The Mysterious US Trade Deficit

Pat Choate and Charles McMillon

[1997]

INTRODUCTION

Consider this. The World Economic Forum's 1996 Global Competitiveness Report concludes -- again -- that the United States economy is the world's most competitive. President Clinton proclaimed in his February 4, 1997, State of the Union Address, "I'm proud to say that today America is once again the most competitive nation and the number-one exporter in the world." In the spring of 1997, the Federal Reserve raised interest rates to slow an economy with booming corporate profits, soaring stock prices, and low unemployment.

Yet, a peek behind the glitter of record stock prices and high corporate profits reveals a deepening economic dry rot -- a nation that is eating its seed corn and squandering its economic leadership position, here and abroad, in the pursuit of short-term gains for a few global firms. Though largely ignored, the facts are these: US consumer debt ratios are at an historic high, sales are weak, wage growth is flat, savings are low and US economic growth is anemic. The world's economy is also slowing, with the weakest recovery on record, but it is still growing far more rapidly than the U.S. economy. This is a poor foundation on which to build a secure future for the U.S. or the world.

Specifically, the US economic recovery of the past six years is the weakest on record -- continuing at a rate barely half that of the 1982-90 recovery and far less than half the rate of the 1960s. The US productivity growth of the past four years -- that is, the annual growth in all nonfarm output per hour of labor -- is only 0.22 percent or roughly 1/7th that of the 1980s; about 1/15th that of the 1960s.

Perhaps most illuminating for the long-term future of the nation and its businesses, the US seems unable to control its trade deficits. Between 1991 and 1996, for example, the merchandise trade deficit more than doubled. It went from a $74 billion deficit in 1991 to a $187 billion loss in 1996. For the period 1982-1996, the total accumulated US trade deficit was $1.8 trillion.

Do these trade deficits matter? Of course, they do. While many global firms owe much of their current good fortune and cost advantages to cheap foreign sourcing and production, trade deficits stunt the growth of the overall economy.

Trade is one of the four defining components of Gross Domestic Product; the other components are personal consumption, gross private investment and government spending. In 1996, for instance, the net trade deficit ($114 billion) equaled a full 1.65 percent of the Gross Domestic Product. Had the US trade accounts simply been in balance, the 1996 growth rate would have been a robust 4.1 percent rather than a weak 2.5 percent. The vital point is that a trade deficit -- more outlays than receipts -- reduces, not expands, the domestic market and domestic production.

Put into statistical context: But for our persistent and rising trade deficits, the US economy would have high growth rates akin to those of the booming 1960s. Indeed, today trade is largely providing the reverse of its traditional "creative destructive" function by now shifting resources out of highly productive, high wage traded manufacturing sectors and into far less productive, lower wage service sectors that do not face global competition. Modern policies, together with today's fabulous new technologies, could provide unprecedented growth and prosperity for the U.S. and the world.

The obvious questions about all this are these:

If the US economy is so competitive and strong then;

• why have we run massive trade deficits for 36 out of the past 38 years even with growth generally far slower in the U.S. than in the world economy?
  
• why do we now have the largest trade deficit in US history even with the global exchange value of the dollar the weakest ever in 1995 -- and only slightly recovered today?
  
• why in 1996 did we have a US merchandise trade deficit with the European Union of $15 billion, a $16 billion deficit with Mexico, $23 billion with Canada, $39 billion with China, and $47 billion with Japan?
  
• why do we have big deficits with Mexico and China, while Europe and Japan have big surpluses with these same two nations?
  
• why do two of our principal competitors, Japan and Germany, have massive trade surpluses year after year, business cycle after business cycle -- more than $135 billion for Japan in 1996 and more than $70 billion for Germany -- while we have massive trade deficits?

Again, the basic question is: Why are other nations -- though they are supposedly far less technologically advanced, less productive or less competitive than we are -- able to amass a $3.5 billion per week trade surplus with us?

There is no single answer to these questions. Why? Because with the end of the Cold War, the entry of more than one billion new workers into the global labor market, and the unbounded global pursuit of profits, capitalism has entered a new phase. It is a new capitalism -- raw, dynamic and largely unregulated in a world desperate for capital and jobs. It is competition where the speed of today's information and transportation technology has abolished old assumptions about the geographic location of state-of-the-art production. It is a way of doing business where change is swift and no job, no worker, no company, and no nation is safe. Most important, it is a form of capitalism where the interests of the global company and those of the nation-state are often in conflict.

