One year ago, the
chorus of the consensus told America that the dollar's exchange
rate was due to fall in 2005. Under relentless assault from cheap
Chinese imports and facing a record trade deficit, the dollar had
nowhere to go but down. The influential Economist magazine
went so far as to say, "[t]he deficit is unsustainable: sooner or
later it will need to shrink, and that will involve a cheaper
dollar." Politicians and pundits predicted economic trauma at the
hands of outsourcing. Time has proven them wrong. What the U.S. needed then and needs now is to
stick to the reliable keys to growth: low tax rates, deregulation,
limited government, and especially free trade.
A Dollar - Deficit
Link?
The U.S. economy
did set two records last year. First, 2005 saw a new record trade
gap. Imports to the U.S. exceeded exports by $724 billion, or 5.8
percent of GDP. Second, more Americans were employed than ever
before in history, arguing against those who preached doom and
gloom.
The data continue
to support our contention of last May that the trade deficit is not
the signal to watch: "This is all wrong... Many economists and the
weight of history suggest that the trade deficit, a symptom of
investment capital inflows, is a sign of national economic
strength."[1] Additionally,
two papers published last spring pointed out the lack of a
historical relationship between currency values and trade
deficits.[2] Indeed, despite the
widening trade gap, the dollar gained value against other
currencies.
The January 5,
2006, Economist admits that the dollar pessimists "were all
wrong." Yet the conventional wisdom of "trade hawks" is again
resurgent, arguing that trade deficits are unsustainable and the
dollar cannot hold. Last week, the government reported the third
deepest trade gap on record, with imports outweighing exports by
$65.7 billion. Current exchange rates, however, appear normal
compared with exchange rates over the last few decades.
Unless Congress
moves from protectionist rhetoric to protectionist legislation,
there is no reason to expect the dollar to slide significantly.
Trade flows are the "tail of the dog," as Fed Chairman Ben
Bernanke once explained. From time to time the dollar does fall
when the world's investors lose confidence in the superiority of
America's institutions and markets. Sadly, congressional hostility
to the U.A.E. port deal was a bipartisan embarrassment and isn't
likely to reassure the world that America is as free and fair as it
proclaims. Equally troubling is the Schumer-Graham proposal in the
U.S. Senate to place trade barriers on imports from China.
The Chinese
Invasion
According to the
last week's data from the Department of Commerce, the U.S. trade
deficit with China was $13.8 billion in February. In 2005, the U.S.
trade deficit with China grew by 25 percent to $202 billion. That
amounts to nearly twice the $103 billion bilateral deficit in 2002.
The ratio of imports to exports with China is now 5 to 1, perfect
for the "Chinese invasion" storyline. The U.S.-China deficit's
growth probably won't continue, but not because it can't. Consider
these points:
-
Mathematically, trade
flows are balanced by investment flows. The bigger the trade
deficit, the more capital flowing into the U.S. Chinese and other
foreign investors prefer to trade their goods for America's equity
and debt. America is seen as the safest, surest investment bet in
the world. That's bad news?
-
Realistically, trade
represents voluntary exchange. Any "imbalance" is voluntary. As
with trade between a consumer and a retailer at the local mall, the
two consenting parties each benefit from the voluntary trade of
goods for currency.
-
Empirically, record
trade deficits have coincided with positive economic news in the
U.S.: record levels of employment, low unemployment rates, rising
pay, and fast GDP growth. The argument that this is a debt-driven
party is far less credible than the argument that imports are as
economically valuable as exports.
-
Pragmatically, much
of the trade deficit with China represents re-importation by U.S.
firms with factories overseas, such as General Motors, Motorola,
and Boeing. Parts leave the U.S. and come back as more valuable
assembled products. A 2005 National Bureau of Economic Research
study
[3] reported that 90
percent of U.S. exports and imports flow through U.S.
multi-national companies, with 50 percent flowing within a single
firm. The lesson for Congress is that American companies, not just
China, will be injured by protectionism.
We should cheer
the triumph of capitalism and its alleviation of poverty within
China, as well as its benefits for American consumers and
shareholders. The only point of debate is whether American workers'
wages are suffering due to trade with China, but there is no clear
evidence of wages "racing to the bottom." Instead, China is
experiencing a severe labor shortage that is driving wages up
rapidly in a "race to the top"-the level of free-market
workers.
The real dangers to America are not free trade
or China's currency. That's not to say there aren't smart policies
that should be taken to curb abuses of fair trade, rather that
protectionism and currency haggling aren't part of the smart mix.
The real danger is that Congress will try to fix what is not broken
and adopt a mercantilist policy of import limitation. Congress
would do well to stick to the reliable keys to growth spelled out
in The Heritage Foundation's Index of Economic
Freedom: strong property rights, low tax rates, low
regulation, limited government, and especially free
trade.
Tim Kane,
Ph.D., is Director of, Marc
Miles, Ph.D., is Senior Fellow in, and Anthony
Kim is Research Associate in, the Center for International
Trade and Economics at The Heritage
Foundation.