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The Fiscal Cliff and the Trade Deficit

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First, let’s get the definitions straight, as confusion about definitions is the single biggest avoidable cause of economic nonsense.

The trade deficit measures how much America’s imports exceed its exports.

The federal deficit measures how much America’s government’s expenditures exceed its revenues.

The cure for a trade deficit, for the U.S. or any other country, is to either export more or import less.

The cure for a central-government deficit (which is a federal deficit in other nations with federal political systems, not otherwise) is to either reduce government expenditures or bring in more taxes.

Despite enormous clouds of intellectual squid’s ink spewed about these two subjects, deliberately designed to create phony complexity and thereby enable sophistry, the above is just accounting. It isn’t even economics. So while there are an infinite number of legitimate controversies attached, this itself shouldn’t really be controversial. Anyone who’s tempted to pick a fight over it is either a) nitpicking pedantic details that I would cover if an article like this were the place for footnotes, or b) hasn’t understood it properly. You can be a liberal, a conservative, or anything in between and agree with the above.

Now for the controvertible stuff.  Why should anyone care about trade or federal deficits?

In a nutshell, because there’s no such thing as a free lunch.

This concept is something one normally hears from the right, but it’s not a right-wing idea per se. They just find it a more useful trope of propaganda right now.

When America runs a trade deficit, this means we’re getting imports we haven’t earned by producing exports. So we’re getting something for nothing. Or at least it seems that way.

Same deal when we run a federal deficit.  We get to have all this spending without having to pay taxes to finance it. It looks like free money.

Only it isn’t, of course. And this applies to both deficits.

When we run a trade deficit, we must make up the difference between what we import and what we export by either a) going into debt to foreigners, or b) selling off existing wealth to them.

When we run a federal deficit, the U.S. government has to borrow the money, by selling off Treasury Bills and other debt instruments.

See where this is going?  There is no magic money tree for either deficit.  Each is a way of pushing costs around, not making them go away. Which is exactly what a common-sense appreciation of the non-existence of unicorns and free lunches would lead one to expect.

Now for the politics.

Obviously, there’s a left-vs.-right bone of contention about whether a federal deficit should be closed by reducing expenditures or increasing revenues.  That’s what elections are for.

Less obviously, there’s a disagreement as to whether Keynesianism (named after Maynard Keynes, a British economist who died in 1946) is true.  This basically comes down to the idea—pace the subtleties—that running a federal deficit during recessions will help blunt the severity of the recession and spur recovery.

Now I personally believe, based on a whole pile of historical evidence dating back to the 1930s, that Keynesianism is, to at least a first approximation, quite simply true, and therefore shouldn’t be a partisan bone of contention. Richard Nixon, among others on the right, agreed with this. But unfortunately, there are today people on the right who insist on manufacturing an argument here when they really should be arguing about other, legitimately disputable, parts of the picture.

Oddly enough, some of the same people who deny Keynesianism in theory are also counting on it in practice to blackmail the Obama administration with the fear that the economy will slump if the so-called “fiscal cliff” is allowed to happen.

What’s that?  The fiscal cliff is the fact that, based on legislation passed in 2011, if Congress doesn’t agree to a better long-term deficit-reduction plan, there will be automatic budget cuts starting next year. Plus the Bush tax cuts, and a temporary payroll-tax cut, are scheduled to expire about the same time.  The result? A sudden contraction of the federal deficit by about $500 billion in 2013 and $680 billion in 2014. Which is a recipe, according to Keynesian thinking, for tipping the economy back into recession.

What’s the connection of the trade deficit to all this?  A couple of things.

For one thing, when America runs a trade deficit, we have to either borrow money from foreigners or sell off existing assets to them to cover the gap. And a lot of that borrowing and asset selling takes the form of federal debt instruments like T-bills. So our appetite for foreign credit to buy imports is related to our appetite for foreign credit to finance our government.

For another thing, the reason the fiscal cliff could tip us back into recession is that it would suddenly reduce so-called aggregate demand.  That’s the economy’s total demand for goods and services.  But a trade deficit does the same thing, because it means that demand for goods and services is being satisfied by foreign producers, not American ones.  So output, jobs, and industries suffer the same way.

If you rebalance trade, shifting to more domestic production, you expand the tax base and reduce the federal budget deficit.

Right now, a lot of attention is being paid to the federal deficit.  But it’s high time attention got paid to our other deficit, the trade deficit.  It all comes out in the wash in the end.

Ian Fletcher is Senior Economist of the Coalition for a Prosperous America, a nationwide grass-roots organization dedicated to fixing America’s trade policies and comprising representatives from business, agriculture, and labor. He was previously Research Fellow at the U.S. Business and Industry Council, a Washington think tank, and before that, an economist in private practice serving mainly hedge funds and private equity firms. Educated at Columbia University and the University of Chicago, he lives in San Francisco. He is the author of Free Trade Doesn’t Work: What Should Replace It and Why.

