TRADE DEFICIT 

by

JOSEPH ZODL

© 2001 by Joseph Zodl

    The United States has consistently run a trade deficit for which many observers blame tariff and non-tariff barriers in destination countries.

    (Tariff barriers are duty rates whereas non-tariff barriers can be government quotas on imports, marking regulations, cultural barriers, and other factors. All of these also exist for imports into the United States. Our duty rates are lower than those of many other countries, but we do have government-imposed quotas (many agricultural and textile goods, for example), marking regulations as to country of origin and other information, and cultural barriers. A point could be made that the United States has established a major trade barrier against imports from other nations by its reluctance to "go metric.")

    While many countries have higher duty rates than the United States, as well as stricter import quotas, import licensing requirements and other restrictions, this does not explain the trade deficit. Rather it is a partial reason for a deficit with a specific country.

    The United States imports a product from another country, whether from an independent company or a  U.S.-owned subsidiary company in the foreign country, for one of the following reasons:

1. the product can be made and transported to the United States more inexpensively than a product made in the United States.
2. a better product can be made and transported to the United States marketplace for the same cost as a product made in the United States. This is an extension of reason #1.
3. the product cannot be produced  in the United States but there is a marketplace demand for it (e..g., French wine. While wine is made in the United States, French wine is not and cannot be).
4. the product is not produced in the United States in sufficient quantity for the demands of the marketplace (e.g., oil).

    In all cases, for the product to enter the United States and succeed  it must be brought into the marketplace at an affordable price. There are however different markets in the huge U.S. marketplace. For example, there is a market of wine drinkers who are not interested in French wine; there is a market of those who will pay a slightly higher price for an imported wine, and a small market of those who will pay quite high prices.

    So it is important to recognize that French wine, for example, in quality and price, varies across a spectrum and is not one commodity.

    There is also a substitution question between imports and domestic products. If the price of French wine dramatically increases, some U.S. consumers will substitute domestic wine. If the price dramatically drops, some U.S. consumers of domestic wine will decide to try French wine. Price changes can be due to production costs, cost of materials, or other factors, both domestically and internationally. Internationally, there is the added factor of currency fluctuations (e.g., the French Franc and the Euro rising or falling versus the U.S. Dollar).

    Likewise, U.S. companies entering foreign markets must compete on one of the four factors shown above, and are also subject to currency fluctuations versus the foreign currency.

    Given all this, why does the U.S. consistently run a trade deficit while other countries do so only occasionally, and in some cases consistently run a surplus (See Trade Statistics)? The answer lies in our national economic statistics.

For the year 2000, here our trade deficit figures:    

    These figures take into consideration exports and imports of goods and also of services (financial services, insurance policies, payment to a foreign versus a U.S. airline for a passenger ticket or for cargo transportation, etc.). It considers purchases by tourists in other countries of goods (souvenirs) and services (restaurant meals), and so on. So strictly speaking, some factors are not true exports or imports (A French tourist paying admission to a Broadway play in New York, for example is not getting something that he will carry back to France with him. But his money was still exchanged for U.S. Dollars and spent in the United States and so affects the surplus/deficit between both countries, and therefore between the United States and rest of the world.

  Here is a table based on the idea that exports are what we produce but did not consume (Again, in the broadest sense, even where the French tourist is "consuming" the entertainment that a U.S. theater company produced.). Imports are what we consume but did not produce (a U.S. tourist paying admission to a show in Paris). 

    On the surface, this appears to be an identical route to an identical destination as the first table. Indeed, it brings us to the same numerical answer. But the implication is different. 

    We take our total production of goods and service, and then state that our exports are what we produced but did not consume. So that is subtracted from our GDP. Then our imports are what we consumed but did not produce. So we add that into our table. This gives us the total of what the United States consumed during 2000. Bear in mind this consumption includes domestic wine and French wine consumed in the U.S. It doesn't include California wine sold to a wholesaler in Paris any more than it would include a French wine consumed in France. It includes  a ticket purchased by a U.S. tourist in France, but not a ticket purchased by a French tourist in the U.S. 

    The difference between our Gross Domestic Product and our Gross Domestic Consumption then equals the trade deficit, because it must. The goods and services we consume must come from someplace. What does not come from domestic production must come from foreign production and be imported into the United States.

    Therefore:

    (GDP) minus (EXPORTS) plus (IMPORTS) =  GROSS DOMESTIC CONSUMPTION

    (GDP) minus (GDC) = Trade Deficit

   Trade Deficit = Consumption of United States population over and above what the United States population produces.

    (Trade Deficit) divided by (Gross Domestic Product) = Consumption of United States population over and above what the United States population produces.

