Brad Setser

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Is the US trade deficit declining?

by Brad Setser
September 27, 2007

Michael Pettis

In an article in yesterday's Financial Times, Jim O'Neill, who heads global economic research at Goldman Sachs, asks if the US trade deficit is about to disappear.  According to him the latest monthly data show that the US trade deficit, at $59 billion, has declined from 7% of GDP to 5%.  Exports have been growing nearly 15% year-on-year whereas imports have been growing at just over 5%.  If a subprime-crisis-related economic slowdown keeps import growth at this level, and a weak dollar also keeps export growth at this level, the trade deficit would drop to 3% of GDP within one or two years. 


I am not smart enough to say whether O'Neill's speculations are loony or sound, and I am not sure what is driving this shift, but O'Neill points out that retail sales are growing in all the BRIC countries at double-digit levels (China recorded over 17% growth in July).  They only account for half the global share of GDP that the US does, but their spending growth is double the US rate.  

This satisfies the savings-glut model by suggesting that a slowing down of the growth rate of developing-country savings is having the expected effect on the US balance of payments.  The weaker dollar and the consumer fears arising from the sub-prime crisis, I guess, satisfy the excess-US-consumption model.  Either way, if things continue at this rate and the US trade deficit declines sharply – a big if, I know, I know – we could see a major shift in the world economy, and it might not necessarily be a very pleasant one. 

I say this not because I am one of those apparent crazies who are not terribly worried about the US trade deficit, and even believe it is a necessary pre-condition for the very difficult demographic adjustment needed by Europe, Japan, Russia and especially China in the coming decades.  I am, but my concern is different. 

As I said in an earlier post I believe that the recycling of the US trade deficit has been the main factor underpinning the recent globalization cycle.  If so, and when the current cycle ends, if history is any indication the adjustment from the insanely happy days of too much liquidity (with its attendant surge in risk appetite) to a more “normal” level of liquidity will be a very difficult one and can result in significantly reduced global growth lasting many years – especially for those countries that begin the slowdown with the weakest and most rigid financial systems.   

In previous cycles, financial systems, which during the good times had evolved into greater risk-taking activity and more-tightly-stretched asset-liability structures, were suddenly caught short by the secular change in risk appetite.  In many cases their ability to intermediate the flow of capital slowed considerably, and what followed often involved considerable economic slowdown.



My evidence is largely anecdotal, but it seems to me that those countries with the highest levels of financial risk-taking and the least flexible financial systems were the ones that did most poorly – the United States in the 1930s, with its reliance on thousands of small banks with rigid deposit bases, a weak and inexperienced central bank, and an investment banking industry in shock, of course did among the worst, although there were plenty of other non-financial factors that exacerbated the problem (by the way, it is worth remembering that in 1929 the US had, after several years of very high trade and capital account surpluses, very high levels of reserves, which in the end didn't help).   

I am curious to know what readers of this blog think are the major economies with the most susceptible financial systems.  IF the US trade deficit really is declining sharply, and IF the recycling of the US trade deficit really was the industrial-strength punch that kept this party going for so long, who is most likely to be hurt when the punchbowl is taken away? 


  • Posted by Twofish

    RebelEconomist: Sometimes the distinctions between government departments or agencies and the central bank are more confusing than they are worth. I tend to think in terms of a consolidated public sector.

    That’s very unwise in the case of China. The distinctions between government departments and agencies and the central bank are hugely important. Both politically and legally, the Chinese government doesn’t have complete discretion to move money between different entities, which makes which entity controls which account an extremely important thing to keep track of.

    The fact that you have such a complex system of interacting entities is how China resolves the socialist calculation problem that von Mises and Hayek provides. Basically, you can think of the market as a giant calculating machine, and the Chinese government has set up a legal and political framework by which various entities “owned” by the state act as market entities.

  • Posted by Anonymous

    RebelEconomist on 2007-09-28 08:39:03

    Does the government keep deposits with PBOC or the state banks or both?

    Depending on which, it would make a difference to your point.

  • Posted by Twofish

    There is a school of thought that attributes the American trade deficit to essentially a moral failing on the part of Americans.

    I don’t really find these arguments convincing since it seems strange that people’s moral character is so responsive to macroeconomic effects, and also because it takes two sides to make a financial transaction and there needs to be an explanation about why the world is so willing to fund the United States and not Zambia. The other problem is that every time these arguments have been used before (most recently Japan-1990), the “immoral” US ends up in good shape and the “moral” savers end up in trouble.

  • Posted by Twofish

    One big reason for the glut in Chinese savings is that the government spent about a decade trying to transform Chinese state-owned industry into profitable market driven companies, and they succeeded. The huge losses in the SOE sector in the 1990’s are now profits, and this creates a huge cash reserve that the government doesn’t quite know what to do with. Because state-owned enterprises have so much cash, they reinvest it directly into construction without going through the banks.

  • Posted by Anonymous

    Twofish on 2007-09-28 09:07:52

    Is the moral failing theory one of succumbing to the temptations of the savings glut, or something else?

  • Posted by Guest

    So therefore in the national accounts “spending splurge” = “savings glut”.

    Try…. there is a global spending splurge… and it all becomes clear.

