Saturday, December 31, 2011

The U.S. Trade Deficit: Why It Matters … and Potential Solutions

Several years ago I wrote about three fundamental problems which posed significant long-term challenges for the United States, in terms of overall U.S. economic growth and the standard of living of its citizens. These challenges were:

· (1) Huge U.S. federal trade deficit … in effect transferring a good portion of our wealth overseas;

  (2) The annual budget deficits and the federal debt, in effect leveraging the future of our children and grandchildren in order to benefit us today; and 

  (3) The decline of the U.S. personal savings rate – with its serious

In this blog post I provide an update on the first of these challenges – the U.S. trade deficit – and suggest some potential solutions.

What is the U.S. Trade Deficit?

At $550 billion the projected U.S. trade deficit for 2011 remains an alarming number, and it is running about 10% higher than the 2010 U.S. trade deficit. The U.S. trade deficit is a calculation of the difference between the goods and services Americans sell to foreigners and the goods and services that Americans purchase from foreigners. Over the last 30 years the United States has run consistent and increasing trade deficits.

Why Does the U.S. Trade Deficit Matter?

Some economists like to recite evidence that several decades of U.S. trade deficits has not, according to the evidence, negatively impacted U.S. growth. But truths emerge when confronting the issue with a dose of basic common sense. Indeed, the enormous size of the trade deficits over the last several decades, and the very high size of the trade deficit over the past several years in particular, raises several crucial difficulties for the long-term health of the U.S. economy.

(1) First and foremost, the net outflow of U.S. dollars to purchase imports (net of exports) are offset each year by a net inflow of foreign capital to purchase U.S. assets. Sounds like balance? Not so. In essence, foreigners are purchasing our assets – whether it be debt issued by U.S. corporations or the federal government, stock in our corporations, and even real estate. With each purchase of an asset comes an expectation of profits. In other words, the greater the purchase of our assets, the greater the profits from U.S. assets flows overseas. This in turn boosts, over time, the U.S. current account deficit (the trade deficit plus the income earned by foreigners on their asset holdings in the country net of what the country's citizens earn on the assets they have invested abroad). In essence, any country that runs a current account deficit is borrowing money from the rest of the world. As with any loan, that money will need to be paid back at some point in the future … and until repaid will act as a drain from the debtor nation (i.e., the United States).

(2) A large trade deficit is a sign of an unbalanced economy. In the case of the United States, there is a mismatch with high levels of consumer demand for goods (discussed below) and the weak U.S. industrial sector.

(3) The large trade deficit eventually results in less economic output and less U.S. employment. This is because the transfer of wealth abroad represents a net leakage from the circular flow of income and spending. Workers who lose their jobs in export industries, or whose jobs are lost because of a rise in import penetration, often find it difficult to find new employment – especially at the wage levels they previously had.

(4) Additional potential economic problems can arise from the sources of financing for the U.S. current account deficit. Foreign investors may eventually take fright, lose confidence and take their money out. Or, they may require higher interest rates to persuade them to keep investing in an economy. Higher interest rates then have the effect of depressing domestic consumption and investment.

(5) There exists the possibility of a severe international economic crisis should foreigners begin to dump the dollars they hold in world currency markets. Not to mention the world political crises which might thereafter follow.

How Can the U.S. Trade Deficit Be Solved?

There are three potential broad solutions to the U.S. trade deficit. Neither works alone, and all must co-exist to solve this systemic economic threat to the long-term fiscal health of the nation.

Solution #1: Reduce Oil Imports Through Aggressive National Tax Policies.

First, we can reduce oil imports. In this regard, look no further for a fix to 70% of the trade deficit problem than imports of oil and petroleum products. The hope is that, with very encouraging developments in renewable energy technologies, we can substantially reduce oil imports over the next few decades.

