By Jeff Ferry, CPA Research Director
Summary
The US government should adopt balanced trade as a key performance measure for trade policy. Following 40 years of recurrent trade deficits, our industrial base is depleted, American living standards have suffered, many of our cities and towns are in disrepair, and social problems are growing. Our huge trade deficits have depressed economic growth, destroyed millions of jobs, and enabled foreign nations with mercantilist policies to take dominant positions in economically and politically strategic industries, while we’ve lost share in those key industries. Balanced trade is a quantitative measure, rather than a process, which would guide trade policy decision-making and performance evaluation in the national interest rather than merely for special interests.
Historical Background
For the 30 years after World War II, the US economy led the world, delivering consistently rising living standards to the American people. In the 1970s, growth started to slow down. Recoveries in the 1980’s and 1990’s too often coincided with bubbles which artificially inflated economic growth. Since 2000, US economic underperformance has been the norm.
The trend is clearly illustrated by real family median income: in the 1950s and 1960s, it grew by around 3% a year, meaning real family income doubled every 24 years. Between 2000 and 2015, real median family income eked out growth of just 0.1%. At that rate it would take 835 years to double family income.
In the post-WWII years, the US ran a small trade surplus (in other words, our exports of goods exceeded our imports). In 1971, we began running trade deficits, importing more than we exported. While small at first, by 1985, the deficit exceeded 3% of GDP causing the Reagan Administration to take action. In an agreement nicknamed the Plaza Accord, the Administration persuaded our leading allies to join in coordinated intervention to drive down the value of the dollar in foreign exchange markets. Over the next three years, the dollar fell some 50% in yen terms and the trade deficit improved significantly, falling from negative $151 billion in 1987 to a low of negative $31 billion in 1991 (aided too by a recession which restrained imports).
In the 1990s though, the trade deficit grew once again, surpassing $200 billion for the first time in 1999. Last year, our trade deficit was $500 billion, equivalent to 2.8% of our GDP (see Fig. 1). It is no accident that median family income scarcely grew between 2000 and 2015 and fell in eight of those 15 years.
The best way to address US economic underperformance and stagnant living standards is to shift the policy focus to net trade. A balanced trade goal will cause policymakers to target policies that address the most significant factors – foreign or domestic – that cause overall deficits. Current policies, which focus merely upon exports or tariffs, result in special interest driven trade policy that depends upon the political power of an industry rather than the national interest.
The net result will be a stronger industrial base, less foreign debt, and freedom from dependence on foreign partners, which will enable us to implement a stronger foreign policy. Finally, balanced trade will drive a new wave of economic growth, comparable to the growth levels we enjoyed in the post-WWII period, delivering higher living standards to the mass of our population.
How Net Imports Depress the Economy
Aggregate or total demand is the result of all spending by businesses, consumers, and governments on U.S. goods and services. When foreign customers buy US goods or services (exports) that boosts demand for US products. When American customers purchase goods or services from foreigners (imports) that depresses demand for US production. Net exports (exports minus imports) expand the economy while net imports contract the economy.
An expansionary or contractionary effect is amplified by the additional spending as employees and shareholders spend the dollars they get as receipts for net exports, a factor known as the multiplier. Economists at the Congressional Budget Office (1)
and the Department of Agriculture (2) have estimated the multiplier to be in the range of 1.5 to 3. The effects of the multiplied demand are spread out over some two to five years.
If for argument’s sake we choose a conservative multiplier of 1.5, then the effect of last year’s 2.8% trade deficit is a contractionary effect on the economy worth 4.2% of total GDP, spread out over the next several years. The cumulative impact of two decades of large and rising deficits is a significant reduction in US economic growth. This persistent contractionary pressure reduces wages and job creation. It also forces the federal government to take countervailing measures, chiefly a larger federal budget deficit and a looser monetary policy than would otherwise be required. The budget deficit and the lower interest rates cause trouble in other areas which eventually have to be dealt with. While most recent commentary attributes our recent historically loose monetary policy to the after-effects of the 2008 financial crisis, the trade deficit has been an additional factor.
The trade deficit has also caused a long-term decline in our industrial base. Industrial production has moved to mercantilist economies, chiefly in Asia, which have subsidized their export industries and exploited their low costs to achieve dominance in critical industries including steel, silicon chips, and Internet networking equipment. Our manufacturing employment has thus fallen by more than 30% since 1999 (see Fig. 2).
A balanced trade goal will cause policymakers to target policies that address the most significant factors – foreign or domestic – that cause overall deficits. Current policies, which focus merely upon exports or tariffs, result in special interest driven trade policy that depends upon the political power of an industry rather than the national interest.
