The International Monetary Fund (IMF) just came out with a report downgrading U.S. growth forecasts, to 2.1% in 2017 (down from 2.3%) and 2.1% in 2018 (down from 2.5%). Their updated outlook for the U.S. economy assumes that the Trump administration will not be able to get any of its fiscal policies off the ground – plans for tax reform, infrastructure spending, regulatory easing, and the administration’s budget to reprioritize spending and cut the debt and deficit are all left wanting for details, not to mention the fact that divisions in Congress have stalled any progress. Hence, growth is expected to continue along recent trend.
This dovetails with what we wrote in a previous post on the “Trump trade”. Falling long-term yields in the bond market suggest that the market believes economic growth is going to continue along its recent trend (about 2% annually), with lackluster inflation and wage growth. As President Trump’s chief economic advisor, Gary Cohn, said, the bond market takes a longer-term view of economic growth and where policy is going. At this time, the market clearly does not believe any of the administration’s fiscal policies or budget will pass through Congress, at least in a form that will provide a huge boost to the economy.
However, one missing piece here is the idea that the President Trump, and several appointees of his, see export-led growth as the future for the U.S. economy.
Pursuing growth via aggressive trade policy
Trade has been an area where President Trump has stood firm on throughout his campaign, and was just as unyielding in his inaugural address, saying:
“From this moment on, it’s going to be America First. Every decision on trade, on taxes, on immigration, on foreign affairs, will be made to benefit American workers and American families. We must protect our borders from the ravages of other countries making our products, stealing our companies, and destroying our jobs. Protection will lead to great prosperity and strength.”
Trade policy is clearly a top priority and this is reflected in his appointees to positions that oversee trade, including the Commerce Secretary (Wilbur Ross), the U.S. Trade Representative (John Lighthizer), and the head of a newly created White House office that will oversee American trade and industrial policy (Peter Navarro).
Unlike any of the other fiscal proposals, which need to go through Congress, the administration has significant flexibility when it comes to trade. As Chad Brown, an economist at the Peterson Institute for International Economics, points out, the administration is already using little-known, and little-used, provisions of existing U.S. law for aggressive enforcement and to restrict imports. These include:
1. Invoking rarely-used rationales for the imposition of trade barriers by citing national security concerns
2. Initiating its own investigations and actions rather than waiting for companies to request them
3. Signaling willingness to undertake routine, technocratic trade policy responses to low-priced imports
While these may seem small-bore compared to completely scrapping trade treaties (like NAFTA) or imposing a 35% tariff on all Chinese imports, these protectionist measures will invite retaliation and create unintended consequences, eventually damaging the economy.
For example, the Trump administration is currently assessing whether steel imports from China constitute a national security risk. A little-known provision of the 1962 Trade Expansion Act allows the administration to set up significant trade barriers against the import of materials that are deemed important to national security (typically during war time). In this case, the administration can argue that procuring steel, a key defense industry metal, from China is not reliable and proceed to impose import restrictions on steel – providing a boost to the domestic steel industry.
The problem here is that China is not even one of the top 10 sources of steel for the U.S. – Canada, Brazil, South Korea and Mexico make up the top four. Various penalties for violating trade rules have already slowed Chinese imports considerably. So potential tariffs will impact U.S. allies more, raising the possibility of widespread retaliation, as opposed to retaliatory actions from just the Chinese.
The administration is clearly pursuing an aggressive approach to boost manufacturing and exports – believing this is a key part of the formula to raise economic growth. In a white paper released prior to the election, Navarro and Ross contend that when a country runs a trade deficit by importing more than it exports, this subtracts from growth. They argue that reducing the trade deficit drag, which stood at $558 billion as of March 2017, would increase GDP growth to above 3%.
The question is whether this is actually possible.
Will lowering the trade deficit lift GDP growth?
In its most basic form, the accounting identity for gross domestic product (GDP) states that it is the sum of
1. Household consumption (C)
2. Business consumption (investment) (I)
3. Government consumption (G)
4. Net exports (exports minus imports) (E – I)
In other words,
GDP = C + I + G + (E – I)
Since imports are preceded by a negative sign in the above identity, it would stand to reason that reducing imports and boosting exports (so that net exports rise) would result in higher GDP.
