Smith Faculty Opinion Article	August 14, 2007
By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

U.S. Records $58.1 Billion Trade Deficit in June
Oil, China and Auto Parts Push Up Deficit

Today, the Commerce Department reported the June deficit on trade in goods and services was $58.1 billion. This was down from the $59.2 billion deficit in May but was still about 5.1 percent of GDP. This was lower than expected. The consensus forecast was $61.0 billion.

The petroleum deficit decreased to $23.4 billion in June from $23.8 billion in May, while the trade deficit on nonpetroleum products increased to $42.3 from $42.2 billion.

The trade deficit with China increased to $21.2 billion in June from $20.0 billion in May.

Trade with China contributes nearly as much to the trade deficit as petroleum, making the yuan-dollar exchange rate as important as the price of oil in determining the size of the trade deficit and the outlook for U.S. GDP and jobs growth.

The deficit on automotive products increased to $10.0 million in June from $9.0 billion in May. This has been pushed up mostly by imports of auto parts.

Since December 2001, the U.S. monthly trade deficit has increased $31.5 billion. This has saddled the economy with a huge foreign debt and slowed growth. Dysfunctional energy policies and the overvalued dollar against the Chinese yuan are responsible for 100 percent of this growth.

To finance trade deficits, Americans have borrowed more than $6 trillion, over and above foreign direct investment in the United States, and the debt service comes to about $300 billion a year.

By reducing the demand for high-skill and technology-intensive products, U.S. made goods and services, the deficit reduces GDP by about $250 billion , and by cutting investments in R&D and labor skills, the trade deficit cuts potential annual economic growth from about 4 percent a year to 3 percent.

The manufacturing sector is particularly hard it. Over the last 85 months, over 3.3 jobs have been lost. The rapid growth in the nonpetroleum deficit is responsible for the loss of about 2 million manufacturing jobs, mostly in technology-intensive durable goods industries where inexpensive Chinese labor offers few competitive advantages. The balance of the job losses were caused by improvements in labor productivity.

Breaking down the Deficit

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

Petroleum products account for $23.4 billion of the monthly trade gap. Since December 2001, net petroleum imports have increased $17.9 billion, as the average price of a barrel of imported oil has risen from $15.46 to $ 60.95, and monthly imports have increased from 353 million to 413 million barrels.

Technologies such as simply retuning conventional gasoline engines and transmissions, hybrid systems, lighter weight steel and other materials, and alternative energy sources could substantially reduce U.S. dependence on foreign oil. Also, more reliance on nuclear power could substantially reduce dependence on imported oil.

Accelerating the build out of these solutions requires national leadership, but both Republican and Democratic Party leaders have failed to champion a policy framework that would accomplish what is now clearly possiblegreatly reduced dependence on Middle East oil and the threats to national security it creates.

China accounted for $23.4 billion of the June trade deficit, up from $5.5 billion in December 2001. The bilateral deficit remains stubbornly keeps rising, because China undervalues the yuan, and this makes Chinese exports artificially inexpensive and U.S. products too expensive in China. Efforts to curb Chinas exports through administrative measures have failed, and without meaningful exchange rate adjustments, the trade deficit will continue to bedevil U.S.-China relations.

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 7.58. Rather than letting the yuan float against a basket, China has established a crawling peg against the dollar.

Through tightly choreographed intervention, the yuan has been permitted the yuan to rise 3.2 percent every twelve months. Modernization and productivity advances raise the implicit value of the yuan about 5 percent every twelve months, and 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 its value down against the euro, the Chinese central bank purchases about $250 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 two trillion yuan to purchase Chinese exports, and create a 25 percent off budget subsidy on foreign sales of Chinese goods, 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. The Bush Administration has filed a WTO petition to force China to either rescind these practices or ultimately to face WTO approved tariffs to offset their effects.

Consistent with WTO rules, the United States has recently decided to apply its countervailing duty laws to subsidized Chinese imports, as it does to imports from Japan, Korea and most industrialized and developing countries. This will permit private U.S. firms harmed by Chinas subsidized exports to bring suit for relief, and these actions would bring quicker and more certain action than the WTO complaint process.

However, the Bush Administration did not include Chinas undervalued currency and foreign exchange market intervention in its WTO complaint, despite the fact that these practices have been identified as a subsidy encouraging exports by Federal Reserve Chairman Ben Bernanke. Currency subsidies are the largest single subsidy China applies to exports, and export subsidies are considered to be among the most egregious violations of WTO rules.

Many U.S. multinationals corporations, like GE, Caterpillar and GM, earn huge profits from investments in Chinas protected markets. U.S. MNCs have profited greatly from currency manipulation and other Chinese protectionism that blatantly violates WTO rules; hence, it is not surprising they have lobbied the Congress and Administration not to take action against Chinese mercantilism and have persistently characterized as protectionist U.S. advocates for affirmative steps to offset Chinas export subsidies. The Bush Administration has bent to these pressures, refusing to even acknowledge the subsidy on exports Chinas currency market intervention creates, and has placed these corporate interests ahead of free trade principles.

The history of WTO disputes addressing broad subsidies, like tax holidays and bank credits, indicate the U.S. complaint against tax and credit subsidies will likely take years to resolve. China will have many options to reconfigure these practices before it ultimately, if ever, relinquishes them. The real danger is that the Bush Administration is using the WTO complaint process to butt congressional pressure to apply the countervailing duty laws to China and to avoid taking meaningful steps against Chinese currency manipulation.

Automotive products account for about $10.0 billion of the monthly trade deficit. Since December 2001, the deficit on vehicles and parts has increased $421 million or 4.4 percent, while the parts deficit has increased $1.2 billion or 87 percent.

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.

The U.S. remains a competitive place to make cars and many components; however, GM, Ford and Chrysler carry a $2,900 cost disadvantage against Toyota plants located in the United States, thanks to clumsy management, excessive executive compensation, and the unrealistically high wages, costly health benefits and arcane work rules imposed by contracts with the United Auto Workers. These disadvantages far exceed those imposed by legacy costs, such as providing health benefits for retired blue collar workers, and it would persist even with the implementation of national health insurance.

In addition, the yen may be even more undervalued against the dollar than the yuan, thanks to sluggish growth and near zero interest rates in Japan. However fundamental realignment of the yen dollar exchange rate is unlikely, because Treasury Secretary Paulson has voiced an agnostic position about the significance of the values of the yen and yuan.

The auto industry sorely needs a fairly valued yen, better management, and new labor contracts that align costs with Toyota and other Asia transplants operating in the United States. Essential elements would include pay for performance, health benefits in line with those offered by most U.S. employers, and adopting defined contributions pensions systems. Without these essential reforms, even the reincarnation of Henry Ford and Alfred Sloan could not save the domestic automakers from their inevitable ride through Chapter 11.

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 nearly $50 billion each month. The total debt is more than $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 where productivity is lower and reduces domestic demand and employment.

Productivity is at least 50 percent higher in industries that export and compete with imports, and reducing the trade deficit and moving workers into these industries would increase GDP. Also, by suppressing wages and benefits, the trade deficit has pushed down the percentage of adults participating in the labor force.

Were the trade deficit cut in half, GDP would increase by nearly $250 billion, or about $1500 for every working American. Workers wages would not be lagging inflation, and ordinary working Americans would more easily find jobs paying higher wages and offering decent benefits.

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 durable goods and throughout manufacturing.

Longer-term, persistent U.S. trade deficits are a substantial drag on growth. U.S. import-competing and export industries spend 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