Smith Faculty Opinion Article	October 12, 2006
By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

U.S. Trade Deficit Hits New Record in August
Paulson Dialogue with China Offers Little Hope as U.S. Multinationals
Continue to Lobby Washington on Chinas Behalf

Today, the Commerce Department reported the August deficit on trade in goods and services was $69.9 billion, up from $68.0 billion in July, setting a new record.

The petroleum deficit was $27.2 billion in August, up from $25.7 billion in July, as prices and the quantity of oil imported rose.

The trade deficit with China was $22.0 billion in August, up from $19.6 billion in July.

The ballooning trade deficit will tax third quarter growth by about two-tenths of a percentage point. Longer term, the trade deficit substantially slows investments in R&D, education and training, and the multiplier effects on U.S. growth are disturbingly larger.

In addition, trade deficits must be financed by foreigners investing in the U.S. economy or lending Americans money. Direct investment in U.S. property and productive assets provides only a small portion of the needed funds, and the balance is obtained through the sale of Treasury securities, corporate bonds, bank accounts, and other paper assets. Americans borrow about $60 billion each month to consume more than they produce. The total debt will exceed $6 trillion by early 2007.

Oil, Currency and China

Since December 2001, the trade deficit has increased $43.3 billion. Net imports of petroleum account for 50 percent of the increase in the trade deficit. Increased U.S. imports of consumer goods, automobiles, business equipment, and industrial components and materials, especially from Asia, account for 50 percent. The trade deficit with China, alone, has increased $16.5 billion.

In significant measure, the trade deficit remains stubbornly high, because the overvalued dollar pushes up imports of Chinese and other Asian manufactures and handicaps U.S. exports of durable goods and high-end services.

China continues to peg against the dollar. Although China revalued the yuan from 8.28 to 8.11 in July 2005 and announced it would adjust the currency to a basket of currencies, the yuan continues to track the dollar closely and currently is trading at about 7.93.

To limit appreciation of the yuan against the dollar, the Chinese central bank purchases more than $200 billion in U.S. and other foreign securities each year. This comes to about 9 percent of Chinas GDP and about 25 percent of its exports. These purchases provide foreign consumers with 1.6 trillion yuan to purchase Chinese exports, and create a 25 percent subsidy on foreign sales of Chinese goods.

The competitive advantage this affords Chinese exports impels other Asian governments to similarly manage their currencies, to limit their loss of market share in the United States.

U.S. manufacturers are particularly hard hit. Chinas currency market intervention creates a 25 percent subsidy on its exports, and competitive advantages in industries not dependent on low-wage labor. Other Asia economies follow suit with similar industrial policies.

Since 2000, through recession and recovery, the U.S. manufacturing sector has lost 3.1 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.

Factoring in the multiplier effects of higher wages and increased demand for workers, adult labor force participation would likely match 2000 levels, instead of its current depressed level. Overall, about 4 million more Americans would be employed, and as in 2000, unemployment would dip below 4 percent.

This impact of manufacturing and other export and importing-competing activities is likely to worsen. Although the underlying value of the yuan rises at least 5 percent each year, China is permitting the yuan to appreciate less than 2 percent a year. Hence, the dollar will remain at least 40 percent overvalued against the Chinese yuan, and significantly overvalued against other Asian currencies too.

Trade Deficits and Growth

Increased trade with China and other Asian economies should raise U.S. GNP and incomes by shifting demand from import-competing activities to export industries, where worker productivity and wages are highest. Instead, growing trade deficits with China and other Asian economies have shifted U.S. employment from both import-competing and export industries to nontradable services, like the retailing and hospitality industries, where worker productivity and wages are lowest. Were the Chinese yuan revalued and the trade deficit cut in half, U.S. GDP would increase about $300 billion or $2,000 for every U.S. worker.

Also, import-competing and export industries spend more than three times as much on R&D per dollar of value added than the private business sector as a whole. Cutting the trade in half would boost R&D enough to accelerate U.S. productivity and GDP growth at least one percentage point a year. That would amount to more than a 25 percent increase in potential growth.

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 over the last two decades, U.S. GDP would likely be 20 percent greater than it is today.

Politics, Protectionism and the Trade Deficit

Treasury Secretary Henry Paulson urgently needs to persuade China to significantly revalue the yuan; however, President Bush has been reluctant to give his Treasury Secretary levers that could move China to action. The President has limited U.S. efforts to diplomacy, instead of specific trade measures to neutralize Chinese currency subsidies, even though diplomacy has repeatedly failed.

At the conclusion of his recent trip to Asia, Treasury Secretary Henry Paulson announced the initiation of a U.S.-China Strategic Dialogue. As in earlier talks, the American approach will be to link currency to broader financial sector reforms and to persuade Beijing that revaluing the yuan to reflect market fundamentals best serves Chinas interests. However, under the current regime, China is growing at more than 10 percent a year and its economy shows no signs of overheatinginflation is less than 2 percent. It is hard to find disadvantage for China in such a macroeconomic performance.

The unvalued yuan permits China to create employment for underutilized rural workers on export platforms, and to provide competitive space for inefficient state-owned enterprises to modernize. China may want to cool growth a bit, but it is not about to give up its most powerful development toolan undervalued yuan.

Subsidizing Chinese exports with an undervalued currency is nothing more than high profit protectionism that harms the U.S. economy; however, President Bush refuses to make protectionism costly to China and instead has chosen the path of appeasement. The Chinese sense weakness and exploit it.

Many U.S. multinationals, like GE, Caterpillar and GM are making huge profits in the protected Chinese market, and anticipate comparable opportunities in other similarly rigged Asian markets like India.

For example, GM and Ford are competitive in China, while their North American operations burn cash, hemorrhage jobs, and crush suppliers and cripple communities from Pennsylvania through the Middle West. International sales account for about half of GE profits abroad, and that share is likely to grow. A stronger yuan would slash profits for many U.S. multinationals like Caterpillar.

All those firms profit hugely from Chinese protectionism by moving jobs from the United States to China. Executive bonuses and the values of executive stock options are now aligned with the Chinese mercantilist cheap yuan policy. Each of these firms has demonstrated callous neglect for the interests of U.S.-based manufacturing and employment in the currency debate.

Branding their critics protectionists, instead of Beijing, these companies have opposed strong action against China, and have persuaded President and Secretary Paulson to oppose measures, proposed in Congress, to combat forcefully Chinese protectionism.

For example, the Bush Administration, at the behest of Caterpillar and others, opposes a bipartisan bill sponsored by Congressmen Duncan Hunter (R-CA) and Tim Ryan (D-OH) that would add the subsidies provided by currency manipulation to the list of unfair trade practices actionable under U.S. countervailing duty law, and permit domestic manufacturers to petition the Department of Commerce and U.S. International Trade Commission for duties to offset Chinese imports to offset these subsidies.

President Bushs reluctance to tackle currency issues and other industrial policies unfairly advantaging industries in Asia will harm Republicans in the fall elections. Many of the manufacturing jobs lost to subsidized imports are in swing districts in western Pennsylvania, Ohio, Indiana and elsewhere along the ridgeline between red America and blue America.

Presidents reluctance to address the root cause of job losses in these communities could cost Republicans their majority in the house.

Republican congressmen, finding themselves in minority status, will need only look up Pennsylvania Avenue for the policies and man responsible. They might also consider sending thank you notes to the Washington offices of GM, Ford, GE, and Caterpillar.

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