Key Questions and Answers

The reality of a global capitalism where drugs, arms, investment, piracy, political bribery, capital flows, protectionism, and traditional commerce often mix, often by the same people, is brought into sharp relief by three questions.

The first is: Why does the United States have a $3.5 billion per week merchandise trade deficit?

Second: how do other nations maintain their trade surpluses, sometimes certainly at their own expense, but often at US expense?

Third: can the US build a prosperous and peaceful future by moving its productive capacity to other nations and undermining its most highly productive working consumers?

Here are some answers.

1. Cold War Thinking

Economic gain is the principal goal of other nations' international economic policy making. Geopolitics dominates US decisions.

Thus, the United States ignores China's violations of nuclear treaties, counterfeiting, human rights abuses, religious persecution of Christians and Buddhists, and all other outrages. Why? The excuse is "constructive engagement"-- the professed hope that more trade with China will create more democracy and responsible behavior there. The reality is "constructive engagement" is little more than political appeasement that helps a handful of former US government officials and transnational corporations profit from political tyranny.

Similarly, the President and Congressional Leaders are willing for US taxpayers to bear the cost of Japan's defense, even as that nation keeps its markets closed to US exports and mounts massive annual trade surpluses with us. Likewise, the United States purchased the Turkish Government's support of our 1991 military campaign against Iraq by increasing the quota of textiles that Turkey's producers could export to the US market.

Now as in the past, US leaders and opinion-makers stand ready to sacrifice the well-being of specific US industries to ill-defined and often unrealized foreign policy objectives, such as our current China and Japan policies. The consequence is comparatively more foreign imports to US exports.

2. Low Foreign Production Costs

The International Labor Organization has identified 1.2 billion unemployed or grossly underemployed workers worldwide -- 1/3 of the world's labor force -- in what the ILO describes as the worst global unemployment crisis since the 1930s. The end of the Cold War and breakup of the Soviet Union has brought almost one billion new workers into the world labor market. Vast numbers of these workers are intelligent, educated and desperate enough to work for wages which are at or below subsistence even for the local area. For many products, other nations have sufficient production capacity to meet the entire world demand. China, for instance, can supply many types of apparel for the entire world and at a price no other country can match. The labor pool of China, India, Pakistan and the balance of Asia is so great that they could be the source of all the world's manufacturing and do so at labor rates 1/20 that of the industrial world.

Today, the sure path to lower costs and higher profit for manufacturers is to shift production to these low cost locales. This is precisely what is happening. It is why half of the US merchandise trade deficit is now with developing nations.

As a few corporations in an industry shift production to low-wage developing nations, the entire industry then faces increasing pressure to do the same. This is the pattern now well underway in the United States. The result is to shift jobs in this nation from highly productive manufacturing jobs to lower wage, less productive service work. In the process, US productivity growth is undermined, even as the flow of imported manufactured goods increases.

3. Global Firms Dominate US Economic Policy Making

The Chairman of Boeing says that in 20 years he wants Boeing to be thought of as a "world corporation," not as an American company. The CEO of United Technologies says that his company is now doing so much manufacturing in Asia that part of the company headquarters is being shipped to the East. The head of NCR reports that his corporation is a transnational enterprise with interests no longer bound by national borders.

Most of today's CEOs share this global view. Likewise, this sentiment dominates the thinking of CEOs whose companies depend on foreign goods, academics, think tanks and media funded by global firms, and free-trade ideologues. These are the people who set US trade policies.

One index of their influence is that they overwhelmingly dominate the membership of every influential Presidential Advisory Committee for Trade including that for Policy and Negotiations (ACTPN). These people support the shift of US production to other nations and have large financial interests in that outcome.

Consequently, imports now dominate US manufacturing in the American market. Specifically, in 1970 imports were equal to less than 11 percent of the US manufacturing Gross Domestic Product. Today, they equal 51 percent.

Most significant, much of what constitutes US trade is intra-firm transactions between the foreign and domestic operations of global firms. For example, in 1995, more than 66 percent of the US-produced automotive exports to Mexico were to firms that were "related" by equity holdings with the seller. More than 85 percent of US imports of cars and parts from Mexico were from related sellers. How could this be? Largely, these numbers reflect that the Big Three auto makers and their suppliers are shifting much of their manufacturing to their low cost Mexican factories. This is why trade patterns no longer have anything to do with traditional patterns of national "comparative advantage." It is why Mexico now exports more cars to the U.S. than the U.S. exports to the world.