However, it is not the case that GDP growth is inversely related to imports. The U.S. has run a trade deficit since 1977, i.e. importing more than it exports, over which time real GDP has grown by almost 190% (as of the first quarter of 2017).
In fact, as the above graph illustrates, the trade deficit has shrunk during periods when GDP was contracting and the economy was in a recession. The trade deficit shrunk by more than $350 billion between December 2007 and June 2009, a period during which GDP fell more than 4%.
This starts to make sense when you consider the fact that the consumption accounts for close to 70% of the U.S. economy, and significant portion of goods consumed are imported. Since consumption falls during a recession, imports fall, thereby shrinking the trade deficit.
In reality, imports are subtracted in the GDP identity to account for the fact that imports also add to household, business or government consumption. As economist Noah Smith notes, if you buy a video game console made in Japan, household consumption rises but since the console was made overseas, the value of the console has to be subtracted. If a business imports a German machine tool, investment spending rises, but this also has to be subtracted so that GDP remains the same.
If all goods and services that American households and businesses consume could easily be replaced by inexpensive equivalents produced within the country, we would really see a boost to economic growth. However, the U.S. does not currently possess the capacity to replace all foreign-produced goods and services with home-grown ones and it would take years to build this capacity.
Can the U.S. move to an export-led economic model?
A simple way to think about long-term GDP growth is by considering its long-term drivers: growth in workers (workforce growth) and growth in output per worker (productivity).
Workforce growth has been declining rapidly recently. Growth in the working age population has fallen from above 1.0% annually to about 0.6% over the past decade, and this trend is expected to continue as the population ages. As the following chart from J.P. Morgan shows, workforce growth is projected to rise only 0.3% over the next decade. Also, more than 80% of that increase is slated to come via immigrants, as opposed to the native-born populace.
At this time, there appears to be no political capital for raising workforce growth by adding more immigrants. In which case, the U.S. will have to boost economic growth by achieving significant productivity gains.
The problem is that gross domestic investment in the U.S., which is critical for productivity growth, is financed through foreign savings. In other words, foreigners send their excess savings to the U.S. in return for stocks, bonds, factories, businesses and real estate. However, by another accounting identity, a net import of foreign savings means you are also importing more goods and services than you export i.e. a trade deficit.
Moving to an economic model in which the U.S. exports more than it imports, would imply that the country is also exporting its excess savings – exactly the opposite of what it does now. As John Hussman pointed out in an astute commentary earlier this year, the issue is that the combined savings of U.S. households, businesses and the government are nowhere close to being able to finance gross domestic investment.
As the next chart shows, 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, more imports). At the same time, a fall in gross domestic investment has occurred while the trade balance was improving (more exports, less imports).
In other words, the U.S. has historically used foreign savings to boost gross domestic investment and raise productivity.
If the Trump administration pushes fiscal spending that raises deficits, the US will need even more foreign savings, not less. If the administration simultaneously pursues policies that reduce imports, and thereby reduce foreign savings, that will have the effect of crowding out and restraining investments.
China, which is the second-largest economy in the world today, is currently trying to manage its transition from an export-led economic model to one dominated by consumption. They are increasingly recognizing that this is not easy. The Chinese are finding it difficult to simultaneously clean up the financial excesses that built up over the past decade while sustaining high levels of economic growth.
The U.S. will probably find it just as difficult to re-tool its economy in the opposite direction after decades of following a consumption-led economic model. It will require more comprehensive policies that affect every sector of the economy as opposed to narrow policies that only seek to improve the fortunes of the domestic manufacturing sector, like tariffs. At the same time, immense political capital would have to be expended to manage and sustain the transition.
Comprehensive tax reform could perhaps start the push in such a direction, eventually raising savings of domestic consumers and businesses. A policy like the border adjustment tax, would be an example of a broader policy shift that seeks to boost domestic industry and reduce reliance on imports (as opposed to tariffs). Yet, even this faces deep opposition from businesses and consumers that rely on imported goods.
It is still an open question as to what fiscal policies will ultimately be implemented. The momentum that any new administration carries at the beginning of its term wanes with each passing day, and the likelihood of large-scale reform of the economy, if that is indeed the goal, reduces.
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