Trade Deficit Gets Even Worse

Dirk van Dijk, CFA, On Tuesday July 13, 2010, 12:33 pm EDT

In May, the trade deficit expanded to $42.27 billion from $40.32 billion in April. Relative to a year ago, the trade deficit is up 70.0%, but May of a year ago marked the low point in the trade deficit after world trade collapsed following the 2008 financial meltdown. The May trade deficit was also significantly worse than the $39.5 billion that was expected.

If there is a silver lining in these numbers it is that it went up for the “right reason — both imports and exports are expanding. That means that world trade is growing, and that is generally a good sign for world economic growth.

For the month, our exports rose by 2.37% to $152.25 billion, and are up 21.0% from a year ago. On the other hand, our imports rose by 2.90% to $194.52 billion on the month and are up 29.1% (on a larger base) from a year ago. Thus we are well on our way towards President Obama’s objective of doubling out exports over the next five years. If the year over year pace could be maintained, we would reach the goal In less than four years.

But so what? If our imports also double over the next five years, the trade deficit will rise, not fall. The first graph below (from http://www.calculatedriskblog.com/) shows the path of imports and exports since the mid-1990’s.

While I would rather see both imports and exports rising than falling, what is most important is getting the trade deficit under control. It should be noted that the trade deficit is still not as bad as it was two years ago, when it was at $61.18 billion — and that was not an aberrant number.

The collapse in world trade that followed the financial meltdown caused a massive shrinkage in the trade deficit, and the shrinkage of the trade deficit was just about the only thing that was holding the economy together then. For example, if not for the fall in the trade deficit in the first quarter of 2009, GDP would have fallen by 9.0% instead of by “just 6.4%.

Goods Side Not So Good

The problem is entirely on the goods side of the equation; we regularly run a surplus in services. In May, the goods deficit was $54.46 billion, up from $52.54 billion in April and $35.90 billion a year ago. On the service side, our surplus fell slightly to $12.19 billion from $12.22 billion in April, but up from $11.4 billion a year ago.

Both imports and exports of goods rose, with exports up 2.84% on the month, and up 26.5% year over year. On the other hand, imports rose 3.11% for the month and are up 34.0% from a year ago. Put another way, for each dollar of goods (grain, airplanes, etc.) we sell abroad, we are buying $1.51 worth of goods (oil, clothing, toys, etc.) from overseas. That is up from $1.42 a year ago, when we simply had stopped buying anything from anybody, but down from the $1.65 level of two years ago, before it all hit the fan.

Our Thirst for Oil

Within the goods deficit, the chronic problem is our thirst for oil, although it was not the culprit in this month’s increase. The oil deficit fell to $21.46 billion in May as oil prices softened from $24.07 billion in April, but up from $13.56 billion a year ago. The increase from a year ago is mostly due to a higher price for oil.

Still, oil was responsible for 50.76% of the overall trade deficit (and 39.4% of the goods deficit) in May. While that is an improvement from the 59.7% of the total trade deficit last month (and 54.5% a year ago), it remains by far the single biggest reason we run chronic trade deficits.  The second graph (also from http://www.calculatedriskblog.com/), breaks down the trade deficit into its oil and non-oil parts.

It is clear to me that until we manage to shift away from oil as our primary transportation fuel, we are never really going to be able to solve the trade deficit problem. If we never solve the trade deficit problem, the country will go bankrupt. Cheap oil prices like we had in the late 1990’s can help ameliorate the problem in the short term, but in the long term are really destructive as they encourage more and more wasteful use of oil.

We have been facing the same basic oil problem now since Nixon was in the White House and have yet to get serious about dealing with the issue. Yes, we have tinkered around the edges, with some administrations doing a bit more productive tinkering (Carter, Obama) and other administrations paying lip service to energy conservation but actively pursuing a cheap-energy-and-use-more policy (Reagan, Bush II).

We simply do not have the reserves to be able to drill our way out of our need to import oil. We have only 2.1% of the world’s reserves, but account for 8.5% of the world’s oil production and a staggering 21.7% of the world’s consumption (data from the most recent BP statistical Review of World energy). Even before we ran into problems in the Gulf, it is clear that the problem ultimately is in the amount of oil we consume. So much for “Drill, Baby, Drill. Domestic production may be somewhat helpful, but is it going to solve the problem? No way.

Command & Control vs. Cap & Trade

To really get serious about reducing our consumption of oil would require one of two things. The first option would be strict command and control, as in rationing of oil. Other command and control procedures would be mandating new building codes and higher mileage standards for cars and trucks. That is not a path that makes a lot of sense — it is horribly inefficient, and opens up major avenues for corruption and political favoritism, particularly if one gets down to the level of rationing.

The other approach is to put a price on carbon, though either a direct carbon tax or a cap-and-trade system. To the extent a cap-and-trade system is 100% auction-based to get the permits to emit carbon, it is the economic equivalent of a carbon tax. To the extent that some parts of the economy are protected and given carbon credits for free, it is like the income tax system: loaded with loopholes, credits and deductions.

The first cap-and-trade system was put in place by the first President Bush to deal with sulfur dioxide emissions that were the key source of acid rain. It worked spectacularly well, and today acid rain is not considered a serious problem in this country (it is still a very big problem in places like China and India). It also cost FAR less than was anticipated when the program was put in place.

