Do trade deficits call for a sledgehammer?

By Phil Levy

It’s still early to take the measure of Obama administration’s trade policy. The new U.S. Trade Representative, Ron Kirk, has not even been in office a month. From his statements and those of President Obama during the campaign, though, we do know they intend to emphasize aggressive enforcement and fair trade. These emphases are intended to contrast with the approach of the Bush administration. But all of this begs a question: how do we know that trade is unfair now?

One way is to tally up objectionable actions by our trading partners. This is what USTR has just done with the National Trade Estimate. This list of barriers can then be pursued through complaints under existing trade agreements or through new agreements, depending on whether or not the actions are covered. But that’s pretty much what the Bush administration did.

The other approach was clearly stated by Sen. Debbie Stabenow (D-MI) as part of a confirmation question to Ambassador Kirk:

Last year was the fourth consecutive year in which the U.S. trade deficit in goods exceeded $700 billion. That is an enormous sum…. The trade deficit has been in large part caused and exacerbated by the unfair tactics of our trading partners…. Are you committed to stronger and more effective enforcement of our laws against unfair trade to address the root causes of this imbalance?

Under this approach, trade imbalances are evidence of foul play on the part of our trading partners. To the credit of Ambassador Kirk and his staff, he cast doubt on this reasoning in one of his written answers:

The overall trade balance of the United States reflects important macroeconomic factors, such as relative rates of economic growth, fiscal and monetary policies, patterns of saving and investment, domestic price levels and exchange rates.

Now that Kirk is safely tucked into the Winder Building, we can say that this answer would have been embraced by economists in the Bush administration and in academia more generally. But large trade deficits have been central to demands for change in trade policy, and these two quotes set out very different visions of what drives them. One side argues that unfair trade barriers are the root cause, while the other points to macro variables.

To sort this out, a little background can help. The broadest measure of the trade balance, known as the current account, must exactly offset the balance of financial transactions (the capital account). If we send $100,000 abroad to buy a shipment of DVD players, there are only a couple things that can ultimately happen with that money. It can find its way back to buy U.S. goods, in which case exports and imports offset and there is no current account imbalance. Or it can be held abroad as cash, or turned into stocks, bonds, or a lovely assortment of mortgage-backed securities. These would all serve as IOUs and would show up on the capital account. In that case, there would be a current account deficit (the value of the DVDs) and an offsetting capital account surplus (the value of the mortgage-backed securities).

Since this is an accounting identity, it’s pretty uncontroversial. The controversial part comes when we talk about cause and effect. We can tell two different stories. A "Stabenow Story" might go like this: other countries distort trade through subsidies and barriers. As a result, the United States runs up a large current account deficit and then needs to borrow money to finance that deficit by selling stocks, bonds, and the like.

Alternatively, a "Finance First Story" might go like this: broad macroeconomic variables like consumption, savings, government spending, and investment determine how much a country borrows or lends on world capital markets. Exchange rates adjust so that net borrowers run current account deficits while net lenders run current account surpluses. This would happen even in the complete absence of tariffs, quotas, or subsidies.

Which version we believe makes a big difference. If it’s the Stabenow Story, then USTR has its work cut out attacking the deficit, even if it means souring relations with trade partners as we hit them with enforcement actions. If it’s the Finance First Story, then it’s not the job of Kirk to address the trade deficit, but rather that of Treasury Secretary Geithner, who might discuss global macro imbalances at the upcoming IMF Spring Meetings, or perhaps a task for OMB Director Orszag with his plans for trillions of dollars of federal borrowing across the next decade.

It would certainly be helpful to know which story is right. The problem is that usually all the variables are moving at once. We could see which story rings true — if only we had a time when trade policy held still and macro variables moved sharply…

Well, actually, we’re in luck. Over the course of the current crisis, incomes and consumption have been fluctuating wildly (downward). Despite some unfortunate protectionist moves — mostly symbolic — the overall level of trade barriers in the world has not changed significantly. Under the Stabenow Story, the trade deficit shouldn’t have changed much, either. Under the Finance First story, we could expect some big swings.

It was announced last week that in the first two months of 2009, the U.S. trade deficit in goods and services fell almost in half from the same period a year earlier, from $121 billion to $62 billion. There have been similarly large changes in countries like Japan. This would seem to support the Finance First story. It would also seem to belie claims that growing trade deficits imply job losses. The logic behind those arguments also implies that shrinking trade deficits bring job gains. In fact, as the U.S. trade deficit halved, we lost 4.25 million jobs.

One enthusiastic congressman recently called for the United States to use a sledgehammer to address its trade deficit problems. Before we do so, we should figure out whether we’re dealing with a nail or a screw.