The correct answer to this question is, “Of course, the U.S. trade deficit is not sustainable.”

But then, what is? Neither the Roman nor the British Empire endured. Economic and political phenomenon eventually fade and die. Indeed, the U.S. trade deficit, one day, like everything else will be a thing of the past.

A more practical question would be, “How much longer might the U.S. trade deficit last? One year? Ten years? Thirty years?”

Some observers may presume that the demise of the trade deficit is imminent, perhaps by the end of 2006; but, it this reasonable?

The trade deficit has been growing for thirty years — which almost qualifies as a [1] Keynesian ‘long-run’ . Since no clear mechanism exists whereby the trade deficit must end in, say, six months or a year, it could be that in thirty years our children will still fret about a trade deficit that has grown even larger.

The longevity of the U.S. trade deficit is quite germane to Capital Flow Analysis, since it is the dollars earned by foreign exporters that support the price of American bonds.

(See: “[2] Trade Deficits Have Depressed Bond Yields for Twenty Years.”)

It is worthwhile to speculate about the sustainability of the trade deficit.

What Is Sustaining The U.S. Trade Deficit?

There is no mystery about the causes of the U.S. trade deficit:

• The Lack of a Gold Standard: The world went off the gold standard in the 1970s, at a time when the U.S. dollar was the strongest fiat currency, widely sought as a store of wealth by hundreds of millions of people worldwide, including most exporters of goods and services. This preference for dollars continues today.

(See: “[3] The Almighty Dollar“.)

• Free Trade and Globalization: The world has embraced free trade and globalization, with nations pushing exports as fast as they can, trying to increase their reserves of the international trading currency, the dollar.

(See: “[4] Globalization and Capital Flows“.)

• An Efficient U.S. Bond Market: The U.S. has a central bank and treasury department that work well together to minimize inflation of the dollar, mopping up government spending by selling Treasury bonds, while managing short-term bank rates to smooth business cycles. This system of strong government finance is admired throughout the world, giving prestige to the dollar.

• Securitization of U.S. Household Debt: The U.S. has an extremely efficient consumer and home mortgage financing system, that got even better in the 1970s with the invention of asset-backed securities. This allows borrowing by American households to be transformed into high-quality, long-term corporate bonds, with liquidity in an effective secondary market. Furthermore, as anyone knows from watching ditech.com ads on American TV or from sorting through junk-mail flyers offering credit cards, marketing of consumer finance is aggressive, pushing money upon consumers as fast as it becomes available.

(See: “[5] Issuers of Asset-Backed Securities“)

• Laissez Faire regarding Deindustrialization and Excess Imports: For over a generation, policies of the U.S. government have encouraged free trade, the reduction of tariffs, high domestic labor costs, the expansion of residential mortgage financing, and unfettered consumer credit — while taking a position of benign indifference regarding the trade deficit and deindustrialization.

• Inflation-Control Through Low Import Prices: The U.S. government aims to contain inflation and one way to do this is to allow consumer goods to enter from low-cost overseas markets. The greater the flow of low-cost imports, the more that consumer prices may be contained. Although the masses may carp about sending jobs overseas, nothing is likely to be done as long as unemployment stays low, along with consumer prices — excepting, of course, services such as medical care and college education.

• Worldwide Neo-Mercantilism: Most other countries embrace globalization and industrialization in a neo-mercantilist context, seeking to increase exports and decrease imports, while building reserves of the new ‘bullion’, the U.S. dollar. The critical element in this neo-mercantilism is that countries are willing to exchange their goods and services for dollars, not only with the U.S., but with all other countries. The dollar has served as a means of payment for Americans buying merchandise from China, but, more importantly, for Chinese buying iron ore from Brazil.

Continuity of these elements will sustain the U.S. trade deficit.

Diversified Neo-Mercantilism

The other day, I heard a distinguished academic fret on C-span that China might suddenly ‘pull out of dollars’ and collapse the U.S. economy. This fellow argued that the U.S. had become too dependent on a single country and had sacrificed national security to the Chinese. He claimed that their was a ’stealth’ campaign among foreign central bankers to ‘get out of the dollar’.

Even Warren Buffett, reputed by many to be the smartest investor ever, said that the trade deficit will lead to foreigners taking over the United States, and that this will lead to ‘major trouble’.

(See: “[6] Warren Buffett Fears Foreign Ownership“.)

Worried that I might have overlooked something about the trade deficit and that there might be merit in these claims, I checked the country-by-country breakdown of foreign trade with the United States. Could China really pull the rug out from under the United States?

