The failing US response to a chronic issue of trade deficit

 

Political economy seems an apt term for understanding the imbalances that are troubling global markets. The US housing boom and trade deficit are central to these imbalances. We saw in a recent column that, thanks to US politics, there is unlikely to be a skillful policy resolution for the housing bust.  Will trade fare any better?

Market believers have been touting exports as the US economy’s life-saver to take the place of the housing boom. By exports, they probably mean to include import substitution: Americans consuming more stuff that they make for themselves, and less stuff that other people make for them.

It’s reasonably logical to expect the huge cumulative US trade deficits of this decade to become self-correcting. The dollar has been in decline as trade-surplus countries try to offload their greenbacks. As American exports become cheaper for foreign countries and as imports become more expensive for Americans, US exports should rise and US imports should fall until we reach a balance and perhaps even begin to pay back some debt.

This would put Americans to work in the export sector and backfill for the job losses in housing and finance. The alert reader may notice, however, that if markets worked as well as they are supposed to, imbalances such as the American trade deficit would not develop in the first place.

Enough of theory – what are the facts? The trade figures for the first two months of 2008 give mixed comfort that trade is coming to the US economy’s rescue. February’s trade deficit of $62 billion (Dh228bn) was worse than the previous February’s and the same as it was in February of 2006.

Taking January and February together confirms the trade balance is not getting back into line. American households and government continue to consume about six per cent more than they produce. So Americans are continuing to pile on the debt to foreigners, which remains at an unhealthy level by normal standards. 

Yet exports are up by almost 20 per cent, comparing the first two months of 2008 with the previous year, and by 30 per cent compared with the start of 2006. That does suggest that more American workers must have jobs in such export growth sectors as capital goods and tourism.

The statistic jibes with stories of New York City receiving a whopping million more visitors in the first quarter of 2008 than in that quarter last year, as foreigners realise the bargains to be found with a weak dollar.

Actors in Broadway shows, waiters in Manhattan restaurants and employees of 42nd Street electronics stores should all be grateful the exchange rate sends a useful price signal to their customers from overseas. Tourist demand is taking up for these workers where mortgage-bankers’ demand is slackening off.

The trouble is that imports are up by a little more than exports in absolute terms. Why doesn’t the price mechanism work to restrain the American consumer’s thirst for imports, the way it seems to work in beckoning foreign shoppers to US shores? One major culprit is oil.

Another is the massive disparity between the cost of doing business in the West and doing it in China or India. The third, which enables imbalances to persist, is the willingness of surplus nations to lend dollars to the US at unrealistically low rates.

Americans are buying about the same amount of oil as in the past two years, but of course they are paying much more for it, as the world crude price has soared from about $26 per barrel in 2001 to $115 per barrel recently. The US oil import bill was up by 68 per cent for the first two months of this year compared to last.
That increase in petroleum imports accounts for 70 per cent of the overall rise in imports. Oil volume was up by five per cent, perhaps a leap-year quirk with an extra day in February, but prices were up by 63 per cent. Look at it in another way – if oil prices had simply stayed where they were in early 2007, the US deficit would have been trending down by 12 per cent instead of rising by nine per cent.

If the US had the kind of strong leadership and political will that critics like to tell the Japanese that they need, it would change this situation. Americans are addicted to oil. The relatively modest increases so far at the petrol pump produce endless whining but minimal change in the behaviour of motorists, air travellers and the like.
 
Since the crude oil price is only part of the total price of petrol, with refining, distribution and tax accounting for the rest, even when crude rockets in price, petrol rises more moderately. The unaided price signal is not strong enough to curb demand.

The US accounts for about 25 per cent of world consumption and uses far more per head than Europeans do. That makes the country at least as responsible for the price of oil as anyone else. 

If Americans would cut fuel usage significantly, the world price would fall sharply and the US would make a huge dent in its chronic balance of payments deficit. There would also be some job creation in the transition.

The solution is obvious. Opinion columnists, notably Thomas Friedman in the New York Times, have urged it for years. There is nothing to stop the US from doing as the Europeans do: charging a high sales tax on petrol and other fuels to shock consumers into conserving. 