4. The Corruption of US Policy Making

US trade policy making is corrupt. In part, it is corrupt because inexperienced people are in charge. While other nations staff their trade functions fully and well, the United States places the formulation and administration of its trade policy making in the hands of a few amateurs with strong political connections. For most, their primary function is to rationalize the failure of US trade policy to a gullible public and corrupt Congress.

Global interests -- domestic and foreign -- spend vast amounts of moneys to corrupt the process. Their principal mission is to keep US markets open and their foreign investments safe. Much of this money goes to the financing of US politicians. Some goes to propaganda. Some goes to lobbying.

Often, the lobbying position of large US corporations and foreign governments is indistinguishable, because their interests are similar -- open US markets.

The corruption of the process is highlighted by the vast number of former officials who now serve as lobbyists, publicists or advisors for global private interests. These people either do not understand conflicts between US interests and that of other nations or private firms, or simply do not care. Despite what they believe or do, the enrichment of these ex-officials stands as a lesson and lure for those still in office. The lesson, simply put, is that it pays enormously to put the private globalization interests of powerful individual firms ahead of US interests -- or anything else -- in the world marketplace.

5. Ideological Inflexibility

This generation of US opinion leaders is as indoctrinated in the academic principles of free trade as the prior generation of Soviet leaders was indoctrinated in the principles of Marxism. This creates an inflexibility of mind that resists action even in the face of obvious failure. How else can one explain the resistance of honest people to changing policies that have resulted in massive trade deficits in 36 out of the past 38 years? Indeed, the solution to the current trade deficits being proposed by our leaders is an expansion of the very policies that have resulted in the massive US trade deficits. The dogmatic pursuit of failed policies and the ideological inability to alter course even in the face of disaster is a principal reason for continuing US trade deficits.

6. Residuals from Prior Trade Agreements

The United States has several hundred trade agreements in effect. Many were made in an earlier time under vastly different geopolitical circumstances. Often these deals were made at a time when the US was explicitly using trade as aid. While that era is over, these agreements continue in effect, often placing the US economy at a disadvantage.

Auto deals among Mexico, Canada, Japan and the United States are one such example. Autos and parts account for more trade than any other single product. In 1996, US imports of vehicles and parts were two-and-one-half times greater than imports of crude oil: $130 billion versus $51 billion.

Residual elements of prior trade agreements have contributed significantly to this deficit. One US goal in the NAFTA negotiations, for instance, was to eliminate Mexican and Canadian restrictions on the production and sale of vehicles. Yet, the agreement allows Canada to force US auto makers who sell in Canada to manufacture most of their vehicles there. The agreement also allows Mexico to keep most of its auto investment and production restrictions in place until at least 2004, even as the US market remains totally open to imports from those two countries.

As a result, the auto and parts trade deficit with Mexico in 1996 was more than $15 billion and with Canada it was $13 billion.

Similar examples exist with most US trade agreements.

7. Discrimination Against US Producers and Investors

As a matter of common practice, most other governments discriminate against foreign producers and investors in ways both flagrant and subtle. Germany, for instance, allows local content requirements to be part of the bidding process on heavy electrical equipment. Similarly, France has barred GE from bidding on the privatization of Thomson, the giant electronics company, thereby clearing the way for bids from two French companies -- Alcatel and Lagardere. Brazil imposes tariffs of 70 percent on imported cars, but reduces that to 35 percent on those whose manufacturers also produce cars in Brazil. Korean tax authorities have regularly audited Koreans who buy foreign-made products. The goal of this discrimination is to reduce imports and encourage domestic production.

8. Tax Systems

The GATT and its successor, the World Trade Organization, have sanctioned the Value Added Tax System (VAT), allowing a full rebate of all VAT taxes on goods exported from countries that use the VAT. Thus, nations with a VAT tax, such as Germany and France, can get a VAT rebate on their export goods. By contrast, the income tax used in the United States is not trade-approved and not rebated. Consequently, US exports carry a full load of taxes while goods produced in countries that use the VATS do not. The price differential often puts US goods at a disadvantage, particularly in foreign markets.

Equally significant, the US Internal Revenue Service only collects a small part of the taxes owed by foreign-owned corporations operating in the United States. The IRS reports that European manufacturing operations in the United States report taxable profits on sales at half the rate of domestic corporations. Asian companies report taxable profits on sales at one-tenth of US companies. Consequently, foreign companies operating in the United States evade at least $30 billion of US taxes annually, an underpayment that greatly increases their competitiveness against US companies.