19 Responses to “The Fiscal Cliff and the Trade Deficit”

  1. Frank Shannon says:

    Thank you, Ian, for some clarity.

    If more Americans, particularly those in Congress, understood this, we may actually solve our economic malaise.

    It is really quite simple and anyone who has owned a business understands this at a fundamental level. It is all about sales, expenses and profit at the national level. Not tending to these daily, will drive a company into bankruptcy because no individual can print money out of thin air. But the U.S. can…..for some time. The only remaining question is….how long?

  2. China Watcher says:

    Thanks, Ian, for this clear exposition of the illogic suffusing the fiscal cliff debate. Neither spending cuts nor tax increases will help spur sustained growth. Government borrowing is not crowding out private borrowing nor jacking up interest rates. Reducing government borrowing in fact will reduce growth in the near term. In these circumstances, the only path to stronger growth over the medium long term lies with redressing the trade imbalance. It’s striking how little attention is given to that issue by the Washington establishmnet.

  3. Robert Boyle says:

    When President Obama mentioned the phrase “economic patriotism” during the debates and ran an add with that title, I thought he was starting to sound like Ian Fletcher. But the President continues to pursue that Trans Pacitic Partnership agreement (TPP), what some people call NAFTA on steroids. Ian’s book, Free Trade Doesn’t Work, explains what needs to be done to re-industrialize the United States: use a natural strategic tariff to bring manufacturing home. I think the TPP is intended to create a giant free trade block to ease and accelerate outsourcing. The sucking sound will just get louder. The good thing is that “fast track” authority for free trade agreements expired about 2007 so that if the many countries negotiating the TPP arrive at an agreement before October of next year (the announced deadline), there will have to be Congressional hearings.

  4. Will Wilkin says:

    Thank you Ian Fletcher for once again translating our political and economic morass into essential and understandable summary.

    I have a question for you about the politics behind the policies that got us here and that could get us out.

    Dean Baker in his book “End of Loser Liberalism” argues the high unemployment and stagnant wages facing especially non-college-educated workers has been the predictable and inevitable and therefore deliberate effects of the free trade policies and what Baker says is an overvalued dollar that could be lowered by Fed and Treasury action if the political will were there. Moreover, Baker argues the high dollar kills as many jobs as 10 NAFTAs because it applies globally v. the bilateral effects of each individual FTA.

    Baker says “…the Treasury could intervene more actively in currency markets if it opted to do so. Acting in coordination with the Fed, the Treasury could choose to bring the dollar down against other currencies, and thereby produce a huge improvement in the country’s trade balance. In turn, this would create millions of new manufacturing jobs….There is remarkably little awareness, even in policy circles, that the value of the dollar is a policy tool under the control of the government. This is striking because there have been major debates over trade agreements like NAFTA and CAFTA, primarily over concern about their potential impact on jobs in the United States. By contrast, the value of the dollar is almost never mentioned in policy debates. Even small changes in the value of the dollar are likely to have more impact on trade and employment than the most important of these trade agreements….A rise in the value of the dollar against other currencies by, say, 10% is equivalent to giving a 10% subsidy on all the goods imported into the US and imposing a 10% tariff on all the goods we export….”

    Baker goes on in the chapter to describe who in the US benefits from high dollar policies. “At the top of this list would be the financial industry, which receives benefits of a high dollar through two channels. Fist, by making imports cheaper, a high dollar helps keep inflation low, and stable prices are a financial industry obsession. Second, when the financial industry looks to move abroad, its dollar assets go much further when the dollar is overvalued.” Baker goes on to say manufacturers and other industries are more ambiguous about dollar value, depending on whether and how much they establish operations overseas.

    Baker next lists “major retailers like Walmart are advantaged in a similar way. By contracting with suppliers in China and other countries with low labor costs, these chains enjoy a supply of low-cost imports that allows them to undercut retailers that pay higher domestic prices for their products.

    Next Baker describes a “peculiar class dynamic to the dollar debate….” which he says includes American travelers abroad enjoying a high dollar, and this class of travelers overlaps with Congress and their staffers and their pol campaign staffs and the news reporters covering them are all likely to be frequent foreign travelers enjoying the high dollar and removed from the consequences at the bottom of the US socio-economic ladder.

    I do not like Dean Baker’s solutions, which include MORE “free trade” this time opening up the jobs and wages of the educated classes like doctors and lawyers and engineers to the same international competition that NAFTA etc have exposed less educated workers. Baker says that just as the upper class in the US has benefitted from the devastation of the lower class, so too could the lower classes (much more people) benefit if the tax-like subsidies of protectionism were removed from their services to lower the price for the rest of us. In other words, more class war and more internationalism and free trade as opposed to what I would prefer to see: a new PATRIOTISM to replace class war and to give all American citizens a common identity in a common fate as a nation. But nowhere on the horizon do I see any political basis for the patriotic unity I wish we could make.

