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U.S. Trade Deficit Hits New Record in July

Prof. Peter Morici - 9/12/2006

Today, the Commerce Department reported the July deficit on trade in goods and services was $68.0 billion, up from $64.8 billion in June and surpassing the record $66.3 billion set in January.

The petroleum deficit rose to $25.6 billion in July, up from $24.5 billion in June

The trade deficit with China was $19.6 billion in July, not much changed from $19.7 billion in June. However, China reported a record monthly trade surplus for August, indicating the U.S. deficit with China will grow further in the months ahead.

Near term, the ballooning trade deficit will tax third quarter growth by about two-tenths of a percentage point. Longer term, it slows investments in R&D-intensive export-oriented industries.

Moreover, trade deficits must be financed by foreigners investing in the U.S. economy or lending Americans money. Direct investment in U.S. property and productive assets provides only a small portion of the needed funds, and the balance is obtained through the sale of Treasury securities, corporate bonds, bank accounts, and other paper assets. Americans borrow nearly $60 billion each month to consume more than they produce. The total debt will exceed $6 trillion by the end of 2006.

Oil, Currency and China

Since December 2001, the trade deficit has increased $41.4 billion. Net imports of petroleum account for 48 percent of the increase in the trade deficit. Increased U.S. imports of consumer goods, automobiles, business equipment, and industrial components and materials, especially from Asia, account for 52 percent. The trade deficit with China, alone, has increased $14.1 billion.

In large measure, the trade deficit remains stubbornly high, because the overvalued dollar pushes up imports of Chinese and other Asian manufactures and handicaps U.S. exports of durable goods and high-end services.

As computed by the Federal Reserve, the average value of the dollar peaked against other currencies in February 2002. Since that time, the dollar has declined about 17 percent. The dollar is down 28 percent against the euro and other industrialized-country currencies but only 2 percent against the Chinese yuan and other developing-country currencies combined.

China continues to peg against the dollar. Although China revalued the yuan from 8.28 to 8.11 in July 2005 and announced it would adjust the currency to a basket of currencies, the yuan continues to track the dollar closely and currently is trading at about 7.95.

To limit appreciation of the yuan against the dollar, the Chinese central bank purchases more than $200 billion in U.S. and other foreign securities each year. This comes to about 9 percent of China’s GDP and about one-quarter of its exports. These purchases provide foreign consumers with 1.6 trillion yuan to purchase Chinese exports, and create a 25 percent subsidy on foreign sales of Chinese goods.

The competitive advantage this affords Chinese exports impels other Asian governments to similarly manage their currencies, to limit their loss of market share in the United States.

U.S. manufacturers are particularly hard hit. China’s currency market intervention creates a 25 percent subsidy on its exports, and competitive advantages in industries not dependent on low-wage labor. Other Asia economies follow suit with similar industrial policies. Through recession and recovery, the U.S. manufacturing sector has lost 3 million jobs. Following the pattern of past economic recoveries, the manufacturing sector should have regained about 2 million of these jobs, especially given the very strong productivity growth accomplished in the durable goods and throughout manufacturing.

This situation is likely to worsen. Although the underlying value of the yuan rises at least 5 percent each year, China is permitting the yuan to appreciate less than 2 percent a year. Hence, the dollar will remain at least 40 percent overvalued against the Chinese yuan, and significantly overvalued against other Asian currencies too.

Trade Deficits and Growth

Increased trade with China and other Asian economies should raise U.S. GNP and incomes by shifting demand from import-competing activities to export industries, where worker productivity and wages are highest. Instead, growing trade deficits with China and other Asian economies have shifted U.S. employment from both import-competing and export industries to nontradable services, like the retailing and hospitality industries, where worker productivity and wages are lowest. Were the Chinese yuan revalued and the trade deficit cut in half, U.S. GDP would increase about $300 billion or $2,000 for every U.S. worker.

Individual industries are particularly hard hit. Since 2000, U.S. manufacturing has shed about 3 million jobs. Judging from past business cycles, it should have regained about 2 million of those during this recovery. Trade deficits were likely responsible for the loss of 2 million manufacturing jobs, and superior productivity growth in manufacturing the other 1 million

Also, import-competing and export industries spend more than three times as much on R&D per dollar of value added than the private business sector as a whole. Cutting the trade in half would boost R&D enough to accelerate U.S. productivity and GDP growth at least one percentage point a year. That would amount to more than a 25 percent increase in potential growth.

The trade deficit has been taxing growth for most of the last two decades, and the cumulative consequences are enormous. Had foreign currency-market intervention and large trade deficits not robbed this growth over the last two decades, U.S. GDP would likely be 20 percent greater, than it is today.

Politics, Protectionism and the Trade Deficit

Treasury Secretary Henry Paulson urgently needs to persuade China to significantly revalue the yuan; however, President Bush has been reluctant to give his Treasury Secretary levers that could move China to action.

At the IMF-World Bank meetings, Treasury Secretary Paulson will again seek progress from Chinese leaders on currency reform. The American approach has been to persuade China that revaluing the yuan to reflect market fundamentals best serves its interests. But China views these issues through mercantilist lenses.

An unvalued yuan permits China to create employment for underutilized rural workers on export platforms, and to provide competitive space for inefficient state-owned enterprises to modernize. Chinese economic growth exceeds 10 percent and inflation is about 2 percent. China may want to cool growth a bit, but it is not about to give up its most powerful development tool—an undervalued yuan.

Subsidizing Chinese exports with an undervalued currency is nothing more than high profit protectionism that harms the U.S. economy; however, President Bush refuses to make protectionism costly to China and instead has chosen the path of appeasement. The Chinese sense weakness and exploit it.

For example, the Bush Administration opposes a bipartisan bill sponsored by Congressmen Duncan Hunter (R-CA) and Tim Ryan (D-OH) that would add the subsidies provided by currency manipulation to the list of unfair trade practices actionable under U.S. countervailing duty law, and permit domestic manufacturers to petition the Department of Commerce and U.S. International Trade Commission for duties on Chinese imports to offset these subsidies.

President Bush’s reluctance to tackle currency issues and other industrial policies unfairly advantaging industries in Asia will harm Republicans in the fall elections. Many of the manufacturing jobs lost to subsidized imports are in swing districts in western in Ohio, Indiana and elsewhere along the ridgeline between red America and blue America.

President’s reluctance to address the root cause of job losses in these communities could cost Republicans their majority in the house. They will not have to look far for the policies and man responsible.