It's the Free Trade, Stupid

By: Ian_Fletcher

One point seems largely to have been missed in recent weeks, amid all the excitement over the Federal budget and the sovereign-debt crises in Europe: free trade is largely the root cause of all these problems. So let's trace the causation for a minute.

Start with the Federal budget. Federal revenues are derived from the underlying economy, and therefore, if the underlying economy were larger, revenues would be, too -- even without any tax increases. As a result, anything that causes the U.S. economy to be smaller, tends to widen any gap between expenditures and revenues.

Enter free trade.

For it is thanks to America's embrace of free trade (whether genuinely free or not; that's another issue) that we have been running giant trade deficits for years. And these have been costing us economic growth.

The Economic Strategy Institute, a Washington think tank, estimated in 2001 that the trade deficit was shaving at least one percent per year off our economic growth. (See the 2006 report "China's Financial System and Monetary Policies: The Impact on U.S. Exchange Rates, Capital Markets, and Interest Rates" of the U.S.-China Economic and Security Review Commission for the details.) This may not sound like much, but because GDP growth is cumulative, it compounds over time. Economist William Bahr has thus estimated that America's trade deficits since 1991 alone -- they stretch back unbroken to 1976 -- have caused our economy to be 13 percent smaller than it otherwise would be.

That's an economic hole larger than the entire Canadian economy.

Other economists have reached similar conclusions. William A. Lovett estimated in 2004 that, "With stronger, reciprocity-based trade policy, U.S. GDP could have been 10 to 20 percent higher." Another estimate, by Charles McMillion, notes that in the 25 years up to 1980, our real GDP grew at an average of 3.8 per year. But in the 25 years afterwards, as our trade deficit ballooned, it averaged only 3.1 percent.

This is why we're being forced into budget cuts and/or tax increases. We just don't have a big enough economy to pay for the spending we've voted for at the tax rates we've voted for.

The above is usually treated as a conservative insight, because the implication is that economic growth is the real answer to our problem, not higher taxes. The Wall Street Journal crowd loves this stuff. Unfortunately, that school of opinion also loves free trade, which is driving our growth down, not up. So the free-marketeers have painted themselves into a corner here, and it's no accident they don't have a solution.

Now for the debt part of the equation. As I have noted before, a nation's accumulation of debt is closely linked to its running of trade deficits, because when we import more than we export, we must pay for it by either selling off existing assets or accumulating debt. (This is a simple matter of accounting, not even economics, so it shouldn't be that controversial, no matter how controversial other aspect of the issue are.)

Over the past 35 years or so that we have been running trade deficits, we have mostly paid for this by assuming debt, and especially in recent years, a huge part of that debt has been public debt. One consequence has been that in order to manipulate the dollar price of its currency downward and boost exports, China has been buying huge amounts of U.S. Treasury securities. Thus the same mechanism that caused our trade deficits also increased our governmental debt.

If the United States had enforced balanced trade (i.e. no trade deficit) during this period, China would not have bothered manipulating its currency, as it would not thereby have been able to obtain a trade surplus with the U.S. Therefore it would not have accumulated its present huge holdings of U.S. debt and we would not be so indebted today.

It was, indeed, this artificially-induced flood of cheap foreign cash that enabled us to borrow so much money in the first place. So much money, at such low interest rates, would not have been available if we had confined ourselves to domestic sources of funds; the upwards pressure on domestic interest rates would have choked off government borrowing at some point.

The decision to raise so large a part of the government's budget from foreign borrowing dates back to Ronald Reagan's presidency, most explicitly to the 1984 decision by Treasury Secretary Donald Regan to effectively exempt foreign holders of our bonds from taxation. All subsequent administrations (with the limited exception of the latter part of Bill Clinton's presidency, when the U.S. was running budget surpluses) have welcomed the resulting availability of cheap foreign capital.

In the short run, it was a great deal, holding down interest rates and taxes alike. In the long run...

The above analysis holds, in slightly different form, in Europe. Nations like Greece, Portugal, Italy, and Spain have also run chronic trade deficits for years. As in our own case, their deficits were bridged by foreign credit -- largely from Greater Germany (Germany, Austria, Switzerland, Denmark, Finland, Sweden, and Holland.)

As in our own case, the willingness of foreigners to lend them money was politically inflated -- in their case by the replacement of national currencies by the euro, which enabled un-creditworthy governments like Greece to borrow on terms similar to those of creditworthy governments like Germany.

Because these European nations have smaller and weaker economies than the U.S., and because they borrowed in a currency which (unlike our own situation with the dollar) they cannot print, the inevitable long-term consequences hit them first. But we are not going to be exempt forever.

The underlying lesson is the same in our case and theirs: free trade causes trade deficits and therefore debt. The free market, on its own, will neither limit the accumulation of excessive debt nor redress the excess once it has been created. Government is eventually forced to step in, to solve a crisis it could have largely avoided if it had not embraced free trade in the first place.

Ian Fletcher is the author of the new book Free Trade Doesn’t Work: What Should Replace It and Why (USBIC, $24.95)  He is an Adjunct Fellow at the San Francisco office of the U.S. Business and Industry Council, a Washington think tank founded in 1933.  He was previously an economist in private practice, mostly serving hedge funds and private equity firms. He may be contacted at ian.fletcher@usbic.net.

© 2011 Copyright  Ian Fletcher - All Rights Reserved

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