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| Is This History's Greatest Economic Fallacy? |
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Monday, April 22nd, 2002
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Economic thought has a distressing tendency towards faddishness. I know: I have spent more time than most battling various absurd economic fashions over the years. At Forbes magazine in New York in the spring of 1982, I was virtually alone in challenging the pervasive �death of equities� mood of that time (before the great bull market took off in August of that year). In the late 1980s, I was virtually alone among Tokyo-based observers in predicting a crash in Japanese real estate and stock values. Then in the late 1990s, I was unfashionably early in debunking the absurdly euphoric claims being made for the New Economy. But as economic fads go, none is more absurd or more dangerous than the recently fashionable idea that America�s trade deficits don�t matter. In this article, which I wrote for the April issue of The Atlantic Monthly, I explain how fallacious this idea is.
Economics is noted for its extraordinary fads and fallacies -- for episodes that come to be universally regarded in retrospect as sheer lunacy. Many of the most memorable such episodes involve wild speculation such as occurred in the Dutch tulip mania of the seventeenth century and in the Wall Street stock bubble of the late 1920s.
Less picturesque outbreaks of economic error, however, have often done at least as much damage. In the 1840s, a fashion for Ricardian economics in London, for instance, greatly exacerbated the consequences of the Irish famine. Again in the 1920s, ideology got the better of commonsense when the British government restored the pound to its high pre-World War I gold value -- a move that promptly brought British industry to its knees and paved the way for the world depression of the 1930s. That depression in turn was greatly exacerbated by a doctrinaire, and utterly wrong-headed, commitment by both major American political parties in the early 1930s to balancing the federal budget.
In our own time, prominent commentators bulled Japanese stocks to the skies in the late 1980s on the theory that things in Japan were �different� and the Japanese economic system would never let asset prices fall. When the Japanese government failed to play its appointed role, countless billions of dollars of American insurance and pension-fund money promptly went up in smoke. More recently we have seen almost everyone � up to and including the chairman of the Federal Reserve � averring that the rise of the New Economy had wrought fundamental changes in the economic rules. Hence the absurd Internet stock bubble of the late 1990s.
Now that the Internet bubble has been popped, can we assume that for the moment at least we have returned to the path of economic sanity? Hardly. Unbeknownst to most Americans, the United States is currently in the grip of an economic error that in its geopolitical ramifications will one day be seen to dwarf these others. I speak as something of a connoisseur of economic manias, having outspokenly predicted the popping of the two most recent financial bubbles � that of Japanese financial assets in the late 1980s and of U.S. dot.com stocks in the late 1990s.
So what is this under-appreciated new economic mania? It is the belief, repeated daily as a mantra of intellectual sophistication by some of America�s most prominent economic commentators, that America�s rapidly-growing trade deficits �do not matter.� This view is an axiomatic part of introductory economics, with its premise that any exchange between willing buyers and willing sellers will be beneficial to both sides. As applied to trade deficits, this means that chronic-surplus economies � Japan, China � willingly choose to consume less than their industries produce. Chronic-deficit economies, like the modern United States, correspondingly consume more than they produce, and �choose� to borrow or sell assets to make up the difference.
Through the 1970s, even those who generally believed that free markets produced optimal results hesitated to extend that logic to national trade accounts. After all, a national economy was more complicated than even the largest corporation. Debt owed to foreign lenders could affect foreign policy. Since workers couldn�t easily migrate across national borders as jobs shifted there, the shift of production from one country to another could have important political consequences.
The Wall Street Journal started it
But starting in the 1980s, the explicit claim that trade imbalances did not matter began to surface, especially on the Wall Street Journal�s editorial and op-ed pages. Twenty years later, it has now gone mainstream. Not only has it been adopted as the Wall Street Journal�s official editorial position but it has been taken up with enthusiasm by everyone from Foreign Affairs magazine to the Morgan Stanley investment banking firm. It is almost a sign of economic literacy to remind the public that trade deficits aren�t important.
A striking statement of the proposition came recently from David Gardner, founder of the Motley Fool website. Under the heading, �Our Friend, the Trade Deficit,� he wrote: �Trade deficits are in fact a pretty healthy sign in America, and we need not tinker to reduce them.� This would be merely amusing except that the Motley Fool takes itself deadly seriously and is indeed one of the most influential websites for stock market investors. Although the editors of the New York Times and the Washington Post occasionally offer warnings of possible dangers from soaring deficits, their settled position is that the deficits really aren�t important. How else do we explain the fact that as the deficits have tripled in the last few years, they have all but disappeared as a news event?
