Smith Faculty Opinion Article

By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

February 14, 2008

2007 Trade Deficit Exceeds $700 Billion
Slows Growth and Multiplies Recession Woes

Today, the Commerce Department reported the 2007 deficit on international trade in goods and services was $711.6 billion. This is down from $758.5 billion in 2006 but still 5.1 percent of GDP.

Pushed up by rising prices for imported petroleum and a ballooning trade gap with China, the trade deficit is reducing U.S. GDP by $250 billion and significantly adding to the pain imposed by the unfolding recession.

To finance the deficit of recent years, Americans have borrowed about $6.5 trillion from foreign sources, including foreign governments, and the debt service comes to about $2000 for each working American.

The flood of dollars into foreign government hands is bloating sovereign wealth funds that are now buying significant shares of U.S. banks and other property, and threaten to compromise the loyalties of U.S. businesses.

The Chinese government alone holds more than $1.6 trillion in U.S. and other securities, and these could be used to purchase 10 percent of the value of publicly-owned U.S. companies. Add to that the holdings of Middle East sovereigns and royal families, the potential purchases of U.S. business by foreign governments with interests unfriendly to the United States exceeds 20 percent of all publically-owned U.S. companies.

This should give Americans real pause for concern about Chinese and other foreign government intentions to diversify their foreign exchange holdings into U.S. stocks and other real assets.

Anatomy of the Hemorrhaging Current Account

In 2007, the United States had a $104.0 billion surplus on trade in services. This was hardly enough to offset the massive $815.6 billion deficit on trade in goods.

The deficit on petroleum products was $293.5 billion, up from $270.9 billion in 2006; prices for imported petroleum rose 10.8 percent from 2006, while the volume of imports fell 1.5 percent.

The American appetite for inexpensive imported consumer goods and cars is huge factor driving the trade deficit higher. The deficit on nonpetroleum goods was $496.8 billion. The trade deficit with China was $256.3 billion, a new record, and up from $232.6 billion in 2006.

The deficit on motor vehicle products was $121.5 billion. Ford and GM continue to push their procurement offshore and cede market share to Japanese and Korean companies. However, the automotive trade deficit was down 17 percent as Asian automakers continued to expand production in North America and demand for autos flagged.

This situation is likely to become worse in the months ahead. Crude oil prices will be higher in 2008 than last year, and an overvalued dollar against the yuan and yen continues to keep imported automobiles and consumer goods cheap. Announced production cutbacks at GM, Ford and Chrysler will result in more imported motor vehicles and parts. Rising gas prices are driving car buyers away from Detroit’s gas guzzlers and into the arms of Asian brands.

The dollar remains at least 40 to 50 percent overvalued against the Chinese yuan and other Asian currencies. 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 very closely. Currently, the yuan is trading at 7.19.

To sustain an undervalued currency in 2007, China purchased approximately $465 U.S. and other foreign securities, creating a 34 percent subsidy on its exports of goods and services. Other Asian governments align their currency policies with China to avoid losing competitiveness to Chinese products in lucrative U.S. and EU markets.

Financing the Deficit

The trade deficit must be financed by capital inflows, either by foreigners investing in the U.S. economy or loaning Americans money. Some analysts argue that the trade deficit reflects U.S. economic strength, because foreigners find many promising investments here. The details of U.S. financing belie this argument.

Foreign direct investment in U.S. only comes to about 10 percent of U.S. capital inflows and the remainder of the $712 billion trade deficit must be largely financed by sales of bonds and other securities. The cumulative value of this debt now exceeds $6 trillion and will likely pierce $7 trillion in 2008. The interest payments come to about $2000 for each working American.

Consequences for Economic Growth

High and rising trade deficits tax economic growth. Specifically, each dollar spent on imports that is not matched by a dollar of exports reduces domestic demand and employment, and shifts workers into activities where productivity is lower.

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.

Were the trade deficit cut in half, GDP would increase by nearly $250 billion, or about $1750 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 20 years, the U.S. economy is about $3 trillion smaller. This comes to about $20,000 per worker.

Had the Administration and the Congress acted responsibly to reduce the deficit, American workers would be much better off, tax revenues would be much larger, and the federal deficit could be eliminated without cutting spending.

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.