2003 October 30 Thursday
Does A Large Trade Deficit Slow Economic Growth?

University of Maryland professor Peter Morici, in testimony at an October 30, 2003 hearing of the U.S. House Ways and Means Committee, argues that the large US trade deficit is slowing US economic growth.

Given rapid productivity growth and foreign investments in China, we would expect the dollar value of the Chinese currency to rise with its development progress. However, since 1995 the Chinese government has maintained a policy of pegging the yuan at 8.3 per dollar.

Since 1995, the U.S. trade deficit with China has grown from $38 billion to $140 billion, and the overall U.S. current account deficit has grown from $105 billion to $555 billion. In contrast, when China was granted most-favored-nation status by the Congress in 1980, the U.S. bilateral trade and global current accounts were in surplus at $2.8 billion and $2.3 billion, respectively.

Consequently, reduced sales and layoffs in U.S. import-competing industries caused by Chinese competition have not been matched by increased sales and new jobs in U.S. export industries at the scale a market driven outcome would require. The free trade benefits of higher income and consumption to the U.S. economy have been frustrated by currency market intervention.

Morici claims the US economy would be much larger today if the US was not running such a large trade deficit for so many years.

Chronic trade deficits with China, Japan and other countries, which emerged in the 1980s, have reduced U.S. productivity growth and the trend rate of GDP growth by lowering U.S. value added per employee and investments in R&D.

In a nutshell, increased trade with China and other Asian economies should shift U.S. employment from import-competing to export industries. Since the latter create more value added per employee and undertake more R&D, this process would be expected to immediately raise U.S incomes and consumption and boost long-term productivity and GDP growth.

Instead, growing trade deficits with China and other Asian economies have shifted U.S. employment from import-competing and export industries to nontradeable service producing activities. The import-competing and export industries create about 150 percent more value added per employee, and spend more than three times as much R&D per dollar of value added, than the private business sector as a whole.

By reducing investments in R&D, an econometric model constructed for the Economic Strategy Institute indicates the overvalued dollar and resulting trade deficits are reducing U.S. economic growth by at least one percentage point a year—or about 20 percent of potential GDP growth. [1] China accounts for almost half of this lost growth.

Importantly, this one percentage point of growth has not been lost for just one year. The trade deficit has been taxing growth for most of the last two decades, and the cumulative consequences are enormous. Had foreign currency-market intervention and large trade deficits not robbed this growth, U.S. GDP would likely be at least 10 percent greater, and perhaps 20 percent greater, than it is today. GDP and tax revenues would be higher, and the Congress would not be facing large federal deficits. We would not be enduring a crisis in manufacturing and a jobless recovery, and the Congress would not be facing the difficult task of trimming Medicare benefits.

This makes a certain amount of intuitive sense. US companies faced by lower cost competitors are not going to invest in research, development, and capital spending in the United States if they have no chance of competing against such lower cost producers. Also, a deficit represents large amounts of sales not made to companies in the US. Those companies that lost sales to foreign competitors did not pay US salaries and taxes to produce goods and services domestically. Those companies had less revenue to use to develop new products and improvements in manufacturing processes.

Free trade advocates would argue that lower cost imports force domestic producers to innovate. But if the imported products were incredibly successful in making domestic companies more efficient then the importers would not continue to be so successful selling in the United States. Yet, as evidenced by the huge trade deficit, the foreign makers are very successful. Plus, trade conducted with a fixed currency peg is does not constitute free trade anyway. It is trade which is being manipulated by the country maintaining the currency peg.

Clyde Prestowitz, president of the Economic Strategy Institute mentioned above, sees the exchange rates as less important than other factors in explaining the US trade deficit.

As long as the United States runs federal budget deficits and has low domestic savings rates, it will have a current account deficit and will be dependent on capital inflow from abroad, mostly from China and Japan. And that's not to mention the fact that we also want those countries to help us with North Korea and Iraq. Which is why no American treasury secretary or president is going to mean it when he talks about getting tough with either China or Japan.

But the problem with this argument is that the US still had high and rising trade deficits during the later Clinton Administration years when the US federal government was running a large budget surplus. Therefore the argument that a budget deficit causes a trade deficit doesn't seem to work.

In spite of his views about the cause of the US trade deficit Prestowitz still sees a very big reason to make China drop the Renminbi-Dollar currency peg: Latin American economies.

CLYDE PRESTOWITZ: Cheap labor has made China a trade powerhouse. Combine that with an undervalued yaun, kept down by pegging China's currency to the dollar, and you have a magnet for factories that produce everything from toys and tech to textiles. That's been great for China, but it's often been a great cost to other countries struggling to develop. Look at Mexico. Every day now factories that once lined the corridor just south of our border are closing up shop and moving. You guessed it: Off to China.

He is exactly right about this. The US would face less of a problem with illegal alien immigrants if jobs were not getting shipped wholesale from Mexico to China. Those illegal aliens who come to the US looking for pay little in US taxes while generating large costs for citizen taxpayers of the United States.

But to get back to the original issue, the US trade deficit: A long sustained US trade current account deficit has negative effects on the long term health of the US economy. Debts to foreigners have to be paid off some day. When US companies lose sales to foreign companies the domestic companies do not pay American citizens to build capital plant, to make consumer products, or to do design and we are worse off in the long run.

Share |      By Randall Parker at 2003 October 30 02:07 PM  Economics Political

Adam said at October 31, 2003 10:43 AM:

Good post.... Unfortunately, the concept of "seconday effect" is two steps removed from how deeply most politicians think about the policies they support.

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