JUST as the Christmas-cracker poser “When is a door not a door?”* can liven up any yuletide party, Christmas spirits can also be lifted by the question “When is a trade deficit benign, when is it malign?”. Except the answer is more difficult to fathom. In reality, in fact, depending on the guest list, the ensuing debate could see the party end in tears. As with most economic issues there are two ardent camps at opposite ends of the scale, with an army of opinions in between.
While the raw merchandise trade deficit betrays much about the competitiveness of the manufacturing sector of an economy, the current account deficit (the broadest measure of a country’s net exports to the rest of the world) sheds more light on its underlying state of health and serves better as an early warning of potentially dangerous imbalances. It is not that long ago that acolytes of the “current account deficits don’t matter” thesis seemed to be winning the argument. The so-called Pitchford thesis states that a current account deficit does not matter if it is driven by capital flows in the private sector. But when the financial crisis struck in 2007/8, countries with sizeable deficits suffered disproportionately as international capital flows shuddered to a halt.
Focusing on the euro zone, the Allianz Euro Monitor, which evaluates EMU countries’ ability to achieve balanced macroeconomic growth, has long been flagging dangerous imbalances on the competitiveness and domestic demand front, one of four key categories in the overall scoreboard.
INTERNATIONAL trade theory has almost nothing to say about whether current account (or “trade”) deficits are good or bad. Yet in press discussion of trade balances, it’s almost a given that surpluses are good and deficits are bad. This is a mistake; not all trade deficits are bad, and even those that are generally reflect some deeper problem in the economy.
It makes sense for a fast growing economy to borrow against the future, as when Korea ran deficits during the 1970s and 1980s. Or take a developed country like Australia. It absorbs a large flow of immigrants, who may borrow to buy a house against their future income within Australia. Indeed some current account deficits don’t even represent borrowing, at least in the ordinary sense of the term. Consider the case where Australians buy cars from East Asia, and pay for the cars by selling vacation condos on the Gold Coast to wealthy Asians. In many respects this is ordinary trade, except that the products that are built with Australian labour (the condos) never leave the country.
A COUNTRY that runs a current account deficit is borrowing money from the rest of the world. As with any loan, that money will need to be paid back at some point in the future.
The cost of these loans is the interest that must be paid, and any vulnerabilities to speculative attacks that come with them. But so long the benefits from the investment of the borrowed money exceed the costs, then there is no reason to be concerned about running a deficit. The profits from the loans will be more than sufficient to pay back the interest and principle.
TRADE deficits, or more concretely current account deficits, have to be financed by net capital inflows, and it is really the cause of the deficit and the nature of the financing that determines whether or not persistent trade deficits are harmful. If a country is running a trade deficit mainly because domestic investment levels are very high, the high investment levels should generate enough growth in the economy that the costs of servicing the foreign capital inflow can easily be covered. In that case many years of trade deficits are unlikely to be a problem.
THE answer to the basic question is "it depends" and I will let the others describe what the issues are. But I would like to use this opportunity to discuss the fallacy of measuring bilateral trade deficits.
Consider the iPad.
According to research by Ken Kraemer at UC Irvine, the component parts of the iPad are imported to China from South Korea, Japan, Taiwan, the European Union, the US and other places for final assembly. None of the component parts are made in China: it's only role is assembly.
ALL kinds of geographic entities have persistent trade deficits. The state of Florida has a trade deficit with the rest of the U.S. Buckingham Palace has a trade deficit with the rest of Britain. So do other groups of people, defined non-geographically. The under-18s have a trade deficit with the rest of society, as have the over-65s. In all of these cases what matters is how the deficit is financed, and whether the terms of its financing create coherent expectations for the future.
A COUNTRY'S trade deficit and, for that matter, its current account deficit (the trade deficit plus the income earned by foreigners on their asset holdings in the country net of what the country's citizens earn on the assets they have invested abroad) are never a problem. But they may reflect a problem. To see this, suppose Raul Castro and his brother were finally to die and the country were to normalise relations with the U.S. and move to a market economy. A vast amount of capital would then flow into Cuba, where labour is cheap and vacation beaches are splendid. The equipment, building materials, vehicles, furniture—you name it—flowing into Cuba would all be counted as imports and show up as a huge trade deficit for Cuba. That wouldn't reflect Cubans spending beyond their means. It would reflect something terrific for Cuba—investment that will lead to jobs, higher wages, and higher living standards. The Cubans might have the highest saving rate of any people in the world and they would still run a massive trade and current account "deficit". But the term deficit is loaded because there is no sense in this illustration in which Cubans are going into debt by spending more than they earn.
TRADE deficits are not a problem when they are the result of temporary imbalances between investment and savings. For example, an emerging country may need to invest a lot in physical capital, and it makes little sense for it to finance this investment with a reduction in consumption. Instead, it must maintain its consumption at a reasonable level and borrow from abroad, which means running a trade deficit. Later, when it has grown richer, it will reimburse its debt by saving more than it invests, i.e. by running a trade surplus.
THERE are worrying similarities between 2008 and today as indicators point to another interbank lending freeze. But there also some important differences: credit bubbles are deflated, housing prices adjusted, private debt reduced and, last but not least, banks have started to deleverage their balance sheets, mainly by strengthening their capital and reserves; even in Europe, banks have increased their capital by more than 20% on average since Lehman.
However, the decisive difference is with regard to the distribution and probability of expected losses, resulting in 2008 mainly from housing loans but today from government debt.
In 2008, losses resulting from the subprime and securitisation debacle were a done deal; there was (and still is) no quick remedy to revive the housing market. But what was unclear was the exposure of each bank to these toxic assets, especially as exposure came not in plain vanilla but in wrapped and structured style. Governments’ task was to make sure that banks could withstand the losses that were bound to hit the banks. Not knowing which banks were most exposed, they offered a wide range of public support to all of them.
THE euro-zone crisis is not solved and is not likely to be solved soon, but the greatest immediate danger has been avoided. Two points worth stressing.
1) The euro-zone economy has some "unexploded ordinance" in it that is likely to explode eventually, but no one really knows whether it is a grenade, a 1000kg bomb, or a nuclear device; what leaders did last week and are doing this week is making sure it is NOT a nuclear device.
Europe still faces a number of vortices that could pull down the euro zone if allowed to get going: the “Greek” austerity-budget deficit vortex, and the “Lehman vortex” that sucked Dexia below water, as per the diagram below.
Featured guest
Laurence J. Kotlikoff is a William Fairfield Warren Professor at Boston University, a Professor of Economics at Boston University, a Fellow of the American Academy of Arts and Sciences, a Fellow of the Econometric Society, a Research Associate of the National Bureau of Economic Research, and President of Economic Security Planning, Inc., a company specializing in financial planning software. Professor Kotlikoff publishes extensively in newspapers, and magazines on issues of financial reform, personal finance, taxes, Social Security, healthcare, deficits, generational accounting, pensions, saving, and insurance. His most recent book is Jimmy Stewart Is Dead.
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