For example, a substantial number of wind turbines continue to be erected. As wind turbines grow even larger, and equipment is developed to erect these larger turbines in places where nearby residents are not negatively affected (i.e., offshore and out-of-sight), efficiencies will take place which will further reduce the already-competitive price of wind energy. According to the latest edition of the U.S. Department of Energy’s “Wind Technologies Market Report,” turbine prices decreased by as much as 33 percent or more between late 2008 and 2010. More efficient U.S.-based manufacturing is saving on transportation costs, and technology improvements are making turbines better and more efficient. The U.S. Departments of Energy and Interior made several important announcements that moved offshore American wind power forward, including the unveiling of a plan to pursue the deployment of 10 gigawatts (GW) of offshore wind capacity by 2020 and 54 GW by 2030, the creation of high-priority “Wind Energy Areas” off the coasts of New Jersey, Delaware, Maryland, and Virginia. However, wind energy development remains dependent upon the federal Production Tax Credit (PTC), which expires at the end of 2012. A long-term extension of the PTC is required to stimulate investments in long-term, sustainable and more efficient wind farms.

In terms of technology development and reduced costs, solar energy has been the real story of 2011. Rapidly falling solar panel prices over the past two years (including a 30% price drop in 2011), along with predictions of further falling prices in the two years ahead, have the U.S. on course for some form of “grid parity” with solar energy.

Solar grid parity is considered the tipping point for solar power, when installing solar power will cost less than buying electricity from the grid. But, of course, “grid parity” is more complex than just a single measure, as differences exist depending upon the size of the solar installation, its location, and the costs of electricity. Also, the costs of existing electrical resources – already constructed and depreciated coal, gas or nuclear power plants that produce electricity for 3-4 cents per kilowatt hour – is vastly different from the costs of new power plants. The marginal cost for a utility of getting wholesale power from a new power plant is more likely around 10-12 cents per kilowatt hour (for coal, gas or nuclear energy installations).

Still, it is interesting to note that there are claims that “grid parity” has been reached already in some areas of the country where residential electric prices are high and solar energy is abundant. Indeed, the “levelized” cost of solar PV was projected to likely fall below 15 cents per kilowatt hour for most of the developed countries of the world and reach as low as 10 cents per kilowatt hour in sunnier regions like parts of southern California and Arizona (although by other measures the costs of most areas is more like 30 cents per kilowatt, and 21 cents for southern California). While there are debates about just how to properly compute the “levelized” cost of energy production, one thing is certain - there has been an explosion of solar energy installations over the past few years, especially in providing powers to residential users.

Significant financing occurred for new solar initiatives in the 4th Quarter of 2011, and this emerging industry (and driver of new jobs, many of them in the U.S.) will likely continue to attract large amounts of capital. And with significant developments which will likely further increase efficiency in solar photovoltaic cells over the next few years and/or substantially reduce manufacturing and installation costs, the outlook for solar power over the foreseeable future is … to use a pun … very “sunny.”

Battery technology is evolving, as well. New technological breakthroughs are permitting large utility-scale battery development (essential since solar power and wind power don’t provide energy all the time). There have been several research-related breakthroughs which could significantly increase energy density in auto and other batteries; however, commercial application of most of these recent research lab results is not yet certain.

In addition to current (though soon-to-expire) federal tax initiatives, many states have state tax incentives or impose other requirements which stimulate the use of renewable power. For example, many states have Renewable Portfolio Standards (RPS), which require electricity providers to generate or acquire a percentage of generation from renewable sources. Other states provide for Renewable Energy Certificates/Credits (RECs) as part of their Renewable Portfolio Standards. California, with its 40 million people, has through its Air Resources Board recently announced an ambitious goal of moving toward zero-emission vehicles within the next two decades. Energy executives, responsible for long-term planning of their utility companies’ fortunes, are also painfully aware that carbon credits – while stalled for the present – are likely within a decade. Hence, utilities are increasingly likely, from the standpoint of economic costs, to consider the development of large-scale renewable energy plants.

Energy conservation has also made waves, with the costs of LED lighting falling dramatically over the past two years, and with more price drops ahead. Federal fuel efficiency requirements for cars are expected to double by 2025 to a whopping 54 miles per gallon. Currently the average car or light truck sold in the U.S. averages 22 miles a gallon, and some estimate that the new fuel mileage standards will drive that average above 40 miles a gallon by 2025. Despite these positive developments, much more could be done in the area of energy conservation – by both consumers and by businesses.

