Trade Deficit Disorder

Trade Deficit Disorder March 16, 2006; Page A12

The economy is growing smartly, more Americans are working, wages are rising, capital spending is robust and federal tax revenues are rising at a double-digit year-over-year pace. This must mean it's time for everyone to worry about the trade deficit as the latest sign that all this prosperity is an illusion.

On Tuesday, the Commerce Department reported that the U.S. current-account deficit (the amount of net American borrowing from foreigners) grew by 20% to $804.8 billion in 2005. Last week's related headliner was that the U.S. merchandise trade deficit hit $726 billion in 2005. And all of this has caused the trade protection caucus on Capitol Hill to start hyperventilating.

One protectionist group in Washington is claiming that three million manufacturing jobs have been lost to low-cost imports. Warren Buffett moans that Americans who aren't as rich as he is "have been selling off the farm" to live beyond their means. He even lost a bundle for his shareholders betting that the dollar was headed for a dive. Senators Lindsey Graham of South Carolina and Chuck Schumer of New York are proposing a 27.5% tariff against imported goods from China.

Here we go again. For at least the past 30 years protectionists have warned that the trade deficit will lead to ruin, but it's closer to the truth to say this has it exactly backward: Since the mid-1980s the trade deficit has risen when the economy has grown and receded when the economy has faltered. The lowest annual U.S. trade deficit in recent times was recorded in 1991, a recession year. Dan Griswold of the Cato Institute recently ran the numbers and discovered that "there is a strong correlation between rising trade deficits and falling unemployment."

Part of the problem here is simply one of accounting definition. In the national income accounts, the mirror image of a merchandise trade deficit is a capital-import surplus. When the U.S. investment climate improves -- through such policies as reducing the tax rate on capital gains -- global investment dollars flow into the U.S. Foreigners in turn earn the dollars to pay for those investments by selling Americans more goods and services than they buy from us.

This global exchange process has been a formula for U.S. success: American workers get the auto, technology and financial services jobs that come with foreign investment here; American consumers get the benefit of low-priced products from China and elsewhere, which raises workers' standard of living.

We would all be better served by simply throwing overboard the term "trade deficit" -- which inaccurately connotes a disadvantage or inferiority. To refresh some memories, that was precisely the conclusion of the U.S. Advisory Committee on the Presentation of Balance of Payment Statistics during a previous trade-deficit scare in 1976.

That group of eminent economists advised that "the words 'surplus' and 'deficit' should be avoided insofar as possible" because "these words are frequently taken to mean that the developments are 'good' or 'bad' respectively. Since that interpretation is often incorrect, the terms may be widely misunderstood and used in lieu of analysis." (Our emphasis.)

Senators might also consult a new study by Ricardo Hausmann and Federico Sturzenegger, of Harvard's Kennedy School, who argue that these current-account deficits are in reality a statistical illusion. They found that the net return on the U.S. financial position in 2004 was roughly a positive $30 billion and not much different than it had been in 1982, despite 22 years of deficits.

How can that be? "A correct descriptive explanation of this puzzle is that the rates of return of U.S. liabilities is significantly smaller than the return on its assets," Mr. Hausmann writes. Foreigners are willing to accept a lower rate of return on their U.S. investments, such as Treasury bills, because they are partly buying dollar currency stability, liquidity, and a safe haven against political and economic risk. Foreigners, for example, hold hundreds of billions of dollars of U.S. currency, which is the equivalent of a zero interest loan to Americans.

By contrast, American assets abroad earn higher than normal rates of return because of noncounted factors such as insurance, know-how, and the value of universally recognized brand names like McDonald's and Disney. When taking these into account, the authors conclude that America is a net creditor, not a net debtor, nation. Even more surprising, correctly measured, China is a net debtor to the U.S.

Ironically, those who are most alarmist about a fire-sale on U.S. assets are promoting policies that would encourage that capital flight. Raising the U.S. capital gains tax rate back to 20% from 15%, or the dividend rate to 35% from 15%, would reduce the after-tax return on capital invested here and contribute to the very investment sell-off that the critics fret about. Capital also flees nations with protectionist trade policies, so the Graham-Schumer tariff bill would be economically self-defeating.

There are things Congress could do to raise net national U.S. saving -- notably, spend less money. This means we wouldn't borrow so much from abroad. But in a global capital market, the key to growth is providing the opportunities to invest, not whether your national accounts balance. The time to worry about the trade deficit is when Congress tries to do something about it.

Correction

Despite a loss of $955 million in 2005, at year end Berkshire Hathaway had made $2 billion overall in pretax profit since putting a trade on against the dollar in 2002. CEO Warren Buffett says the company has made additional profits from its dollar-short position this year, bringing the overall gain to about $2.2 billion. Yesterday's editorial, "Trade Deficit Disorder," said Mr. Buffett "lost a bundle for his shareholders betting that the dollar was headed for a dive."

-- March 17, 2006

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