    Here are the equations in current (2000) numbers:

($9,400,000,000,000) - ($1,068,000,000,000) + ($1,438,000,000,000) = $9,770,000,000,000

($9,400,000,000,000) - ($9,770,000,000,000) = $370,000,000,000

     Therefore, the United States in the year 2000 consumed $370,000,000,000  more than it produced. Thus we identify the cause of the trade deficit but not yet its effect.

      Many observers state that the United States' trade deficit is anti-inflationary. This is correct. If imports were taken out of the equation, we would be attempting to consume 103.9% of our annual production. 

(GDC) divided by (GDP)

($9,770,000,000,000) divided by ($9,400,000,000,000) = 103.9%

(Put another way, the excess consumption over production is 3.9% 

(EC) divided by (GDP)

($370,000,000,000) divided by ($9,400,000,000,000)

This is too many dollars chasing too few goods and services, which is the classic definition of inflation.

    However, with imports being a factor that keeps inflation from rising faster, it means dollars are flowing out of the country above and beyond the foreign currencies flowing in. 

    Foreign governments, companies, and consumers then decide what to do with the dollars they earn, and have the following options:

1. Purchase U.S. goods and services. That is, buy U.S. products, consume U.S. services, tour the U.S., and so on. Foreign parties do so by the billions of dollars,  but not to the extent where it makes up for the deficit. Remember that the savings rate in many countries is much higher than in the United States.
2. Invest in the United States by purchasing corporate stock and bonds, real estate, companies, etc. The United States is very attractive to foreign investors, but not all the dollars come back this way. 

        (Note that a foreign investment in the U.S. represents funds in, and dividends or interest paid to the investor represent funds out. Ultimately, when the asset is sold, the capital is also returned to the investor and is funds out.

        In a profitable investment in the U.S. by a foreign entity, it represents net funds  out of the U.S. in the long run. For a U.S. investment in a foreign country,  the investment is funds out and the dividends or interest are funds in.  The sale of the asset results in funds in.)

    3.  Invest in the United Sates by purchasing U.S. government debt, and, to a lesser degree, state and municipal debt (e.g., bonds issued by states, cities, power authorities, and so on).

• U.S. Treasury bills are redeemable within one year.
• U.S. Treasury notes are redeemable in more than one but fewer than five years.
• U.S. Treasury bonds are longer than five years.

    Obligations of the government of the United States are considered by bankers and economists to be "risk-free" investment. That is to say, companies can go out of business and default on their obligations, but the U.S. government is expected to never default. This is one reason why foreign investors favor U.S. government debt, in many cases, over the obligations of other governments. U.S. investors do not always consider foreign government debt a good investment, but may under some conditions (e.g., a higher interest rate but a stable currency that will remain exchangeable for dollars are a more or less constant rate of exchange).

    As shown above, a profitable investment means an inflow of investment capital and an outflow of dividends or interest. When the bill, note, or bond is sold or eventually redeemed by the U.S. government at the end of the term for which it was issued, the owner of the debt can reinvest it in the U.S. or take the proceeds out of the U.S. (outflow).

     So in the long run, the U.S consumer-caused trade deficit has provided foreign countries with the means with which to purchase U.S. government debt. The debt has been there because of the U.S. government budget deficit (government-caused) and has been built up over many years by presidents and legislators of both parties. See recent history of national debt.

    With the national debt currently at about $5,600,000,000,000 dollars, this represents a huge amount of interest each year. The interest rate varies by the type of bill, note, or bond, and when it was issued, but is now about 6.5%. Dealing with very round figures, this comes to an annual interest payment of $364,000,000,000 which is about a billion dollars a day. Some of it we pay to ourselves. Much of it we pay to other countries, sometimes to governments which hold some of our debt, sometimes to bankers and investors in other countries.

    At this time, approximately $1,250,000,00 0,000 (about 22.3%)  is held by investors in foreign countries. This is a vulnerable point for the United States. Supposing a foreign country decides that it wishes to sell all its U.S. debt on a given day:

• The United States government must pay interest when due and must redeem the obligations when due. It need not redeem debt before the due date.
• Private investors (banks, insurance companies, speculators, you and me), may buy and sell debt as they see fit. The resell price (the "secondary market") fluctuates daily on factors such as the fluctuation of interest rates. In other words, if the interest rate on your $10,000 bond is 5%, and the going rate is 6.5%, someone else will not pay you $10,000 for that bond. An investor may pay less for the bond to get the same rate of return. (See here.)
• If any holder of bonds sells huge amounts of holdings at one time, and the buying power of the rest of the marketplace remain the same, then the price of the bond is expected to fall (law of supply and demand--more supply, no change in demand (also called "constant demand").
• If the price starts to fall, than the actual interest rate the new buyer receives will be higher. (See here.)
• If interest rates rise, this creates an inflationary pressure.
• If inflation rises, then the value of the dollar decreases (the value of a dollar is going down).
• If the value of the dollar is going down and the value of foreign currencies remain constant, then the value of the dollar versus a foreign currency will go down in the foreign exchange (FX) market.
• If the exchange value of a dollar goes down, it in the end make our products cheaper for buyers in other countries and their products more expensive for us.

    Would this cure the trade deficit? Not likely because with the dollar becoming worth less as a result of the consequences of a massive selling of U.S. debt obligations, other holders of bonds in other countries will see an incentive to sell. (Why hold a bond that you paid $10,000 for if it means that the return is becoming less and less in your home currency? There is an incentive to sell now.)

    This could, (in theory) create a domino effect that would result in huge sales of U.S. government obligations over a period of time, turning the U.S. economy and (because of the U.S. position in it) the world economy into chaos.

    On the other hand, the Federal Reserve Bank is limited in its ability to weaken the U.S. dollar to stimulate exports. If the Fed was to do so:

• The dollar becomes weaker against foreign currencies. Our exports become cheaper (more competitive). They compete more successfully against products from other producing countries, and also compete against domestic producers in other countries. Exports increase.
• Because the dollar is weaker against foreign currencies, foreign products become more expensive for Americans. U.S. buyers substitute domestic products. Imports decrease.
• Because the dollar is weakening, the foreign holder of U.S. debt sees a lower and lower return on each interest check as he converts it into his currency. Therefore, he has a disincentive to keep holding the debt and an incentive to sell.
• U.S. domestic holders of bonds will have a motivation to join the stampede and sell their bonds in order to obtain funds to invest in strengthening overseas markets.
• As sales of U.S. bonds increase in a constant market, the scenario shown above is triggered, creating more and more monetary turmoil.

Therefore:

1. The U.S. Trade Deficit is caused by overconsumption by the United States population (we consume more than we produce and so additional goods and services needed are sourced from abroad).
2. The Trade Deficit over the years has resulted in an excess of dollars in foreign countries which can be spent on U.S. goods and services or to invest in the United States.
3. The lower consumption of our trading partners (consuming less than what they produce) has led to import limited goods and services from the United States. Their high savings rate results in excess dollars available for investment.
4. In addition to investing in U.S. companies and real estate, foreign holders of dollars have chosen in many cases to invest in U.S. bills, notes, and bonds, because they see a balance between a reasonable return on investment and security of the principal and payouts.
5. The United States cannot implement policies that result in a lower exchange rate for the dollar because this will cause a capital flight with serious ramifications.
6. The United States cannot implement policies that result in reduced imports (high tariff rates, quotas) because as imports decrease and demand remains constant, serious inflation will ensue.
7. The United States can continue policies which result in a fiscal budget surplus and pay down the national debt which results in less treasury debt available. While this can result in a bidding up of the price of available debt on the secondary market, it will also divert some foreign funds into capital investment.
8. As the national debt is decreased (and as it decreases in proportion to a rising GDP), more funds are available for capital investment.
9. Foreign investment in the U.S. economy results in more investment being made in the U.S. economic machine, which increases production and therefore GDP, which continues to make the U.S. a more and more attractive focus for investment.
10. The dollar continues to rise making U.S. exports less attractive (on price) in the world marketplace.
11. As the U.S. is not a favored location for labor-intensive manufacture, its competitive advantage is technology and hence a more productive economy. The U.S. can produce a better product at a similar price or an equal product at a better price only if technology permits it to be more productive. Technology is an area where the United States is generally in the lead.
12. In some products, foreign trading partners purchase from the U.S. because it is the only place from which the product can be sourced. Today, computer software and medical technology produce examples of this..
13. The foreign investment as well as continuing domestic investment in the U.S. economy results in the continued lead and competitive advantage in the United States in technology.
14. As technological and technologically-heaving exports increase, the United States establishes a trade surplus. This does not directly contradict the overconsumption argument because once research and development costs are recovered, the selling price of a high-tech product is many times its manufacturing cost. Therefore, the United States software company finds itself in a situation where it consumes $5.00 worth of materials and labor to produce a software package sold wholesale for $100.00 domestically or internationally. $5.00 of GDP consumption then becomes $100.00 worth of exports.
15. The ultimate solution is for the United States to                                             

                 A) export its way out of the trade deficit and

                 B) save its way out of the trade deficit by increasing the savings rate while

                 C) reducing the national debt in order to 

                        1) decrease the opportunity for foreign ownership of government debt.

                        2) increase the opportunity for foreign direct investment in the United States as a result of the reducing availability of U.S. government debt for purchase.

END

Statistical Sources: U.S. Department of the Treasury, Bureau of the Public Debt          
                             U.S. Department of Commerce

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