IBD: Get Over the Gap

Get Over The Gap
Posted Friday, May 09, 2008 4:20 PM PT

Trade Deficit:

We have long been told that when the dollar “corrects,” making our goods cheaper abroad, the trade deficit will begin to fall sharply. Well, it’s finally happening. Now that it is, do you feel any better?

You shouldn’t. Because even though the trade gap narrowed by $3.5 billion, or 5.7%, to $58.2 billion in March from February, it was a sign of weakness rather than strength.

Compared with a year earlier, March exports rose 15.5% — a good thing, we suppose. But imports increased just 7.9%, a gain that would have been a lot lower if not for oil.

True enough, the deficit appears to be declining — after hitting repeated records in recent years. Exports are booming while import growth has slowed noticeably, due mainly to the slumping dollar.

On the surface, this looks like a good thing. After all, don’t we want to buy less from abroad and more from our own country? The answer is no if it means that the U.S. economy has slowed and is no longer pulling its weight in the world.

Journalists and pundits call the smaller deficit an “improvement,” or “good news.” It isn’t. We run a trade deficit not because we’re uncompetitive or others protect their markets, two great economic myths; we run deficits because we’re such an attractive place for investors from around the world to park their money. The deficit, in other words, is a sign of strength.

As any economist can tell you, the flip side of our trade deficit is our capital surplus, which measures foreign investment flows into and out of the U.S. When we run a trade deficit, by definition we must run a capital surplus — and vice versa.

Last year, for instance, we rang up a record $708.5 billion deficit for both goods and services. But we imported the equivalent of $738.6 billion in investment capital to offset that. This was used to buy Treasury notes, bonds and stocks, and to fund real estate, plants, equipment and worker training.

That foreign capital created jobs and added to our ability to consume. It may even have helped keep us out of recession.

So what does it say that our deficit is now shrinking?

On the whole, it means foreign investors find the U.S. economy a less inviting place to be, maybe because of the housing meltdown and concern over the upcoming election. But if the trend continues, it means we’re all going to have to consume less and save more to make up for the decline in foreign capital.

That might not be a bad thing, but don’t let anyone tell you it will be painless. In the short run, a falling trade deficit will boost GDP. Indeed, based on Friday’s data, it’s likely first-quarter GDP growth will be revised up from the first estimate of 0.6% to roughly 1.2%.

But in the long term, having less foreign investment means our economy will grow more slowly. That’s the downside.

Don’t believe it? Just look at Germany and Japan. They’ve run huge trade surpluses for years, yet their economies have grown slowly at best since at least 1990. They export lots of their capital, as all trade surplus nations do, so they have less to grow on. We import it — and grow faster.

As such, should we root for a smaller deficit? Well, a smaller trade deficit doesn’t have to be a negative. If it got smaller because Congress wised up and created private investment accounts for Social Security — which would raise the U.S. private savings rate — that might be a good thing.

But making the deficit smaller isn’t necessarily a laudable goal, since doing so often covers for other bad policies such as raising taxes, devaluing the dollar and reverting to protectionism.

All these things, by the way, have been proposed as “remedies” for the trade deficit, mostly by wrongheaded Democratic candidates and talk-show hosts. What they’d do, in fact, is shrink the deficit by shrinking the U.S. economy. We’d rather keep the deficits.