Smith Faculty Opinion Article	November 9, 2007
By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

U.S. Records $56.5 Billion Trade Deficit in September Risk of Recession Rises

Today, the Commerce Department reported the September deficit on trade in goods and services was $56.5 billion. This was down slightly from $56.8 billion in August but was still 4.9 percent of GDP.

The trade deficit was lower than analysts expected, because the volume of petroleum and auto imports fell more than expected, and these enough to offset an increase in the trade deficit with China. These September data do not reflect the recent surge in crude oil prices, and the trade deficit will likely head up again in October and November.

The deficit on trade in goods was $65.8 billion in September, down from $66.1 billion in August, while the surplus on services was virtually unchanged at $9.3 billion.

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 prospect that the trade deficit will rise with the surging price of oil further raises the risk of recession.

The deficit subtracts about $250 billion from GDP, and that amount could double if the economy slips into recession.

Breaking down the Deficit

Petroleum, China and automotive products account for nearly 100 percent of the trade deficit, and no solution to the overall trade imbalance is possible without addressing these segments.

Petroleum products accounted for $24.1 billion of the monthly trade gap. Since December 2001, net petroleum imports have increased $18.6 billion, as the average price of a barrel of imported oil has risen from $15.46 to $ 68.51 , and monthly imports have increased from 353 million to 387 million barrels.

Retuning conventional gasoline engines and transmissions, hybrid systems, lighter weight steel and other materials, 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.

China accounted for $23.8 billion of the September trade deficit, up from $5.5 billion in December 2001. The bilateral deficit remains stubbornly high , 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 3.6 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.

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 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 central bank is on track to purchase about $500 billion in U.S. and other foreign currency and securities. This comes to about 16 percent of Chinas GDP and about 45 percent of its exports. These purchases provide foreign consumers with 3.6 trillion yuan to purchase Chinese exports, and create a 45 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 Chinas obligations in the WTO, and it agreed to remove those when it joined the trade body.

Automotive products account for about $9 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.

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 more than 45 billion each month. The total debt is about $6 trillion, and at five percent interest, the debt service comes to about $2000 per U.S. worker each year.

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 3.3 million jobs since 2000. Following the pattern of past economic recoveries, the manufacturing sector should have regained about 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.