Why Record Trade Deficits Haven't Slowed U.S. Growth
Knight-Ridder/Tribune Media Services, February 22, 1999
Every now and then economists blurt out the truth about things that our political leaders would prefer they didn’t talk about. "International trade isn’t so important for the U.S. that we couldn’t get by without the rest of the world," Harvard’s N. Gregory Mankiw told the Wall Street Journal in a recent interview. Mankiw is considered one of the country’s leading macro-economists.
He’s also right. The Journal was quick to note that he was not advocating such a thing, but his statement still stood in sharp contrast to the "globaloney" that saturates the media: how we are all tied to the global economy, we must learn to compete in the global economy, the future of America depends on the global economy, and so on.
As the record U.S. trade deficit for 1998 graced the headlines last week, some readers must have noticed that our economy still managed to grow at nearly 4% for the second year in a row. Unemployment is still at a 28 year low of 4.3%. How could the economy perform this well while our trade deficit increased by 53%?
There are a couple of reasons. First, we are much less dependent on trade than most people think: 89 percent of what we produce in the United States is consumed here.
The second reason is a little more complicated, but still well known to economists and many readers of the business press. This is that the Federal Reserve determines the rate of growth of the economy, and unemployment, through its control over interest rates. Whenever the Fed believes that unemployment has fallen "too low," or that the economy is growing too fast, it is able to slow things down by raising interest rates.
If we look at what happened last year, the increase in our trade deficit was enough to knock about 1.5 percentage points off of our economic growth rate. This would be very significant-- it translates into more than $120 billion in lost income and well over a million jobs lost. But would we really have had 5.4% growth last year (instead of the 3.9% actual rate), if not for weakness in the international economy that caused our trade deficit to swell? The odds are very good that the Fed would have intervened to slow the economy, if the burgeoning trade deficit hadn’t done so.
As it turned out, the Fed responded to the international financial crisis by lowering interest rates. The Fed probably still considers the current 4.3% unemployment rate "too low"-- recall that just a few years ago, the Fed held to the doctrine that 6 or 6.25% unemployment was the minimum allowable rate. But they are afraid to raise interest rates in the current climate of international financial fragility, and there is little excuse to do so, with inflation at 1.7% and no sign of increase.
The Fed also does not want to be blamed for a stock market crash. Fed chairman Alan Greenspan seems to believe that stocks are overvalued, and there is good reason to believe that he is right about this. Price-to-earnings ratios are at more than twice their historic levels. Greenspan tried to talk the market down at the end of 1996 with his famous speech about "irrational exuberance," but it has risen more than 60 percent since then.
It is important to understand these relationships, because our economic growth over the last few years has been largely fueled by the rising consumption of households who have piled up huge capital gains in the stock market. It is easy to imagine a scenario in which economic events in Latin America, Asia, or elsewhere precipitate a downturn in the U.S. stock market. If this were to happen, it would be widely interpreted as more evidence of our deep and inevitable dependence on "the global economy." But this would be more accurately described as the collapse of a speculative bubble in our own stock market.
Meanwhile, the trade deficit still has its casualties. Thousands of steel workers have lost their jobs, as steel imports have surged from 20 percent to 50 percent of the U.S. market in less than two years. The manufacturing sector has lost 272,000 jobs since last March. And over the long run, the most important effect of globalization on the American economy over the last 25 years has been to lower the wages of the majority of the labor force. In this sense, we are indeed all part of the global economy.