by Steve Forbes
That such scenarios are being considered reflects the dangers we all face. A new and more destructive monetary crisis is on the way unless policy makers come to their senses and abandon ridiculous ideas such as the trade deficit. The real danger today is not the trade deficit but rather the deficit of understanding about trade and money.
The Trade Deficit Fallacy
Just about no one questions the neo-mercantilist assumption that imports are supposedly money-draining job destroyers while exports that bring in money are wealth creators. A nation’s trade deficit is considered the equivalent of a company losing money, and a trade surplus is analogous to a profit. A trade deficit is therefore viewed as a sign of economic weakness.
This misguided perception has even influenced how the government computes gross domestic product (GDP). Since the 1930s, exports have been calculated as increasing GDP; imports are regarded as subtractions. Another puzzling computation is that government spending is calculated as a positive contribution to GDP—something that would be news to anyone who had ever lived in the Soviet Union.
Yet trade deficits and surpluses have historically reflected little about the health of an economy. Neo-mercantilists overlook the fact that the United States has had a merchandise trade deficit for roughly 350 of the last 400 years. America ran a trade surplus during the Great Depression of the 1930s, for all the good that did. It has run trade deficits generally in more prosperous times, such as the late 1990s. That’s because in those environments the United States is seen as a desirable market that’s rapidly growing and consuming. People want to sell to America. The fact that the United States buys products and services from other nations doesn’t mean it is weak; it means that the U.S. economy is strong and has the wealth and resources to buy what others are selling.
All of us incur trade deficits in daily life. When you go to McDonald’s and buy a Big Mac, you have a trade deficit with McDonald’s. You’re buying from the restaurant, but it’s not buying from you. No one gets upset. McDonald’s may get your money, but you get the Big Mac. You get something in return.
Forbes magazine has a trade deficit with our paper supplier. We buy more paper from them than they buy subscriptions or ads from us. The fact that we have a trade deficit with our supplier doesn’t say anything about our health as a company. It only says that we have a need for paper.
The myopic focus on the trade deficit ignores the fact that transactions don’t take place between nations; they take place between the people and companies within those nations. America’s imports or exports reflect the needs and wants of people at any given time. For example, in 2008 Reuters reported that a major part of the U.S. trade deficit with China consisted of $2.74 billion in “oil country tubular goods”—for example, pipelines.
Why did the United States need so much steel pipe? Primarily because of the increase in shale gas exploration made possible by hydraulic fracturing and technical advances in oil drilling, which spurred greater demand. American entrepreneurs and producers were mobilizing to meet the nation’s demand for energy. They bought pipes from China, and citizens ended up with greater access to much-needed energy. That’s not a deficit; that’s a plus.
A sizable part of supposedly foreign trade in fact takes place within U.S. companies. Much of America’s commerce abroad takes the form of foreign affiliate sales—movement of goods and services between a U.S. corporation’s global subsidiaries. More than half the imports ostensibly responsible for the U.S. trade deficit come from the foreign divisions of American companies, according to the U.S. International Trade Commission.
In today’s global marketplace, there’s really no such thing as an American product or a Chinese product. In one study, researchers from the U.S. International Trade Commission and Columbia University estimated that the share of foreign (that is, non-Chinese) content in China’s exports is about 50%. The iPhone assembled in China, for example, wholesales at about $180. While considered a Chinese export, Chinese labor accounts for only about $6.50 of its cost. The device is made of parts from a number of Asian and European countries.
With all of the iPhone’s imported parts, the sale of just one may increase the U.S. trade deficit by around $180. Does that mean America loses? Hardly. Consider that the device sells for around twice its cost. Apple’s profit, and the gain to the U.S. economy, therefore, exceeds the trade deficit.
Restricting Apple’s, or any other company’s, international trade is as counterproductive as keeping Ford Motors from buying critical components from domestic suppliers because Ford might have a trade deficit with those companies. America doesn’t win in any sense of the word. It loses because U.S. companies are rendered less productive, less innovative, and less efficient.
Nor does a deficit with a trading partner necessarily indicate that a country is blocking U.S. exports. Daniel Griswold, director of the Cato Institute’s Center for Trade Policy Studies, points out that the United States runs a bilateral surplus [our emphasis] with Brazil, which is relatively protectionist, while we run deficits with Canada and Mexico, which are almost totally open to U.S. exports thanks to the North American Free Trade Agreement.
What about the argument that trade deficits mean the United States is losing jobs to cheap labor overseas? Dan Griswold reminds us that, in the prosperous 1990s, the U.S. trade deficit practically tripled. Industrial production and manufacturing output, meanwhile, dramatically increased. The lesson, he writes, is that:
Trade deficits do not cost jobs. In fact rising trade deficits correlate with falling unemployment rates. Far from being a drag on economic growth, the U.S. economy has actually grown faster in years in which the trade deficit has been rising than in years in which the deficit has shrunk. Trade deficits may even be good news for the economy because they signal global investor confidence in the United States and rising purchasing power among domestic consumers.