One thing is undeniable: the deficits are now vastly larger than even most of America�s best informed citizens realize. The current account deficit in 2000 represented fully 4.5 percent of gross domestic product. That was an all-time record for the United States, an impressive statement given that the statistical series goes back to 1889, and that the American economy was seen as being stronger in 2000 than ever before. An inkling of how large the latest deficit is can be gauged from the fact that before 1983, the deficit had never exceeded even 1 per cent. The then-huge seeming trade crisis of the early 1970s was puny by today�s standards. The deficit in 1972, for instance, was a mere 0.5 percent of the GDP. Yet so troubled was President Nixon by the prospect of bad trade figures in 1972 that he was forced in the summer of 1971 to go off the gold standard.
When all the accounting is done for 2001, the trade deficit will probably have �fallen� to about 4.2 percent, according to Professor Alfred Eckes, a trade expert at Ohio University. In a way that is more shocking than the previous year�s 4.5 percent, because the contraction of purchases during recession years, like 2001, usually hits imports disproportionately and shrinks a trade deficit. In the last recession year, 1991, the current account was actually in surplus to the tune of $4 billion -- or about 0.1 percent of GDP. (Admittedly the 1991 performance was boosted by government to government transfers, connected with the Gulf war. Even without them, the deficit would have been minuscule compared to today�s level.)
Perhaps the best gauge of the present crisis is the record of other Group of Seven nations. It has to be admitted that other nations have on occasion incurred deficits that have been proportionately even larger. But virtually without exception they incurred huge deficits only in the acute economic devastation of World War I and World War II and in the immediate aftermath of those wars. In fact the one huge deficit that cannot be blamed on war was in Italy in 1924. But, given that Mussolini seized dictatorial control in Italy the following year, this precedent offers little consolation to the United States today.
America�s trade deficits matter for several fundamental reasons. As the author and economist, Pat Choate, points out, not only do excessive imports displace American jobs but in many cases they weaken America�s defense base. One well documented case in point occurred during the Gulf War of 1991, when, as reported by the Washington Post, American defense officials were �sweating bullets� as they waited for a reluctant Japan to supply crucial high-tech components for America�s weapons systems. It should be noted that though America�s jobless figures do not yet show much evidence of the crisis, this is partly because the full impact on jobs takes time to come through and partly because the effect is disguised in the disappearance of discouraged job seekers from the labor market.
The most immediate effect of the deficits is that they have to be paid for. Every dollar of current account surplus must be funded with a dollar of foreign finance. Ultimately the issue is who owns the world�s assets. In just a few years in the 1980s the United States went from being the world�s greatest net creditor to the world�s greatest net debtor. Things have got much worse since then. Between 1989 and 2000, the trade deficits inflated America�s net foreign liabilities seven-fold to total more than $1.8 trillion. Much of the financing has come in the form of increasing foreign ownership of American industry. Why should Americans care who owns American industry? There are many reasons: just the most obvious is that foreign corporations are much less likely than American corporations to site their most productive plants in the United States.
How come the current mania has hitherto been subjected to so little reality checking in the American press? For anyone familiar with economic history, the answer is obvious. As J.K. Galbraith has pointed out, an economic error proliferates when someone somewhere has an interest in promoting it.
In the case of the present U.S. trade crisis, two key sources of error have been playing a decisive role -- the foreign trade lobby and the Wall Street securities industry. The former�s role is obvious. In Wall Street�s case, the error is driven in part by a recognition that many American corporations gain a short-term profits boost from shipping jobs to places like Mexico and China � a boost, however, that comes at the expense of America�s already fast-dwindling manufacturing workforce. Particularly where American workers have no similarly productive new jobs to move to, the result is a serious weakening of the American economy. A further reason why Wall Street downplays the trade crisis is that many investment houses benefit from arranging the international financial transactions that faciliate the trade deficits.
Those sources of error apart, there is actually widespread unease among the American economics profession about the deficits. This emerged clearly in a survey I conducted of the profession�s ten most recent winners of the Nobel prize. Only one laureate was prepared to endorse the media/Wall Street view that the deficits posed no policy problem for the United States. But despite the now obvious debacle of the Internet stocks, Wall Street continues to enjoy such exaggerated prestige among the American business press as to drown out other voices.
Eamonn Fingleton is the author most recently of In Praise of Hard Industries: Why Manufacturing, Not the Information Economy, Is the Key to Future Prosperity (Houghton Mifflin, 1999).
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