The Dangers of Deficit-Talk

When you talk to Mexicans these days, you get two underlying opinions about the man in the White House.

The first is that Donald is playing a poker game with international relations. This article by the New York Times sums it all pretty well, at least when it comes to NAFTA:

In interviews with politicians, analysts, economists, business leaders and former diplomats, a general sentiment had emerged throughout the day on Wednesday that Mr. Trump’s threat to withdraw from the treaty using an executive order was mostly a piece of political theater — aimed as much at his voting base as at Mexico and Canada — and not something to get terribly worked up about.

“Clearly, in Mexico, this should be seen as a type of tantrum of a spoiled child who did not get the presents he expected for his birthday, for the 100 days,” said Rafael Fernández de Castro, an expert on United States-Mexico relations at the Autonomous Technological Institute of Mexico in Mexico City.

Perhaps because Mexicans are accustomed to being lied to by politicians, there is no sense of outrage per se when Trump backtracks on promises, but more of a “what will happen next?” curiosity.

But the second underlying notion seems scarier, because it reveals a deep flaw in economic thinking that has plagued humanity since at least the 15th century.

When asked about the trade deficit, most people would argue that having a deficit is something wrong, irregardless of other things in the economy. This is basically Trump’s whole economic premise and so it falls on understanding ears when Mexicans hear it. They believe his premise is right, but are worried we will be the losers in the game.

Therefore, most Mexicans are keen to agree that “Trump is doing the best for his country” (although that apparently would be against our interests). The cancelation of NAFTA is seen as a “we” vs. “them” issue, or in other words, a cero-sum game.

This idea of the country-as-a-factory (loosely termed mercantilism), is not new but could not be further from the truth.

Trade deficits are not a necesarrily bad thing for the economy and they also do not necessarilly slow growth. This article on Bloomberg gets at the point perfectly, but I think it’s so important that it is worth mentioning again.

GDP (the most accepted measurement of growth) is composed of these basic parts:

GDP = Consumption + Investment + Government Spending + Exports - Imports

Thus, it might seem like more imports and less exports will substract from the equation. However, most rookies will forget that imports are also counted in either consumption, investment or government spending. Obsessively trying to balance the trade deficit is essentially ignoring the other 3 terms in the equation.

Here is an easy example, borrowing again from the article:

Imagine a situation where the U.S. keeps consuming and investing the same amount of domestically made goods, but starts exporting $1 billion more to foreign countries and importing $3 billion more. The trade deficit just went up by $2 billion dollars, but GDP went up by $1 billion! Growth was positive! The new imports didn’t change U.S. GDP, but the new exports added to it.

Similarly, cutting the trade deficit doesn’t necessarily make the U.S. richer. Suppose the country enacted trade restrictions that cut imports by $10 billion and cut exports by $1 billion, but (as in the previous example) left consumption and investment of domestically made goods unchanged. The trade deficit just shrunk by $9 billion, but GDP declined by $1 billion. That’s negative growth. That’s a recession! That’s going to cost American jobs.

This mercantilist notion of a cero sum game has been proven wrong again and again, but it will not die because it is really close to what people experience everyday. If you have a small business or work in one, selling more is your main objective. Loosing market share is a huge thing.

Nonetheless, when it comes to countries, it is actually more important to understand the relationship between imports and domestic production, because they can complement you and make you more competitive (as is the case with the U.S.), or between consumption and imports, because they can help you reap important benefits of costs (think Wal-Mart).

The specific case of the American trade deficit is telling because it actually benefits from both of these benign effects of trade deficits. Because cheap imports play an important role in the U.S., if Trump would like to keep growth and eliminate the trade deficit, he would have to magically also make Americans save more, basically picking up the slack in consumption through investment or government spending.

The frustration is that even if we know the obssesiveness with the trade deficit (trade deficit disorder, as Roach coins it) is absolutely wrong, it takes a lot of resources to get the general public to believe it.

The last few decades of American leadership in selling free trade (even with democratic presidents) has been instrumental in pushing countries to forget about the mercantilist policies of yore. This in turn has helped sustain a drop in extreme poverty around the world.

Trumps ill-conceived ideas, and his insistence on deficit-talk, risk bringing these old debates back in countries with a shakier tradition to free trade, such as Mexico. Considering the awful public relations track record of liberalism, that is a very frightening prospect.