Many of the most strategic industries in today’s economy are subject to large economies of scale. In other words, to achieve dominance in an industry like steel or silicon chips, extended investments of many billions of dollars in huge industrial plants are required, often followed by years of losses. But at the end, the owners of these industries reap large profits and pay employees high wages that increase over time, because these are high-productivity industries.
China’s state-capitalism model followed that strategy successfully in steel, transportation, technology and other industries, making China the world’s largest exporter last year, with $2.2 trillion in exports, 40% more than the US (see Fig. 3). South Korea and Taiwan achieved dominance in silicon chip production with similar strategies.
The fact that other countries can be driven almost entirely out of strategic industries due to economies of scale is explained in Global Trade and Conflicting National Interests (3), an analysis by Professor William Baumol of NYU, and former IBM executive Ralph Gomory. Baumol and Gomory’s thesis explains why the only way for the US to provide high-paying jobs to a large number of people is to focus on building worldwide scale in a number of strategic, well-paid industrial supply chains. These industries have two key characteristics: first, they pay an average wage level equal to or above that of the US average (currently around $25/hour or $890/week), and secondly they are capable of delivering consistent labor productivity improvements to support steadily rising wages, the key means of fulfilling the American dream of a rising standard of living.
The manufacturing sector contains thousands of firms that meet these criteria. The agriculture sector increases productivity and creates jobs but often at lower wages. But the growing service sector meets neither criterion. Service industries like health care, education, and retail, have pay rates typically lower than the national average. Even more important, these service industries inherently do not generate consistent productivity improvements, partly because the personal nature of these services makes it hard, and often undesirable, to drive up productivity. Services are essential to our economy and already account for the majority of our GDP. But any plan to restore economic growth and wages to prosperous levels requires a focus on goods producing industries. Balanced trade is the first, critical step down that road.
Free Trade Fallacies and the Rise of Asia
Many economists and pundits argue that free trade benefits an economy by reducing the price of imports. However, as Tufts economist Jeronim Capaldo (4) has pointed out, to support their arguments, pro-free-trade economists rely on economic models that assume zero trade deficits worldwide, no unemployment, and freely floating exchange rates. In other words, their models assume away the real-world costs and burdens but not the benefits. This is an important reason why many past forecasts of large US benefits from past international trade agreements have been wrong. Higher deficits and significant unemployment has often resulted instead.
Here are some common free trade fallacies, along with the truth:
Conclusion
As Milton Friedman wrote in his classic work, Capitalism and Freedom: “There are only two mechanisms that are consistent with a free market and free trade. One is a gold standard…The other is a system of freely floating exchange rates determined in the market by private transactions without governmental intervention”. (6) Neither condition is true today. If the world had truly freely floating exchange rates, the dollar would be far lower and our trade would be in balance. The unique position of trust that US assets enjoy worldwide sustains our dollar at an unrealistically high level perpetuating the ongoing decline of our industrial base. The dollar’s strength is an illusion, like the lord of the manor who runs up debts at every store in town yet tells his sons the family is wealthy. The only two similar examples in history that can be found for such profligate spending on imports from overseas are the Roman Empire and the British Empire in their declining years.
The US can avoid following their fate by acting aggressively now to implement a balanced trade goal to guide future policy towards creating the conditions under which we can begin rebuilding our national economy. A balanced trade goal would require boosting the growth of important industrial supply chains, both low-tech and high-tech, breathing new life into cities and communities that have been desolate and declining for decades. Entrepreneurs and companies would respond to new opportunities by building businesses targeting the domestic market. Further incentives, such as favorable tax policies to counter foreign border taxes, could be created to incentivize US companies’ growth and enable increased market share domestically and abroad. We would regain position in key industries, including some industries that are essential for national defense and self-sufficiency but have been lost in recent decades. The policies would need to be phased in gradually over time, to avoid sudden changes, and to win a broad base of support, so business and our trading partners would perceive that the new regime would be reliable and enduring. It represents nothing less than a new federal commitment to economic growth and higher living standards.
Footnotes
(1) Whalen an Reichling, The Fiscal Multiplier and Economic Policy Analysis in the United States, (Congressional Budget Office, 2015)
(2) US Department of Agriculture Economic Research Service, Effects of Trade on the US Economy-2014
(3) Gomory and Baumol, Global Trade and Conflicting National Interests (MIT Press, 2000)
(4) Capaldo, Izurieta, Sundaram, Trading Down: Unemployment, Inequality and Other Risks of the Trans-Pacific Partnership Agreement, (GDAE Institute, Tufts University, 2016)
