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Thoughts on the US Trade Deficit

by Christopher Lynch

· Trade Policy,Foreign Exchange,Know-How,Global Business

The US trade deficit has been in our headlines, but most of the analysis of it has not identified the underlying causes. Without understanding the origin of the deficits, many of the proposed “fixes” could have significant negative impacts on the economy. For example, tariffs on Chinese products could result in retaliation against US agricultural and aerospace exports, in addition to higher prices for US consumers. Each of the policy options has pluses and minuses, so let’s first break down the major factors behind the continuing US trade deficit.

I.Exchange rates (floating). This is probably the largest component of the problem, and one that literally overnight can change the competitiveness of US products. Most of our largest trading partners have floating exchange rates, which reflect market supply and demand. However, as I have pointed out in previous blog posts, the key factor influencing floating rates is interest rate differentials (90%), not trade flows (10%). The Fed has announced a series of interest rate hikes for the rest of 2018 and, given the low rates in Europe and Japan, the dollar will likely strengthen throughout the year, widening trade deficits. Note to politicians: a strong dollar does not mean the US economy is strong. It means that our exports will be more expensive and imports cheaper.

II.Exchange Rates (Safe-haven effect). The US dollar remains the safe-haven currency when economic conditions go south. Thus, there will be a demand for the currency above what market conditions would warrant, resulting in a strong dollar. As a result, exports will be less competitive and imports more attractive, laying conditions for a continuing trade deficit.

III.Exchange rates (managed or fixed). Most of the non-OECD countries have some sort of managed or fixed exchange rates. A change in those rates becomes a political problem for the countries involved. China deliberately kept its currency undervalued for many years (estimated at 37.5% at one time) as a way to spur its export-led economic development policy. Since 2010, the Chinese government has revalued its currency in the face of massive trade surpluses and a desire to join the international economic community. At present, it appears that the Renminbi is still slightly undervalued but the currency “manipulation” is not the factor that it once was.

IV.Twin Deficits. Economists have talked for some time about the twin deficits – the relationship between the fiscal deficit and trade deficit. When there is more money in the economy as a result of a deficit, demand for imports goes up more quickly than demand for domestically produced goods. We should have expected more inflation due to Federal deficits over the past 18 years, but it appears that much of the injection of money translated into demand for low-cost imports, keeping down overall CPI increases.

V.Trade Regimes. The US has long been a leader in the reduction of trade barriers, both tariff and non-tariff. Having worked on and around trade negotiations since the late 70’s, I have seen trade surge. The effect on our economy, particularly for consumers, has been generally been very positive. There have been drops in manufacturing employment over the past 40 years to be sure, but one study finds that only 13% was related to trade. The rest of the drop is due to advancing technology. The reductions in tariffs rates, especially from our major trading partners, has been easy to achieve. Non-tariff barriers (NTBs) are more challenging to trade negotiators since the restraints could be not only regulatory, but also cultural (strong consumer preference for local goods). To be fair, the US has many of its own NTBs, so the fault is not entirely with our trading partners.

VI.Lack of Capability by US Companies. Less than 1% of US companies export. By contrast, in Germany (where I lived and worked for six years), exporting is an essential part of business. German business schools integrate the study of global business into the entire curriculum. At the same time, I find that US business schools treat global business skills as an afterthought. Our B-schools do a great job of preparing students to be part of a large multinational team but don’t teach them the skills to handle a global export function at a small or medium-sized enterprise. That’s why in the US, we need programs like my International Business Accelerator which focus on giving US businesses the skills and confidence to compete internationally. The current skill level of US companies explains why only 1% export and is certainly a contributing factor in the continuing US deficit.

The Executive Master Class in International Business has courses that go into greater detail on these mega-trends in global business. One advantage of the classes is that each session is customized to your individual needs. Interested? Contact me today.