Even with all of the foregoing “good news” on renewable energy technologies and energy conservation developments, oil imports are unlikely to substantially drop under current U.S. tax policy. Some savings in oil consumption will result from hybrid and electric cars, and natural gas cars, and developments in the fuel efficiency of gas engines. Other savings will come from the deployment of renewable energy technologies. However, in reality the growth of the U.S. economy will absorb these savings and keep the demand for oil imports at high levels.

Yet much more can be done to reduce oil imports, if the politicians possess the tenacity to act for the long-term good of the country. It requires the phase-in of taxes on gasoline purchases, year-over-year, and the corresponding use that tax revenue to provide for long-term tax credits in support of renewable energy deployment and in the continued support of research in the renewable energy area. Only then will we likely make a serious dent into the huge long-term fiscal problems posed by exporting hundreds of billions of beautiful U.S. greenbacks a year overseas in return for barrels of ugly crude oil.

Hence, this first solution relies not just on the important developments affecting the efficiency and deployment of renewable energy technologies, but also is dependent upon our leaders making some tough decisions which will, in the shorter term, be painful – but which will help reduce our demand for oil, and trade deficits, substantially in the decades ahead.

Solution #2: Increase the Personal Savings Rate, Reduce Personal Spending, and Cut Imports of Consumer Goods.

While decreasing imports for oil is a major part of the solution, we must also reduce our demand for consumer goods manufactured abroad in order to further reduce our trade deficit. In so doing, we can also increase the U.S. personal savings rate (thereby maintaining cash available for capital formation activities – essential to growth of the U.S. economy).

Of course, saying this and doing it are two different matters, altogether. Much more is needed from our leaders to combat “consumerism.” Not in terms of legislation, but in terms of education and persuasion.

There are lots of resources on the web on how to combat consumerism. Here are just a few to consider:
Solution #3: Promote a Weak U.S. Dollar Policy.

This solution is more controversial. In essence we possess a weak dollar policy currently, but the reason for this policy is to keep interest rates low in order to stimulate the economy and promote the creation of jobs. As the U.S. and global economies improve, central banks will likely raise interest rates. With each interest rate rise in the U.S., the U.S. dollar becomes more attractive to foreign investors. This in turn affects currency exchange rates.

But what if the U.S. Federal Reserve Bank did not raise interest rates as much over the next several years, by continuing its weak dollar policy (relative to that of other countries)? This would make the U.S. dollar less attractive, thereby weakening the U.S. dollar. This in turn would boost U.S. exports and (because of resulting price increases) likely decrease imports.

Of course, weak dollar policies don’t come “free.” The price to pay is the prospect of higher inflation. Hence, there is a difficult balancing act here. But one may argue that permitting a higher degree of inflation in the U.S. – above the 2% or so assumed target of the Federal Reserve – would also lead to serious economic difficulties over the long term.

What NOT To Do – Adopt Protectionist Policies.

The solution is not, however, the erection of barriers to trade. However, I’m all for aggressively enforcing treaties on trade, and seeking sanctions against countries who violate these treaties. And I’m all for increased pressure on China to float its currency. But raising tariffs or imposing other barriers to trade lead to far more long-term negative economic (and political) consequences than the problems sought to be addressed.

In Conclusion

Trade deficits are solvable – with the right adoption of policies and education of the American consumer. It will take a concerted effort, but this threat to the future of U.S. economic growth can be averted.

Investor Warren Buffett was quoted in the Associated Press (January 20, 2006) as saying: “The U.S trade deficit is a bigger threat to the domestic economy than either the federal budget deficit or consumer debt and could lead to political turmoil ... Right now, the rest of the world owns $3 trillion more of us than we own of them.” I concur with the wise sage of Omaha as to the severity of this threat. We must address it … not “next year” – but through policies adopted now.

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