9. Selective Enforcement of US Laws

While trade constitutes a substantial portion of the US economy, the US Government devotes limited resources to the enforcement of US trade laws. In this environment, the choice of which abuses to attack is most often a political decision. For example, the first case brought by the United States at the World Trade Organization was for Chiquita Banana -- a company whose principal work force is in Central America -whose exports are locked out of the European market. The principal reason for US interest here is the owner of Chiquita Banana contributed hundreds of thousands of dollars to the 1996 Presidential campaigns of both Bill Clinton and Bob Dole, making them advocates of this case. This example is neither unique nor extreme. US trade officials ignore most foreign violations of US trade laws. The result is a vast flood of goods into the US market.

10. Foreign Labor and Plant Closing Standards

Continental Europe and Japan have rigorous plant closing regulations that severely restrict the freedom of companies to reduce their work forces or constrain their production. Many multinational companies operate with duplicate factories, but in different nations. As overall demand falls, these companies reduce production and employment in those nations with lax public requirements and continue operation in those with tough regulations. The US has the weakest such standards among any industrial nation. Therefore, US factories are the first to face layoffs and reduced production. The net effect is to close US factories, increase US imports from the foreign plants, and create a larger US trade deficit.

11. Theft of Intellectual Property

America has the most creative and prolific inventors in the world. Equally important, much of US basic science in done in open universities and federal laboratories where foreign nationals are welcome, even subsidized.

The primary focus of international espionage today is to secure the results of that research and the details of US technology. America is the principal target. Countries on the USTR's "priority watch list" include Argentina, China, the EU, Greece, India, Indonesia, Japan, Korea and Turkey. These and other nations have thousands of full and part-time economic spies at work in this country. Politically, these nations' agents of influence are working vigorously to weaken US protections for holders of intellectual property. Commercially, these spies are scooping up information and sending it to their masters. Lost sales and greater trade deficits flow from this piracy and theft.

Software is a clearly visible example of the cost of technology piracy. Three days after Microsoft introduced Windows 95 in the United States for $89.95, copies were available throughout Asia for $4 or less.

The unique problem faced by software makers is that there is no degeneration of quality from copy to copy. The result is blatant piracy, particularly in the developing world. Of every four software programs in Mexico, only one is legal. In China the piracy rate is 98 percent. Some countries, notably the Philippines, Indonesia, and Thailand, are jokingly called "one disk countries" because their piracy rate is almost 100 percent. By contrast, the piracy rate in the US is 25 percent.

At the same time, other governments provide inadequate protection and impose extraordinarily high fees associated with the filing, issuance and maintenance of a patent over its life. The European Union's patent fees, for instance, are higher than those of the United States. Other nations, such as India, refuse to adopt even the weak standards they agreed to under the WTO. Japan continues it practice of "patent flooding"-- a quasi-legal way to extort licenses from foreign patent holders. The net result is a diminished technological capacity for the United States, weakened exports, and more imports derived from pirated technology.

12. Non-Tariff Barriers

As a succession of trade negotiations have lowered tariffs, other nations have excluded US imports through a host of non-tariff barriers. Japanese public works authorities apply dozens of criteria to engineers, architects and construction that effectively preclude all non-Japanese. Mexico requires partial ownership by Mexican nationals of trucking and other vital commercial services. Europe has adopted a set of product standards that are unique to the European market, thereby giving local manufacturers a competitive advantage. China requires corporations to produce in China if they are to sell in China. China also requires foreign corporations to share or license their technology to Chinese enterprises.

The imagination of local protectionists is the only limit on non-tariff barriers. The net result is substantially fewer US exports and a higher trade deficit.

13. Tariff Differentials

The United States provides Most Favored Nation status to most other nations -- that is, the US gives all nations the same low tariffs that it provides any other nation. If we give France an extraordinarily low tariff on cutlery, for instance, we give all other nations the same deal. Yet, other nations, particularly developing nations such as China, often do not reciprocate. While the average US tariff on imports is less than 3 percent, for instance, China's average tariff on imports from the United States is 23 percent, plus an additional 17 percent Value Added Tax or a total of 40 percent. This vast differential encourages imports into the United States and discourages exports to other nations such as China. The result is a higher US trade deficit.

14. Bribery and Corruption

The USTR reports that "the most consistent complaints that the Administration receives from US industry and labor representatives are that bribery and corruption compromise US market access in many foreign markets." Bribery and corruption determine procurement decisions in many countries. Yet, if US firms pay there, they are subject to criminal prosecution here. The US Government has repeatedly attempted to get other nations to adopt procedures that will eliminate, or at least reduce, the effects of bribery and corruption on procurement decisions. Regrettably, these efforts have been largely unsuccessful. Consequently, US producers, while secure in their integrity, often lose to others with no scruples or constraints.

