Commentary: That Trade Deficit Is No Debacle
The latest report on the U.S. trade deficit was a headline event. In November, imports exceeded exports by a record $60 billion -- more than a million bucks for each minute of the month. The gap was up 32% from January, surprising analysts who had expected the falling dollar to help shrink the gap. The trade deficit now stands at around 6% of gross domestic product, the highest level ever.
How worried should we be? To many businesspeople and politicians, the trade deficit shows the U.S. is living beyond its means and stealing from the living standards of future generations. They worry that foreign creditors, by propping up the dollar and allowing Americans to overconsume, are giving the U.S. the rope to hang itself. They fear an abrupt plunge of the dollar could boost inflation, devastate the stock market, and force the Federal Reserve to jack up interest rates to defend the currency. Says Morgan Stanley (MWD ) Chief Economist Stephen S. Roach: "We're guilty of taking excess consumption to an entirely different plateau than any leading modern economy has ever seen."
But there's a different way to look at the trade deficit that's much less frightening. In this view, U.S. policymakers have properly stayed focused on what really matters: fostering strong economic growth to increase prosperity. At the moment, the U.S. is growing faster than many of its trading partners in Europe and Japan, so imports are rising faster than exports, and the trade gap is growing. But fighting that trend -- say, by slowing domestic growth -- would be pure folly. Robert Z. Lawrence, a trade economist at Harvard University's John F. Kennedy School of Government, is among those who warn against focusing on the trade deficit as a problem unto itself. Says Lawrence: "I'm more into getting our fundamental fiscal and monetary policies right."
Sure, the November trade deficit was a shocker: It set a record when it seemed the gap should be shrinking. But Lawrence says that's no surprise. His research shows that it takes up to three years for a cheaper dollar to curb the deficit. The dollar peaked against other currencies in February, 2002, and only began dropping in earnest a year later. As the effects of this plunge filter through the economy, Lawrence expects an increase in exports in the months ahead, restraining the overall trade deficit.
Promoting prosperity at home makes the U.S. a magnet for the world's capital. Given its strong growth prospects, investors from other nations want to own American stocks, factories, real estate, and the like. This inflow of foreign money, in turn, enables Americans to purchase foreign goods. Over the years the U.S. has shifted toward the production of knowledge-oriented goods and services, from biotech to movies, while relying on other countries to supply manufactured products. Yes, the U.S. buys a lot from overseas, but it can afford to -- as long as the rate of return on investments in the U.S. remains high enough to continue attracting foreign capital.
Certainly, there are good reasons for the world's investors to put money in America. The U.S. has an unmatched record of innovation. Meanwhile, Western Europe and Japan are stuck with perennially slow growth and aging populations. Chinese and Indians can hedge their bets by putting some of their money into the U.S., which is safe and stable. And while it may appear from the official savings statistics that the U.S. is living beyond its means, the U.S. is actually investing heavily in the future in the form of education and research and development (BW -- Jan. 17). If Americans were selling off their inheritance to pay for a spending spree, you would expect it to show up in the statistics. Far from it: The net worth of Americans has continued to rise in spite of the transfer of some assets abroad.
While pundits wring their hands about a coming dollar crisis, foreigners with real money on the line seem less concerned. They're putting their euros, yen, and pesos in the U.S. True, for several months last year, much of the investment inflow was from Asian central banks, including those of China and Japan, which seemed to be trying to prop up the dollar so Americans could afford to buy their countries' products. Lately, though, the central banks have backed off, and private investors have come to the fore. The Treasury Dept. announced on Jan. 18 that private foreign investors bought a net $72 billion of long-term domestic assets from Americans in November, while official foreign organizations bought a more modest $28 billion worth. The private flows alone were more than enough to finance the $60 billion trade deficit. And the dollar rallied on the news to its highest level in two months against the euro. Says Daniel Griswold, director of the Center for Trade Policy Studies at the libertarian Cato Institute: "There's no reason to think that foreigners are going to wake up one day and say: 'I'm going to pull all of my money out of the U.S."'
Deciding how scary the deficit really is has big implications for real-world policy. Those most concerned about the trade gap favor the most drastic actions. The AFL-CIO, for example, wants to slow down future free-trade agreements and favors strong action to get China to revalue its currency by 40%. Many mainstream economists focus on increasing the national savings rate by shrinking the federal budget deficit and getting households to sock away more of their paychecks. Morgan Stanley's Roach goes further than most, arguing that the Federal Reserve should raise interest rates to cool off households' financial speculation.
But such cures range from impractical to counterproductive. China won't revalue the yuan by 40% no matter how much the U.S. jawbones, and threats of sanctions against China would only risk a trade war. As for increasing the national savings rate, it's hardly a cure-all. There's little support in economic research for the view that low savings rates are damaging. Proof: The U.S. is growing handsomely with a low savings rate, while Germany has been dogged by years of slow growth in spite of abundant savings. And Fed rate hikes? Sure, they make sense -- but not to the point where they choke off consumer demand and risk a recession.
President George W. Bush, for one, seems to side with the view that promoting growth matters more than targeting trade deficits. He told USA Today in a recent interview that "the best way to deal with the trade deficit is to make sure that America is...the best place in the world to do business." The Administration has wisely resisted calls to lobby for a lower dollar, while avoiding the equally misbegotten course of trying to prop it up above its natural level.
The trade deficit may look scary, but the U.S. would be wise not to overreact to it. Get the big things right -- such as healthy domestic growth -- and the rest will take care of itself.
By Peter Coy