    So my question to you, Ian Fletcher, is what do you think the role of the dollar value and policies affecting it have on our larger problems of unemployment and stagnant wages and spreading poverty? Is dollar value a policy lever the federal government can use to balance our trade and put people back to work?

    And the deeper question behind all this: Can there be a new patriotism to replace the class war, to unite our people around a revived American economy and society with opportunity and security and prosperity for ALL our people?

    • Arthur Taylor says:

      Will,

      You are correct. These agreements were outsourcing agreements intended to deliver a gift to the distribution class of this nation at the expense of the production class, the working class and the middle class of this nation. The gift was hugely increased gross margins and less cost pertaining to U.S. workers. They never intended the theoretical benefits of trade to accrue to the customer because the distribution class of this country knows that price and cost are not linked and that they could continue to charge historical prices while paying far less for product. Thus the huge increase in wealth disparity over the last 18 years (beginning with NAFTA, implemented in 1994)

    • Mo says:

      The problem with globalization is that it’s not free trade but the global trade of US dollars created out of thin air to buy real goods and services which explains why Central Banks around the world today have hundreds of billions and trillions of US dollar assets. It’s goal was never to fully reduce trade barriers but to expand the influence of the dollar.

      The problem with the world unsound monetary system that is not anchored to a commodity is that currencies can be overvalued, undervalued and very rarely at equilbrium parity. An overvalued dollar does act as subsidy for importers and the services industry but works like a tariff for exporters. But just by itself, an overvalued dollar shouldn’t have caused the tremendous amount of offshoring that has occured. Only an overvalued dollar with artificially low interest rates that stimulate consumption and fund wars could the offshoring like today occur.

      Other countries with undervalued currencies are able to to subsidize production because they have higher savings. Even countries with higher valued exchange rates that have stable savings can remain competitive in manufacturing. One only has to look at Germany.

    • Bruce Bishop says:

      Mr. Wilkin,

      Re: “Baker next lists “major retailers like Walmart are advantaged in a similar way. By contracting with suppliers in China and other countries with low labor costs, these chains enjoy a supply of low-cost imports that allows them to undercut retailers that pay higher domestic prices for their products.”

      China can manufacture anything that we can manufacture at one-third to one-tenth the cost. This is because of their cheap labor and lack of work rules.

      Major retailers like Walmart have no choice but to import cheap goods from China. There are no equivalent goods being manufactured in significant volume in the United States. The “Buy American” campaign is a myth.

      For more on this, see my new e-book, “Don’t Blame Wal*Mart If Your Job Went To China,” available on Amazon/Kindle. If you don’t have a Kindle, you can download the Kindle software for free onto your PC, laptop or smartphone.

      • Mo says:

        Considering the increase in all the buildings, factories, roads, railroad tracks, power stations, cars, etc per the given population, Chinese wages should probably be higher. Countries that have stable savings are able to subsidize their production at the expense of their savers. Technically other countries could make goods at the same price as China does if they were forced by government fiat. But the problem is not that China can make goods cheaper by government fiat but that the US has kept interest rates artificially low to stimulate consumption of foreign made goods and to fund wars which has discouraged increased savings.

        If interest rates in the US were not artificially low then there would be stable savings that would keep input prices like commodities very stable. Less consumption would mean less buying of foreign imports. Production would then be more domestically oriented like investments being made in infrastructure. It’s only ecnomically viable to offshore if production is made in high quantities which means there has to be stable demand for the products. Low interest rates is the stimulus used to have people consume more which winds up buying mostly foreign made goods today.

      • Will Wilkin says:

        Hi Bruce, I just bought your Kindle book, give me a little time to read it….

  5. Don Rongione says:

    Clear and on point!
    Let’s use our economic power as consumers and buy American this season.
    American Made Matters.

  6. Mo says:

    There currently is a relationship between the fiscal and trade deficits. Fiscal deficits can lead to larger trade deficits when they are funded by inflation. For example the wars that the US has been involved with have have caused increased federal spending and larger fiscal deficits that increasingly have been monetized by the Federal Reserve and banking sector. As the money supply increases prices for oil and other commodities rise. So as it costs more to import oil it raises the dollar value of these imports which has contributed to the increased trade deficit. Additionally as the rise in commodity prices squeeze profit margins for domestic manufacturers, it can force manufacturers to either close up shop or offshore which further leads to larger trade deficits. So there is a relationship between the two. They may not be identical but are fraternal.

    • Maggie says:

      Is it true that a weakened dollar (inflation) relative to other currencies would tend to favor domestic production over imports, hence reducing the trade deficit?

