Testimony by Robert E. Scott, EPI economist
Senate Finance Committee
June 11, 1998

Mr. Chairman and members of the Committee, thank you for the opportunity to testify here this morning. Make no mistake about it, the trade deficit is a problem. It is destroying jobs, depressing wages, hurting our competitiveness and contributing to the stagnation of real incomes that has plagued our economy for the past two decades. The trade deficit results from the use of the U.S. as a “market of last resort” for exports from around the world, and from several macroeconomic problems. Both kinds of problems can and should be addressed with new trade and international policies.

Many attempts have been made to create economic excuses for the trade deficit. A frequently heard claim is that trade deficits do not matter, while others argue that “the trade balance is generally determined by macroeconomic factors.”¹ Both views suggest that trade deficits will be largely unresponsive to trade policies, and may be safely ignored, as long as the nation is following sound macroeconomic policies.

These laissez-faire views are both wrong and dangerous to the health of our economy. One major source of confusion is the use of simple correlations, or economic identities, in the place of meaningful economic analysis of the causes of our trade problems. The most recent Economic Report of the President makes this mistake in several places, as shown below. The Report emphasizes the accounting relationship between savings and investment without sufficiently examining the cause of changes in these variables. Improvements in our trade balance, through increased exports, can increase income and hence raise national savings, thereby reducing our reliance on imported capital while creating better jobs in the economy at the same time. If, on the other hand, we ignore the trade deficit, our incomes will continue to stagnate and the risks of an economic collapse will grow in the future.

Consequences of trade deficits
Trade deficits have harmed the domestic economy in at least three direct ways. First, the steady growth in our trade deficits over the past two decades has eliminated millions of U.S. manufacturing jobs. Between 1979 and 1994, trade eliminated 2.4 million jobs in the U.S.² Growing trade deficits were responsible for most of these job losses, which were concentrated in manufacturing, because most trade involves the sale of manufactured goods. NAFTA added to the flow of jobs out of the U.S. by encouraging firms to move production to Mexico and Canada. Our trade deficit with both countries increased from $16 billion in 1993 to $48 billion in 1996 (in constant 1987 dollars). The U.S. lost 395,000 jobs as a result of the NAFTA deficits.³

The Asia financial crises are expected to increase the trade deficit by $100 billion or more over the next two years. Deficits are already growing with Korea and with Japan. The Japanese economy is contracting sharply as a result of the crisis, and U.S. exports to both countries have fallen sharply. The expected increase in the U.S. trade deficit could eliminate an additional 1 million jobs in the U.S. over the next 18 months if the Fed does not act quickly to lower interest rates and keep unemployment here from rising.⁴ Even if the Fed does lower interest rates enough to keep unemployment constant, 600,000 jobs will shift from the high-wage manufacturing to lower-paying service sector.

Second, trade deficits have also had a depressing effect on wages, in several ways. The jobs lost through trade do not raise the unemployment rate in the long-run. Macroeconomic policies such as interest rates and government spending have much greater influence on the total level of employment and output than does trade. But trade does effect the composition of employment. Workers not employed in manufacturing find jobs elsewhere in the long run, usually in service industries where wages are much lower.

The growth in imports, especially from low-wage countries, also puts downward pressure on the wages of U.S. workers. If the prices of these products fall, then this puts downward pressure on prices in the U.S. Domestic firms are then forced to cut wages or otherwise reduce their own labor costs in response.⁵

For the past two decades, our living standards have stagnated, and the level of income inequality in our society has increased dramatically. As a result, the real wages of production and supervisory workers have declined steadily since 1979.

Many economists who are proponents of free trade have now concluded that trade is responsible for 20 to 25 percent of the increase in income inequality over the past two decades.⁶ Our own research suggests that trade is responsible for 15% to 25% of the increase in income inequality that occurred between 1979 and 1994.7 However, existing research can only explain about half of the change in income inequality. Therefore, trade is responsible for about 40% of the explainable share of increased income inequality.

There are several other ways in which trade and trade deficits depress wages that are not included in the preceding estimates. One of the most important is through foreign direct investment. When U.S. firms move plants to low-wage countries, as they have done at an increasing rate in recent years, they clearly eliminate good jobs and increase the trade deficit. These moves also have a chilling effect on the labor market. The mere threat of plant closure is often enough to extract wage cuts from workers. This tactic has also been used with increasing frequency in the 1990s and is effective even when plants don’t move.

The third problem with trade deficits is their corrosive effect on our long-term trade competitiveness. When the U.S. dollar and our trade deficit soared in the early 1980s, many domestic firms and industries in sectors such as steel and semiconductors were decimated. Once closed, many plants in such industries failed to re-open, even after the dollar depreciated later in the 1980s.

Dr. Peter Morici, in an important new study for the Economic Strategy Institute, has identified another major reason why deficits have such corrosive, permanent effects on our competitiveness. Morici found that eliminating the U.S. trade deficit would increase U.S. spending on R&D by an estimated 3 percent. This would in turn increase productivity growth by about “0.5 to 0.6 percentage points per year.”⁸ This single shift alone would have a massive impact on U.S. living standards, by allowing firms to raise wages for all workers.

To summarize, trade deficits have eliminated millions of high-wage U.S. manufacturing jobs. They have also put downward pressure on the wages of production workers, not only by eliminating good jobs but also by pushing down the prices of domestic products and by decreasing labor’s bargaining power with multinational firms. Finally, trade deficits have reduced investment in research and development, thereby undermining productivity growth and contributing to the stagnation of incomes that has plagued our economy since the 1970s.

There is also another way in which trade deficits could destabilize our domestic economy at some point in the future, causing an economic collapse even deeper than the downturns that have resulted from the Asian financial crisis. Over the past two decades the U.S. has accumulated over $2 trillion in trade deficits. We have used foreign capital inflows to finance these deficits. As a result, we have now become the world’s largest debtor nation. In a forthcoming report from the Center for Economic Policy Analysis at the New School for Social Research, Dr. Robert Blecker of EPI predicts that the net indebtedness of the U.S. will exceed $2.1 trillion within four years.⁹

Our trade deficit and foreign debt have yet to reach critical levels. However, the U.S. current account deficit is expected to increase by $100 billion or more as a result of the Asian crisis within the next two years. If the crisis deepens, perhaps triggered by further devaluations by China or Japan, then the current account deficit could reach $350 billion or more.

At $350 billion, the deficit will come perilously close to 5 percent of GDP, a widely accepted trigger point for currency instability. A deficit of this size could trigger concern among foreign investors about our ability to borrow sufficient funds to finance this level of spending. A sharp outflow of short-term capital would result, causing the dollar to collapse, at a minimum. Short-term interest rates could also increase dramatically, as they have throughout Asia, pushing the economy into a deep recession, or worse.
As long as foreigners are willing to hold an ever-increasing supply of dollars, then we can avoid this “hard landing” scenario. However, structural changes in the not-to-distant future (such as the successful creation of the euro) could weaken dollar demand and lead to a crisis, if our trade problems persist and deepen in the future.

Persistent trade (current account) deficits are a fundamental risk factor in this potential shock to our economy. Lester Thurow has referred to the U.S. deficits as the key “fault line” in the international economy.¹⁰ In his view, the Asian financial crises are only a mild precursor to the devastation that will result if the U.S. deficits are reduced through a financial crisis. In the long run, the only way to avoid such a collapse is to reduce the trade deficit to at least sustainable levels through some other means, such as more effective trade policies.

The causes of structural trade deficits
Many economists have emphasized the importance of fundamental accounting identities in explaining trade flows. For example, the Economic Report of the President notes that, by definition, any excess of national investment over national savings must be financed through an inflow of foreign capital, which must, in turn be matched by an offsetting deficit in our current account, the broadest measure of our trade balance. In this view, a low level of national savings must necessarily result in a trade deficit.

However, just because trade is influenced by macroeconomic forces such as savings rates and currency values, it does not follow that trade policy cannot influence the level of the trade deficit. There are at least two key issues that must be considered. First, what determines the macroeconomic flows that affect trade, and second, how can public policies at home and abroad affect our trade balances?

Accounting identities do not, and cannot, explain the causal relationships between savings, investment, and trade flows. Do low savings rates cause trade deficits, or does causation run in the other direction? A trade deficit reduces the incomes of domestic workers, pushing many into lower income brackets. Families with lower incomes generally find it much harder to save. Therefore, increasing trade deficits can and do reduce national savings.
The CEA report also notes that, since 1980, the size of our trade deficit has been closely correlated with movements in the exchange value of the U.S. dollar. As the dollar appreciated in the early 1980s, the trade deficit expanded, and the deficit shrank as the dollar fell later in the decade. The CEA emphasizes the influence of macroeconomic factors, such as U.S. monetary policy, in determining exchange rates. However, our exchange rates and trade deficits with several key countries are also heavily influenced by other countries’ economic policies.

For example, in 1994 China devalued its currency by 30% against the dollar. Since that time it has continued to purchase dollars and by 1997 it had accumulated total reserves of $143 billion.¹¹ Since then, our bilateral deficit has increased by 25% or more per year. China’s mercantilist policies contributed significantly to the trade problems of other countries in South Asia, many of which were swept into the financial crisis which began in mid-1977.

Japan has also intervened heavily in foreign exchange markets, with similar consequences. In 1995, Secretary Rubin reached an agreement with Japanese Vice Minister of Finance for International Affairs Eisuke Sakakibara to devalue the yen.¹² In 1996, more than $125 billion in official capital (asset) purchases flowed into the U.S., much of it from Japan. The yen has lost 50% of its value since 1995, and our bilateral trade deficit widened rapidly last year as a result.

Exchange rate intervention is not our only trade problem, by any means. Over the longer term, since 1982, the yen has doubled in value, and yet our bilateral deficit has never fallen below $19 billion since then, and the deficit has exceeded $40 billion in every year since 1985. Japan maintains numerous structural barriers to U.S. imports. For example, Japan condones restrictive practices that have limited U.S. penetration of their domestic markets for film, auto parts, flat glass, and many other products.

China maintains even heavier import restrictions than Japan. These barriers have generated our most imbalanced bilateral trade relationship: our imports from China in 1997 were $63 billion while exports were only $13 billion, a 5-to-1 ratio, leading to a $50 billion bilateral deficit. China also uses discriminatory offset and technology transfer policies to capture market share and move rapidly upscale into high-tech products such as automobiles, computer products, and aircraft. Over 148,000 jobs in aerospace and related industries alone could be lost over the next two decades because of offsets policies and other types of outsourcing. ¹³

Many other countries in Europe, Asia, Africa, and Latin America use protected home markets as a base to support industries that dump excess output in the U.S. market, especially in capital-intensive sectors such as steel and semiconductors. Government subsidies also distort trade flows, especially in high-tech industries.

For the past 18 months, the dollar has also been appreciating because of significant private capital inflows into the U.S., because of relatively high rates of growth here, and in search of a “safe haven” from the Asian financial crises. These private flows have also contributed to the growth of our trade deficit, while also pushing asset prices (such as the stock market) to unsustainable levels. This experience shows that our trade balance can be destabilized by both public and private forces. It is also worth noting that the surge in private capital inflows was made possible, in part, by the liberalization of capital outflows from many developing countries, in the 1990s, often with IMF encouragement.

U.S. trade deficits have been increased by both mercantilist, macroeconomic policies of foreign governments as well as interventions and distortions in individual product markets. They have been exacerbated by the Asian financial crisis and financial market deregulation. The resulting deficits have contributed to widening income inequality and the stagnation of income and productivity growth in the U.S.

Policy implications
The preceding analysis suggest that, at a minimum, the following steps should be taken:

• Devalue the dollar against key currencies such as the yen and the Chinese yuan. In the long-run, devaluation is not a desirable way to improve the trade balance because it reduces our living standards. However, we must end the practice of allowing and encouraging these particular countries to manipulate their currencies for mercantilist reasons. A substantial appreciation in the yen will also bring additional pressure to bear on Japan to deregulate, reform, and expand its domestic economy. These policies will require coordination with other countries, probably through the G-8 or a similar institution.
• Coordinate macroeconomic policies with Japan and Europe, and encourage those countries to reflate and stimulate their economies, thus building demand for our exports. Restructure the IMF so that its policies do more to promote growth, rather than austerity, in East Asia and other countries with banking and financial crises. At the same time, steps are needed to gradually deflate asset price bubbles in the U.S. while depreciating the dollar against all currencies. The U.S. can no longer serve as the import market of last resort for the rest of the world.
• Attack barriers to U.S. exports and other policies and business practices that bring dumped and subsidized products into the U.S. market. In particular, China should not be allowed to enter the World Trade Organization until it removes all nonconforming barriers to imports, both formal and informal. In addition, the U.S. should substantially increase public investments in research and development needed to improve the competitiveness of U.S. industries, in part to offset the effects of similar policies used in other countries, especially in Japan and Europe. Additional resources for the enforcement of trade agreements and our trade remedy laws are also desperately needed.
• Promote international labor rights and environmental standards, through aggressive agreements that are enforceable with trade sanctions, in the WTO. These policies will raise wages and environmental quality in developing countries, and give consumers in these countries the resources to buy more products from the U.S. These policies will also foreclose the “low road” in international competition that has increased income inequality in the U.S. and in poor countries, while fueling a race to the bottom in the regulatory environment.
• Develop a plan for addressing the critical problems that both cause and result from trade deficits. Senator Dorgan has proposed a congressional commission to end the trade deficit, and I support that proposal. Issues to be addressed include mechanisms for coordinating with other nations to reduce macroeconomic imbalances; assessment of the impact of other countries’ trade and industrial policies on U.S. competitiveness; and the development of new principles and approaches for addressing these problems through reform or replacement of the WTO.