It would take on the order of a 100 per cent tax to get people’s attention and make them change the behaviour that determine the amount of fuel that they consume. It would be easy enough to rebate the petrol tax increase back to the public by cutting payroll tax. That would be fairest to lower-income workers and would leave them no worse off, just with an incentive to use oil wisely. Between car-pooling, using mass transit, living closer to work, buying fuel-efficient cars and cutting out marginal trips, the potential for the gas-guzzling American to become more of a gas sipper is enormous.
Beyond petrol, Americans could conserve oil by insulating their homes better and being more sparing with thermostat settings for air-conditioning and central heating. Designing and making hybrid cars and insulating houses would create jobs, and so would building nuclear power plants.

Free-market economists object that such an oil tax would distort consumer choice and reduce “welfare.” But if the pure economics model worked, the US would not be able to borrow its way into chronic deficit in the first place. Also, the suburban sprawl and car culture, built up over more than half a century, distort choice, too. Rebating payroll tax would eliminate a different distortion.

Readers of this column whose own welfare is linked to high oil prices can rest easy.  American politicians will do nothing to upset the status quo. It helps that big oil corporations fund politicians and that there are cosy relationships between the current administration and oil-producing nations.

However, the strongest assurance that the US will not impose a demand-changing petrol tax is that politicians lack the nerve to ask the public to sacrifice and the credibility to explain the need for it. A few days ago, the Republican presidential candidate, John McCain, once known for straight talk, pandered to motorists who are irked by pump prices.

He called for removal of the pitifully low current fuel tax, which would actually blunt the already-weak price signal. The loss of manufacturing and service jobs to China and India is celebrated by mainstream economists. It is Adam Smith and David Ricardo at work. Those nations have comparative advantage in low-skill work, goes the theory, and everyone is better off when those jobs move offshore.

While there is some truth to this, reality is much murkier.  Many of the cost advantages to making toys and pharmaceutical ingredients in China have to do with escaping Western product-safety, quality and environmental protection rules.

Welfare economics may be stumped when it comes to measuring the impact of such factors, but common sense tells us lead-tainted toys and contaminated pet food and heparin do not add to anyone’s welfare.

Once more, US policy could tackle these problems if there were political will. It makes no sense, for example, that China, with its lack of reliable quality regulation, has become the primary source of active pharmaceutical ingredients for US drug companies. 

Americans pay the highest prices in the world for drugs and should surely be able to demand assurance that the drugs will work as advertised and not harm them. However, would consumers notice if the statin pills they pop are keeping their cholesterol down? Some little overseas job-shop, hard-pressed by a corporate purchasing agent out to earn a bonus, could substitute a filler for the active ingredient and probably nobody would be the wiser.
 
The US Food and Drug Administration is not staffed or organised to inspect and assure the quality of ingredients produced in China or in third world countries. A few more scandals such as this year’s heparin fiasco, in which several dozen patients have died from contamination, might lead to outright banning of such imports from unreliable sources.
 
Jobs that disappeared from the United States and other well-regulated producer nations would be restored if this happened. Congress has taken no action. The pharmaceutical industry is one of the most generous political lobbies. 

China also stubbornly refuses to let its currency appreciate in the way that free-market economic theory requires. China’s massive trade surpluses result from its export prices being kept artificially low, its import prices artificially high, and its loans to the United States keeping the American debt binge going. Congress makes occasional noises about imposing tariffs to adjust for China’s mercantilist currency policy, but never acts. 

In the meantime, the ramifications of the never-ending US trade deficit are interesting.  Creditor nations have to do something with their dollars, and buying up American assets is an obvious way to go.

US banks are desperate to augment their capital, although foreigners seem to be getting wise to the fact that returns on such investment may be even worse than returns on the depreciating dollar. It is almost comical, in these circumstances, to read of the US Treasury Secretary flying to surplus nations and demanding assurances that their sovereign wealth funds will follow American-style investing practices.

Paulson has no bargaining leverage. He needs external investors to buy US bonds and stocks or he will not be able to fund the deficit and interest rates will go sky-high.  Creditors do not want a dollar collapse, which would cut the value of their portfolios, so there is a mutual interest between the two.
 
Presumably these trips are understood by Paulson and his hosts as mere political theatre, staged to ensure that Congress does not impose new barriers to foreign investment in American banks and other businesses.

Political economy explains the persistence of the huge American trade imbalance. Ballooning foreign debt is the other side of the US consumer and government debt binge since 2000. This is a disequilibrium that seems to have still longer to run, but when it does unravel the consequences for the global economy seem likely to be ugly.   

 

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