Thursday, September 10, 2009

Does The Trade Deficit Threaten The U.S. Recovery?

The U.S. trade deficit increased more than expected in July, from an upwardly revised $27.5 billion in June to $32 billion in July. The main causes of that were higher oil prices and increased imports of car and car parts. The latter being a result of the "cash for clunkers" scheme and the way it particularly benefits buyers of Japanese and Korean cars.

Now Peter Morici, Professor at the University of Maryland School of Business claims that "the trade deficit threatens the recovery" based on a crude "imports destroys jobs" reasoning.

The empirical facts are hard to square with this theory. The U.S. trade deficit rose when employment grew between 2003 and 2007, and then it collapsed at the same time as employment started to fall sharply (from $65 billion in July 2008 to $26 billion in May 2009) , which is to say during the second half of 2008 and the first half of 2009. And if imports really is bad for the economy, then North Korea would be the most prosperous nation on Earth and being subject to trade sanctions should be a big boon to any economy. And if reduced trade deficit really created jobs, then Latvia should have seen a big drop in unemployment during the latest 18 months when a trade deficit of 20% of GDP has been turned into a trade surplus (if trade in services is included). In reality, Latvia has seen a dramatic increase in unemployment.

These empirical facts do not necessarily prove that his theory is wrong, especially since there are cases seemingly consistent with the theory, such as the slump in the German economy when its trade deficit decreased during late 2008 and early 2009 and the recovery in the last few months when the surplus increased. However, as it happens there are good theoretical arguments for believing that it is wrong.

Using the traditional GDP accounting, it would at first glance appear that the theory is correct, as Y=C+I+G+NX where Y is GDP, C is consumer spending, I is investment spending, G is government spending and NX is net exports (the trade balance). However, that is an accounting identity and accounting identities do not establish causal relationships. The theory that a lower NX will lower Y implicitly assumes that the size of NX does not affect C, I or G. But that is not a reasonable assumption because the flip side of a lower NX (smaller surplus or bigger deficit or shift from deficit to surplus) is that capital inflow increases, something which lowers interest rates and thus enables higher domestic demand. And the correct theory that a lower NX causes C, I and/or G to be higher is just as consistent with the accounting identity as the theory that NX causes Y to be lower. Furthermore a lower NX means that the aggregate supply of goods and services increases, something which puts downward pressure on prices and therefore increases purchasing power.

Trade deficits do not lower Y, they increase C, I and G. And because of the lower prices, real Y will in fact increase. Because of the mutual gains created from comparative advantage, real Y will increase from increased trade both in the country where NX increases and where NX decreases. This explains why the big drop in world trade was associated with slumps in both countries where NX increased (such as the U.S. and Latvia) and countries where NX decreased (such as Germany).

One exception however to the above is when government interventions distort incentives, as is the case with for example the “cash for clunkers” scheme. But the higher trade deficit is then only a symptom of the underlying problem which is the interventions.


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