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.

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.

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.

When monetary inflation leads to consumer price increases, it doesn't lift all prices by an equal amount; some prices soar, while others languish.

Similarly, when monetary inflation shows up in asset prices, not all households benefit to the same extent. Therefore, asset inflation usually leads to an enormous widening of wealth and income inequity, unless fiscal policy is designed to redistribute wealth, which then creates new maladjustments.

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.

According to its director of marketing, "We were doing the same thing [in Utah] with more people taking longer to get it done at a higher cost." Here you have the reality about the great US productivity miracle!

Moreover, according to SJ Consulting, a transport consultancy, a warehouse worker in China costs about $2 per hour compared with $14-$15 in the United States. (But note that US$2 per hour in China is considered a very good salary.)

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.

For example, IBM has just announced that it has signed an agreement establishing an Indian outsourcing company, HCL Technologies, as the first Power Architecture design centre outside of the company's own facilities. The design centre is based in Chennai (formerly Madras) and has 25 employees, but according to company executives it could grow into a 1,000-employee operation in two years.

Given that in 2004 China graduated around 500,000 engineers and India 200,000 - compared to 70,000 in the United States - and since a company can hire five chemists in China or 11 engineers in India for the cost of one engineer or one chemist in the United States, it is only a matter of time until most R&D will be carried out in Asia.

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.

In 2005, ipIQ ranked the following ten companies as having the highest-quality patents, based on the innovations' impact on industry and scientific significance:

1. IBM

2. Micron Technology

3. Hitachi

4. Intel

5. Hewlett Packard

6. Samsung

7. Canon

8. Matsushita Electrical Industrial

9. Toshiba

10. Fujitsu

And while this ranking may be debatable, it nevertheless shows that six out of the ten top-ranked companies are based in Asia and supports the view that the technological and scientific advantages of the United States and Europe are waning.

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.

When a company loses market share, it affects its profitability in the long term and can threaten its survival (witness General Motors). When a country loses market share in export markets and has growing external deficits it will have a negative impact on standards of living and on its financial strength in the long term.

I do, however, concede that temporary standards of living can be maintained or even boosted if such an economy goes deeper into debt, as is clearly the case for the United States.

By Marc Faber for The Daily Reckoning

Dr Marc Faber is the editor of The Gloom, Boom and Doom Report and author of 'Tomorrow's Gold', one of the best investment books on the market. Headquartered in Hong Kong for 20 years and now based in northern Thailand, Dr Faber has long specialised in Asian markets and advised major clients seeking bargains with hidden value, unknown to the average investing public.