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13 September 2008

Are you worried about the US trade deficit?

If you are worried about the US trade deficit, read the article "Another Nonproblem" by Richard W. Rahn, a senior fellow of the Cato Institute and chairman of the Institute for Global Economic Growth. How is it that through most of its history the US has had a trade deficit?

He explains that US citizens hold investment assets in other countries and the people of other countries also hold assets in the US. The difference in the value of these assets has remained steady at 17% of the US GDP for many years, despite the absolute size of our trade deficit increasing. This is because the value of our assets in other countries and of the assets of other countries' people in the US have grown at a rate keeping pace with the trade deficit. The investments of US citizens in other countries yield more income on less money invested on average than do the investments that foreigners make in the US. Foreigners like our higher interest rate government bonds compared to those of their own countries for both the higher rate and the low risk. Americans like the higher rates of return on equity investments in other countries. Equity (stock) investments commonly produce a higher rate of return than do government bonds. The net flow of money is in equilibrium and is likely to remain that way provided the US remains politically and economically more stable than most other countries.

2 comments:

Pete Murphy said...

Charles, it's a common tactic employed by those who benefit from America's trade deficit to tell the rest of us not to worry, that the dollars balance out.

Of course the dollars balance out. The U.S. is the only place where American dollars can ultimately be used. Thus, every dollar spent on imported goods returns to the U.S. They return as any one of three different types of investments: (1) direct investment (like building factories), (2) the purchase of U.S. treasuries, and (3) the purchase of private securities like stocks and corporate bonds. Only number 1 does anything to create jobs in the U.S. and, unfortunately, net direct investment is actually negative. More direct investment flows out of the U.S. than is returned by foreigners. In 2006 it was negative by $65 billion. So jobs are actually being destroyed, not created. The other two forms of investment are nothing more than a transfer of ownership of American assets. This does nothing to create jobs and transfers control of America to its foreign owners. To use a recent example, the purchase of Anheuser-Busch by Inbev, the Beglian company, has done nothing to create jobs in the U.S. On the contrary, A-B employees are now all fearful for their jobs, knowing full well that Inbev sees A-B as just a brand, one that can be supplied from their own breweries. That’s the problem with foreign ownership of American assets. Those assets are now put to work for their benefit, with no regard for the effect on Americans.

Our enormous trade deficit is rightly of growing concern to Americans. Since leading the global drive toward trade liberalization by signing the Global Agreement on Tariffs and Trade in 1947, America has been transformed from the weathiest nation on earth - its preeminent industrial power - into a skid row bum, literally begging the rest of the world for cash to keep us afloat. It's a disgusting spectacle. Our cumulative trade deficit since 1976, financed by a sell-off of American assets, is now approaching $9 trillion. What will happen when those assets are depleted? Today's recession may be just a preview of what's to come.

Why? The American work force is the most productive on earth. Our product quality, though it may have fallen short at one time, is now on a par with the Japanese. Our workers have labored tirelessly to improve our competitiveness. Yet our deficit continues to grow. Our median wages and net worth have declined for decades. Our debt has soared.

Clearly, there is something amiss with "free trade." The concept of free trade is rooted in Ricardo's principle of comparative advantage. In 1817 Ricardo hypothesized that every nation benefits when it trades what it makes best for products made best by other nations. On the surface, it seems to make sense. But is it possible that this theory is flawed in some way? Is there something that Ricardo didn't consider?

At this point, I should introduce myself. I am author of a book titled "Five Short Blasts: A New Economic Theory Exposes The Fatal Flaw in Globalization and Its Consequences for America." My theory is that, as population density rises beyond some optimum level, per capita consumption begins to decline. This occurs because, as people are forced to crowd together and conserve space, it becomes ever more impractical to own many products. Falling per capita consumption, in the face of rising productivity (per capita output, which always rises), inevitably yields rising unemployment and poverty.

This theory has huge ramifications for U.S. policy toward population management (especially immigration policy) and trade. The implications for population policy may be obvious, but why trade? It's because these effects of an excessive population density - rising unemployment and poverty - are actually imported when we attempt to engage in free trade in manufactured goods with a nation that is much more densely populated. Our economies combine. The work of manufacturing is spread evenly across the combined labor force. But, while the more densely populated nation gets free access to a healthy market, all we get in return is access to a market emaciated by over-crowding and low per capita consumption. The result is an automatic, irreversible trade deficit and loss of jobs, tantamount to economic suicide.

