Dirty Deficits and GDP

This week we'll see the first revision to the GDP estimate for Q210. Most observers expect a downward revision. Brian Wesbury of First Trust Advisors explains why:

…the pessimists are all talking about the fact that real GDP will be revised downwardly to an annualized growth rate of about 1% in the second quarter. What they don't tell you is that this low number was caused by a 35% surge in imports. That's right, consumers and businesses bought more from overseas (lot's more), and since imports are a negative in the GDP accounts, it made the economy look worse. When we adjust for this, American households and businesses increased their spending at a 4% annual rate in the second quarter – over and above inflation. 

The average investor thinks that trade deficits are bad, imports are bad, and a lower GDP is bad. There is little understanding about the relationship between trade and GDP.

The article below is a generous contribution from my brother, Steven L. Miller, Ph.D., recently retired from Ohio State. Steve continues to improve economic education around the world with his frequent trips and seminars. His article follows several of our frequent themes including causal relationships, media coverage of the economy, and general understanding of economic data. I urge a careful reading, and as usual, checking out the links.

You will be surprised and enlightened by the conclusion.

Dirty Deficits by Steven L. Miller, Ph.D.

This post is prompted by "Return of Killer Deficits," an editorial in the NYT from 8/15 (http://www.nytimes.com/2010/08/16/opinion/16mon1.html?_r=1). In essence, it says that the US trade deficit has "ballooned" again, as US consumers are on another import binge while China (with its "artificially cheap goods") and Germany are pushing exports. This threatens the weak US recovery and "isn't sustainable."

What is happening with the trade balance is especially newsworthy during periods of high unemployment. The increasing trade deficit was the major factor in the possible downward revision of the GDP Q2 estimate, net exports being a component of that calculation. That was perceived immediately as bad for jobs and bad for the stock market. Moreover, a widespread public perception is that every import that could have been made in the US represents jobs that have been lost. This prompts political leaders to act in ways they think will promote exports and reduce imports—consider the "Make It In America Bills" recently passed in the US House of Representatives (http://www.speaker.gov/newsroom/legislation?id=0390).

It is tempting to do as the NYT editorial does and chalk the trade deficits up to US demand for imports, foreigners not doing their part, and the Chinese gaming the system.

But, the iron logic of CA+K=0 forces us to consider whether the trade deficit might be a result of the continuing inflow of capital into the US, despite concerns about long-term government deficits. The equation simply states that whatever happens in the current account is matched by offsetting items in the capital account. In the US, the current account (CA) is overwhelmingly the balance of trade; the capital account (K) is the net of capital flows. This suggests that a trade deficit (-CA) might be the result of net capital inflows (+K). Positive capital flows maintain a higher value for the dollar relative to other currencies making US exports more expensive and imports cheaper than they would have been otherwise. Hence, the trade deficit.

William Poole, when he was still President of the St. Louis Fed, noted:

A common mistake is to treat international capital flows as though they are passively responding to what is happening in the current account. The trade deficit, it is said, is financed by U.S. borrowing abroad. In fact, investors abroad buy U.S. assets not for the purpose of financing the U.S. trade deficit but because they believe these are sound investments promising a good combination of safety and return. http://research.stlouisfed.org/publications/review/04/01/poole.pdf

He suggested that there are multiple reasons why this might be the case, and that different ones of these might have been the major suspect at different periods of time (We are looking at a long period of trade deficits). For example, the 1980s "twin deficits theory" of inadequate US savings combined with large government deficits was seen as the prescription for capital inflows. While Poole points out that this theory breaks down in the 90s, he more generally maintains that the relative safety, liquidity, transparency, and efficiency of US capital markets makes them attractive to foreigner investors and governments, even in periods when US government borrowing or interest rates are low.

So, now? One explanation consistent with Poole is that the US is currently seen as the world's "Safe Haven," as is explained at http://www.forexblog.org/ and http://www.nytimes.com/2010/08/16/business/economy/16rate.html?hp

All of this could mean that foreign demand for US assets, including US government obligations, is likely to continue, and with it sizable net capital inflows and corresponding current account deficits.

There is any number of significant conclusions from this analysis. One is that policies designed presumably to create jobs by chopping into imports might not work as expected. Rather, it could be like plugging a leak in one place, but another opens. An inflow of capital means there will be a trade deficit—maybe not in the industry or with the country where the leak was plugged—but with somebody. In this scenario, the voracious demands of future government deficits presumably also mean higher interest rates eventually, since the government simply has to get the requisite funds, no matter the cost (See Kitchen and Chen at http://www.econbrowser.com/archives/2010/08/financing_us_de.html).

So, at least in the shorter run (however long that is), the US looks like it will need to continue to be a net importer of capital. As Poole noted "…whether continuing infusions of financial capital are sustainable depends on how the financial capital is employed." Maybe trade deficits aren't such a bad thing.

Comments

[scm0330]

Jeff, I think more highly of you than rely on sell-side commentary such as Wesbury's to make a point. I skip over to Brian's weekly column once in a while simply to marvel at all the spin and data mining he puts forward. Truly impressive. Like the superhero cartoons of my youth would say, when the villian was captured, "if only he used his powers for good..."