U.S. Trade Gap Widens on Oil Imports – WSJ.com

Terms of trade is a term that is often misunderstood by IB Economics students. Simply put, a nation’s terms of trade refers to the relative price of a country’s exports to its imports.

When a country’s imports increase in price, while the value of its exports stays the same, the country’s terms of trade are said to deteriorate. As a nation experiences deteriorating terms of trade, it finds itself moving towards a deficit in its current account, meaning that expenditures on imports are growing more than income from exports, also called a trade deficit.

The United States has run trade deficits for most years since 1970. Since 2004 the US has annually spent over $600 billion MORE on imports than it earned from the sale of its exports. (Balance of trade data going back to 1960 can be found here).

Usually, when a country enters a recession, it would be expected that its balance of trade would improve, since households demand fewer imports and domestic inflation decreases making the country’s products more attractive to foreign households. In fact, in 2008, when the US entered its current recession, its trade deficit actually decreased. Recently, however, due to the weakness of many of its trading partners and a deterioration in terms of trade, America’s recession is accompanied by a deepening trade deficit:

The U.S. trade deficit widened for the first time in eight months during March, as the price and use of imported oil both climbed.

The U.S. deficit in international trade of goods and services increased to $27.58 billion from February’s revised $26.13 billion, the Commerce Department said Tuesday. Originally, the February deficit was estimated at $25.97 billion.

U.S. exports in March slipped by 2.4% to $123.62 billion from $126.63 billion as trading partners bought less consumer goods and cars from the U.S. U.S. imports fell at a lower rate, dropping 1.0% to $151.20 billion from February’s $152.76 billion

Discussion Questions:

1. How did rising oil prices lead to an increase in America’s trade deficit?
2. What determines demand for American exports in the rest of the world? Why is demand for American goods and services falling even as their prices decline due to deflation in the US?
3. Where does America get the money to buy hundreds of dollars more in imports than it sells in exports? What do foreigners do with all the US dollars they earn from their enormous trade surplus with the US?
4. Why doesn’t the US government simply place tariffs or quotas on imports to try and achieve more balanced trade with the rest of the world? Is this an appropriate response to a trade deficit?

One of the greatest “ah-ha” moments in all of economics is when an economics’ student or citizen learns for the first time that every time a domestic buyer purchases a foreign product or import that those same U.S. dollars spent on the foreign product go to a U.S.-based company, not a foreign company. Yes, I am telling you that when you (or Wal-Mart) buy Chinese shirts, your same U.S. dollars spent quickly end up in the hands of, say, Apple, Microsoft, Garmin, or General Electric to increase U.S. employment, profits, and U.S. stock prices!

I decided to write this particular blog because of the fact that the recently passed $800 Billion U.S. stimulus bill has some “buy American” provisions within it. Based on an intuitive hunch, I believe that over 99% of adult Americans believe that these “protectionist” clauses somehow help our economy. Yes, the vast majority of U.S. adults believe that it is clearly more advantageous to “buy American” in order to keep the money or wealth within America in order to increase U.S. employment, profits, and U.S. stock prices. In true economic fact, however, if U.S. citizens “buy American” solely out of patriotism (and not because they think it is a superior product) they actually HURT America because the U.S. dollars spent out of patriotism on that American company are, therefore, unintentionally withheld from another more efficient and deserving American country via the “trade loop”.

Let me try to explain this “trade loop” in more detail so that I may actually be able to convince you of this amazing “180 degree” revelation: “Buy American” is Un-American

Let’s say that the United States (we’ll say Wal-Mart) decides to buy many shirts costing $400 from a Chinese shirt manufacturer, in lieu of buying those same shirts from, say, a shirt manufacturer in Elon, North Carolina (USA). The first key point is that when Wal-Mart buys the shirts from China for $400 it can only pay China with US dollars. Why? Because Wal-Mart has only US dollars! It has no Chinese currency (Yuan). It literally drains its bank account of US dollars that are transferred/paid to China! The second key point is that when China receives that same $400 US dollars for the shirts, China cannot, unfortunately, spend any of the $400 in its own economy since only the Yuan is accepted as a medium of exchange in China! China is now forced to either throw the U.S. currency away (not advised!), or immediately spend the money back to the USA (advised!).

