Trade Deficits, Dollars, and China: Wrong Lessons Make Dangerous Policy

The March trade deficit fell back from its record high in February, according to numbers released by the Commerce Department this week. So does this mean we are out of the woods? There is a better question to ask: What woods? Despite cries of impending doom, the U.S. economy continues to expand faster than all other advanced economies. In the just-ended quarter, even with a record-level trade deficit, the U.S. economy grew at a 3.1 percent rate, four times faster than Germany, which consistently runs a trade surplus. Could it be that trade deficits are not a drag on growth?

Since the end of the Cold War and through the booming 1990s, the U.S. trade account has trended consistently towards deeper deficits. The media, politicians, and consensus economists regularly warn that larger trade deficits mean that America is losing in the global trade war. As the dollar rose in the late 1990s and the trade deficit kept widening (see Chart 1), many believed that a correction was inevitable, and some even prescribed a "weak dollar" policy to fix things.

Now that the dollar has lost roughly a third of its exchange value on a trade-weighted basis, things look different. The trade deficit keeps on getting bigger. It appears that the conventional assertion that the dollar and the trade deficit move in opposite directions does not hold much water. All we have to show for the dollar's decline are higher oil prices, a jump in inflation, and blip upwards in short-term interest rates.

You might think that they would learn, but now the same alarmists want to bet our trade policy with China on the same misguided logic. Make no mistake-those who call for China to end its policy of pegging the yuan to the dollar are calling explicitly for a weaker dollar. In 2005 to date, the U.S. has a $42 billion trade deficit with China, but China has a trade deficit with the rest of the world. As a result, China's overall trade account is roughly in balance. And China too has suffered from more expensive oil and gas prices, unlike Europe, because global oil markets are priced in dollars, not Euros. If China floats the yuan, it may do so to devalue the currency, not to appreciate it. As they say, be careful what you wish for.

The same goes for the "twin deficits" theory. According to this story, the budget deficit exacerbates the trade deficit. But the deficits are not twins at all and probably aren't even cousins. Japan's persistent trade surplus, according to twin deficit theory, is impossible with a national debt that has grown to 169 percent of GDP, and yet there it is. Another example: during the late 1990s, the U.S. federal government ran a budget surplus (as we are often reminded), and yet the trade deficit continued to set records.

Here's how to make sense of all this. Trade deficits are a symptom of one thing only: capital inflows. The trade account and capital account must be equal and opposite. The trade deficit is therefore a symbol of the continued attractiveness of investing in the U.S. As Ben Bernanke, the new chairman of the Council of Economic Advisors, put it, the trade deficit is the "tail of the dog." It's time we started focusing more on the dog.

The real dangers are not free trade agreements or China's currency peg. No, the real danger is that Congress will try to fix what isn't broken and adopt a mercantilist policy of import limitation. Mercantilist trade strategy has proven a failure in Japan, where despite ample trade surpluses, Japanese per-capita income growth has been stagnant for over a decade.

A wise policy is to focus on economic growth and avoid questionable theories about trade. Congress would do well to stick to the reliable keys to growth spelled out in Heritage's Index of Economic Freedom: rule of law, private property rights, low tax rates and regulation, limited government, and especially free trade. What a shame if the world leaders forgot that lesson.

Tim Kane, Ph.D., is Bradley Fellow in Labor Policy in the Center for Data Analysis, and Marc Miles, Ph.D., is Director of the Center for International Trade and Economics, at The Heritage Foundation.