Is the US Trade Deficit Sustainable? Is China’s Trade Surplus?

China’s December trade figures came out and, following November’s lead, everything is moving in the wrong direction. Exports were down 2.8% (versus up 21.7% in December 2007) which although bad at least is better than the average forecast of over 4%. Within overall trade exports to Europe were down 3.5% and to the US 4.1%. Given how quickly things are deteriorating in both countries, with rising unemployment likely to cut further into consumption, I suspect that this isn’t the last of the poor export numbers. As recently as three months ago most economists were forecasting export growth in 2009 of over 15%, but now most seem to be forecasting a contraction of over 10%.

Imports were way down, by 21.3%. I am still having trouble reconciling some of the other numbers for consumption, but generally speaking people who know more about this than I do say that of all the macro data produced in China, trade numbers are usually the most reliable. This suggests that Chinese consumption is dropping quickly, and it is probably no good blaming this on declining exports (about half of China’s exports are processed imports) or declining commodity prices since the decline in imports is much too large for either explanation to cover.

For the first time in six months China’s monthly trade surplus did not hit a new world record, but at $39.0 billion it is just a whisker below November’s $40.1 billion, and it is easily the second highest monthly trade surplus ever, beating out number three (China’s October trade surplus) by well over 10%. For those who are counting, the trade surplus in 2008 was $297.5 billion. The second half of 2008, at $197.6 billion, accounts for two-thirds of the total and the last quarter, at $114.3 billion, accounts for nearly two-fifths of the total. This is not a picture that the rest of the world, struggling with overcapacity and too little demand, is going to be happy to see.

Yesterday Peter Morici, former chief economist at the U.S. International Trade Commission and currently a professor at the University of Maryland, called on President-elect Barack Obama to press China to allow the yuan to appreciate because weakness in the currency is hurting U.S. jobs and manufacturing. According to an article in yesterday’s Bloomberg:

Ending Chinese currency market manipulation and other mercantilist practices are “critical” to reducing the U.S. trade deficit and creating jobs in the U.S., Morici said. “Obama must address the huge cost of imported oil and the trade deficit with China,” he said. “Otherwise, any effort to resurrect the economy is doomed to create massive foreign borrowing, another round of excessive consumer borrowing, and a second banking crisis that the Treasury and Federal Reserve will not be able to reverse.”

Morici is making the point that if demand leaks out the US trade account at anywhere near current levels, US government borrowing required to create the demand needed to boost employment in the US will be much greater than otherwise. Instead of requiring the US to initiate debt-funded policies to boost employment in the US, China, and everywhere else, it is politically much easier for Americans to demand that the US government borrow to fund employment in the US, and let China and other countries generate employment by their own fiscal borrowing. It is hard to dispute this logic. Others will make the same argument in the US, the UK, France, Italy, Spain, Australia and many other countries with large deficits.

I want to digress a little here. My fears about the hard-to-combat logic of trade friction in a world of collapsing demand and large trade imbalances seem to have thrown me into a group of analysts with whom on the issue of trade I do not always agree. For the record, I do not have a problem with secular trade deficits and I do not believe in “balanced trade”, whatever that means. This means I have never been a trade-deficit hawk.

In the days when everyone complained about the sustainability of the US trade deficit, they always argued that it was unsustainable either 1)because the continued foreign financing of the US trade deficit was unsustainable, or 2)because trade deficits represented the “giving away” of the US to foreigners. I did not agree with either of those arguments. I am not worried at all about the “giving away” argument for a bunch of reason that are probably obvious to most of my readers.

As for the other claim, given the huge size, efficiency and flexibility of the country’s financial system (and no, the current crisis does not change my view at all), I never doubted the ability of the US to receive net capital inflows for very long periods of time. Furthermore I believe that given the terrible demographics that Europe, China and Japan face (not to mention Russia) and the relatively benign US demographics, it makes sense for all of these countries to run up claims now against the US – which they can only do by running trade surpluses with the US – since they will need to liquidate those claims over many decades (and so run trade deficits against the US) to pay for their demographic adjustment. Surprisingly whenever I say this there is always some one who howls (for some reason this is a subject on which polite disagreement is difficult) that the US faces its own demographic crisis and if I don’t believe this why don’t I offer to guarantee the payments needed to resolve the upcoming pension crisis.

Aside from the fact that my guarantee would not be credible, the point is largely irrelevant. The fact that the actuarial assumptions underlying the US pension system turned out to be wrong does not indicate a demographic crisis like that facing Europe, Japan and China, who also have their own pension crises in addition to their aging problems. Unlike the US, these countries are facing a sharp drop in the size of the working population relative to the total population which, as I see it, creates a demographic bias to trade deficit (I think of total population as a proxy for consumption and working population as a proxy for production). This is not nearly as serious a problem in the US, and in the US would likely anyway simply lead to a relaxation of immigration restrictions. The US has a very different sort of demographic problem – one that represents intergenerational transfers, and these have almost no bearing on the global balance of payments.

What was unsustainable about the current global balance, in my opinion, was not the fact of a US trade deficit (although by 2006 and 2007 it had gotten too high to last very long), but rather the level of household borrowing needed to sustain it. These are not unrelated things, of course, but I would argue that if the US trade deficit had been funded by equity inflows that resulted in an increase in domestic investment, there would not be a trade-sustainability problem. If it was funded by a household borrowing binge, then trade-deficit sustainability is necessarily constrained by the household balance sheets. This is why I have argued that a program of massive fiscal spending to replace household demand is not going to solve the current problem. It simply replaces one kind of unsustainable behavior with another, and still has to be resolved at some point with massive deleveraging.

To get back to China and current issues, the problem with the US trade deficit now is sort of a “Keynesian” problem. US demand has the impact of generating both US production (and employment) as well as foreign production (and employment), and in a world of contracting demand, it is natural that countries that export demand – i.e. trade deficit countries – are going to be a lot less eager to do so. Anything that brings imports closer into balance with exports is likely to have a demand-enhancing impact similar to fiscal expansion, with the benefit that this isn’t achieved by running up fiscal debt. On the other hand it will have a demand-reducing impact for trade surplus countries. That is why trade disputes are likely to be very attractive to trade deficit countries who have – I will continue to insist but it seems recently that this has become a much less “surprising” claim – the upper hand in any dispute with the “virtuous” countries with high savings rates and trade surpluses.

There is a lot of other recent news that I wanted to discuss, especially about reserve accumulation and the banking system – the recent closing of a bunch of informal banks, for example – but this post is long enough and I will postpone the discussion for later this week.

About Michael Pettis 166 Articles

Affiliation: Peking University

Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups.

Visit: China Financial Markets

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