The Hidden Danger of Trade Deficits
In 2005, the US current account deficit reached 805 billion US dollars or about 7% of the US gross domestic product. For some analysts, this figure is way beyond the standard critical threshold, while other observers see no risk at all and rather contend that this number indicates the strength and the attractiveness of the United States economy.
Of course, trade deficits indeed present no problem as long as they get financed. What, however, will happen when the United States is forced to reduce the deficit and needs to obtain surpluses in its foreign trade?
The problem is not the trade deficit per se but how to get rid of it when foreign financing stops. In this article, it is argued that only when the analytic elements of capital and time are included in the analysis can the answer to this question be found.
Analysts who base their assessments of the US trade deficit on historical evidence tend to conclude that a frightening level has been obtained, and that the outlook seems even worse, because there is no tendency in sight for a gradual reversal. But this view is only one of several ways to judge the matter. One could also argue that in economic history, empirical evidence does not provide a solid standard. Records are here to be broken. In economic matters we are confronted with heterogeneous cases, and the United States is different in many respects from those countries where the evidence of a deficit limit was gathered.
In another perspective, based on the macroeconomic accounting framework, the current account reflects the relation between national savings and investment. With this approach, the dispute arises about the direction of the causal chain. Do insufficient savings provoke the trade deficit and is it therefore "bad" — or is it high investments that "cause" the deficit and is it therefore "good"? The standard formulae of this approach are:
(I) (EX — IM) = (SPR — IPR) + (TA — G)
(II) → NX = S - I
When leaving aside the unilateral transfers, the current account balance is given by exports (EX) minus imports (IM) and is equal to private savings (SPR) and public savings (TA — G) minus private investment (IPR). Public savings reflect the government budget balance in terms of government income (TA) and government expenditure (G). Private and public savings together form national savings (S). This analysis points to insufficient national savings in relation to investment as the counterpart of the negative trade balance (- NX):
(III) -NX = S < I
Based on the same accounting identities, however, one can also put forth the proposition that it is not low savings that cause the trade deficit, but the true reason for the left side in the equation to be negative is high investment, i.e., a good performance of the US economy relative to the other economies. In this vein of thinking the trade deficit would be no reason for concern because high investment will bring about future economic growth. Instead of being a sign of weakness the trade deficit would be an indicator of strength.
Other observers take the analysis a step further and look at the problem through the balance of payments accounting. One can simplify the balance of payments by concentrating on the two sub-balances of the current account (NX) and the financial and capital account (CF) of the balance of payments (BP):
(IV) BP = NX + CF = 0
(V) → - NX = CF
In this equation, a negative NX would imply a positive CF. This means that the trade deficit is being financed by capital inflows. Nevertheless, here, too, one could also come to a different interpretation when reading the equation from the right hand side to the left. Then the inflow of capital would be the "cause" for the negative trade deficit. This can be interpreted in two ways. First, in form of the no-worry position, that the United States is highly attractive for foreign investors who are eager to apply their funds here, and, second, as a proposition of concern, that the United States is addicted to debt which in turn brings about the trade deficit.
The worry-position sees the United States addicted to cheap imports and to debt. The no-worry argument says that the US trade deficit is a symptom of the strength of the US economy as it is borne out by the readiness of foreign investors to provide financing. The basis of the no-worry argument is that the US economy is growing and that it will continue to grow in the future and that therefore neither low private savings nor high government debt and on-going negative public savings would pose a problem. The adherents of the "worry"-position argue the other way round. In their view, the trade deficit is the result of insufficient private and public savings. Their argument says that the debt accumulation is unsustainable. Some time in the future, foreign lending will stop and the debt pyramid will come crashing down.
These kinds of analyses that work within the macroeconomic accounting framework are inconclusive at best and deceiving at worst. Analyses based on the macroeconomic accounting are inconclusive because when it comes to the roots of the trade deficit they provide no answer and when it comes to the consequences they offer a seemingly instantaneous cure. In other words: analyses that are based on the standard macroeconomic accounting framework neither provide the basis to detect the causes of the imbalances nor do they provide an adequate framework in order to inform about the consequences.
It is only in Austrian economics where capital and time do matter. Capital and time have disappeared in Keynesian macroeconomics and they play no role in Monetarism.[i] But it is capital and its structure that provides the link between micro and macro and between the short and the long run.[ii] Economic analyses that leave out capital and time suffer from incompleteness and provide deceiving answers. Analytically they suffer from excessive aggregation and are downright contradictory when the micro level analysis leads to different results from the macro analysis.
Where do capital and time fit into the context of the trade deficit? First of all, a distinction must be made between capital as an entrepreneurial plan and as an ordered structure of capital goods aimed at profits on the one hand and financial capital, either in the form of monetary savings or as an access to loans, on the other hand. Under a fiat monetary system, money can be created by the central banks and in the commercial banking system. This money need not represent authentic savings and it does not need to reflect time preferences. Under a fiat monetary regime, there can be more money flowing around than resources are available and the interest rate can differ from the prevailing time preferences, as they would show up in the "natural" interest rate.
In the older Austrian school of economics, monetary policy impacts mainly on the higher stages of production, i.e., on those economic activities that represent more roundabout processes. Under loose monetary conditions, markets receive a signal from the interest rate that wrongly says: there are sufficient savings available. Business is induced to ask for more investment loans. A green light for more debt is given, when the expansive monetary policy has artificially lowered the monetary rate of interest. The result is a constellation where the more roundabout production gets a boost. However, this additional demand that is generated through money, is not matched by domestic production, or, more specifically, additional investment demand is being generated that is not matched by authentic domestic savings. Therefore, the monetary expansion will be unsustainable.
Under modern conditions, however, with large parts of the financial sector directed at retail banking and at dealing in government debt instruments, monetary policy will impact strongly on those activities that are closer to consumption — both for private and government purposes. In earlier times, when the government sector was small and the access of consumers to loans was limited, the impact of monetary policy fell directly on the business sector and here mainly affected the long-term financing of investment projects. Under current conditions, monetary policy will directly affect also the borrowing at the consumption level and together with government borrowing will find in these areas its main impact. Additionally, under current conditions, the external sector serves as a mechanism where excess domestic demand can be satisfied by imports for some prolonged period of time, particularly for an economy like that of the United States that is also the provider of the leading international currency.
In this perspective, the reason for the persistence of the US trade deficit is to be found in the Federal Reserve's expansive monetary policy. The trade deficit is the consequence of a monetary policy that has stimulated private and public consumption at the cost of the so-called higher stages of production whose relative decline is reflected by the import of tradable goods and thus by the trade deficit. With consumption getting the boost from loose monetary policy, those investments close to consumption have received the major impulses.[iii]
In the models below[iv], the structure of production is depicted as an order of production goods in their relation to consumption in terms of the stages of production.[v] Looking first at a closed economy, the model (figure 1) shows that in order to invest in the higher stages of production, potential consumption must be foregone in order to provide the resources. Capital investment provides the basis for future economic growth, but in order to produce capital, a part of the current consumption potential must be given up and resources have to be transferred to the production of capital goods. In the model presented here, the straight line of the "stages of production" shows the existing production structure with a given amount of consumption goods on the left end point of the stages of production line. Higher consumption in the future requires more investment in the higher stages of production. In order to achieve that, the output relative to the existing potential must be reduced at and close to the consumption stages in order to provide the means to increase investment in the so-called more roundabout stages of production, i.e., in those that are further away from immediate consumption (see figure 1):
In this model (figure 1), the reduction of potential consumption (- D C) allows that enough funds are available to invest in the higher stages of production (+ I). Investment nearer to consumption is being reduced — or more specifically, in a growing economy, a part of potential consumption is given up in order to make the resources available that are applied in more roundabout production processes, which later will allow a higher output of consumption goods.[vi]
Due to a prolonged loose monetary policy that has been practiced by the US central bank, a different production structure has emerged in the United States. It is a production structure that has shifted to consumption and investment close to consumption. Under the conditions of a closed economy, an unsustainable situation would have emerged. In an open economy, however, the gap can be bridged by imports and the accumulation of foreign debt as long as this country is deemed as being creditworthy. Foreign savings that flow into the country in the form of loans substitute for domestic savings. Not only is the interest rate deceivingly low in the deficit country, there is also a cover-up going on in so far as the net imports fill the gap between higher domestic demand and insufficient domestic production (see figure 2).
As imports of some country imply exports of another country, the export surplus country that enters into a kind of symbiosis with the importing country, generates a production structure, which forms the mirror image to the net import country. The export surplus country foregoes potential consumption. Depending on the size and duration of these imbalances, different kinds of production structures are built up in the import versus the export surplus country. The net import country will experience an increase of economic activity in private consumption and government spending while the export surplus country will enlarge its production structure in the manufacturing sector by producing tradable goods. For some time at least a blissful symbiosis will emerge. Those goods and services close to consumption — such as retailing, wholesaling, internal transports, and direct services such as health and education etc. — cannot be imported and consequently investment in these areas will rise, while the more roundabout production will be abandoned.
Imports are limited to tradable goods and services, and these typically are items that require more roundabout production — such as vehicles, electronic and mechanical parts and goods including manufactured consumption goods. In other words: the production of car parts is further away from immediate consumption than their assembly into limousines, and the production of a coffee machine is further away from consumption in household use than its transport or its exposition in a store as likewise the production of coffee beans is further away from consumption than their serving in the form of a cup of coffee in the coffee shop.
By ignoring the stages of production, conventional measures such as aggregate investment or average productivity may indicate a terrific economic performance, when in fact the economy's production structure is shrinking and its long-term growth is fading while current figures indicate high growth and a highly productive economy. Additionally, price inflation may appear to be tamed when in fact it is imports that bridge the gap between a domestic demand that exceeds domestic production.