Here is what I found.

(See: [7] U.S. Census Bureau Foreign Trade Statistics)

1. Well-Diversified, Multi-Country Exporter-Investors: Most countries, with the exception of a half dozen, showed an export surplus in foreign trade with the U.S. in November 2005. (The exceptions were Singapore, Hong Kong, Australia, Belgium, Netherlands, and Egypt. Total net trade with these countries was only 3.6% of the U.S. trade deficit.) This suggests that the goal of trying to accumulate foreign exchange reserves through a foreign trade surplus is almost universal — except for the United States. If all countries seek a trade surplus in dollars, while the U.S. doesn’t seem to care, the result must be an increasing U.S. trade deficit.

2. Over-Dependence on Chinese Exporter-Investors: About 25% of the November 2005 U.S. trade deficit was due to commerce with China. If China were to stop trading with the U.S., other countries would need to increase exports to the U.S. by 35% in order for the trade deficit to remain at the same level. The deficit with China was equivalent to 7% of total net lending in U.S. credit markets in 2005. A drastic drop in imports from China could push up U.S. interest rates, unless other exporting countries were to make up the difference. The impact of eliminating the trade deficit with China would be double that of the next largest net exporters to the U.S., Canada and Japan.

The graph shows how the trade deficit was distributed by country in November 2005.

The question is,not whether foreigners will continue to buy U.S. bonds, but rather whether they will continue to strive to build foreign exchange reserves and whether the favorite currency of exporters will continue to be the dollar.

As for over-dependence on China, the role of ‘offshore Chinese’ in China’s development, discussed below, reduces the likelihood that leaders in Beijing will use the U.S. trade deficit for political purposes.

How to Eliminate the Trade Deficit

In order to eliminate the U.S. trade deficit, one of two things must happen:

• There Must Be Less U.S. Imports: Foreign exporters must reduce sales of goods and services to the U.S., relative to purchases from the U.S.. This might occur if:
• there was a general loss of confidence in the dollar as a suitable international currency;
• the U.S. or foreign governments intervene to restrain trade;
• Americans lose interest in buying goods or services from abroad, preferring domestic products;
• Americans become too poor to buy goods from overseas, even on credit; or
• foreign exporters, in general, prefer to sell in markets other than the U.S., for whatever reason.
• There Must Be More U.S. Exports: American exporters must increase sales of goods and services abroad, relative to imports. For this to occur, American industry would need to offer a wide range of competitive products at low prices, at a time when such products are in demand throughout the world;

Neither of these alternatives seem likely in the near future.

Reducing the Trade Deficit: the American Side

On the American side, well-established U.S. institutions and customs resist reduction in the trade deficit:

• Institutionalized Non-competitiveness: American industry, operating under “[8] Workers Capitalism“, is burdened by high pay levels, minimum wages, over-regulation, entrenched unions, short-term management goals, lack of industrial policy, destructive litigation, unionized teachers degrading educational standards, poor school discipline undermining work habits, and a strong bias against business, in favor of employees. As much as President Bush might speak about improving American competitiveness, powerful opposition can be counted on to defeat such measures.

• Automatic Mechanisms that Keep the Dollar Strong: The trade deficit delivers dollars into the hands of foreigners who, in turn, reinvest these dollars in U.S. bonds, including government bonds that finance the fiscal deficit, staving off inflation, and strengthening the dollar. The larger the trade deficit, the more savings from the rest of the world that are available to fortify the dollar against inflation by buying U.S. government bonds.

• High Credit Quality of U.S. Bonds: Despite wailing from doomsayers, the U.S. is not really taking on debt that it cannot handle. Most of the debt that foreign investors buy is in dollars with no currency risk for the debtor. Furthermore, much of the debt is consumer-oriented, with extreme diversification of debtors, each independently evaluated by one of the most effective consumer credit systems in the world, sometimes insured against default upon securitization, and largely collateralized by residential real estate, often backed by life-insurance on the debtor. Whining about ’spendthrift Americans’, is based on a misunderstanding of the significance of economists’ ‘personal savings’ statistics.

(See: “[9] Credit Profiling the U.S. Flow of Funds Data“.)

(See: “[10] Homes are America’s Piggybanks“)

• Commitment to Free Trade and Globalization: With a large population that has deep historical, cultural, and commercial roots in almost every country, and with membership in the World Trade Organization, and other international associations dedicated to globalization, the United States is firmly committed to free trade. There are institutional and sociological barriers against actions that might restrain imports of foreign goods.

• Relatively High U.S. Standards of Living, Compared to Other Countries: For most products and services, the trade deficit is sustained by America’s high standard of living compared to that of other countries. (Note that in November 2005, countries with which the U.S. had a trade surplus (Singapore, Hong Kong, Belgium, Australia, and the Netherlands) had as high or higher standard of living than the U.S.. A factory owner in Indonesia knows that the price of his goods in the local market, due to low wages, is less that the price available in the U.S.. It is not only low costs that drive foreign exporters, but also relatively low domestic prices. It will almost certainly be years before workers in Africa, Latin America, India, China, and other less-developed regions have standards of living sufficiently high to impair the price advantage of products they sell to the U.S..

What Keeps the Rest of the World from Reducing Exports to the U.S.?

For the rest of the world, there are equally strong institutional and cultural restraints that favor persistence of the U.S. trade deficit:

1. Institutionalized Neo-Mercantilism: Central bankers and government economists throughout the world believe that the goal of their nation should be to maintain reserves of foreign currency to protect their own currency against fluctuations that might hinder trade. The only way countries can build foreign currency reserves is to favor exports over imports. Despite oversight by the World Trade Organization, governments have many ways to encourage local exports, some obvious, some subtle.
2. Maximizing Return on Industrial Assets: The world is full of factories operating below capacity. In countries with low wages relative to the U.S., there are limits on sales in the local market. To maximize return on industrial assets, foreign trade is a natural solution. The United States is the largest market with an enormous supply of the international trading currency in the hands of its citizens, combined with an efficient financial system to handle foreign trade financing.
3. Providing Jobs For Local People: An idle factory is not only a poor investment for the industrialist, but also a political liability for governments. No matter what central bank economists might think about the savings rate of Americans or the outlook for the dollar versus the euro, politicians know that crowds of angry, unemployed workers will trump quibbles of economists. ‘Export or Die!’ is the slogan is many countries.
4. Capitalist Fears: Many countries have legal systems that do not adequately guard property rights, or have governments that regard capitalists as, at best, a necessary evil — the target of taxation, possible expropriation, shake-downs by officials, or worse. Business people working in such countries understand the wisdom of having export operations that serve to send money abroad, using transfer pricing and other devices, safe from the grasp of those in power. Also, most governments have a relatively short history, compared to the U.S., and the wealthy understand that the next regime might not be as favorable as the current. An efficient offshore financial industry, located in the Caribbean and other havens, helps the industrious exporter (or corrupt official) divert wealth from those who might take it.
5. Multinational Direct Investment: The industrial capacity that produces the goods and services that America imports can move from one country to another in a few years. When we look at Chinese exporters, we see not only Chinese who have been residents of China for generations, but also ‘offshore Chinese’, whose home may be in Taiwan, Singapore, Thailand, or Australia, and also foreign corporations headquartered in the United States and Europe. Vietnam today is exporting from factories that were created by direct foreign investment in the last decade. Countries compete for direct investments that will produce dollar-earning exports. If China were to impose policies that would reduce exports to the United States, direct investors would go elsewhere, resulting in decreasing exports from China being replaced by increasing exports from other countries.

As long as there are countries with standards of living below those of the United States, and as long as ‘neo-mercantilism’ guides government economists, the U.S. trade deficit is likely to continue.

Furthermore, as long as there is movement towards ‘free trade’, there will be need for an international trading currency, which will require the country (or countries) issuing such currency to run a trade deficit.

(See: “[11] The Trade Deficit and Dollarization“.)

Limits on China’s Control of the U.S. Trade Deficit

When we think of China, we should really think of two countries: one the nation located on the Eastern Asian mainland, represented by the Communist Party, and the other the ethnic group known as the ‘offshore Chinese’, the world’s biggest ’shadow’ economy, made up of case-hardened capitalists with centuries of experience in the practicalities of globalization.

(See: “[12] A Chinese Century“, by Joel Kotkin.)

Estimates are that the 51 million “Overseas Chinese” — ethnic Chinese now living throughout the world, including some of the fabulously wealthy taipans of Southeast Asia — now control $700 billion worth of annual sales. This is roughly the size of the GDP of their 1.2 billion brethren on the mainland. Their liquid wealth (cash, gold, shares) may run to as much as $2.5 trillion, more than the combined GDP of France and Germany.

From Big Dragon by Daniel Burstein and
Arne de Keijzer, 1998

The current export boom in China, which started when the Communist Party embraced capitalism without democracy, has been driven largely by investments of the Overseas Chinese, who brought generations of business skill and extensive overseas networks, ready-made for expanding international trade. Businesses that had been located in Taiwan, Singapore, or Hong Kong, with clients in America and Europe, now set up shop in mainland China, taking advantage of low labor costs and an enormous internal market.

We might think of China as two countries — one political and rooted in geography, the other a social network, with no fixed home — each cooperating for mutual benefit, but ready to go their own way if things don’t work out. If the Communist Party (mainland China) were to try to reduce exports to the United States, perhaps for political reasons, the trade would likely be transferred elsewhere through the network of business interests of offshore Chinese, who have every intent on maintaining profits by selling goods to the U.S. while building bank accounts in the Virgin Islands.

In other words, although China holds top position regarding the U.S. trade deficit, it does so with the help of the offshore Chinese. There is more diversification in the China trade than is apparent.

The End of the Deficit: Slow or Sudden?

From this, it seems that, with a quarter century of an increasing U.S. trade deficit, the phenomenon has become institutionalized throughout the world and need not necessarily be regarded as unstable.

Although in fifty years the United States may no longer be the industrial power it is today, the nation may still supply the world’s trading currency, long after its role as producer of real goods has faded.

A gradually erosion of the role of the U.S. trade deficit and a slow change in economic policies and institutions supporting the dollar, will probably be evident well before the trade deficit disappears.

However, it is also possible that the U.S. trade deficit will end with a bang, rather than a whimper.

This could occur as the result of a terrorist nuclear attack on New York City, forcing the closing of U.S. ports and a retreat into isolationism. If the U.S. loses the War on Terror, this would be tantamount to the abandonment of globalization, the re-partitioning of the world into ideological blocks, and the creation of a new economic alignment in which the role of the U.S. dollar would be redefined.

Many think that that chances of a successful nuclear attack on a major U.S. city within the next fifty years may be as great as fifty percent. Now that Iran is about to acquire a nuclear bomb, with a declared goal of annihilating Israel and identifying itself as an enemy of the United States, with links to terrorists, the odds that America might lose the War on Terror have increased.

(See: “[13] Nuclear Terrorism: How to Prevent It.”)

The bitter political divisions in the United States suggest that the nation might not take the War on Terror seriously enough to avoid nuclear disaster:

1. Opposition to Strict Defense Measures: Almost every measure suggested by the government to catch terrorists in time to thwart an attack is opposed by strong political groups. Because of this, it is unlikely that there will be universal identity cards, surveillance or ‘profiling’ of persons that pose a danger, or that terrorists will be taken more seriously than ordinary criminals. Should a terrorist be caught in time to prevent an attack, restrictions may impede the government from extracting information in time to save a U.S. city.
2. Free Flow of Secrets to Terrorist Enemies: The U.S. media, ever since the Pentagon Papers in 1971, has shown indifference to keeping secrets from enemies, claiming ‘the public right to know’. Any counter-terrorist methods that are discovered will be published to the world, causing irreparable harm to U.S. defense. Domestic traitors and spies are no longer shot, but instead are interviewed on CNN.
3. Open Collaboration with the Enemy: Ever since the War in Vietnam, lost primarily because the media was able to break the will of Americans and declare defeat, a small band of news barons have provided anti-American propaganda that comforts the enemy and erodes the will of the nation to defend itself. A war against terrorists is not won by heavy artillery and long-range bombers alone, but also by propaganda and psychological operations. Because a powerful group dominates public opinion, the entertainment and information industry, unlike in World War II, is now engaged in undermining efforts to defend the country.
4. Political Partisanship at the Cost of National Security: Leaders of the opposition party, in time of war, call for the impeachment of the commander-in-chief of America’s efforts to defend itself against terrorism. Important politicians call for an immediate withdrawal of U.S. troops from Iraq, surrendering to terrorists. ‘Peace’ activists oppose government eavesdropping on conversations between al-Qaeda operatives and spies within the U.S. intent of doing damage to its cities.

This suggests that, if the trade deficit ends in the near term, this is more likely to come from America’s losing the War of Terror, than from economic instability that some claim to see in the excess of imports over exports or the ownership of U.S. financial assets by the rest of the world.

The answer to the question, “Is the Trade Deficit Sustainable?”, is probably yes, perhaps for a another decade or so, unless America loses the War on Terror in the interim.