State the Issues - June 2006

State the Issues

by Frank Shostak, Christian E. Weller

Does the trade deficit pose a threat to the U.S. economy?

No, the Real Culprit is the U.S. Central Bank

By: Frank Shostak, Ph.D.

The massive current account deficit that most economists are worried about is not the major issue of the US economy. The main problem is the Fed’s reckless monetary policies, which undermine individuals’ well-being. For instance, between August 1987 to December 2005, the money supply increased by 173 percent. Focusing on the trade account statements only diverts the focus of attention from the true culprit behind the erosion of U.S. economic fundamentals, which is the loose monetary policy of the central bank.

What matters for the process of wealth formation is the flow of real savings, which can be ascertained by grounding economic analysis on the actions of individuals and not some misguided aggregate called the balance of payments. Various pessimistic assessments regarding the U.S. economy, which are based on the state of the balance of payments, are therefore likely to be without much foundation.

A balance of payments describes how much money a particular country spent on goods from other countries and how much money it received for the goods it sold to other countries. It is not money, however, that funds economic activity, but real savings. (A baker pays for the shoes with the bread he has produced – money just helps to facilitate the payment).

If the national balance of payments is an important indicator of economic health, as various economists are saying, one is then tempted to suggest that it would be a sensible idea to have balances of payments of cities and regions. Imagine that economists in New York City have discovered that their city has a massive trade deficit with Los Angeles. Does this mean New York City authorities must step in to enforce the reduction of the deficit? Luckily, we do not have balances of payments between cities, and it seems that no one is concerned with this issue. Why then be concerned with the so-called international trade account?

The Trade Deficit is Hurting the U.S. Economy

By: Christian E. Weller, Ph.D.

The trade deficit is a rising rift between our imports and exports. At the current rate, it will approach $800 billion by the end of 2006, up from $726 billion in 2005. This disparity is not sustainable and poses a threat to our future standard of living.

One of the primary reasons we export less than we import is the high value of the dollar. To pay for the budget deficit, the U.S. has borrowed money overseas, creating upward pressure on the dollar. The result is a vicious cycle. Overseas borrowing keeps the dollar high, thus making exports more expensive and imports cheaper and widening the trade deficit. Since a trade deficit means that we are spending more than we make, it further necessitates overseas borrowing by selling off the "family silver", e.g., treasury bills, buildings and companies.

There comes a point when foreigners become more reluctant to invest here. Only higher interest rates could entice investors to continue to come to the U.S. Interest rates, though, slow economic growth further, leading to more demands for higher interest rates – a vicious cycle of a slowing economy.

Further, as our trade deficit grows, our debt to the rest of the world increases, and so too do interest payments on that debt. For instance, the federal government spent $32 billion in debt payments to overseas investors during the fourth quarter of 2005, up from $21 billion in the first quarter of 2001. In effect, a growing share of our national economic resources is being "shipped overseas."

Step one to reduce the trade deficit is to return to fiscal responsibility. Reining in our budget deficits would lessen the need for the federal government to borrow overseas and bring down the value of the dollar. Additional measures to make U.S. exports more attractive, such as more investment in innovation, will also be needed.

Frank Shostak, Christian E. Weller
Frank Shostak, Ph.D. is an adjunct scholar of the Mises Institute, a libertarian think tank. Christian E. Weller, Ph.D. is a senior economist at the Center for American Progress.