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

U.S. Records $59 Billion Trade Deficit in October
Deficit with China Keeps Getting Worse

Today, the Commerce Department reported the October deficit on trade in goods and services was $58.9 billion. This was down from a $64.3 billion deficit in September but remains about 5.3 percent of GDP.

The improvement was attributable to a decline in the price and volume of oil imports, and some increase exports of services. The trade deficit with China increased to $24.4 billion in October from $23.0 billion in September.

Since December 2001, the U.S. monthly trade deficit has increased $32.3 billion. This has saddled the economy with a huge foreign debt and slowed growth, and Bush Administration policies have exacerbated these problems.

Petroleum

Petroleum, automotive products, and goods from China account for nearly 95 percent of the trade deficit, and no solution is possible without addressing issues particular to these segments.

Crude oil and refined products account for $18.8 billion of the monthly trade gap. Since December 2001, net petroleum imports have increased $13.3 billion, as the average price of a barrel of imported oil has risen from $15.46 to $55.47, and monthly imports have increased 352 to 400 million barrels.

Technologies, such as simply retuning conventional gasoline engines and transmissions, hybrid gas-electric systems, lighter weight steel, and alternative fuels, could substantially reduce or eliminate U.S. dependence on foreign oil. Implementing and accelerating the build out of these solutions requires national leadership, which has been sorely lacking,

President Clinton sought an across the board energy tax that would handicap the international competitiveness of basic industries like petrochemicals and aluminum. President Bush pushed through energy legislation that made Exxon and other oil giants happy but accomplished little to change the fundamental energy equation.

Now the incoming leadership of the new Democratic majority seems intent on punishing oil companies for higher oil prices largely created by surging demand in China and Asia, shortages of refining capacity, and Detroit's obsession with overpowered vehicles.

Automotive Products

Automobiles and parts account for about $12.4 billion of the monthly trade deficit; however, since December 2001, the deficit on vehicles has risen $1.0 billion or 3.7 percent, while the parts deficit has increased $1.8 billion or 135 percent.

Japanese and Korean manufacturers have captured larger market share by offering more attractive and reliable vehicles than U.S. competitors, 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.

The U.S. remains a competitive place to make cars and many components but GM and Ford carry a $2,500 cost disadvantage thanks to costly labor contracts and clumsy management. These cost disadvantages far exceed those imposed by legacy costs, such as providing health benefits for retired blue collar workers, and these cost disadvantages would persist even with the implementation of national health insurance.

Moreover, the sorry financial state of the domestic automobile industry limits its ability to move rapidly into advanced vehicle technologies that would both reduce U.S. dependence on imported petroleum, and match Toyota and Hondas successful hybrids.

Rather than effectively addressing core structural problems, GM and Ford have used their purchasing power to hammer down component, steel and other material prices to levels that have bankrupted many suppliers. It remains a puzzle why the Bush Administration Justice Department has not investigated GM or Ford for abuse of monopoly purchasing power.

China

The U.S. trade deficit with China was $24.4 billion in October, and has increased $18.9 billion since 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.

In July 2005, China revalued the yuan from 8.28 per dollar to 8.11 and announced it would adjust the currency to a basket of currencies. However, the yuan continues to track the dollar closely and currently is trading at about 7.84, a 3.3 percent appreciation over 17 months.

Modernization and productivity growth raise the implicit value of the yuan about 5 percent a year; therefore, at the current rate of appreciation, the gap between the value enforced by Beijing and the true market value of the yuan grows each month. The yuan remains undervalued against the dollar by at least 40 percent.

Chinas 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 it down against the euro, the Chinese central bank purchases more than $200 billion in U.S. and other foreign currency and 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 off budget subsidy on foreign sales of Chinese goods.

Other Asian governments must follow Chinas lead and limit the appreciation of their currencies, lest their industries lose competitiveness to Chinese products in the U.S., European and even their own markets. Therefore, although the Federal Reserve index of the value of the dollar against all trading partners has fallen 18 percent since February 2002; the dollar has fallen 28 percent against the euro and currencies of other industrialized countries, while falling only 4 percent against those of China, India, and other developing countries.

Diplomatic efforts to persuade China to stop manipulating currency markets have so far failed. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke are again visiting China. Should they return empty handed or with only symbolic gestures from Beijing, the United States will be left to either impose tariffs or accept the consequences of large and widening trade deficits for U.S. growth and living standards.

Many U.S. multinationals, like GE, Caterpillar and GM, have earned huge profits investing in protected Chinese and other Asian markets, and have lobbied the Congress and Administration not to take action against Chinese mercantilism. Together they have persistently characterized as protectionist critics of Chinas policy that advocate affirmative U.S.
steps that would either offset Chinese export subsidies or move China to change its policies. This is puzzling as the United States regularly takes steps to offset subsidized imports from the EU or Japan that harm U.S. industries.

Why the Bush Administration insists on affording China special status is a mystery.

Deficits, Debt and Growth

Trade deficits must be financed by foreigners investing in the U.S. economy or Americans borrowing money abroad. Direct investment in the United States provides only a small fraction of the needed funds, and Americans borrow more than $50 billion each month. The total debt will exceed $6 trillion by early 2007, and at five percent interest, the debt service comes to about $2000 per U.S. worker each year.

The trade deficit reduces growth, near term, by reducing the demand for U.S.-made goods and services, and longer term, by shifting U.S. labor and capital away from export and import-competing industries that invest more in R&D and highly-skilled labor.

In the third quarter, the trade deficit subtracted about 0.2 percentage points from GDP growth. Over the last two decades, large deficits have reduced U.S. growth by about one percentage point a year, and were it not for these deficits, U.S. GDP would be at least 20 percent larger in 2006.

Despite this disturbing calculus, the Bush Administration has repeatedly sided with the interests of large multinational corporations that profit from foreign government policies and business practices that drive up the trade deficit.

Hopefully, the new Democratic majority in the Congress will call the president to account for these choices and effect a change in policy.

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