One need look no further than the U.S.'s trade data for proof of this effect. Using 2006 data, an in-depth analysis reveals that, of our top twenty per capita trade deficits in manufactured goods (the trade deficit divided by the population of the country in question), eighteen are with nations much more densely populated than our own. Even more revealing, if the nations of the world are divided equally around the median population density, the U.S. had a trade surplus in manufactured goods of $17 billion with the half of nations below the median population density. With the half above the median, we had a $480 billion deficit!

Our trade deficit with China is getting all of the attention these days. But, when expressed in per capita terms, our deficit with China in manufactured goods is rather unremarkable - nineteenth on the list. Our per capita deficit with other nations such as Japan, Germany, Mexico, Korea and others (all much more densely populated than the U.S.) is worse. In fact, our largest per capita trade deficit in manufactured goods is with Ireland, a nation twice as densely populated as the U.S. Our per capita deficit with Ireland is twenty-five times worse than China's. My point is not that our deficit with China isn't a problem, but rather that it's exactly what we should have expected when we suddenly applied a trade policy that was a proven failure around the world to a country with one fifth of the world's population.

Ricardo's principle of comparative advantage is overly simplistic and flawed because it does not take into consideration this population density effect and what happens when two nations grossly disparate in population density attempt to trade freely in manufactured goods. While free trade in natural resources and free trade in manufactured goods between nations of roughly equal population density is indeed beneficial, just as Ricardo predicts, it’s a sure-fire loser when attempting to trade freely in manufactured goods with a nation with an excessive population density.

If you‘re interested in learning more about this important new economic theory, then I invite you to visit my web site at OpenWindowPublishingCo.com where you can read the preface, join in the blog discussion and, of course, buy the book if you like. (It's also available at Amazon.com.)

Please forgive me for the somewhat spammish nature of the previous paragraph, but I don't know how else to inject this new theory into the debate about trade without drawing attention to the book that explains the theory.

Pete Murphy
Author, "Five Short Blasts"

Charles R. Anderson said...

Actually, because the US is so stable politically and economically and has been for so long, dollars are still in considerable demand in much of the world and are held overseas for very long periods of time in very large amounts. They are used in many world-wide transactions and do not have to come back to the US to be spent.

Foreign investments in the US as direct investments do fall short of our direct investments abroad as I noted in my post and as Rahn noted. No quibble here.

Foreign money used to purchase US treasury bonds can be a good thing for keeping the government from killing American jobs. I would rather see government reduce its spending and live within a lower tax revenue than it now takes from us, but given that the thieves will not live morally, it may be better for us that government pays out a modest interest rate rather than take money that will create American jobs in the private sector. If the government borrows money at bond rates in the 2 to 4% range instead of taking that money from Americans, that money remains in private hands and helps the economy to grow. The key question here is whether the economy grows at a rate greater than that of the bond rate. If it does, then jobs are created, or more exactly, fewer jobs are destroyed by government taxation.

You claim that the purchase of private securities and corporate bonds does nothing for American job growth. If this were so, then American companies would have no reason to issue stock or corporate bonds. They would also have no reason to occasionally buy their own stock back. Sorry, but whether investors are Americans or foreigners, money invested in American companies is used to create goods and services in America for the purpose of growing companies and their profits. This process often means increased jobs, though it can mean more mechanization and fewer jobs, which is the trend in manufacturing, as it was in agriculture in decades gone by. But there is no need to despair on jobs, since we have a good record of creating more professional jobs.

One should not get too hung up on the transfer of American assets for the reason which I think Rahn did a good job of explaining and which I summarized in my post. He noted that foreigners are gaining assets in absolute terms, but because our economy grows and is not static, the percentage of American assets owned by foreigners has not grown in relative terms. It has long been stable at 17%.

Suppose I am setting up a business and I take on a minority partner who owns 17% of this business. If we have any business being in business, we take our initial investment and we make it grow in value. His 17% of our initial $100,000 is $17,000. Now, if our business grows in value, as most American businesses do, then I own 83% of whatever that increase in value is and my partner makes 17% of it. If the company is worth $110,000 at the end of one year, I made $8300 and he made $1700. How does the fact that he made money hurt me? I'm a nice guy. I like to see other people make money, especially if they are helping me to make it!

