Trade Deficit Improves

In August, the monthly trade deficit fell to $30.7 billion from $31.9 billion in July. We got improvement from both sides as exports rose by $0.2 billion to $128.2 billion and imports fell to $158.9 billion from $159.8 billion in July, a decrease of $0.9 billion. This reverses two months where the trade deficit rose slightly.

On the other hand, over the last year the trade deficit is down dramatically. A year ago our imports were $63.6 billion higher than now, at $222.6 billion, and our exports were $33.4 billion higher at $161.7 billion, resulting in a deficit of $60.9 billion.

While the year-over-year improvement in the trade deficit is very good news, the reason for it is not so good. It was a refection of the overall collapse in world trade, something that makes everyone poorer. As far as the GDP calculations are concerned, it does not make any difference -- a decline in the trade deficit is a decline in the trade deficit -- and it is something that feeds directly into the calculations.

However, it is not like there has been a big surge in people buying domestically produced Fords (F - Analyst Report) rather than foreign produced Hondas (HMC - Analyst Report). Rather, the fall in imports has been simply fewer people buying cars, period. Currently, for every dollar of goods and services we export, we import $1.24 -- down from $1.38 a year ago, but still way out of whack.

As the chart below shows (from http://www.calculatedriskblog.com/), a big part of our overall trade deficit comes from our addiction to foreign oil. The blue line shows the total trade deficit, while the black line shows the oil portion, and the red line shows everything else. Our overall trade deficit actually peaked (or hit bottom, as shown in the graph) at the end of 2005, and then went into a broad valley that lasted until last summer. That actually masked the underlying dynamics, as the non oil deficit actually started about the time the overall deficit first hit the valley floor, but the oil portion of the deficit soared along with the price of oil.

It was not until the price of oil crashed last fall that we started to see real improvement in the overall deficit. Now that benefit is largely gone. While the price of imported oil has a bit of a lag with the prices in the pits, there is clearly a relationship. The price of imported oil bottomed in February at $39.22 and was $64.75 in August. It will most likely go up again in September.



It is somewhat ironic that the most dramatic part of the improvement in the trade deficit came as the dollar dramatically strengthened a year ago in the flight-to-safety trade. The path of the trade deficit has not yet been greatly affected by the path of the dollar, for two major reasons.

First, a very large part (over half) of our trade deficit is due to oil imports, and when the dollar is weak, the price of oil tends to go up to compensate. Second, our biggest single deficit is with China, which has effectively pegged the Yuan to the dollar. In August, the China deficit fell to $20.2 billion from $20.4 billion, but still represented 65.1% of the total deficit. Put another way: in August, our deficit with China was more than our deficits with OPEC, The European Union, Japan and Mexico...combined!

The flight-to-safety dollar trade is now unwinding, and the greenback is almost back to the levels it was at before the fall of the House of Lehman. Over time, this should lead to further improvements in our non-oil trade deficit -- if not with China, then with the rest of the world. It might even indirectly help with the Chinese deficit even though the value of the Yuan is effectively fixed to the price of the dollar.

This would happen at the expense of the Japanese or the Europeans, as the Chinese decide to buy their heavy earth-moving equipment from Caterpillar (CAT - Analyst Report) rather than from Komatsu, or airplanes from Boeing (BA - Analyst Report) rather than Airbus.

An expansion of our exports is vital to our long-term economic health. Consumption is a far higher percentage of our economy (71%) than it is for the rest of the G7 (average is about 64%). We have not always been an economy that was so lopsided in favor of consumption -- in fact, on average since the end of WWII we have consumption has averaged 64.5% of GDP, but consumption has been an ever-increasing share since the early 1980’s.

If our consumption share were to trend back down to that historical average, and the level that most comparable countries are at, then something else has to increase. It would be nice if it were offset by an increase in business investment as a share of GDP. But where is the incentive for businesses to invest if consumers are spending less?

Remember that capital is by far the most mobile factor of production, so if you answered "cut capital gains taxes" to provide the incentive, that would not work. For starters, they are already greatly preferentially treated, and secondly, they apply as much to investments abroad as here.

If investment is as likely to fall as rise in response to a decline in the consumer as a share of GDP, that leaves either government spending or net exports to pick up the slack. In case you have not noticed, the government debt is a bit on the high side, and we are running a deficit of about $1.8 Trillion, so there is not a lot of room there. If the import side of net exports is constrained by the price of oil, and a pegged Yuan, the only variable that provides much hope is increased exports.

Efforts to bring down the amount of oil we consume but replacing it with domestic sources of energy would also help a great deal, as they would raise investment (say building windmills, or drilling for Natural Gas in North Dakota) as well as reducing our need to import oil. A falling dollar will help stimulate our exports, and should be seen as a good, or at least necessary, thing.

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