15. Manipulated Exchange Rates

Changes in exchange rates alter the price competitiveness of goods and services virtually overnight. When the dollar is strong, the competitiveness of US exports is reduced and that of foreign imports is increased. The reverse is also true. Many other governments explicitly use their exchange rate as a balance wheel to set the level of their trade balance. The Chilean government, for example, is currently manipulating their Peso, which does not float freely. They have recently re-weighted the basket of currencies to which the Peso is pegged. Much like the recent experience in Mexico, the Chilean Government's goal is to maintain a US trade surplus with Chile during the time Congress considers Chile's accession into NAFTA.

US policy makers have never developed an exchange rate policy and rarely consider the exchange rate consequences of economic policy. The Plaza Accord of 1985 in which the U.S. joined with other industrial countries to weakened the dollar and to improve the US trade position was a rare exception. The value of the dollar to the Yen fell from 256 Yen per dollar in 1985 to 82 per dollar in the mid-1990s. This currency manipulation provided temporary trade relief. Nevertheless, other nations increased their competitiveness to offset the US move and again the US trade deficit soared. Japanese auto makers, for instance, are competitive at an exchange rate of 90 Yen per dollar.

Virtually every other time that the U.S. Treasury has engaged significantly in exchange rate measures has been to assist other countries or global financial interests. In 1995 -- as the U.S. faced record trade deficits -- the US Treasury increased the value of the dollar against the Yen to assist Japan's Government and banking sector deal with a recession and financial pressures. The result of US actions was to reduce the cost-competitiveness of US products in the Japanese market and increase that of Japanese manufacturers here. It worked. Japanese auto makers are now flooding the US market with their exports. The U.S. trade deficit soared to a new record in 1996 and seems assured of setting another record in 1997.

In short, the price competitiveness of goods in many nations is as much a function of the Government exchange rate policy -- theirs and ours -- as of producers' competitiveness. The net effect of all this is fewer US export receipts and more foreign import bills.

16. The Trade Deficit Phobia of Other Nations

Many US opinion leaders argue that trade deficits do not matter. Leaders in most other nations are phobic about trade deficits, as are the citizens of their nation. Consequently, nations such as Japan, Korea and others will undertake virtually any action required to maintain a trade surplus, even if only a small one. To do otherwise would result in the replacement of the head of government. In such an environment, public policy dominates market forces. As a result of this phobia, other nations are willing to limit what US producers can export to their markets regardless of foreign competitiveness.

The United States is the only nation in the world that tolerates an unbounded trade deficit, which means that we are the dumping ground for the excess production of others. Again, the outcome is massive US trade deficits.

17. International Cartels

The first legislative action of the Japanese Diet upon the end of the US Occupation was to authorize the creation of economic cartels for Japanese industry. Likewise, Germany has always encouraged the formation of cartels. Cartels are illegal in the United States, except in a handful of areas approved by the US Justice Department.

As European and Japanese industry have strengthened, they are cartelizing a large and growing number of industries. Consumer electronics is one of the most obvious cartels. According to Akio Morita, co-founder of Sony, the Japanese and European consumer electronics industries formed their cartel-like arrangement in the mid-1980s. Their goal is to coordinate and focus the actions of the members' companies in a way that increases profit and reduces risk. The leaders of this industry meet at least twice a year to discuss products, production and markets. The participants use patent pools, price fixing, production scheduling, market allocations and other techniques to control competition.

The net result of foreign-dominated, global cartels is that the ease of entry into various markets for US producers is impeded and competitive US companies face predatory competition, here and elsewhere. The consequence is fewer US exports, foreign domination of key industries, and a growing vulnerability to imports.

Conclusion

The global mechanisms that have long guided international trade are trapped in a time warp of the Cold War, a moment when the United States had an uncontested superiority in most industries and the Soviet Union posed a real and imminent danger. But that era is past. The old mechanisms of trade are now severely dysfunctional and require fundamental overhaul.

In the interim, the remaining competitive advantages of the US economy and its workers are being dissipated by a trade policy that favors foreign over domestic production.

Our economic rivals have trade surpluses not simply because of their competitiveness, but also because the basic goal of their national trade policies is to advance the interests of their nation and people, not adhere to some abstract theory of global trade. This is the economic lesson our ancestors taught the rest of the world, but one that we seem to have forgotten. Until we learn it again, our trade deficits and our future prospects will only worsen.