Let us consider a foreign company buying a US company in its entirety. We have to ask why the company was sold by its US owners. Perhaps they sold it because they were disappointed in their return on investment and knew that they could use the sale money to make a better investment. The better investment is very likely to create more jobs than was the investment they chose to leave. If the foreign company chooses to take a brand and eliminate the company they bought, that is their decision. They are likely to sell the assets to someone else then. If the plants involved go out of business altogether, well that is surely a sign that no one could figure out how to make a good investment in the plant. It was going out of business anyway then. At least the original American owner got as much money for the poor investment as possible to put to better use.

You make the claim that our median wages have declined for decades. This is misleading. Total work compensation has remained constant for decades. Because of the rising tax burden, people are taking more and more of their work compensation in the form of untaxed benefits and we have more types of untaxed benefits available than ever before. People take more vacation time, more sick leave, more family leave time, more 401(K) and other retirement money, more insurance, and medical savings benefits. They slap the tax man for his cruel greed by protecting as much of their work compensation as they can.

You claim our net worth has declined. When our assets are growing at the same rate as foreign ownership is, this cannot be so due to foreigners taking them. The size of the American GDP has grown steadily, so it must surely be the case that the value of its assets has also grown.

It is probably true that at some limit of population, per capital consumption may have to decline, but we sure are in no imminent danger of that in America. Most of America is still unoccupied. Indeed, most of it is less occupied now than it was 100 years ago when people were spread all across the country on farms and ranches. Much of this land has reverted to forest now that we are much more efficient agriculturally.

Now, I am not doubting that you have found mathematical correlations that are consistent with your thesis that most of our trade deficits are with countries more densely populated than our own. Japan, China, Korea, Singapore, Taiwan, Israel, and all European countries are more densely populated than the US. Few of the less densely populated countries even have much to trade with us, since many of them are mostly wasteland or saddled with feudal governments. They also have fewer people to either buy or produce goods, so they are small markets. Correlation does not mean there is a cause and effect relationship.

Through July 2008, the countries listed in order of the size of our trade deficit with them are:

China, 138/km2
Canada, 3.2/km2
Saudi Arabia, 11.4/km2
Japan, 339/km2
Mexico, 55/km2
Venezuela, 29/km2
Germany, 323/km2
Nigeria, 142/km2
Angola, 12.8/km2
Iraq, 66/km2

where the population density is also given as of 2005. The US population density in 2005 was 31/km2, so six of these countries do have a higher population density than does the US, but there seem to be more important factors at work.

Of the top 10 countries we have a trade deficit with, 7 are oil producers who send more oil to us than buy our products. No surprise there and this has nothing substantial to do with population density. Of these ten countries, China, Japan, and Germany could possibly support your thesis, but I do not think they do. The deficit with China is because they want to take on much of the world's manufacturing as a means of catching up technologically and to develop military power. The government simply does not allow the people to consume as much as they would like to. Wage rates are low and corporate taxes are much lower than in the US. Japan and Germany specialize in exports of high quality and these are desired by our wealthy American population. There is surely nothing wrong with this.

We also have trade surpluses with many countries. In order of the amount of surplus through July of this year these are:

Netherlands, 395/km2
Australia, 2.6/km2
Hong Kong, 6,407/km2
United Arab Emirates, 54/km2
Turkey, 93/km2
Singapore, 6,489/km2
Belgium, 341/km2
Gibraltar, 4,654/km2
Switzerland, 176/km2
Chile, 22/km2

If your thesis were a dominant factor in determining whether a trade deficit would exist, it should also apply in the inverse to those countries we would have surpluses with. But...only Australia and Chile have lower population densities than the US! Meanwhile, how on earth do you explain our surpluses with countries such as Singapore, Hong Kong, the Netherlands, and Belgium, especially?

Some of the dominant factors are these:
Oil production
Cost of Labor
Cost of Business Regulation
Corporate Taxes

I have already pointed out that 7 of the top 10 countries we have a deficit with sell us a lot of oil. You mentioned Ireland as the country with whom we have the largest per capita trade deficit. I expect that is because Ireland has a phenomenally low corporate tax rate of 12.5%, while the US corporate tax rate is 39.3%!

I do not doubt the correlation you claim, but I am convinced that it does relate cause to effect.