The key was that it put a price on the emission of sulfur. That gave an incentive to the market to do its magic. Companies instantly attacked the low-hanging fruit, and sulfur emissions plummeted.

The same thing would happen with carbon emissions if we put a price on them. Oil and coal are the biggest sources by far of carbon emissions. Natural gas, of which we have abundant domestic supplies (abundant, but not infinite or inexhaustible) produces far less carbon per BTU.

Most importantly, we have a lot of it here and it does not need to be imported. To the extent we import it, we do so from Canada, whose economy is tightly linked to ours through NAFTA. Making a major effort to shift to natural gas as a transportation fuel would be a big step in resolving the trade deficit problem.

Putting a price on carbon, or a tax on oil consumption, would encourage people to cut back on their consumption of oil. Auto companies would compete more on fuel efficiency and less on power and towing capability. They would do so because that is what customers would be interested in.

The main problem is that a tax on oil or on carbon would be somewhat regressive. The poor tend to spend a higher percentage of their income on gasoline and on electricity than do the rich. The money raised through a carbon tax (or the auctioning off of permits under a cap-and-trade system) would have to be rebated back into the economy through other tax cuts.

A weak economy is not the time to be dramatically cutting the fiscal deficit, which is what a carbon tax would do if not offset. Ideally, the revenues raised would go towards cutting other taxes that most hinder job creation, and are very regressive. Payroll taxes are just that: extremely regressive (start paying on the first dollar of income, and when you get to about $100,000 of income for the year, the Social Security taxes stop) and a hindrance to job creation (employers are directly taxed every time they say “welcome aboard to a new employee).

What Drove the Trade Deficit Increase This Time?

What really drove the increase in the trade deficit this month was the non-oil goods side. That deficit rose to $32.31 billion from $27.78 billion in April and $22.38 billion a year ago, increases of 16.3% and 44.4%, respectively. The rise is most likely related to the strength of the dollar in recent months as a result of the crisis in Europe. This is the principal transmission mechanism for the trouble on that side of the pond to affect the U.S. economy.

The trade deficit really is a much bigger problem than is the fiscal deficit. It is the trade deficit that is responsible for our being deep in debt to the rest of the world, not the budget deficit. That is something that cannot be argued, it is simply an accounting identity.

For every dollar of goods and services we buy that is more than the amount of goods and services we sell abroad each month, we have to either be selling off assets or going into debt by that amount, dollar for dollar. This month, we effectively sold off Kraft Foods (NYSE: KFTNews); if the deficit is the same size next month, we will effectively sell off Bristol Myers (NYSE: BMYNews). How much longer before we don’t have anything left? Actually it is mostly T-bills and notes that are being sold abroad, but the key point is that it is the trade deficit, not the budget deficit, that drives how far we are in hock to the rest of the world.

Think about it this way: during WWII, our budget deficits were far larger as a percentage of GDP than what we are running right now. If it were budget deficits that drove us to be in hock to the rest of the world, we would have owed just about everything to the rest of the world at the end of the war. That was not the case; we emerged from the end of the war as by far the world’s biggest creditor, not the worlds largest debtor — like we are now.

Inflation or Deflation?

The strength of the dollar in recent months is not a good thing. We need for the dollar to slowly fall in value relative to other major currencies. Yes, that would result in higher inflation, but right now, more inflation would be a good thing — the economy is on the edge of deflation. Deflation would raise real interest rates and make it impossible for many debtors to be able to repay their loans, leading many of them to default. Deflations lead to depressions, and need to be avoided at all costs.

The problem is that every country in the world wants to be a net exporter. Unfortunately, unless new trade routes are opened to Mars, that can’t happen. For too long, the U.S. consumer has been the buyer of last resort, sucking up the excess production of the rest of the world.

We have benefited from lower prices for most tradable goods. All the stuff that stocks the shelves of Wal-Mart (NYSE: WMTNews) and Target (NYSE: TGTNews) would have been much more expensive, and the Wal-Mart shoppers worse off if it were not for cheap imports from abroad. However, it has also meant fewer jobs, most notably in manufacturing in this country. It has been a party that the country has been putting on the credit card. I’m not sure exactly where the limit is on the card, but I think we must be getting close to it.

Trade Deficit – In Summation

Owing trillions of dollars to China is a very different thing than owing trillions to domestic investors and pension funds. Getting serious about reducing our consumption of oil would be a good place to start bringing down the trade deficit, and a lower dollar would also be very helpful.

The trade deficit is like a cancer on the economy. We don’t feel it acutely at any given time, but slowly but surely it is going to kill the economy. Not just put it into a recession for a few quarters (although each dollar increase in the trade deficit translates to a dollar decline in GDP) but a real tangible and permanent decline in the standard of living for the country.

The trade deficit is a far bigger problem than the budget deficit. Right now a budget deficit is needed to fill a huge gap in aggregate demand as the consumer is trying to deleverage and repair his balance sheet. There is no such temporary need for a trade deficit — it is simply harmful to the economy, both short-term and long-term.

The chronic trade surplus countries — most notably China, Japan and Germany — need to take steps to increase their domestic consumption. Their currencies need to rise in value so their consumers will buy more from the rest of the world, and the U.S. — which is by far the biggest deficit country — will buy less from them. A stronger Euro though would make the problems faced by the Southern European countries that much worse.

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: