The Economy April 2002

The Other Deficit

America's ballooning trade deficit may be the worst economic problem we face—and no one wants to talk about it
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Economics is known for extraordinary fads and fallacies—for episodes that in retrospect are regarded as sheer lunacy. The most memorable such episodes involve wild speculation: the Dutch tulip mania of the seventeenth century, the Wall Street stock bubble of the late 1920s.

Less fabled outbreaks of economic error, however, have often done at least as much damage. In the 1840s, for instance, a fashion for extreme laissez-faire in London greatly exacerbated the consequences of the Irish famine. Rather than interfere with the workings of the market, British government officials looked the other way as wealthy Irish landowners exported large amounts of food at a time when millions were starving. In the 1920s ideology again got the better of common sense when the British government restored the pound to its high, pre-World War I value—a move that brought British industry to its knees and paved the way for the Great Depression of the 1930s. A doctrinaire, and utterly wrongheaded, commitment by both major American political parties in the early 1930s to balancing the federal budget greatly worsened the Depression.

In the late 1980s prominent commentators promoted Japanese stocks to the skies, on the theory that things in Japan were somehow different and the Japanese economic system would never let asset prices fall. When the Japanese government failed to play its putative role, countless billions of dollars in American insurance and pension-fund money vanished. More recently we heard from nearly everyone, up to and including the chairman of the Federal Reserve, that the rise of the New Economy had wrought fundamental changes in the economic rules. Assertions like these helped to inflate the Internet-stock bubble of the late 1990s.

Today, entirely unnoticed by the American public, the United States is in the grip of a new economic error—one that will ultimately be seen to dwarf these others: the belief, a daily mantra for some of America's most prominent economic commentators, that America's rapidly growing trade deficits do not matter.

The view that trade deficits aren't harmful has its roots in an axiom of introductory economics: that any exchange between willing buyers and sellers benefits both sides. As applied to trade deficits, this premise supposedly means that countries with chronic-surplus economies, such as Japan and China, willingly choose to consume less than their industries produce. Conversely, countries with chronic-deficit economies, the United States among them, consume more than they produce, and "choose" to go into debt or sell assets to make up the difference.

Through the 1970s even people who believed that free markets generally produce optimal results hesitated to extend that theory to international trade. After all, a nation's economy is more complicated than even the largest corporation: debt to foreign lenders can affect foreign policy, and because workers can't easily migrate across borders for better jobs, the shift of production from one country to another has important political consequences.

But starting in the 1980s the claim that trade imbalances do not matter began to surface, especially on The Wall Street Journal's op-ed pages. Twenty years later it has gone mainstream. Not only is it the Journal's official editorial position but it has been taken up with enthusiasm by everyone from Foreign Affairs magazine to the Cato Institute. It is almost seen as a sign of economic literacy to remind the public that trade deficits aren't important. For example, David Gardner, a co-founder of Motley Fool, which is an influential Web site for stock-market investors, wrote recently (under the heading "Our Friend, the Trade Deficit"), "Trade deficits are in fact a pretty healthy sign in America, and we need not tinker to reduce them." Although the editors of The New York Times and The Washington Post occasionally offer warnings of possible dangers from soaring deficits, their usual position is that there is little to worry about. This attitude explains why, even as deficits have tripled in the past few years, they have all but disappeared from the news.

One thing is undeniable: the deficits are now vastly larger than most of America's best-informed citizens realize. On the "current account," as the broadest measure is known, the trade deficit in 2000 represented fully 4.5 percent of gross domestic product. That is the highest figure the United States has ever recorded—an impressive statement, given that the statistical series goes back to 1889, and that in 2000 the U.S. economy was seen as being stronger than ever. Before 1983 the current-account deficit had never exceeded even one percent in any year of the twentieth century. In 1972, for instance, the deficit was a mere 0.5 percent of the GDP—yet so troubled had President Richard Nixon been by the prospect of bad trade figures for that year that in the summer of 1971 he chose to go off the gold standard.

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