Selected Observations About Trade Deficits

Trade deficits are hard to understand. There are wide disagreements about what they mean and why they develop. The facts set forth below appear to show that two factors seem to explain most of the empirical variance in trade deficits. One is net oil and gas imports or exports, and the other is the size of public sector government deficits.

* Many of the nations with trade surpluses have surpluses for the obvious reason that they export oil and natural gas. Many examples of this are obvious. Less obviously, most, if not all, of Canada's trade surplus is attributable to oil and natural gas exports.

* Mexico is an oil exporter, although it isn't clear to me what share of its trade surplus is attributable to mineral fuel exports, although this can be easily determined.

* China, like the United States, is an oil importer, but it uses far less imported oil and gas, and far more domestic coal, as a share of its energy mix than the United States. So, it may import fewer mineral fuels relative to its GDP (this can be easily determined).

* The U.S. trade deficit is attributable to oil and gas imports is roughly 2% of U.S. GDP. Another 3% of GDP trade deficit comes from the rest of the U.S. economy. The U.S. is a net exporter of agricultural good and services, and a net importer of manufactured goods.

* Many nations we think of as having export driven economies, because they have large trade surpluses with the United States, actually have an almost even balance of trade. Japan and South Korea, for example, each have a trade surplus that is less than 1% of GDP. These nations import a lot (including mineral fuels, which neither have in any great quantity), they simply aren't importing it from the United States.

* The European Union provides an interesting natural experiment in trade deficits. One theory of trade deficits, for example, attributes them mostly the a lack of an appropriate exchange rate, or to customs policies. While both make great sense, neither theory is consistent with the fact that Germany has a trade surplus equal to about 10% of GDP, Italy has almost precisely equal exports and imports, and France has a trade deficit of 4.5% of GDP, yet all use the same currency (the Euro), and all are part of a customs union. All three also have high taxes on gasoline leading to retail gasoline prices roughly double those of the United States and modest domestic supplies of oil and natural gas.

The comparison of France and Germany is particularly striking. Both have social democratic economies with high taxes, high levels of public services, high levels of unionization, similar high per capita GDP levels, the same currency, the same customs rules, a history of government driven industrialization, both have similar levels of economic immigration from Islamic countries, and both have reputations for having relatively uncorrupt civil service systems. Furthur, the adjacent countries that enjoy the maximum level of free trade in goods and services in Europe can't very well horde technology from each other. Both are economically "mature" as opposed to being a period of rapid economic growth. Yet, France has a large trade deficit, while Germany has a large trade surplus.

Cultural explanations may make more sense than standard economic indicators to explain the reality.

One could argue that France is predominantly Catholic, while Germany is a mix of Protestants and Catholics, but neither nation is particularly observant, and Italy and Ireland with far more observant Catholics have, in the case of Italy trade balance and in the case of Ireland trade surpluses.

Perhaps more persausive would be the possibility that Germany is a "high trust" society relative to France. While both are highly unionized, management-labor relations are far less adversarial in Germany than they are in France. Deals that would be made in the boardroom in Germany (where unions have guaranteed seats on the Board of Directors), are made in the streets or via the tolerated practice of kidnapping members of senior management in France. Perhaps a more trusting population is more willing to defer consumption for the management towards the greater good, while a less trusting population is not willing to do so.

* China has the largest trade surplus with the United States of any country, making up about half of the non-oil and gas portion of the U.S. trade deficit. In that case, at least, it is pretty clear where the trade surplus funds are going. They are being used to purchase Treasury obligations that finance the U.S. nation debt, rather than being repatriated to allow ordinary Chinese citizens to import more consumer goods. Pervasive state involvement in the economy makes it possible for China to impose this de facto tax on its people and create a rainy day fund of sovereign wealth.

