BOSTON — The biggest challenge facing the US economy today is job creation. Despite massive fiscal stimulus and unprecedented liquidity injections, unemployment remains stubbornly high. Policymakers are now groping for solutions that won’t take our national debt further into the red zone, debating the effectiveness of tax cuts versus spending increases. However, they seem to have missed one big solution that wouldn’t increase our debt and in fact would likely reduce it: cutting the trade deficit.
It’s surprising that people aren’t up in arms over the trade deficit the way they used to be. Perhaps we simply got used to it; it’s old news and it didn’t seem to hurt our growth before (despite the hysteria over Japan in the ‘80s), so there may be skepticism that it’s hurting our growth now. However, what’s missing from this view is that we are in a fundamentally different economic environment today, and unlike before, every dollar of trade deficit is now like a dollar of negative stimulus.
To understand why, one must look at the trade deficit from a flow-of-funds perspective. When the US runs a trade deficit, money spent by Americans on goods and services flows out of the US rather than to other Americans. If that money had flowed to other Americans, it would have increased employment of those Americans, and they in turn would have saved a portion of that money and spent the rest (helping even more Americans). But when there is a trade deficit and the money flows out of the US, there is no spending or savings that accrues to Americans. So far, the trade deficit looks destimulative.
However, the money sent abroad finds its way back into our banking system. This is because foreign governments buy those dollars from their exporters in exchange for local currency and invest those dollars into dollar-denominated assets, primarily US Treasuries. During normal times, our banking system lends out this money for consumption and investment by Americans, largely replacing the direct spending that was lost due to the money flowing out of the country. This is credit-financed spending, not direct spending, but it is spending nonetheless and also puts Americans to work. When credit is expanding, therefore, the trade deficit does not seem destimulative.
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The issue with today’s environment is that our banking system isn’t working the way it normally does. During normal times, banks want to lend and consumers and businesses want to borrow. Today, after the bursting of the credit bubble, banks are wary of lending, consumers are still deleveraging, and businesses don’t have the confidence to borrow for investment. The trade deficit is causing a drop in direct spending that is no longer being offset by credit-financed spending. The result is simply lost spending.
The negative stimulus involved is huge. After spiking and subsiding in the 80s, US trade deficits have increased over the last 20 years from 1 percent of GDP to almost 5 percent today. Our trade deficit with China alone reached an all-time high last year of 2 percent of GDP, accounting for over 40 percent of our overall trade deficit. Including China’s regional trading partners, one could say that China accounts for 50 percent of our trade deficit.
The US actually imports more from Europe ($382 billion) than China ($365 billion), but the difference is that Europe also buys a substantial amount from the US ($286 billion), whereas China does not ($92 billion). In fact, imports from China are 4 times exports. This multiple is 1.3 for Europe, 1.4 for Canada, and 1.1 for Mexico (our other top trading partners).
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This lopsided imbalance is due at root to China’s pegging its currency to the dollar at an artificially low rate. Some blame export subsidies, import barriers, under-consumption or low labor costs. All those exist. However, without its central bank involved, China’s exporters would sell their dollars on the open market to buy renminbi and the renminbi would appreciate, making our imports pricier and exports cheaper until the two reached parity.
Instead, China’s central bank prints renminbi to buy these dollars and stockpiles them, investing them in dollar-denominated assets like US Treasuries. China’s regional trading partners have done the same, in part emboldened by the Chinese example and in part to remain competitive with China.
Today, China’s purchases of Treasuries, just like the Fed’s purchases of Treasuries, are effectively “pushing on a string” since there is already ample liquidity in the banking system that is not translating into additional lending. What we urgently need from China now is not help with quantitative easing but more purchases of American goods and services. That will provide not just jobs but also the private savings to help consumers pay down debt.
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Three years after the financial crisis, cutting our trade deficit is now more urgent than ever. Till now, massive government stimulus of 8 to 10 percent of GDP has contained what would have been a depression, overcoming the destimulative impact of our trade deficit and setting us on a path to recovery. However, with support for deficit spending waning, paralysis in Washington and state and local governments cutting spending, there may well be total cuts to stimulus of 2 percent of GDP this year, and much more the following years. Combined with possible demand shocks from Europe, there is a real risk of our recovery foundering.
Reducing our trade deficit now could completely offset lower government stimulus and assure a continued recovery. Seen another way, reducing our trade deficit will reduce the stimulus spending required, reducing our national debt by up to a trillion dollars over the next few years. And longer term, it also means that we’ll own more of our own assets.
President Barack Obama’s recent statements about bringing manufacturing jobs back to the US are a good start, but they need to be followed up with effective actions to force real change from trading partners like China. Fears of sparking a trade war are overblown as China stands to lose a lot more than the US, as are fears of a sell off in Treasuries as we can buy our own Treasuries with the extra savings we’ll have. Furthermore, China has the political will and the balance sheet to support their economy as domestic consumption catches up.
The US, meanwhile, cannot afford to wait any longer.
Raj Yerasi is a money manager who has invested in public and private companies across the US and emerging markets. He spent the last seven years based in India and helped manage a top-performing hedge fund.
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