Alan Blinder bugs me (Part 2: What's causing our trade deficit?)

On Charlie Rose, Alan Blinder also tossed out the old “We have no one to blame for our trade deficit but ourselves” argument. He claimed:

How do you get a trade deficit [this large]? You get a trade deficit when the domestic economy — the people and the government together — spend a lot more than they save. Then you have to borrow the rest from the rest of the world… The fundamental causes of the overall trade deficit (as opposed to the allocation — is it cars? is it toasters? is it wheat? — trade policy’s relevant to all of that), but the fundamental cause of the overall trade deficit is how much does society is how much does it spend and how much does it save?

One criticism of this view was raised on the show by none other than pro-free-trader and former Bush Administration U.S. Trade Representative Susan Schawb, who said we should be seeking “comparable access.” She didn’t spell out the implications of unequal access, so let me.

If — hypothetically — every country in the world banned all imports of American goods but continued exporting to the U.S., the U.S. would automatically run a trade deficit because America would be importing foreign goods but not exporting any. So the argument that the U.S. saving rate determines our trade deficit is simply untrue. Formal and informal trade barriers and exchange rates affect who buys what from where and at what price. The saving rate does change when imports and exports change, but the saving rate’s not causing those changes. Trade barriers and relative prices (exchange rates) drive purchasing decisions. The savings rate is what remains after economic actors make purchasing decisions. The saving rate doesn’t drive consumers to buy domestic or foreign products.

Here’s a clear analysis from Thomas Palley:

On average every dollar of consumption spending generates two dollars of income since the money initially spent circulates and creates jobs and more spending. Households also spend about fifteen percent of their income on imports. Now, suppose Americans increased their saving by three hundred billion dollars. That would initially reduce consumption spending by three hundred billion dollars, causing an ultimate six hundred billion dollar drop in income. As a result, imports would decline by ninety billion dollars, reducing the trade deficit to around six hundred billion dollars. Thus, a major increase in saving triggers a deep recession, and causes a modest dent in the trade deficit. Clearly, lack of saving is not the primary cause of the trade deficit.

Reducing the trade deficit requires increasing exports and decreasing imports. That requires inducing foreigners to buy more U.S. made goods, and inducing Americans to switch their spending from imports to domestic made goods. How do market economies accomplish this? They do it by changing relative prices, making foreign goods more expensive for American consumers, and American goods cheaper for foreign consumers.

To get concrete, improving the trade deficit begins with shoppers at Wal-Mart buying American goods rather than imports. They don’t do this because they have decided to save more. They do it because American goods are cheaper than foreign goods, and they therefore switch spending to American goods. That is where exchange rates enter. A depreciation of the dollar makes foreign goods more expensive to Americans, and it also makes American goods cheaper to foreigners. Which is exactly what the doctor ordered.

If exports go up, the trade deficit will improve… Saving will have increased, but not because households made a decision to save more. Rather, it is because the exchange rate changed, changing relative prices and increasing exports, and those exports are accounted for as increased saving.

The trade deficit is principally determined by our trade policies and those of other countries that affect tariffs and non-tariff barriers; exchanges rates which determine the prices of exports and imports; the state of the U.S. economy which affects our demand for imports; and the state of the rest of the world’s economy which affects their demand for U.S. exports. Trade policy and exchange rates are the way to affect the trade deficit while retaining high employment. The focus on saving is a pure distraction.

Posted by James on Thursday, May 07, 2009