Smith Faculty Opinion Article	March 11, 2008
By Dr. Peter Morici, Professor of International Business                                                                       E-MAIL       WEB SITE

Trade Deficit Rises to $58.2 billion in January Stokes Recession, Lowers GDP by $250 Billion

Today, the Commerce Department reported the January deficit on trade in goods and services was $58.2 billion. This was up from $57.9 billion in December and was about 5 percent of GDP.

Undervaluation of the dollar against the Chinese yuan and high oil prices keep dragging the trade deficit up.

The dollar has weakened against the euro, pound and Canadian dollar, and this boosts exports. However, the trade deficit remains stubbornly large, because imports of petroleum and from Asia are not much affected by exchange rate movements.

Petroleum is priced in dollars. Consumer goods from China and automotive products from Japan and Korea remain strong, because these countries’ central banks sell billions of yuan, yen and won in foreign exchange markets to keep their currencies undervalued against the dollar.

The stubbornly large trade deficit heightens the risk of recession. The deficit subtracts about $250 billion from GDP, and that amount could double if the economy slips into a prolonged recession.

Breaking down the Deficit

Petroleum and China and automotive products total about 95 percent of the trade deficit, and no solution to the overall trade imbalance is possible without addressing these segments.

Petroleum products accounted for $35.1 billion of the monthly trade gap. Since December 2001, net petroleum imports have increased $29.6 billion, as the average price of a barrel of imported oil rose from $15.46 to $84.09, and monthly imports have increased from 353 million to 421 million barrels.

Retuning conventional gasoline engines and transmissions, hybrid systems, lighter weight vehicles, nuclear power, and other alternative energy sources could substantially reduce U.S. dependence on foreign oil. These solutions require national leadership, but both Republican and Democratic Party leaders have failed to champion policies that would reduce dependence on Middle East oil.

Last year, the Congress managed to push through the first increase in automobile mileage standards in 32 years but don’t cheer loudly. The 35 mile-per-gallon standard to be achieved by 2020 is far less than what is possible.

The bill also requires the production of about 2.4 million barrels a day of ethanol. Along with other conservation measures, the 2007 Energy Act could reduce U.S. petroleum consumption by 4 million barrels a day by 2030. Over the last 23 years, petroleum consumption has increased by about 5.5 million barrels a day, despite improvements in mileage standards, automobile and appliance technology, and conservation.

Being optimistic, in 2030 we will be just as dependent on imported oil as before. Factor in falling production from U.S. oil fields, the situation gets worse.

China accounted for $20.3 billion of the January trade deficit, up from $18.8 billion in December and $5.5 billion in December 2001. The bilateral deficit keeps rising, because China undervalues the yuan, and this makes Chinese exports artificially inexpensive and U.S. products too expensive in China.

China revalued the yuan from 8.28 to 8.11 in July 2005 and has since permitted the yuan to rise 4.6 percent every twelve months. Modernization and productivity advances raise the implicit value of the yuan about 7 percent every 12 months, and the yuan remains undervalued against the dollar by 40 to 50 percent.

China’s huge trade surplus creates an excess demand for yuan on global currency markets; however, to limit appreciation of the yuan against the dollar and drive its value down against the euro, the Peoples Bank of China sells yuan and buys dollars, euros and other currencies on foreign exchange markets.

In 2007, the Chinese government purchased $462 billion in U.S. and other foreign currency and securities. This comes to about 14 percent of China’s GDP and about 44 percent of its exports. These purchases provide foreign consumers with 3.5 trillion yuan to purchase Chinese exports, and create a 44 percent “off budget” subsidy on foreign sales of Chinese products, and an even larger implicit tariff on Chinese imports.

In addition, China provides numerous tax incentives and rebates, and low interest loans, to encourage exports and replace imports with domestic products. These practices clearly violate China’s obligations in the WTO, and it agreed to remove those when it joined the trade body.

Automotive products account for about $10.4 billion of the monthly trade deficit. Japanese and Korean manufacturers have captured a larger market and are expanding their U.S. production. However, Asian manufacturers tend to use more imported components than domestic companies, and GM and Ford are pushing their parts suppliers to move to China.

GM, Ford and Chrysler carry a significant cost disadvantage against Toyota plants located in the United States, thanks to clumsy management and unrealistic wages, excessive fringe benefits and arcane work rules imposed by United Autoworker contracts. Recent negotiations have improved the Detroit Three’s cost position but did not wholly close the labor cost gap with Toyota and other Asian transplants.

Recently negotiated labor agreements should reduce, but not eliminate, these cost disadvantages. Even with retiree health care benefits moved off the books and a two tier wage structure, the cost disadvantage will remain well above $1000 per vehicle.

Also, the central banks of Japan and Korea have aggressively stepped up sales of yen and won for U.S. dollars and other securities to keep their currencies cheap against the dollar. This discourages Toyota, Hyundai and others from moving more auto assembly and sourcing more parts in the United States.

Deficits, Debt and Growth

Trade deficits must be financed by foreigners investing in the U.S. economy or Americans borrowing money abroad. Direct investments in the United States provide only about a tenth of the needed funds, and Americans borrow about $50 billion each month. The total debt is about $45,000 per U.S. worker.

High and rising trade deficits tax economic growth. Each dollar spent on imports, not matched by a dollar of exports, shifts workers into activities in non-trade competing industries like department stores and restaurants.

Manufacturers are particularly hard hit by this subsidized competition. Through recession and recovery, the manufacturing sector has lost 3.6 million jobs since 2000. Following the pattern of past economic recoveries, the manufacturing sector should have regained more than 2 million of those jobs, especially given the very strong productivity growth accomplished in technology-intensive durable goods industries.

Productivity is at least 50 percent higher in industries that export and compete with imports. By reducing the demand for high-skill and technology-intensive products, and U.S. made goods and services, the deficit reduces GDP by about $250 billion a year or about $1750 for each worker.

Longer-term, persistent U.S. trade deficits are a substantial drag on growth. U.S. import-competing and export industries spend at least three-times the national average on industrial R&D, and encourage more investments in skills and education than other sectors of the economy. By shifting employment away from trade-competing industries, the trade deficit reduces U.S. investments in new methods and products, and skilled labor.

Cutting the trade deficit in half would boost U.S. GDP growth by one percentage point a year, and the trade deficits of the last two decades have reduced U.S. growth by one percentage point a year.

Lost growth is cumulative. Thanks to the record trade deficits accumulated over the last 10 years, the U.S. economy is about $1.5 trillion smaller. This comes to about $10000 per worker.

The damage grows larger each month, as the Bush administration dallies and ignores the corrosive consequences of the trade deficit.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.                                                          ►More Faculty Opinion Articles