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.

When the accounting is done for 2001, the trade deficit will probably be seen to have fallen to about 4.1 percent, according to Charles McMillion, an economist at the consulting firm MBG. But given that imports are expected to fall disproportionately in a recession year, it is shocking that the drop from 2000 was not much greater. In 1991, the most recent previous recession year, the current account (which includes not only trade but also interest payments and government-to-government transfers) was actually in surplus.

Perhaps the best gauge of the present crisis is the record of other Group of Seven nations. Some have certainly on occasion incurred deficits that were proportionately even larger—but virtually without exception they did so only in the economic devastation of the world wars and their immediate aftermath.

America's trade deficits matter for several fundamental reasons. As the author and economist Pat Choate points out, not only do excessive imports displace American jobs but in many cases they weaken America's defense base. During the Gulf War of 1991, for example, The Washington Post reported that American defense officials were "sweating bullets" as they waited for a reluctant Japan to supply crucial high-tech components for America's weapons systems.

The most immediate effect of the deficits is that they have to be paid for. Every dollar of current-account deficit must be funded with a dollar of foreign financing. Ultimately, the issue is who owns the world's assets. In just a few years in the 1980s the United States went from being the world's greatest net creditor to the world's greatest net debtor. Things have gotten much worse since then. From 1989 to 2000 trade deficits inflated America's net foreign liabilities sevenfold, to more than $1.8 trillion. A big factor in this trend was a major increase in foreign ownership of U.S. industry. Why should Americans care who owns U.S. industry? There are many reasons; the most obvious is that foreign corporations are much less likely than U.S. corporations to build their most productive plants in the United States.

For anyone familiar with economic history, it should be obvious why the current mania has hitherto been subjected to so little scrutiny in the American press. As John Kenneth Galbraith has pointed out, an economic error proliferates when someone has an interest in promoting it. In the case of the present trade crisis two sources of error have played a decisive role—the foreign-trade lobby and the Wall Street securities industry. The foreign-trade lobby, representing foreign exporters who sell into the American market, has an obvious interest in fudging the long-term consequences of trade deficits. Wall Street's motivation derives in part from the fact that many U.S. corporations gain a short-term increase in profits by moving jobs to low-wage places like Mexico and China. That increase comes, however, at the expense of America's fast-dwindling manufacturing work force. Particularly when American workers have no similarly productive new jobs to move to, the result is a serious weakening of the U.S. economy. Another reason Wall Street downplays the trade crisis is that many investment houses benefit from arranging the international transactions needed to finance trade deficits.

Apart from these interested, and influential, parties, many in the U.S. economics profession feel uneasy about the deficits. This emerged clearly in a survey I conducted of the ten American economists who had most recently won the Nobel Prize. Only one laureate, Gary Becker, of the University of Chicago, was prepared to endorse the media and Wall Street view that deficits pose no policy problem for the United States. Robert Solow, of MIT, said that deficits do pose a problem; Daniel McFadden, of the University of California at Berkeley, was less worried about the short term than the long term. Although the other seven were unwilling to comment publicly, several of them were clearly discomfited by the worsening trend in trade. Yet Wall Street's prestige in the American business press remains so great—despite the Internet-stock debacle—that dissenting opinions, like the ones the laureates express publicly and privately, get drowned out.

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