The Trade Deficit Jude Wanniski January 23, 2004

Memo To: SSU Students
From: Jude Wanniski
Re: The US Trade Deficit

In last week’s guest lecture on globalization by Federal Reserve Chairman Alan Greenspan, at the center of the discussion was the US deficit on current account, the trade deficit as it is more usually called in news reports. From the reactions I got from students, I gather Greenspan was not as lucid as I suggested he was, relative to the density of most of his writings and utterances. Instead of getting the questions I’d hoped for, I got requests for “translations.” The topic is an important one in this political season, given the reports of a trade deficit running at $500 billion alongside a federal budget deficit that might reach or exceed that number. The one thing that should be clear from Greenspan’s lecture is that he seems far more sanguine about the trade deficit than he is when he talks about the red ink in the federal budget. He practically says “forget about the trade deficit,” at least the way it has grown these past years while he has been watching from the Fed. I’d basically agree with his analysis, which is sufficiently classical to warrant him lecturing at our SSU.

What’s happening is that the Rest of the World (ROW) seems perfectly happy sending the United States a volume of goods and services that have a net value greater than the volume of goods and services we send to the ROW. We produce bread and the ROW produces wine, with an exchange rate of one loaf for one bottle. But the ROW is sending us $500 billion more wine than the bread we are sending the ROW. The difference is made up by the ROW’s willingness to take our IOUs, in the form of debt and equity. In my simple “translation” of the Greenspan model, there are 300 million Americans making exchanges with the 6 billion people in the ROW. Those trading decisions made by private producers and traders are really nothing to worry about, because the foreigners sending us wine in exchange for promises of bread are being paid interest on the bonds they hold, or are holding stocks in companies they figure will pay dividends with an even greater return than what they would get if they demanded loaves of bread on the spot. If they hold and IOU from an American baker who goes bankrupt, they are stuck with bad paper. Tough luck. The American people as a whole are not held liable for bankrupt American bakers who cannot deliver bread to the ROW.

Indeed, for most of the history of the world, governments and the politicians who managed them had not the foggiest idea of whether their economic system was in surplus or deficit with the neighbors. Such statistics were not compiled. Efforts to do so did not even begin until the 20th century and we can’t really rely on the accuracy of the numbers compiled by the Commerce Department when they tell us month-by-month what’s going on, as there is so much they don’t know about cross-border trade. In his lecture, Greenspan mentioned how the exports of the world must of course add up to the imports of the world. No bread or wine slip out to the moon. Yet when international agencies sit down with the statistics and add things up, imports always exceed exports by some enormous amount. That’s because governments are eager to check imports in order to collect duties on them, so they have more accurate numbers than they do of exports, which don’t concern the tariff collectors because they don’t collect revenues one way or another.

In one of Greenspan’s more lucid moments, he explained how trade deficits work themselves out by themselves, using as an example the cross-border trade between the 50 states of the USA:

“The experience over the past two centuries of trade and finance among the individual states that make up the United States comes close to that paradigm of flexibility, especially given the fact that exchange rates among the states have been fixed and, hence, could not be part of an adjustment process. Although we have scant data on cross-border transactions among the separate states, anecdotal evidence suggests that over the decades significant apparent imbalances have been resolved without precipitating interstate balance-of-payments crises. The dispersion of unemployment rates among the states, one measure of imbalances, spikes during periods of economic stress but rapidly returns to modest levels, reflecting a high degree of adjustment flexibility. That flexibility is even more apparent in regional money markets, where interest rates that presumably reflect differential imbalances in states' current accounts and hence cross-border borrowing requirements have, in recent years, exhibited very little interstate dispersion. This observation suggests either negligible cross-state-border imbalances, an unlikely occurrence given the pattern of state unemployment dispersion, or more likely very rapid financial adjustments.”

In other words, because all 50 states use the dollar as a unit of account, currency exchange rates cannot play a part in settling a New York deficit with California. New Yorkers either deliver the bread they got in exchange for the California wine, or they go out of business and the Californian vintners write off the bad debt and vow to sell on credit only to folks close to home, who can be watched more closely. “The home bias,” Greenspan called it in his lecture. But that is and has always been true. Cave men might extend credit to the guy in the next cave, but for the guys over the mountain it was bread on the barrelhead. Local newspapers always have a separate little list of the stocks of local companies being traded on the national or regional exchanges, because their readers are more likely to be invested in the nearby “caves.”