The very idea of a trade deficit is the invention of theoreticians. It is meaningless.
What the Trade Deficit Doesn’t Measure
For all the public angst over the trade deficit, most people have a hazy idea of what this number actually measures. Trade deficit numbers are reported in balance of payments data released by the Department of Commerce. The statistic is included within a category called the “current account,” which measures international trade in goods, services, investment income, and unilateral transfers such as foreign aid and remittances.
The problem with focusing on the current account is that it is only a partial indicator of U.S. overseas economic activity. It doesn’t measure, for example, when a U.S. company sets up an office in another country to manufacture products there.
The trade deficit doesn’t capture the flow of capital—that is, what Americans are investing in other countries or, conversely, foreign investment in the United States. “Capital flows,” analyst Marc Chandler points out, “are larger and more important than trade.” To ignore them, he tells us, misses the bigger picture: “America is richer, better, and stronger than it was before the late 1970s and early 1980s when it began recording a sustained current account deficit and became a debtor nation again.” He concludes, “The current account shows the value of goods and services that cross national borders. It doesn’t show anything else.”
Remember Adam Smith. There can be no “deficit” in a trade because it is a reciprocal exchange. The United States isn’t just buying from companies or individuals outside its borders. Like those who purchased a hamburger at McDonald’s, they are getting something in return.
What America gets in return for its overseas purchases and investment is measured by two largely overlooked balance of payments indicators that measure the flow of capital into the United States: the capital account and the financial account.
University of Michigan business professor and American Enterprise Institute scholar Mark Perry notes that U.S. cash outflows for imports, income payments, foreign asset purchases, and unilateral transfers are offset by cash inflows from
exports, income receipts, and asset sales. He explains that, in 2012, for instance:
There was a $3.4 trillion cash outflow from the US as American consumers, businesses and governments purchased goods, services and assets from abroad, and as US businesses and governments made income payments to foreigners (e.g. dividends and interest) for investments they previously made in the US, and there was a $3.4 trillion cash inflow to the US as foreigners purchased American goods, services and assets, and as foreign businesses and governments made income payments to Americans for assets owned abroad. . . . Once we account for all international transactions that took place last year, the cash inflows from abroad of $3.4 trillion paid to Americans exactly equaled the $3.4 trillion in cash outflows paid by Americans to foreign recipients.
The Cato Institute’s Dan Griswold makes a similar point. Not only is America’s trade deficit balanced by a foreign investment surplus—the foreign money flowing into the country also “keeps long-term interest rates down, prevents the crowding out of private investment by government borrowing, and promotes job creation through direct investment in U.S. factories and businesses.”
Those American dollars flowing overseas, therefore, are doing anything but creating imbalances. They are being used to facilitate commerce across borders—transactions between people who create wealth both overseas as well as in the United States. America benefits from goods and services Americans buy from people in other countries. Foreigners, in turn, benefit from U.S. dollars, which help grow their economies—and which they plow back into the United States by investing in its businesses, stocks, bonds, and real estate.
Who’s Really Doing Currency Manipulation—and Why It Doesn’t Work
Too few politicians of any ideological persuasion fully get it on trade. Shortly after taking office, President Obama made it clear that he shared Washington’s preoccupation with imbalances and deficits. Backed by 130 members of Congress, the president called upon China to revalue its currency to “a more market-oriented exchange rate.” (Translation: raise the value of the yuan so that Chinese imports would cost more, making U.S. exports more competitive.) There was much talk at that time that if China did not comply, the United States would respond by imposing tariffs on Chinese products. But the U.S. government never followed through. That was probably because the charges of currency manipulation were false.
The numbers tell the story: Between 1995 and 2005 China’s exports to the United States increased sixfold. Yet the dollar/yuan exchange rate did not change.
During most of that time, the yuan was pegged to the dollar. Since 2005 it has been pegged to a basket of currencies. The yuan’s value relative to the dollar increased 21% between 2005 and 2008. Chinese exports to the United States indeed cost more. Despite this, Chinese imports continued to grow vigorously for the simple reason that Americans wanted to buy them.
The heated accusations about currency manipulation totally miss the point. Trade is ultimately about the needs of people, not exchange rates. If any nation manipulates currency, it is the United States. As noted, since the early 2000s both the Bush and Obama administrations have deliberately weakened the dollar to spur exports. (As we noted, former Fed chairman Ben Bernanke, a strong believer in a weak dollar trade policy, was a Bush appointee before he was tapped by Obama for another term.)
The Reagan administration constantly fought with Japan and Germany over the strength of the yen and the deutschmark. So did every other administration since Dwight Eisenhower. For all the fireworks, Johns Hopkins economist Steve Hanke notes that these United States–initiated feuds have historically failed to have much effect on the supposed trade problem.
For example, the United States for decades has pressed Japan to strengthen the yen. The value of the dollar compared with the yen slid from 360 yen per dollar in the 1970s to as low as about 80 yen to the dollar in 2012. This depreciation, however, has accomplished little. The United States still continues to run trade deficits with the Japanese. Nor did a strong yen end the problem of competition from cheap Asian exports. All it did was weaken Japan, opening up the door to other Asian nations, such as Korea and Taiwan.
The indignation over currency manipulation may make for good headlines, but the charges are more bluster than fact. The bottom line: currency wars over fake issues like trade deficits are to no one’s advantage. If the U.S. government really wants the Chinese to act with more fairness, it should get them to reduce trade barriers. What about China forcing U.S. companies to reveal trade secrets in exchange for trading relationships? Or Chinese partners stealing from American companies? Those are the real issues.
The Obama administration’s focus on the yuan/dollar relationship is a waste of time. As we saw with Japan and the yen, revaluing one’s currency ultimately fails. Once producers, importers, and exporters recover from the shock, they recalibrate prices to reflect real-world values. One ends up with the same trade imbalances. Meanwhile trading relationships suffer and growth and incomes decline—the inevitable consequence of a needlessly weakened dollar.
Could the Euro or Another Currency Replace the Dollar?
Given the uncertainties of U.S. monetary and fiscal policies, and the equally uncertain world monetary environment, some have raised the question: Could the euro eventually rise up to replace the dollar as the world’s leading currency? Despite all the recent controversy over the euro, it’s a question worth asking. After all, the euro has become the second-most-traded reserve currency after the dollar. It was created, in part, as an alternative to the dollar on the global markets. Unlike the paper gold the Chinese have proposed to replace the dollar, the euro has a track record and is real money. Why couldn’t it supplant the dollar?
Before answering, a little history. The euro was launched in 1999. Its spiritual father was Canadian Nobel Prize–winning economist Robert Mundell, who believed that a single, shared currency would promote trade within the European community and increase investment by facilitating the flow of capital. He also felt that a major currency that was a potential rival to the dollar would force the United States to embrace monetary stability and a sound dollar.
From the beginning, critics have distrusted the euro. Many doubted that European nations with different political traditions and cultures could successfully share a single currency. The misunderstanding intensified in the last several years when overextended nations including Greece, Cyprus, Italy, and Portugal teetered on the brink of insolvency. Several countries have had to be bailed out by the International Monetary Fund, the European Central Bank, and the European Union. These events have been mistakenly reported as a “euro crisis.” But the euro is anything but the cause.
The turmoil in Europe is the result not of the euro, but of bad economic policy that combines excessive taxation, overspending, and stifling regulation. Imagine if the overextended states of Illinois and California were to default on their bonds. Would that mean that they would leave the U.S. dollar zone and adopt new currencies? The sovereign debt crisis is no more a euro crisis than the recent fiscal meltdowns of some states in the United States are a dollar crisis. Greece, Cyprus, Italy, and Portugal have had fiscal problems for many of the same reasons that states such as Wisconsin and New Jersey have nearly had a meltdown: their taxes have been too high, their government bureaucracies too large, and their public employee salaries and pensions unsustainable.
Critics also say that Europe shouldn’t rely on a single currency because countries have different fiscal policies. They believe that, without a central political authority to impose uniformity, these differences will undermine the euro. The debt woes of Greece, Portugal, Spain, and Ireland should in no way threaten the existence of the euro, however, any more than Illinois’s or California’s profligate ways should threaten the dollar’s existence.
Forbes.com contributor Louis Woodhill got it right when he wrote that a European “‘fiscal union’ is no more necessary for the long-term survival of the euro than it is for the long-term survival of the metric s
ystem. ‘The euro’ is a unit of measure, like 'the meter.’ It is the unit of market value used within the euro zone.”
What about predictions that Greece will eventually seek to solve its problems by abandoning the euro or that the euro itself will collapse? Woodhill rightfully calls such suggestions “insane.” Remember that for money to work, people must have faith in it as a reliable unit of measurement based on marketplace experience. Greece would never abandon the euro, Woodhill tells us, because its own currency would be so much worse:
The mere threat of a return to the drachma would precipitate bank runs and the collapse of all Greek banks. No one—and definitely not suppliers of imports—would be willing to hold the drachma, which would be a currency that was designed to be devalued. A “drachmaized” Greek economy would simply disintegrate.
People have also assailed the euro for the same reason they are afraid of gold: because it makes it more difficult for nations to devalue their currencies. Do you think that Greece or any nation can solve its economic problems through devaluations that destroy the wealth of its citizens?
In reality, any euro crisis is a central banking crisis. The system could have worked just fine had the European Central Bank pegged the euro to maintain a constant value. Instead the misguided policies of the region’s Eurocrats have allowed it to become another roller-coaster fiat currency like the dollar.
For all its problems, there is a real need for the euro, which is why most nations in the European Union, with the notable exception of Great Britain, have now adopted it. And in many ways it has succeeded. Former Wall Street Journal top editor George Melloan reminds us that the euro has made transactions in Europe’s close-knit nations many times easier. Two decades ago, he writes, if you needed to make a quick trip to a neighboring country:
