Trade deficits especially with China actually helps the economy.
The only reason anyone cares about China's trade is because it operates within a mercantilist framework. The mercantilists preached that countries should always strive to have a trade surplus and avoid trade deficits at all cost. That is partly because they viewed the flow of gold as central to economic well-being. Deficits led to an outflow of gold, which was bad, while surpluses led to an inflow of gold, which was good.
The Spanish were the best practitioners of mercantilism. When they conquered Latin America, they sent back vast sums of gold to the mother country, for a time making Spain the most powerful country on earth. But it all fell apart in short order as the money was simply wasted. And because Spain did not invest in its colonies, they lost their value when the gold ran out.
By contrast, the British did not find any gold in their North American colonies. This was a huge disappointment to them. But in order to try and salvage some profit from their assets, they were forced to invest in the New World, creating new industries like tobacco. But, being mercantilists, the British insisted that all trade from the American colonies had to go through London, thereby increasing the cost of American goods and creating ill-will that culminated in the American Revolution.
Although many of the Founding Fathers were protectionists, they weren't mercantilists. Rather, they favored protection for the purpose of safeguarding America's "infant" industries. But it never worked very well. In his great book, The Tariff History of the United States, economist Frank Taussig concluded that high tariffs did little to stimulate domestic production. This is evident in the fact that the U.S. ran a trade deficit almost continuously from 1790 to 1875.
A key reason for the trade deficit is that the U.S. was the China of its day: a place where cheap land greatly reduced production costs, just as cheap labor reduces costs in China. This led to a flood of foreign investment into the U.S., especially in transportation technology like railroads, which were the Internet of their day. It is a simple matter of accounting: When a nation is a net capital importer, it must run a trade deficit.
Thus when a nation has good economic prospects and attracts foreign investment, it tends to run deficits. Conversely, when its prospects are bleak and capital is trying to escape the country, it will tend to run surpluses. Therefore, the existence of a surplus or deficit may tell us exactly the opposite of what the mercantilists believed. Deficits may be a sign of strength, while surpluses are a sign of weakness.
Unfortunately, mercantilism lives on at the U.S. Commerce Department, where deficits are viewed as nothing but pure evil, stealing American jobs and wealth. Hence Commerce Secretary Don Evans's increasingly shrill attacks on China for contributing heavily to the U.S. trade deficit. Implicitly, he assumes that if we could make China's costs of production higher, we would somehow benefit because production would shift back from China to here. A new report from the Federal Reserve Bank of Chicago explains why this won't happen:
Rather than displacing domestic production...rising imports may serve rising demand for some types of goods in the home country. So too, imports can consist of intermediate components that become embodied in domestic production of a final good. To the extent that such components are most cheaply sourced overseas, they may help to keep domestic production competitive for the final goods in the domestic market, or even allow domestic producers to export the final good to third country markets.
In other words, by utilizing China's cheap labor, it actually increases the competitiveness of U.S. businesses. They often export unfinished goods made here to plants they own in China and export them back here or somewhere else. When sold here, much of the gain accrues to those in the retail sector and to consumers, while U.S. investors reap the return to capital. Consequently, the vast bulk of the total gains from final sales shifts to Americans even though most of the work is done in China.
Unfortunately, China is too easy a target for unscrupulous politicians in the U.S., who are pushing for tariffs on Chinese goods. Sadly, some of these politicians work in the Bush administration. Those who know better, like Greg Mankiw, chairman of the Council of Economic Advisers, must try harder to make their voices heard.