In summary, China has initially traded a product (shirts!) for paper (US dollars!), and those US dollars cannot be spent in China. For China to receive any value at all for the shirts it sent to America, China must now spend the $400 back into the US economy for, say, a global positioning system (GPS) from FleetMatics out of Waverly, Massachusetts (USA). Cutting through to simplicity, in essence, it’s almost as if Wal-Mart (USA) just paid FleetMatics (USA) $400 directly!

Yes, the economic “punch line” is that all spending by the domestic nation on foreign products (imports), in turn, are spent immediately back to the domestic nation increasing the domestic nation’s employment, income, and standard of living. (Note; this is also shown and reported in a nation’s balance of payments schedule if you are skeptical about what you are reading!)

And, yes, let’s not forget about that Elon, North Carolina shirt maker that did not get the original $400 from Wal-Mart in our above example! Any good economy promotes competition and I am excited to see if that North Carolina shirt manufacturer can “raise their game” (increase productivity and/or quality), and hopefully get the next shirt contract from Wal-Mart! If not, well, that North Carolina firm may just have to close down. But remember, the key point, the $400 spent for the shirts went to Fleetmatics in Waverly, Massachusetts, in lieu of the Elon, North Carolina shirt manufacturer. If you would have “bought American” even though the Chinese shirts were preferable, you would have prevented the more effective U.S. business in Waverly from getting your U.S. dollars by giving them to the less efficient Elon manufacturer. In short, you would have contributed to American inefficiency and slowing productivity, hurting our country! And that is un-American!

Now, you may be thinking the following if you have a little economics’ background: “But the US has a growing trade deficit with China, so China may not immediately buy that GPS system from FleetMatics for $400. And, you are correct, but that is also not a problem for either the United States or China. What China is really doing right now is deciding to temporarily save or invest a minority percentage of their US dollars received form U.S. import purchases. Said another way, China is not buying as many GPS’ as the US is buying shirts and, of course, we call that phenomenon the US trade deficit which immediately seems to speak “problem”. But it is really not as big a problem as most people think! China is still spending their “saved” US dollars back into the US economy, but in different ways. China is saving and investing some of those US dollars directly into the United States economy by building plants in America, buying US stock to fund American companies’ expansions, and temporarily saving some of their dollars, for future US purchases, by buying US bonds to help the US government pay for other US government initiatives necessitating borrowing. Eventually, China will sell these US bonds and be forced to use those U.S. dollars to buy that GPS system or build more plants to employ more Americans!

In summary, when citizens of any country in the world buy the product that is best for them based on a combination of quality and price, they will be taking the most patriotic action possible to help their own country they love so much! If a domestic citizen sees the foreign product as a better alternative to the domestic product, buy it! Your money spent will immediately find its way back through the “trade loop” to another business within your country!

Of course, this is why all economists from around the world know that international trade, and not protectionism, helps a country’s standard of living and promotes efficiency and rising standard of livings!

The $1.4 Trillion Question – James Fallows – the Atlantic

What’s the deal with American consumers? How, exactly, does a nation’s average savings rate fall to 2%, then 1%, and then become negative, like in the US over the last couple of years? What does negative savings actually mean? It means that Americans consumer more than they actually produce.

On the micro level, the only way to consume beyond ones income is to borrow from someone else to pay for the additional consumption. In other words, savings must be negative for one to consume beyond his or her income. The US is a nation of borrowers, but from whom do we borrow? China, for one…

China is a nation of “savers”, where national savings averages 50% of income. What exactly does this mean? Well, just the opposite what negative savings means; rather than consuming more than it produces, the Chinese consume only about half of what it produces. Here’s how James Fallows, a Shanghai-based journalist, explains the China/US dilemma:

Any economist will say that Americans have been living better than they should—which is by definition the case when a nation’s total consumption is greater than its total production, as America’s now is. Economists will also point out that, despite the glitter of China’s big cities and the rise of its billionaire class, China’s people have been living far worse than they could. That’s what it means when a nation consumes only half of what it produces, as China does.

