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e-Magazine (For the Japanese version of this article)

The Uncomfortable Truth about the Trade Deficit Risaburo Nezu Senior Research Advisor Research Institute of Economy, Trade and Industry [Date of Issue: 31/January/2019 No.0286-0287-1095]

Date of Issue: 31/January/2019

The Uncomfortable Truth about the Trade Deficit

Risaburo Nezu
Senior Research Advisor
Research Institute of Economy, Trade and Industry

President Trump claims that long-term failure to address the American trade deficit has allowed other countries to rob the US of trillions of dollars and millions of jobs. To stem this tide, he has flouted international rules in introducing a string of import restrictions, launching trade wars with not only China but long-time friends. Here we examine the veracity of the trade deficit argument.

President Trump genuinely believes that the trade deficit is the American economy's biggest problem. He has openly proclaimed that the massive trade surpluses that Japan, China and Germany have continued to run with the United States for many years—which of course represents a trade deficit for the United States—have robbed the country of trillions of dollars. While Trump's language is extreme, he isn't alone in his belief.

When I was involved in trade negotiations at Japan's Ministry of International Trade and Industry back in the 1980s, I was told by a member of the US Department of Commerce that one billion dollars' worth of imports equates to 25,000 lost jobs. It's an easy argument that is undoubtedly even true for certain industries and companies at certain times: cheap foreign commodities erode the competitiveness of domestic industry, causing businesses to collapse and unemployment to soar; ergo, blocking imports will boost domestic production and reduce unemployment. But how does this apparently logical argument hold up in the context of the economy as a whole?

Let's look at the data. The graph below tracks the US trade deficit, unemployment rate and GDP growth rate over the last 36 years. If the trade deficit does cause unemployment, when the trade deficit increases, the unemployment rate should rise. The trade deficit climbs in three periods: 1980-86, 1992-2006, and 2013 until recently.

Created by the author from IMF (April 2018), World Economic Outlook
The unemployment rate fell during the first period, again during the second period (the eight years from 1992 to 2000), and also in the third period. The only time that it has in fact risen alongside the trade deficit as suggested above is the brief period between 2000 and 2003.

For seven of the past 36 years—1985-89 and 2006-09—both the trade deficit and the unemployment rate fell. In other words, over the last 36 years, the trade deficit and the unemployment rate have only behaved in line with the above argument for 10 years, while in every other year, the trade deficit has either risen as the unemployment rate has fallen, or fallen while the unemployment rate has risen, which is quite the opposite of the assertion that a trade deficit creates unemployment.

Obviously, this is hardly a granular analysis, and excludes elements such as the time lag between trade deficit and unemployment trends, but from the data it would appear that not only is it erroneous to suggest that the trade deficit causes unemployment, but the opposite is in fact true. The relationship between the trade deficit and unemployment is actually more complex.

To facilitate understanding of that complexity, I have added the GDP rate of change to the graph. The GDP growth rate shows whether the economy as a whole is growing and expanding or receding and shrinking. Over periods when the GDP growth rate is high—in other words, when economic conditions are buoyant—the unemployment rate falls but the trade deficit burgeons. When the economy as a whole is in good shape, people have more money in their wallets and buy more, including both imported and domestically-produced goods, while companies invest more proactively. As a result, domestic firms record strong sales and employment also picks up, but at the same time, more goods are also imported, pushing out the trade deficit.

This is by no means a trend confined to America. Even from my own experience, when the US economy was buoyant, we saw a boom in Japanese exports of home appliances and cars, etc., intensifying trade friction but reducing Japan's unemployment rate. Conversely, when the American economy was in recession, the trade deficit would shrink and trade friction would ease, but Japan's unemployment rate would rise. Reducing unemployment therefore requires boosting the economy as a whole, not reducing imports.

This is no surprise to economists, given that they define the trade balance as the difference between supply and demand across the whole economy. If demand increases, domestic supply obviously grows, but there are limits to domestic supply capacity. If all workers are employed, production cannot grow any further. A capacity utilization rate cannot rise beyond 100 percent. As domestic production approaches its ceiling, there is no option but to rely on imports. That's why imports increase when economic conditions are good.

The major tax cuts introduced by President Trump have the US economy on a roll, but the trade deficit too has grown, reaching an historic high with China in particular. In other words, Trump's own policies are blowing out the deficit.

To what extent does limiting imports revitalize domestic production? Labor-intensive industries such as apparel, miscellaneous goods, toys and processed foods have almost vanished from the States anyway, so putting duties on these goods just pushes up the prices paid by American consumers, with employment unchanged. What about steel? I asked a Japanese steel company what would happen if imports were restricted, but apparently they already focus exclusively on high-end products that can't be manufactured in the United States, so they don't expect a massive drop in sales volume. However, steel products will inevitably become more expensive, and that burden will be transferred to user industries, most particularly the auto industry, to the obvious detriment of industry players—epitomizing, in fact, how higher duties disadvantage American industry.

The auto industry is right at the top of the list of those industries which Trump wants to protect. Raising auto import duties by 25 percent would significantly impact sales of vehicles from Japan and Germany, etc., particularly in the case of luxury models. It would also disadvantage American consumers in the form of higher prices and fewer choices. However, over the long term, some companies would probably transfer production facilities to the United States, so employment in the auto industry could potentially increase.

No doubt that's what Trump is hoping, but Japanese car manufacturers other than Toyota, Nissan and Honda are small-scale operations and would struggle to invest in the US. They would have no choice but to raise their prices in the US to compensate for the higher duties, or else shrink their profits. The greater tariff revenue would doubtless benefit the US government to some extent, but there is little to distinguish it from a consumption tax hike, Trump's pet hate.

The bottom line is that the US trade deficit represents only around three percent of the whole economy, so a slight upward trend is going to have limited economic impact. Clearly, with the exception of a few specific industries, it's incorrect to blame imports for unemployment. Particularly with the service industry accounting for 80 percent of US employment, the ratio of both imports and exports is low, so restricting imports is hardly going to boost employment.

President Trump will probably work all this out for himself one day soon, but as he's not inclined to admit to his mistakes, he may well stick to his current course regardless, so we should be ready for this misguided policy line to continue for the meantime. It will be the American public that shoulders most of the cost.

(For the Japanese version of this article)

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