October Trade Deficit Hits New Record;
A Stronger Dollar Indicates More Record Deficits in the Months Ahead;
Deficits Stifle Growth and Don't Look to the Doha Round to Help
By Dr. Peter Morici, Professor of International Business

Today, the Commerce Department reported the October trade deficit was $68.9 billion, piercing the record set in September, $66 billion. A strong dollar and continued currency market intervention by China indicate the trade deficit will likely hit new records in the months ahead.

Longer term, the Doha Round, if it succeeds, will only widen the gap.

It is particularly noteworthy that the U.S. trade deficit with China hit a new record, $20.5 billion.

In October, higher payments for imported oil prices played a key role; however, the deficit on nonpetroleum goods increased significantly too.

Since December 2001, the trade deficit has increased $42.3 billion, and petroleum products account for only 44 percent of this increase. The growing U.S. appetite for low-cost nonpetroleum consumer goods, capital goods, and industrial materials and components, especially from Asia, account for more than half of the growth of the trade deficit.

The trade deficit has increased in 2005, despite a falling federal budget deficit, and with the dollar strengthening again, the trade deficits will grow in the months ahead.

Going forward, increasing demand for petroleum imports and a stronger dollar are likely to push up the trade deficit. Higher deficits in the fourth quarter will slow growth, and wages, which got a lift in October, will barely keep up with inflation over the next six to twelve months.

In large measure, the trade deficit remains stubbornly high, because the overvalued dollar pushes up imports of inexpensive manufactures and handicaps U.S. exports of durable goods and high-end services, and this situation is likely to become worse in months ahead.

Currently, the average exchange rate for the dollar is 13 percent lower than in January 2002; however, the dollar has declined only 2.5 percent against Chinese yuan and is up against other developing country currencies. The dollar is down 22 percent against the euro and other industrialized-country currencies, while it is up an average of 0.2 percent against the Chinese yuan and other developing-country currencies combined.

Business and political prospects in Europe have weakened in 2005, and the dollar has risen. Together with higher oil prices, a stronger dollar will push the trade deficit to new record highs in the months ahead. The monthly trade deficit will likely exceed $70 billion by mid-2006.

As the Fed completes its cycle of interest rate increases, the unemployment rate is not likely to fall below 5 percent. In contrast, in 2000, the unemployment rate bottomed out at 3.8 percent. The more than one percentage point increase in the structural unemployment rate over the business cycle may be laid squarely at the feet of the trade deficit and the overvalued dollar.

Manufacturers are particularly hard hit. Through recession and recovery, the manufacturing sector has lost 3 million jobs. Following the pattern of past economic recoveries, the manufacturing sector should have regained about 2 million of these jobs, especially given the very strong productivity growth accomplished in durable goods and throughout manufacturing.

Large U.S. trade deficits flood international currency markets with dollars looking for buyers, and these should drive the value of the dollar down, raise import prices and reduce the trade deficit. However, led by China, Asian governments mop up those dollars and convert them into Treasury securities and other U.S. financial assets.

Chinese monetary authorities purchase dollars in foreign exchange markets to keep the yuan essentially fixed at 8.08 per dollar. Other Asian developing-country governments support soft pegs by purchasing dollars. China's currency policy compels them to do so lest they lose sales in U.S. markets to China.

Chinese government purchases of dollars and other securities now exceed $200 billion per year and 14 percent of China's GDP. Chinese government purchases of dollars and other securities create a 35 percent subsidy on China's exports.

Overall, China and other foreign governments are purchasing more than $300 billion a year in U.S, currency. These purchases create a 17 percent subsidy on the sale of foreign products in the United States.

Another factor driving up U.S. trade deficits has been lopsided rules WTO rules and the uneven implementation of trade agreements. For example, these permit China to impose investment rules on multinationals that limit imports of components and services from the United States and to subsidize manufacturing with zero interest loans and pirate intellectual property; EU governments to underwrite manufacturers that compete with U.S.-based operations; and most industrialized countries to rebate value added taxes on their exports to the United States.

The United States is much more dependent on personal and corporate income taxes to finance government than other countries, whereas the EU and other industrialized countries levy substantial value added taxes. U.S. trading partners may rebate their value added taxes on exports and impose these levies on imports. An arbitrary interpretation of WTO rules prohibits the United States from making similar border tax adjustment on its exports and imports.

The average standard value added tax in the EU is 19 percent, and when rebated on exports and applied to imports these adjustments provide a 19 percent subsidy on EU products sold in U.S. markets and a 19 percent tax on U.S. products sold in EU markets.

Special and differential treatment under WTO rules permits developing countries to maintain high tariffs and a plethora of other trade barriers under the guise of promoting economic growth. These block U.S. exports of technology intensive goods and services.

The Doha Round, even if it reaches a deal on agriculture will do little to relieve these problems. Currency manipulation, investment rules, most subsidies and the unequal treatment of domestic taxation are not on the table or likely to be addressed.

U.S. manufacturers are particularly hard hit. Cutting the trade deficit in half would create nearly 2 million more manufacturing jobs. An effective policy to end currency manipulation and cut the trade deficit would particularly benefit highly competitive U.S. durable goods' manufacturers, such as producers of machine tools, industrial and construction machinery, auto parts, and electronic equipment.

Manufacturing and other trade-competing industries enjoy higher productivity and pay higher wages, and large trade deficits, by eliminating jobs in manufacturing and other trade-competing industries, have pushed down the wages of workers with only a high school education or a few years of college.

Cutting the trade deficit in half would go a long way toward restoring the purchasing power of workers hard hit by wages lagging inflation in recent years

Longer-term, persistent U.S. trade deficits are a substantial drag on U.S. growth. U.S. import-competing and export industries spend at least 50 percent more on R&D and encourage more investments in skills and education than other sectors of the economy. By shifting employment away from these trade-competing industries, the trade deficit is reducing U.S. investments in knowledge-based industries and skills and handicapping U.S. growth

Slashing the trade deficit in half would add more than one percentage point to U.S. economic growth each year.