What happens to the rest of China’s output? Naturally, it’s shipped overseas for Americans and others in the West to consume. The irony is that the consumption of China’s products has been kept affordable and cheap thanks to the actions the Chinese government has taken to suppress the value of the RMB, thus keeping its products cheap and attractive to American consumers.

When the dollar is strong, the following (good) things happen: the price of food, fuel, imports, manufactured goods, and just about everything else (vacations in Europe!) goes down. The value of the stock market, real estate, and just about all other American assets goes up. Interest rates go down—for mortgage loans, credit-card debt, and commercial borrowing. Tax rates can be lower, since foreign lenders hold down the cost of financing the national debt. The only problem is that American-made goods become more expensive for foreigners, so the country’s exports are hurt.

When the dollar is weak, the following (bad) things happen: the price of food, fuel, imports, and so on (no more vacations in Europe) goes up. The value of the stock market, real estate, and just about all other American assets goes down. Interest rates are higher. Tax rates can be higher, to cover the increased cost of financing the national debt. The only benefit is that American-made goods become cheaper for foreigners, which helps create new jobs and can raise the value of export-oriented American firms (winemakers in California, producers of medical devices in New England).

Clearly, a strong dollar is good for America in many ways. The dollar’s strength in the last decade can be credited partially to the Chinese, who have been buying dollar denominated assets in record numbers over the last seven years.

By 1996, China amassed its first $100 billion in foreign assets, mainly held in U.S. dollars. (China considers these holdings a state secret, so all numbers come from analyses by outside experts.) By 2001, that sum doubled to about $200 billion… Since then, it has increased more than sixfold, by well over a trillion dollars, and China’s foreign reserves are now the largest in the world.

China’s purchase of American assets keeps demand for dollars on foreign exchange markets strong, thus the value of the dollar high relative to other currencies, allowing American firms and consumers the benefits of a strong dollars described above.

As we learn in AP Economics, a nation’s balance of payments consists of the current account, which measures the difference between a country’s expenditures on imports and its income from exports (China last year had a $232 billion current account surplus with the US, meaning the US bought more Chinese goods than China bought of American goods), and the capital account, which measures the difference between the inflows of foreign money for the purchase of real and financial assets at home and the outflows of currency for the purchase of foreign assets abroad. In the capital account, China maintains a deficit (meaning China holds more American financial and real assets than America does of China’s), to off-set its current account surplus.

The two accounts together, by definition, balance out… usually. Any deficit in the China’s capital account that does not cover the surplus in its current account can be held as foreign exchange reserves by the People’s Bank of China. The PBOC, however, prefers not to hold excess dollars in reserve, as the dollar’s value is continually eroded by inflation and depreciation; therefore it invests the hundreds of billions of excess dollars it receives from Americans’ purchase of Chinese goods back into the American economy, buying up American assets, with the aim of earning interest on these assets that exceed the inflation rates.

The “assets” the Chinese are using their large influx of dollars to buy are primarily US government bonds. The government issues these bonds to finance its budget deficits (when government spending is greater than tax revenue; this figure was projected at around $400 billion this year alone!), and the Chinese are happy to buy these bonds for a couple of reasons: They are secure investments, meaning that unless the US government collapses, the interest on US bonds is guaranteed income for China. That’s one reason; but the primary reason is that the purchase of these bonds puts US dollars that were originally spent by American consumers on Chinese imports right back into the hands of American consumers (via government spending or tax rebates), so they can continue buying more Chinese imports.

The Chinese demand for dollar denominated financial assets, including government bonds, corporate stocks and bonds, and real assets like real estate, factories, buildings and so on, has resulted in a long period of a strong dollar. If the Chinese ever decided to stem the flow of dollars into American assets, the dollar’s value would plummet to record lows, leading to high inflation and eventually a balancing of America’s enormous current account deficit with China and the rest of the world.

