The Economist: America's Trade Deficit

How to slay America's monster trade gap?
Jun 22nd 2004
From The Economist Global Agenda

America’s trade gap is growing again. Worse, it may be extremely hard to close it without causing much economic pain—and not just for Americans

LAST year, when the dollar resumed its steady decline after a brief spring rally, many observers felt vindicated and a little relieved. The world had grown too dependent on selling its goods to America. For its part, America was too dependent on flogging its assets to the rest of the world to finance its addiction to imported goods. To be sure, America’s willingness to spend more than it could strictly afford on other countries’ manufactures was welcome at a time when most of these countries’ economies were sluggish. But deficits of over 5% of GDP in America’s current account could not be sustained. Having carried the world economy through the first, crucial leg of recovery from the slowdown of 2001, some economists felt it was time for America to “hand over the baton” to the rest of the world and pause for breath.

But America is refusing to let go of the baton. It continues to import much more than it exports while investing more than it saves. According to figures released last Friday, its current-account deficit, having narrowed to 4.6% of GDP at the end of last year, has widened again in the first quarter of this year (see chart), to 5.1% of GDP.

Were we expecting too much from a fall in the dollar? In other countries, a swift depreciation of the exchange rate has worked wonders. A fall of 20%-plus, in real terms, in the Swedish krone after 1992, for example, turned a deficit of more than 3% of GDP into a surplus of about 4%. But Sweden is a relatively small economy. Providing it remains outside the euro, it can depreciate, gaining competitiveness against its neighbours, without beggaring them. The United States, on other hand, is such a crucial destination for the imports of so many countries that they may struggle to find alternative sources of demand.

A recent study* by economists at the OECD illustrates the difficulty. To narrow the deficit by two percentage points by the end of the decade, they reckon the greenback would have to lose about a quarter of its current value (as measured against the currencies of America’s major trading partners) by the end of this year. Since China and Malaysia peg their currencies to the dollar, and many other Asian countries track it closely, Japan and the euro area would bear the brunt of the dollar’s fall. They would not bear it easily. America is such an important export market for both that neither would cope easily with such a loss of competitiveness. The European Central Bank (ECB) has some scope to ease the blow by cutting interest rates but the Bank of Japan has already cut them as low as they can go. As a result, the strengthening yen would cut Japan’s output in 2009 by more than 2% and condemn the country to another six years of falling prices, the study reckons.

Earlier this month, at the summit of G8 heads of state in the American state of Georgia, France’s President Jacques Chirac worried out loud about the future implications of America’s spendthrift ways. The Europeans point the finger in particular at President George Bush’s government, which is projected to run a budget deficit of 4.7% of GDP this year. America’s outsized trade deficit, the Europeans argue, is the “twin” of this giant budget deficit. One cannot be dealt with, without the other.

But even as Europeans accuse the United States of throwing the world economy off balance, Americans accuse an arthritic Europe of holding the world economy back. Europe’s firms and workers are too cosseted, they argue, and as a result the continent’s economies are unable to pull their weight in the world economy. America is prepared to hand over the baton; but Europe must be ready to take it up.

Neither side of this debate is much willing to listen to the other. But what if they did? The OECD’s economists shed light on what would happen if each side took the advice of the other. Suppose, for example, that the governments of the euro area (and America’s other OECD trading partners) heeded Uncle Sam’s lectures and passed liberalising reforms that raised their trend rates of growth by 0.5%. This would do wonders for the euro area itself, but it would do little to narrow America’s trade deficit. The OECD economists reckon it would cut the deficit by just 0.2% of GDP by 2009. Despite what many Americans would like to believe, America’s trade gap is not simply an expression of its faster growth rate. The study found that America’s appetite for foreign goods is so much stronger than the rest of the world’s desire for American goods that even if the other rich countries raised their growth rates to match America’s, they would still sell more to America than it would sell to them.

Now suppose America gave in to the hectoring of Mr Chirac and others and put its finances back in order. The OECD’s authors imagine an administration prepared to raise taxes by 4.5% of GDP over the next six years while cutting spending by 1.5%. This would put the government into the black to the tune of 1.7% of GDP by 2009. But even such a massive fiscal turnaround, amounting to 6.6% of GDP, would knock only 2% of GDP off the trade deficit. Why? The OECD economists point out that private saving tends to fall when public saving increases. Between 1992 and 2000, for example, the Clinton administration turned a worrying budget deficit into a handsome surplus. But this only helped to unleash a private investment boom. Public saving was offset by private dissaving, ensuring that the country’s trade deficit continued to deteriorate. America’s budget and trade deficits may be twins but one, it seems, can survive without the other.

America’s deficit will not resolve itself without much pain, suggest the OECD economists. America must beggar its neighbours with a competitive devaluation of the dollar, or beggar itself with a massive fiscal contraction—or both. The consequences of letting America’s deficits continue are certainly worrisome, as Mr Chirac suggests. But he should be equally worried about the consequences of bringing them to an end.