      • Mo says:

        Maggie what is needed is a stable and sound dollar. A sound dollar means people can save and not have to speculate in the financial markets to try and savage their purchasing power. The only way to have a sound dollar is to have it anchored by a commodity like gold or silver. Unless anchored the dollar can be overvalued, undervalued or very rarely at equilbrium parity relative to another currency.

        The reason the US is hollowed out is because it has an overvalued dollar relative to some trading parnters with inflationary policies to consume that discourages savings. If the US dollar was overvalued but there was stable or high savings then the US would be more like Germany. On the other hand if the US dollar was undervalued and had stable savings then the US would be more like Japan before their bubbles crashed. Any inflationary policies that induce consumption at the expense of savings whether the dollar is overvalued or undervalued relative to trading partners will cause the emergence of rustbelts.

        Depreciating the dollar further will only cause the trade deficit to rise further. The dollar used to be worth over 300 Yen and over 3 German Marks in the 1970s which means the dollar has depreciated enormously against the Yen and German Mark and this has only increased the trade deficits between these two countries. Actually when you depreciate the dollar it’s like working longer and harder to buy less goods.

        The reason the trade deficit would increase would be that commodity prices would rise further and that savings would be discouraged. For instance the US imports less oil but the amount spent on imported oil has increased because the dollar has gotten weaker due to an increasing money supply that is related to the monetization of the fiscal deficits by the Federal Reserve and banking sector. A weaker dollar which means the US is printing money faster relative to a trade partner rate would cause transportation costs to rise and might cause some manufacturing that is very domestically oriented to return. But the prices of imported raw materials would rise and it would discourage savings which is needed for their to be stable investment in manufacturing. So the US would be importing less raw materials and manufactured goods but the price paid for these imports would rise thus causing the trade deficit to increase further even though the US is importing less goods.

        A stable dollar that allows for people to save is the protector of manufacturing. The reason Germany was able to remain competitive in manufacturing with a higher valued exchange rate and high real wages is because they had stable real interest rates that keeps savings stable which leads to stable investment into manufacturing. The US on the other hand for the last decade has had relatively low real interest rates that has been used to fund wars and consumption of foreign made products. Low real interest lead to less savings and more consumption that pushes up prices of raw materials which squeezes manufacturing profit margins thus leading to the emergence of rustbelts.

  7. Harry Moser says:

    A key difference between the trade and fiscal deficits is: 100% of the trade deficit’s debt is held outside the U.S. while only a portion of the fiscal deficit’s debt is held outside. My conclusion is to put increased emphasis on the trade deficit.
    The Reshoring Initiative is helping to reduce the trade deficit. See http://www.reshorenow.org.

  8. Dan DiFabio says:

    Great article Ian! If the yearly trade deficit problem is finally resolved;the national revenue shortage will end,and the national debt will be lowered.

  9. Milt Heft says:

    Great work, Ian. Just 2 comments:

    1. The government does not “borrow” money. It simply prints it. The “borrowing” is merely a legal fiction.

    2. The trade deficit is the root of all the evil. However, its origin is consistently under-discussed and overlooked: OUTSOURCING. The trade deficit has been caused by a great many of America’s greatest companies shutting down their USA factories and moving mostly to China. It would take drastic federal action to reverse the flow and bring back the outsourced production, but it CAN be done. It MUST be done.

  10. Arthur Taylor says:

    The math is really simple – but then again it’s not – one billion dollars is the equivalent of 16,000 plus jobs at $60,000.00 per year. But then there’s the ancillary benefits those jobs provide to the economy and the rollover benefits that accrue to the economy due to the money sloshing around within the economy (The IRS assumes that it will tax a dollar generated within our economy eight times before it evaporates).

    Given the trade deficit so far this year of $500 billion x 16,000 jobs per billion, the potential is an additional 8 million jobs assuming balanced trade – and or we simply take the production back for ourselves and internally produce to meet the proven demand that actually exists in our own marketplace as the trade deficit so obviously shows. With the stroke of a pen, America could be booming within six months.

    The idiocy of the prevailing economic philosophy – free markets / free trade – currently underpinning our economy is so obvious, one wonders how it can possibly continue. That the economics establishment in this country continues to make the case for it is nothing less than treasonous.

    • Bruce Bishop says:

      Arthur,

      In addition to the eight million manufacturing jobs, there is the “manufacturing multiplier” which says that each manufacturing job generates anywhere from 2.9 to 3.04 additional jobs in the economy. For example, let’s say those 8 million factory workers will have 4 million kids, who will need 200,000 teachers, 10,000 pediatricians, 10,000 dentists and 300 each of McDonald’s, Pizza Hut and KFC.

      You are correct that allowing China to repay our “free trade” with mercantilism is idiotic.

      In my opinion, the Obama administration sees each lost job as a future Democrat voter. When people become dependent on the government, they are most likely going to vote for the Democrats, who keep promising to redistribute the wealth.

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