When the third quarter gross domestic product report came out on Oct. 30, most of the attention focused on the drop in real consumer spending, the first since 1991. Especially in a Presidential election year, the pain for consumers (BusinessWeek.com, 10/29/08) is the most relevant political fact.
But to know where this crisis is headed over the next year or so, you need to watch a different number: the size of the U.S. trade deficit. In the third quarter, the U.S. had a trade deficit of $707 billion—equal to 5% of GDP at an annual rate. That's smaller than the peak deficit of nearly $800 billion in the third quarter of 2006, but it's still an astonishing sum, especially since every dollar of the trade deficit is another dollar that the rest of the world has to lend the U.S.
Homeowners are staggering under giant mortgages, Wall Street is flat on its back, and the country is in the throes of the greatest credit crunch since the Great Depression—yet America keeps borrowing by the truckload. If this crisis was caused by too much debt, how long can the trade deficit stay so high?
In fact, there are three possible scenarios for the trade deficit, each of which implies a different set of consequences for the U.S. economy and for the global economy:
•Business as usual One possibility is that the trade deficit remains high. The rest of the world keeps shipping goods and services to the U.S. while it continues to lend the U.S. the money to pay for the imports.
•Global restructuring Alternatively, the trade deficit shrinks because U.S. consumers cut back on imports and the rest of the world has to adjust to a global economy that lacks the U.S.'s customary demand and borrowing.
•Innovative growth The final possibility is that the trade deficit shrinks because the U.S. exports more innovative goods and services to the rest of the world.
Before going through the pluses, minuses, and likelihood of each scenario, let's take a quick step back and look at the big picture. The global boom of the past 10 years has been driven by three flows. First, multinational companies shipped technological knowledge and business know-how to countries such as China, India, and elsewhere in order to set up supply chains there. This "dark matter" is not picked up anywhere on the economic data, but it was absolutely essential for juicing up global growth. In return for this flow of knowledge, the industrialized world—and especially the U.S.—got back a river of cheap goods and services. Finally, to pay for these imports, the U.S. borrowed a steady stream of money from the rest of the world—roughly $5 trillion worth since 2000.
But here's the question no one really worried about: How did this money get into the country? The federal government borrowed about $1.5 trillion directly from overseas. But most of the borrowing—perhaps $3.5 trillion to $4 trillion worth—flowed through Wall Street in the form of corporate bonds, equities, and exotic securities. Wall Street firms were the major intermediary between the rest of the world and U.S. consumers. For example, firms would package subprime mortgages into a complex security and then sell big chunks to overseas buyers.
This flow of money, an essential part of the global boom, explains why Wall Street was so prosperous in recent years—and why it failed so suddenly. Bankers, hedge fund managers, and other Wall Street types would take their piece of the foreign money as it came into the U.S. They grew rich that way. But when it became clear that U.S. consumers could no longer afford to carry the loans, the financial flows froze up, threatening the global boom.
Thus, the financial crisis is a symptom, not a cause. At root, this is a crisis of the entire global economy as it has developed over the past 10 years.
Federal Borrowing can buy time
So what happens next? In the first scenario, it's business as usual. The trade deficit stays high because the federal government takes over the U.S. consumer's old role of borrowing. In other words, the river of foreign cash would flow through Washington rather than Wall Street. This assumes that the next administration adopts a policy of massive fiscal stimulus—say, on the order of $400 billion next year—which is mainly borrowed from overseas. This borrowing and spending cushions the recession both in the U.S. and globally. It also means that multinationals can keep doing what they were doing, at least for a while: outsourcing production to other countries.
The danger of the business-as-usual scenario is that it requires the U.S. to keep adding debt, which is what got us into trouble. This time, though, it is the federal government that would be doing the borrowing, rather than individual financial institutions. In effect, the entire U.S. economy would be pledged as security for the loans. So unless the money is used wisely—for infrastructure, education, and innovation—there's likely to be an even nastier crisis in the future.
The second scenario calls for global restructuring: The trade deficit falls because the U.S. cuts back on imports sharply. This could happen because the government does not step in with enough fiscal stimulus to ward off a deep recession, or because the dollar falls, or both. In the short run, the global restructuring scenario is very painful for both the U.S. and the rest of the world. Living standards would drop (BusinessWeek, 10/9/08) in the U.S. as cheap imports shrank and there would be massive job cuts in industries such as retailing that depend on a flow of foreign goods. Overseas, a global economy shaped around rising U.S. purchases would falter.
Restructuring would slow growth
In the long run, the global restructuring scenario has both positives and negatives. The positives, of course, are that it doesn't require long-term unsustainable borrowing by the U.S. and it encourages the return of manufacturing jobs to the country. A negative is that living standards will be depressed in the U.S. for a long time. And even if domestic manufacturing can be rebuilt, products will be more expensive.
Overseas, the problem will be a different one. The demand from the U.S. is replaceable, but its knowledge exports are not. With less outsourcing, the flow of technology and business know-how from industrialized to developing countries will slow or even be cut off entirely, which will restrain growth.
The third scenario's innovative growth calls for the trade deficit to shrink because the U.S. produces more innovative goods and services at home and exports them. In the 1990s, in fact, economists projected that exports of high-tech products would rise in step with the expansion of trade. The problems in recent years have come because exports fell short of forecasts, not because imports rose too high. No one anticipated that production of advanced electronics and pharmaceuticals—the crown jewels of American innovation—would be so quickly moved offshore (BusinessWeek.com, 12/27/06), undercutting U.S. exports.
The innovative growth scenario benefits both the U.S. and the rest of the world, because it gives the U.S. something to sell. In order for it to happen, the enormous sums of research money already spent in areas such as biotech and nanotech have to start paying off in a big way. That means a breakthrough on the order of the semiconductor revolution—say, bioengineered bacteria that munch cellulose and efficiently turn out ethanol. In addition, at least part of the associated production has to be kept in the U.S., rather than shipped overseas.
This third scenario won't be easy to achieve. But that's the one we should be aiming for. It gives us the best chance of a happy ending.