Why trade deficits do matter

Some economists have argued in recent years, against the background of ever-expanding US debt, that trade deficits no longer matter. They're sadly mistaken, says Dr Marc Faber in The Daily Reckoning. The growing US deficit is just another symptom of the inevitable decline of Western economic power – which will also mean falling standards of living for Western consumers.

By MoneyWeek

Published 24 May 2006 In Features

One cannot argue a priori that a trade surplus is "good" and a trade deficit is "bad". Much will depend on a country's composition of imports. If a rapidly growing economy imports principally capital goods for the production of goods or pays patent fees for the application of some inventions, I suppose that a trade deficit can be justified as it relates to capital formation, which leads to investment-driven sound growth and, eventually, boosts households' real earnings and their standard of living.

However, when the trade deficit is linked to a sharp loss of competitiveness and over consumption and relates principally to the importation of consumer goods, I doubt that such a deficit will lead to a rising standard of living in the long term.

Temporarily, and in theory, there could be a rise in the standard of living when import prices decline sharply and allow households to buy a larger basket of goods, while the loss of employment in some industries may be immediately offset by employment in other industries that pay the same or even higher wages. But this doesn't seem to be the case in the Western industrialised countries and the United States where the median real household income has declined by 4% since 1999. This seems also to be supported by data from the US Bureau of Labor Statistics and by a survey commissioned by the AFLCIO.

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According to this survey, which was carried out by Peter D.Hart Research Associates Inc. who polled 805 working Americans and which has a margin of error of 3.5%, only 11% of the respondents - concentrated among US families with annual incomes of $75,000 or more - consider their family income to be rising faster than the cost of living. And among the 53% of workers who said their incomes were falling behind, less than a third reported doing better than their parents at the same point in life.

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However, it is still possible that standards of living have been rising even though median real household income is down, as evidenced by rising debt levels, which have created asset inflation and the illusion of wealth. Since 1995, total US credit market debt is up by more than 100% to $37.3 trillion, or over 300% of GDP, while consumer debts have soared by more than 120% to $10.7 trillion, or to more than 120% of personal disposable income.

But if standards of living have been rising as a result of higher debts leading to soaring household wealth, two points ought to be considered. The gains in household wealth have been unevenly distributed. Between 1983 and 2001, the top 20% of US households in terms of wealth received 89% of total growth in net worth, while the remaining 80% of households accounted for only 11% of the growth in net worth. In fact, I would argue that the central problem of monetary inflation is that it distorts the entire market mechanism.

I think it should be obvious even to a non-economist that when production and investments shift to a new region, it creates employment in that region and, through various forms of multiple effects, leads to rising incomes and standards of living. It should not be forgotten, also, that when a manufacturer shifts its production to Asia or any other emerging economy, it is accompanied by a transfer of technology, knowledge, and ancillary services, which then boosts the educational and skill levels of the local population and brings numerous other benefits.

An example of ancillary services also moving to Asia is the shift of warehousing functions to China and other Asian locations. According to the Financial Times (November 7, 2005), "US manufacturers and retailers are increasingly shifting warehouses and distribution facilities to China as part of efforts to make their supply chains more efficient. Until recently, China made goods typically passed through US warehouses en route to their final destination. But that has begun to change, as a growing proportion of goods are sorted, packaged, and labelled before leaving China. Once they arrive in America, the goods are delivered direct to the retailer or consumer, bypassing US warehouses."

According to the article, most US companies don't build their own warehouses but use the facilities provided by logistics partners such as UPS and DHL. UPS is expected to have 50 warehouses in China by the end of this year and plans to open another ten next year. Red Wing, a US shoemaker, the Financial Times reports, has shifted some work from its main US warehouse in Salt Lake City to a UPS facility in Yantian.

In fact, it is wishful - if not arrogant - thinking to assume that all engineers, scientists, and inventors will be stationed in the West and that the "uneducated" Asians will be employed in low paying manufacturing and low-value added service jobs. Rather, my view would be that, in future, research and development centres will follow the migration of manufacturing to Asia, since the benefits - the cost advantages aside - of the proximity of manufacturing and product development would seem to be obvious.

The notion that the Western world has a huge technological advantage over Asia would also seem to be negated by the findings of ipIQ, an intellectual property consulting and service company based in Chicago. Using a proprietary patent database that goes back 30 years, ipIQ's technology rating model tracks patent details and ownership transactions, and ranks companies based on the number of patents granted, including the number of previous-year patents and growth of patents year-over-year. In particular, it also evaluates the impact of patents by looking at the frequency with which they are cited in scientific papers and by producing a science linkage index.

There is one more point I wish to make about the belief that "advanced" nations produce high-profit intellectual property and services and have outsourced low profit manufacturing to the developing economies. While the United States still has a surplus in its balance on service, this surplus has in recent years been declining - suggesting a loss of competitiveness even in high- profit intellectual property and services. Moreover, the surplus in the United States balance on services is tiny and shrinking as a percentage of GDP when compared to the bulging and (as a percentage of GDP) increasing deficit in the balance on goods.

Economists may contend that the US trade and current account deficits are sustainable ad infinitum, which in my view they are not, but very clearly it doesn't take much economic background to see that the decline in the US balance on services and the explosion in the country's deficit in its balance on goods indicates very clearly a loss of international competitiveness. Figures compiled by Bridgewater Associates shows how the United States has lost market share of export markets.

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