The Trade Deficit

| Wed Dec. 3, 2008 3:20 PM EST

THE TRADE DEFICIT....Conventional wisdom says we need to run a big federal deficit in order to stimulate our way out of the current recession. Fine. But if we stimulate demand, that means we're going to be buying ever more stuff from overseas, which in turn means that our trade deficit will continue to remain large and growing, financed by the willingness of China and other trade surplus nations to stockpile U.S. treasury bills in return for shipping their stuff to us. Martin Wolf isn't impressed:

This is not a durable solution to the challenge of sustaining global demand. Sooner or later — sooner in the case of the UK, later in the case of the US — willingness to absorb government paper and the liabilities of central banks will reach a limit. At that point crisis will come. To avoid that dire outcome the private sector of these economies must be able and willing to borrow; or the economy must be rebalanced, with stronger external balances as the counterpart of smaller domestic deficits. Given the overhang of private debt, the first outcome looks not so much unlikely as lethal. So it must be the latter.

....In short, if the world economy is to get through this crisis in reasonable shape, creditworthy surplus countries [i.e., countries like China –ed] must expand domestic demand relative to potential output. How they achieve this outcome is up to them. But only in this way can the deficit countries realistically hope to avoid spending themselves into bankruptcy.

Some argue that an attempt by countries with external deficits [i.e., countries like the United States –ed] to promote export-led growth, via exchange-rate depreciation, is a beggar-my-neighbour policy. This is the reverse of the truth. It is a policy aimed at returning to balance. The beggar-my-neighbour policy is for countries with huge external surpluses to allow a collapse in domestic demand.

I don't know what the answer to this is. U.S. consumption of goods and services is about 5% higher than U.S. production, and this can't keep up forever. Eventually our consumption has to go down and China's has to go up.

But not yet. Because we're in the middle of a financial panic and we need to keep domestic consumption high in order to keep from collapsing. And this isn't hard to do, because in one of the great ironies of a crisis that was brought on by the United States, nervous investors worldwide now believe that U.S. treasuries are the safest place to park their money in a troubled world. So for the time being, there are lots of buyers for treasuries, yields are nearly zero, and we're having no trouble at all financing a big federal deficit.

This won't last forever, of course. Panic will subside soon enough, the treasury bubble will burst, and foreign investors are going to start demanding higher returns. The dollar will have to depreciate, America will have to produce more and consume less, and the domestic economy will trundle along dismally for years until we manage to rebalance things.

Economists have been warning about this for years, of course. But over time, as nothing bad ever came of it, their warnings began to sound like crankery. After all, plenty of them warned us about the housing bubble for years too, and for the most part we didn't listen to them. In a few years, though, when the trade deficit bubble finally goes pear shaped, we're going to be asking once again why no one saw it coming. Even though lots of people did.

Like I said, I don't know what to do about it. The trade deficit bubble helped finance the housing bubble, and now that the housing bubble has burst it's the worst possible time to think about bursting another bubble as well. Eventually, though, the rest of the world will do it for us. Expect a bumpy ride.