Why the rising trade deficit may not be so bad

For much of Donald Trump’s presidency, and prior, there has been a frequent attack on the trade deficit.  The administration has called out a number of countries for their trade surplus with the United States, most notably China.  Even allies like Germany and Japan have come under fire from the White House over what is deemed “unfair trade”.  There is no doubt that the trade deficit is massive and has gotten bigger over the past year, but what has been causing the drag?  We looked at trade data since 2011 and believe that the surge of imports dragging on the deficit may not be such a bad development.

Non-petrol products continue to worsen the trade deficit

The US trade balance continues its downward trend, as the trade deficit has considerably worsened over the past several years.  Between 2011 and March 2018, the trade deficit fell from roughly -$53 billion to  -$62 billion (in 2009 chained-prices), or 19 percent in less than 7 years.  The deficit continues to worsen even though the petroleum balance has improved from -$17 billion in 2011 to less than -$6 billion in March 2018.  A variety of factors could have improved the trade balance of petroleum – increased domestic production, improved fuel efficiency, higher demand for electric vehicles, or other distributional effects.

As a result, petroleum has had less of an impact on the aggregate trade balance, but that hasn’t always been the case.  In 2011, the trade deficit of petroleum contributed over 30 percent to the aggregate deficit.  However, in March 2018, the contribution was under 10 percent.  Since the petroleum trade deficit has shrunk, that means the non-petroleum deficit has grown that much faster.

Exhibit 1. Contribution of petroleum trade balance to overall trade balance, percent; author calculations.  Source: United States Census Bureau. 

A deeper dive into the trade deficit

The breakdown of trade balance by specific products provides a better idea what is being imported and consumed by households and firms.  To no one’s surprise, the biggest portion of the trade deficit is with consumer goods, which typically accounts for over half of the entire deficit.  Autos, which gets its own category, makes up roughly 30 percent of the deficit, another signal that consumer products are heavily dominated by overseas competition.  The deficit in industrial supplies (including energy, steel and other metals and chemical products) has declined over the past few years, thanks to rising domestic production and fewer petroleum imports, as described earlier.  The only category that remains consistently positive is food and beverages, which is no surprise given how important the US agricultural sector is to the rest of the world.

However, the one category that stands out is the capital goods deficit (also referred to as intermediary goods, which would include computers, machinery, or other equipment that is used to produce a final good or service).  Between 2011 and 2014, capital goods made up less than 10 percent of the total trade deficit.  However, since then, the capital goods deficit has increased progressively, accounting for more than 20 percent of the goods deficit since May 2017 – a roughly 10 percentage point increase in only three years.  In absolute terms, the capital goods deficit worsened from -$4 billion in 2011 to nearly -$13 billion by March 2018.

Exhibit 2. Contribution of industrial supplies, capital goods and consumer goods balance to overall trade balance, percent; author calculations.  Source: United States Census Bureau.

Why rising capital goods imports is a positive development, not a bad one

The rise of capital goods imports, which has pushed the capital goods deficit up, is primarily responsible for the worsening of the trade deficit over the past three years.  However, that may not be such a bad development.  For one, there is a significant, positive relationship between capital goods imports and investment in equipment.  In short, rising imports of capital goods is very much indicative of rising investment spending, which raises labor productivity and output. In fact, a recent paper published by the Bank of Canada suggests that from 1975 to 2016, capital goods imports increased output per hour by 5 percent, adding $830 million to annual output by 2016, with the total payoff totaling $11.8 trillion over that time period.  The fact that capital goods imports are rising and, thereby, pushing up the trade deficit may help support the late cycle expansion.

Exhibit 3.  Real imports of capital goods (except automotive), chain-type price index 2009 = 100; real gross private domestic investment, non-residential equipment, price index 2009 = 100.  Source: St. Louis Federal Reserve, FRED Economic Data.

As a result, attempting to reverse the trade flow (of capital goods, especially) may actually hinder economic growth.  In the United States, and other developed countries, there is very little competitive advantage in developing intermediate goods domestically.  Instead, importing capital goods from developing countries is much more efficient, as productivity and labor costs are largely in their favor. As a result, there is evidence, based on a NBER working paper in April 1994, that shows that there is essentially a win-win among developed and developing economies when capital goods flow toward the former.  In this particular case, global trade works in everyone’s favor.

In fact, as we have pointed out before, the US has historically used foreign savings to boost gross domestic investment and raise productivity.  There has been a strong inverse relationship between changes in gross domestic investment and the trade balance (exports minus imports) since 1950.  Increases in gross domestic investment have come while the trade balance was deteriorating (less exports and more imports). At the same time, a fall in gross domestic investment has occurred while the trade balance was improving (more exports and less imports) – essentially, during recessions.

Exhibit 4. Net exports of goods and services and real gross domestic investment, 12-month change as percentage of GDP.  Source: St. Louis Federal Reserve, FRED Economic Data.

The problem is that the combined savings of US households, businesses, and the government are not enough to finance gross domestic investment.  In fact, with the recent tax law, the fiscal deficit is only going to widen, which means even more foreign savings will be needed.  Any policy that restricts imports will thereby reduce foreign savings, which will have the effect of restraining investment.

The widening trade deficit is unlikely to reverse any time soon as the economy continues to grow.  For now, the data shows that capital goods have been the primary factor in pushing down the trade deficit, which also implies rising equipment investment – a development that will only help the economy achieve higher levels of growth, not hinder it.

 

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