However, a falling dollar is the last thing China wants to see happen, for two reasons: One, it would make Chinese imports more expensive thus less attractive to American households, thus harming Chinese manufacturers and slowing growth in China. Two, US dollars are an asset to China. Its $1.4 billion of US debt would evaporate if the dollar took a major plunge. To China, this would represent a loss of national wealth; in effect all that “savings” that makes China so unique would disappear as the dollar dived relative to the RMB. For these reasons, it seems likely that China will continue to be a willing buyer of America’s debt, thus the financier of Americans’ insanely high consumptive lifestyle.

Discussion Questions:

1. Many people in America are terrified that the Chinese might dump their dollar holdings. What would happen to the value of the US dollar if China decided to change its foreign reserves to another currency?
2. Why is it very unlikely that China will do this? In other words, how does the status quo benefit China as well as the US?
3. How do American households benefit from China’s financing of the government’s budget deficits? In what way to they suffer from this arrangement?
4. Do you think America can continue to finance its budget deficits through the continued sale of debt to foreigners forever? Why or why not?

What’s sinking the dollar? – November 26, 2007

The US dollar has continued its downward spiral against the currencies of many of its trading partners. Today an American wanting to exchange his or her dollar for a Euro would have to fork over $1.46; for a British Pound, $2.07, and for a Canadian dollar, $1.05! It’s been 35 years since the Canadian dollar was even near parity ($1US = $1CA)! But what are the real forces behind this continually sinking dollar? This article lays it out straight and clear:

The forces behind the dollar’s weakening have been building for years but didn’t have much effect until recently. Most fundamentally, we Americans have been living beyond our means, buying more from the rest of the world than the world buys from us (that’s the trade deficit); to do that, we have to give foreigners claims on our assets in the form of government bonds and corporate bonds, or sometimes the assets themselves. A country as rich as America can do that for a long time, but eventually the world ends up holding more dollars than there is dollar-denominated stuff they want to buy, so they start offloading dollars. They also worry that any country with loads of debt–even the U.S.–may be tempted to inflate its currency, and that fear reduces its value.

Continue Reading »

Asia Sentinel – A Falling Dollar Does Nobody Any Good

Many economists hail the decline in value of the US dollar as a boon to the American economy. It may sound counter-intuitive, but economic theory predicts that when a currency depreciates relative to other currencies, this could actually be good for the country’s economy? Why, you ask? Let’s consider an example:

In the last four months the value of a dollar in terms of euros has gone from 0.75 Euro cents to 0.69 Euro cents. For Europeans, that means that dollars are cheaper now than they were four months ago, therefore American goods are cheaper now than four months ago. Cheaper American products should mean more business for American companies as Europeans demand more of their stuff. Good for business, right? In the US, aggregate demand will shift out, unemployment should fall, and the price level should rise as more foreigners demand more American products. But what impact does the weaker dollar have on Americans? Continue Reading »

US dollar plummets against euro as ECB rate hike becomes likely — Shanghai Daily | 上海日报 — English Window to China News

“THE US dollar has dropped to a 27-month low against the euro… The United States currency also tumbled to its weakest level against the British pound in 26 years”

What’s happening to the US dollar? The article claims that “interest rate differentials” are causing the weakening of the dollar relative to the Euro and the Pound. How can this be explained? First of all, why is the US Fed predicted to cut rates in the near future?

“The dollar’s losses last week accelerated after a US government report showed that consumer prices excluding energy and food moderated last month. That contrasted with reports from the United Kingdom and New Zealand indicating accelerating price pressure.”

What’s the connection between slowing inflation in the US, accelerating inflation in Europe, falling and rising interest rates, and the exchange rate? At this point in the AP course, you should be able to explain all of these connections.

How can we explain how the following economic trends lead to a weakening of the dollar and a strengthening of European currencies?

“The yield advantage of 10-year Treasury notes over similar-maturity German bunds dropped to 0.47 percentage point last week, the lowest since November 2004. A narrowing yield gap dims the allure of dollar-denominated assets.”

“The economy in the euro zone will grow 2.3 percent this year, beating the 2.2 percent estimate for the US…”

“ECB council member Axel Weber told Handelsblatt newspaper that an ‘extremely positive’ economic outlook meant the bank can’t signal it’s finished raising rates.”

If you can read, understand and explain this article right now, they you probably understand most what what you need to understand from Chapter 38. Let’s hear your comments, folks!

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