Some observers may argue that there really is no "trade deficit"-problem at all if we regard the trading partners not as countries but as regions. This analogy is false, however. It is false because the trade balance also includes services and interest income. Indeed, there is no problem — either on the household, regional or country level — when one unit is primarily a seller of manufactured or agricultural goods and the other unit is mainly a seller of services, and then both exchange and practice what is called the division of labor. Persistent overall current account imbalances, including both goods and services and investment income, however, show that one entity (household, region or country) is not only the net buyer of goods, but that this entity is also not capable of paying for these imports by the sale of a different set of specialized goods or by the sale of its services. The continuation of the blissful symbiosis depends on the willingness of the financiers to provide loans that in turn depends on the esteemed degree of creditworthiness of the borrower — as the creditors will judge it.
The creditor country is as much at risk as the debtor country to build up an unsustainable production structure. When the game ends, both will have to re-adapt; but while the debtor country will be faced with a massive restructuring of its production structure away from consumption, the adaptation that the creditor country faces will be a much easier task to accomplish because in the creditor country the less painful shift to less savings and thereby to less foregone consumption potentials will be needed. What is required in the creditor country is a re-shifting of the direction of its output from exports to domestic consumption. Consequently, the shift that is needed in the creditor country goes from the higher stages of production to the lower stages, i.e., those at and close to final consumption. This movement may be confronted with technical and financial obstacles, including frictional unemployment, but it is beneficial with respect to the increased amount of consumption goods that become available, as less of the consumption potential will be saved now (see figure 3).
The task in the debtor country is not only more difficult to accomplish but it is also much more painful. The debtor country is confronted with the task of re-building the higher stages of production. First, the shift from negative to positive net exports that is implied by the breakdown of external financing — as it is shown in equation IV above — cannot be easily accomplished. By leaving out time and capital these formulae only show conditions and do not indicate the path. What goods can a country export after financing is no longer available, when the sector of tradable goods production has been severely weakened or has partially vanished during the prolonged period of the deficit and debt expansion phase?
The transformation of the production structure has taken place in a gradual manner, but the collapse typically comes suddenly. In the context of the model presented here, this means that the debtor country has to abandon the unsustainable parts of its production structure in a forced manner. In the debtor country this is the production close to consumption goods and this consequently also implies a reduction of direct consumption. With imports no longer available as before due to the lack of foreign financing and with the more roundabout production having been abandoned over time when imports were amply available, this country is now confronted with forced savings that require less consumption.
In the models shown here, the debtor country's economy is forced to move from a production structure as shown in figure 2 back to the sustainable production structure as it is shown in figure 1 above. This kind of adaptation does not only require a much larger re-shifting of resources than those that will be required in the creditor country, the change will also be much more painful, because the debtor country will be forced to abandon its excess investment in the areas close to consumption and must reduce direct consumption in order to generate domestically the savings that are required to re-construct the higher stages of production.
Antony P. Mueller is a professor of economics currently at the University of Caxias-do-Sul (UCS) in Brazil and an adjunct scholar of the Ludwig von Mises Institute. Send him mail. Comment on the blog.
[i] For an extensive exposition of this point see Roger W. Garrison: Time and Money. The macroeconomics of capital structure. London and New York 2001: Routledge.
[ii] Steven Horwitz: Microfoundations and Macroeconomics. An Austrian Perspective. London and New York 2000: Routledge, p. 40 et passim.
[iii] Based on extensive studies done by consultants of McKinsey & Company, William W. Lewis, the founding director of the consultancy's Global Institute, summarizes their findings in the conclusion that the major areas of new investment and productivity gains in the United States were more in retailing and wholesaling along with in security brokerage, and less significantly in terms of its overall contribution in software and computer manufacturing: "the second half of the 1990s was more the day of Sam Walton than it was of Bill Gates … the biggest contributor to the improved US economic performance in the second half of the 1990s has been the sector closest to the consumer. That sector is retailing. Not only did retailing improve its own performance, but its innovation spilled over to revolutionize wholesaling, too." William H. Lewis: The Power of Productivity. Wealth, Poverty, and the Threat to Global Stability. Chicago and London 2004: The University of Chicago Press, pp. 92 and 94.
[iv] For a more detailed discussion of the model see this author's presentation at the Universidad Francisco Marroquin.
[v] "It is possible to think of the producers' goods as arranged in orders according to their proximity to the consumers' good for whose production they can be used." Ludwig von Mises. Human Action. Auburn 1998: The Ludwig von Mises Institute, p. 94 With this definition and as it is represented by the straight line of the model presented here, one need not refer to concepts like the "average period of production," and although the process of roundaboutness contains necessarily time, it is not chronological time that matters but the process of ordering as it shows up in term "stages."
[vi] This way, one can imagine the growth process as a lengthening of the stages of production with the savings/investment trade-off line getting both longer and steeper as it shifts downward signifying that the growth process allows giving up more of the consumption potential in order to be invested in the higher stages. Put in simple words: a "poor" economy has less stages of production than a "rich" economy, and the latter can more easily save out of its consumption potential and thereby can invest more in the higher stages of production than the poorer economy.