from abroad. For large, multinationals, there might be an adjustment in the corporate tax rate based on a formula that measures the ratio of their US market sales to their total sales (the upper part of the ratio) against their Purchases in the US against their total purchases of goods, services, and wages. For example a company that earns 70% of their revenues in the United States but purchases only 35% of their product and services here has a ratio of 2. If the corporate tax rate is 45% then they would multiply this by this ratio to get their new tax rate. Such a program would force companies to weigh the benefits and costs of outsourcing production and services.
There's a third alternative. I suggested this about two years before Warren Buffett got his ass in the ringer for suggesting the same thing in Fortune. Lets say we wanted to reduce the trade deficit by about $100 billion a year. The government would issue or sell in the open market say $2 trillion dollars worth of import rights. Importers would have to buy one of these rights before they could import their products. If they purchased $100,000 worth of imports they would have to have, in hand, $100,000 rights. Third parties would buy and sell these rights. Next year the government might issue only $1.8 trillion and so on until the deficit were reduced. If the rights are issued at an original cost of say 5 cents per right, this would raise $100 billion for the treasury and go a long way to funding new research and development programs or reducing the size the deficit. Third parties would snap these up and buy them like any other financial instrument. If imports fall faster then they would lose value, if demand is greater then they would increase in value. But at the end of the year imports would be limited to the initial offering of rights.
Free trade is not a panacea for all that is wrong with the world. It benefits only a few countries and distorts the natural growth in manufacturing in most emerging and developing markets. Integration with the world economy is a double edged sword. It holds down wages at home and it makes raw materials and intermediates valuable at international prices that are consistent with wages in rich, industrialized countries. Thus it artificially increases the prices of manufactures in developing countries and limits market growth to only those workers who make enough to buy these more expensive finished products. To see this make a graph relating the purchasing power parity index (US = 1.0) for developing economies against their manufacturing wages relative to US wages in an XY graph. If wages were consistent with PPP prices then the points should group close to the 45 degree line. Instead they cluster above that line as PPP prices are higher than relative wages.
There are no easy answers to the question what should be done about the US trade deficit, but the first step is to stop believing that free trade is the only solution to global growth and development. It is not. Trade is important, specialization critical, but trade that is chronically imbalanced, that reduces the ability of countries to feed themselves or make products using the range of human capital available in all countries, is not. Everyday low prices are not worth, lower wages and stifled technologies. Workers are better off with a growing, vibrant manufacturing sector at home, than with cheap goods from China or outsourced software from India.
This author consults with leading institutions through GLG
Analyses are solely the work of the authors and have not been edited or endorsed by GLG.