When there was a gold standard that linked all currencies in fixed rates of exchange, there was no need for governments to bother with collecting trade statistics, except for the fun of it. It was only with the Crash of 1929 and the Great Depression that the idea took hold. England had managed the world gold standard since 1717, but when it devalued the pound sterling in 1933 it caused the ROW to be concerned that changes in the value of a national currency could cheat the exporters of other countries. If the vintner promised to send wine priced in sterling, and contracts with vintners were arranged in sterling, the UK government could help its local vintners by devaluing the sterling in terms of gold (and wine) and the bakers abroad would have to legally accept fewer bottles. The Depression years saw “competitive devaluations” of this kind everywhere, one of the forces propelling mankind toward World War II. Greenspan didn’t mention any of this in his SSU talk last week, because it does undermine his current fascination with the floating dollar as opposed to his commitment to a gold-based dollar before he became Fed chairman. Remember, when the Fed must conduct monetary policy to keep the dollar/gold exchange rate constant, the Fed has very little power to do anything much around the edges. Greenspan prefers the power.

In response to another SSU student who seemed genuinely distressed about the trade deficit, I went a bit further than Greenspan in pointing out that not only goods and services move across borders. So do people. If a Mexican sends us bread and in exchange receives a dollar, that is counted as a dollar on the US trade deficit. But suppose the Mexican decides he can’t make a living at home because his own government is hapless in managing monetary and fiscal policy. He sneaks across the border and becomes one of several million illegal immigrants, but he brings his dollars with him. The US is now liable for payment on those dollars inside our borders. So what’s the big deal? This is why I began arguing almost 30 years ago that the US trade deficit with the ROW could be solved by having economic policies so sensational here and so bad in the ROW that everyone in the world would move to the USA, bringing their dollar debt and equity with them.

Rupert Murdoch, the Australian media magnate, was the perfect example. Here was a fellow from Down Under who had become a billionaire by doing global deals. According to US bureaucrats who track the trade deficit, the USA “owed” Australia $1 billion because of Murdoch. Then Murdoch decides he wants to be a US citizen and moves from Down Under to Up Here. Our bureaucrats scratch their heads. Suddenly the USA doesn’t “owe” Australia a dime of the $1 billion.

It gets a bit trickier when the USA runs a federal BUDGET deficit of $500 billion. It hawks the bonds to finance the deficit and a chunk are purchased by foreign governments. They are really promises to pay loaves of bread, which means if bad decisions are made by the Washington politicians in regard to economic growth, perhaps by raising tax rates that are already unnecessarily high, the ROW will begin to suspect it will be screwed when the US bonds mature and Wall Street tanks. Their appetite for US paper, says Greenspan, will end, and bad things would happen. In this case, private U.S. citizens don’t go bankrupt, because the obligations are those of the citizenry in general. The US can’t declare bankruptcy!! That would be unthinkable for a world power. It would have to either raise taxes to get the bread to send to the creditors. Or it could devalue the dollar, screwing the creditors, but also subjecting its own citizens to an inflationary bath.

What the Greenspan Fed is doing now is playing a super-stealthy game with the ROW. To keep the fed funds rate at 1%, the Fed has to print more money than the economy needs or wants. This causes the dollar to weaken against the euro and the yen, the other key currencies of the world. In order to prevent the yen from becoming to strong relative to the dollar, the Bank of Japan must buy those unwanted dollars with yen, then buy US Treasury notes and bonds with the dollars. This helps keep interest rates low in the US, but is not something that can go on forever. That, Greenspan does make clear, if you read his lecture last week very, very carefully. How does it get turned around? How is this puzzle solved? That’s the kind of question Polyconomics answers for its clients.

This will conclude the Fall Semester of 2003 at SSU. Our first lesson in the Spring semester will open a series of lessons on the political side of the political economy.