* Given the coincidence of large Chinese investments in U.S. sovereign debt, and a large trade deficit between China and the U.S., it may be appropriate to reconsider the widely held belief that an artificially weak Chinese currency is really what is driving the trade deficit between the U.S. and China. The trade deficit may have more to do with how China spends choses to use its foreign exchange earnings than with the exchange rate itself.

* A public finance rather than exchange rate driven explanation of the trade deficit would also explain how China could sustain a suboptimal exchange rate for so long, when the immense amount of money needed to manipulate exchange rate and black markets in foreign currencies have repeatedly caused such efforts to fail in other countries that engage in foreign trade. As Milton Friedman and others have noted, artificially depressing the strength of your own currency to create a trade deficit essentially amounts to China giving the U.S. something for nothing, year after year. In contrast, in a public finance driven explanation of the trade deficit, the international trade deals themselves are arm's length bargains, and trade deficits are simply a manifestation of savings decisions.

* A public finance driven explanation of the trade deficit with China also significantly alters the logic of the merchantalist understanding of the trade deficit. In this view, government is not really creating export driven jobs so much as it is preventing imports from discouraging future economic growth that serves domestic consumption.

* Many countries with oil and gas based trade surpluses with the United States, such as the petro-monarchies of the Middle East, are similarly using the surpluses as a source of sovereign wealth. Many countries in Latin America that are oil rich have nationalized oil companies.

* In oil and gas driven trade surpluses, it makes economic sense for the profits from the sale of these resources to be invested abroad, because often there is little or no domestic economy which is not mineral wealth driven in which to invest.

* It makes less sense for China to make its investments in Treasury bonds. There are surely better investments it could make abroad, and its growing industralized economy would seem to present a multitude of investment opportunities at home.

* I don't know enough about the differences between tax laws and public finance in France, Italy and Germany to know definitively if these policies drive the differences in balance of trade between these E.U. countries. But, if one were to look for an alternative to a culturally based theory of trade deficits, these policies would be a plausible place to look, and the budget deficit numbers for these countries seem to support a public finance driven interpretation of trade deficits.

France does run a larger budget deficit than Germany relative to its GDP, and Italy has an intermediate sized budget deficit, although France is shrinking its budget deficits under the Sarkozy administration:

Among the 16 euro-area countries, Ireland and Greece will have bigger deficits than France next year, while Portugal and Spain will be at about the same 6 percent level. . . Germany will have a shortfall of 3.5 percent of GDP, while Italy, the Netherlands and Belgium will have deficits of 4.7 percent, 4.1 percent and 4 percent[.]

The U.S. budget deficit exceeds 10% of GDP, which is in line with a trade deficit that is large than France's relative to GDP, and France's budget deficits were recently even larger.

Of course, trust isn't entirely irrelevant. Allowing the government to spend less relatively to the amount of taxes that it imposes implies a relatively higher amount of trust in government in the future.

* If the U.S. wants to shift from having large trade deficits to having trade surpluses or neutral balance of trade, looking at the way that the German political economy differs from the French political economy is a natural place to start. It might be possible for the U.S. to adopt some of the practice of the German political economy. But, Canadian trade surplus seems to be driven by mineral fuel wealth that we can do little to change, and the political and economic choices made by countries like Mexico and China that have large trade surpluses with the United States seem neither feasible nor desirable for the U.S. to make at its current point in its economic development.


* Several tax policy and public finance policies may be an important cause of the U.S. trade deficit:

1. We have very low gasoline taxes by international standards, which increases the extent to which we import oil.

2. Government subsidies of agriculture may explain our trade surplus in that industry.

3. We routinely run federal budget deficits which are financed to a significant extent with Treasury bond sales to foreign investors. Reducing these foreign financed deficits through some combination of increased taxation, decreased public spending, and increasing the share of Treasury bonds sold to domestic investors (for example, by changing the tax treatment of interest of Treasury bonds, or imposing income taxes on interest on Treasury bonds earned by foreign investors) would reduce the trade deficit.

4. Our international tax laws discourage multi-national companies from repatriating their profits to the United States.