A great deal of confusion and misinformation exists about the causes and consequences of our trade problems, and these issues are of critical national importance. Public outrage about the negative consequences of globalization is quite strong, both at home and abroad. In the U.S., these concerns resulted in the failure of Congress to approve the President’s request for fast-track trade negotiating authority last year. While the public is highly supportive of the administration overall at the moment because of low unemployment rates, concerns over trade will grow quickly as the full impact of the Asian crisis is felt over the next 18 months, and as we move into the next downturn, whenever it comes.

We have a breathing space, at this moment, to develop plans and policies that will enable us to effectively address our trade problems when the next crisis hits. Effective planning can also nurture a consensus on desirable future directions for our trade policy. This consensus must be achieved before we can move ahead. A continuation of the trade policies of the past is no longer a viable option.

Notes
1. Council of Economic Advisors. 1998. Economic Report of the President. Washington, D.C.: U.S. Government Printing Office. February. p. 246.
2. Scott, Robert E.,Thea Lee and John Schmitt. 1997. “Trading Away Good Jobs: An Examination of Employment and Wages in the U.S., 1979-94,” Briefing paper. Washington, D.C.: Economic Policy Institute. October.
3. Scott, Robert E. and Jesse Rothstein. “NAFTA and the States: Job Destruction is Widespread,” Issue Brief. Washington, D.C.: Economic Policy Institute. September.
4. Scott, Robert E. and Jesse Rothstein. 1998. American Jobs and the Asian Crisis. Washington, D.C. Economic Policy Institute. Issues Brief. January.
5. Note that the Economic Report of the President (op cit, 243) mentions this problem, but claims that the “prices of such imports actually rose.” This statement appears to reflect a flawed 1994 study that has since been repudiated. See John Schmitt and Lawrence Mishel. 1996. “Did International Trade Lower Less-Skilled Wages During the 1980s? Standard Trade Theory and Evidence.” Washington, D.C.: Economic Policy Institute. Technical Paper No. 213. July.
6. See, for example, Tyson, Laura. 1997. “Inequality Amid Prosperity,” The Washington Post. July 9.
7. Mishel, Lawrence, Jared Bernstein and John Schmitt. 1997. The State of Working America, 1996-97. Armonk, NY: M.E. Sharpe. p. 20.
8. Morici, Peter. 1997. “The Trade Deficit: Where Does it Come From and What Does it Do?” Washington, D.C.: The Economic Strategy Institute. October. P. 20.
9. See also: Blecker, Robert A. 1998. “International Capital Mobility, Macroeconomic Imbalances, and the Risk of Global Contraction.” Washington, D.C.: Economic Policy Institute. Technical Paper.
10. Thurow, Lester. 1998. “Asia: The Collapse and the Cure.” New York Review of Books. Feb. 5.
11. IMF Financial Statistics, May 1998.
12. Johnson, Chalmers. 1998. “Asia’s Financial Meltdown: What Caused It and What Does It Mean?” Prepared remarks delivered at the Economic Strategy Institute. March 24.
13. Scott, Robert E. 1998. “The Effects of Offsets, Outsourcing and Foreign Competition on Output and Employment in the U.S. Aerospace Industry” in Policy Issues in Aerospace Offsets, eds. Wessner, Charles W. and Alan Wm. Wolff. Washington, D.C.: National Research Council. Forthcoming.