  • Posted by RebelEconomist

    Anonymous on 2007-09-28 09:03:33:

    Good point, I was forgetting that big Chinese banks tend to be public sector institutions too! The key is whether the bank that takes the government’s deposits behaves commercially by lending them out, in which case the money is returned into circulation. Central bank lending is not determined by the amount of money deposited by the government, meaning that it effectively ceases to exist. It is conceivable, but unlikely, that the government could achieve the same outcome if it deposited the proceeds of its asset sales with the state banks and accepted zero interest on condition that that money would not be lent out.

  • Posted by vorpal

    The power goes to those with the oil. Nowadays, the oil goes to those who can pay for it. Zimbabwe and Myanmar are 2 countries that can’t pay for it because their financial systems are terrible. The US cannot afford the amount of oil it purchases because we are in a huge trade deficit. As the price goes up, we will be the first major industrial country to feel the bite. Germany and Japan, both wholly dependent on imported oil, are still in better shape because they have trade surpluses. The same goes for China.
    The US has racked up a huge bill, and is dependent on more credit to get by. Moreover, the cost of living is set to increase more rapidly as the price of scarce resources increases (Jeffrey Sachs has a recent article on this.)
    The US is most vulnerable. Because it depends on imports while it’s ability to pay for them has eroded. The true cost of the imports has been depressed, but it is impossible for this to continue forever.

  • Posted by Twofish

    RebelEconomist: Good point, I was forgetting that big Chinese banks tend to be public sector institutions too!

    Yes and no. The big Chinese banks are majority owned by the state, but they are set up both politically and legally so that the Communist Party can’t order them to behave non-commercially.

    One curious part of Chinese economic reform is dealing with the “curse of omnipotence.” If the Communist Party is omnipotent, then people will behave in ways that are not in the Communist Party’s interest. If you think that the Communist Party can and will seize your money at any given moment, then you will not save your money in state institutions.

    In the case of the commercial banks, the solution has been to have foreign banks act as guarantors. If the Party started to force the commercial banks to behave non-commercially, then Bank of America, Goldman-Sachs, the Royal Bank of Scotland, and Temasek Holdings would start screaming. All of the foreign banks also have seats on the board of directors so they can also monitor the banks behavior.

    The other part of the equation is to get up institutions so that when the Party has to act non-commercially, it can do bypass the commercial banks. If it needs macroeconomic adjustments, it operates through the PBC. If it needs to make policy loans, it operates through the three policy banks.

    This is why I don’t think that it useful to aggregate different institutions into one big whole.

    This is also why I’m more optimistic than Michael Pettis is that the PRC government has enough reserves to deal with debt in a business downturn. Basically, I think we agree on the total amount of likely debt in the system. The thing that I think we disagree on is the degree to which debts are defaultable.

    My argument is that the Chinese financial system is set up so that a large amount of hidden debt can be defaulted on without causing a major crisis, and that the amount of debt that can’t be defaulted on, is manageable, and for the most part, non-hidden.

  • Posted by HZ

    I do think your self-assessment of being too focused on monetary system and de-focused on the real economy. Fundamentally China has the capacity to supply its populace with almost anything other than food and oil, which its massive reserve could help importing. Any issue would come from distribution so I don’t see a case of real economic disaster because of the “CCP put” — for survival its government will be willing to underwrite any balance sheet problem that could potentially lead to crisis. In this sense it is the political flexibility rather than financial flexibility that ultimate counts.
    1929 came up a lot. Here we see how the political inflexibility led to disaster. It’s the mis-begotten notion of gold standards, sound money, crime and punishment in the economic sense and the myopia of the moneyed class. It took depression to shake these off, which China does not have to start with (coming from a command economy).
    I am not saying the Chinese system is good. The price paid is massive mis-allocation of resources. It also practically pushes people to take risk. If anything I would look at the physical limit (environmental degradation comes to mind) rather than financial ones for the downside risk.

  • Posted by Dave Chiang

    From Fortune magazine, Irresponsible Federal Reserve policy under Ben Bernanke

    It’s too bad that the governors of the Federal Reserve Board don’t have to take such a pledge when they assume office, because their recent interest rate cut has done a lot of harm to those of us who’ve managed our finances prudently.

    The Wall Street players in the biggest trouble, of course, were the ones who’d taken the biggest fliers in junk mortgages, ultra-risky leveraged buyouts, and other financial esoterica that proved to be malignant.

    If you look at the financial markets’ overall reaction to the Fed move – not at just the stock market’s reaction – you realize that as a result of the cut, those of us who keep score in dollars and didn’t need to be bailed out are less wealthy than we were in terms of anything other than our home currency.

    Why? Because the rate cut contributed heavily to the dollar’s recent sharp drop in the currency markets – parity with the Canadian dollar, and to the price spike in hard assets like gold, silver, copper, and oil. So our real economic wealth, relative to these other things, has diminished.

    And wait, there’s more. Even though the Fed has cut short-term rates, long-term rates, which it doesn’t control, have risen in reaction to the cut. So whatever economic benefits may flow from lower shortterm rates will be partly offset by the rise in long rates, which are at least as important to the economy as short rates.

    Finally, consider this. Even though Bernanke’s cut may mean that some junk mortgages will reset at lower rates, the cost of large, high-quality fixed-rate mortgages, which are tied to long rates, will be higher than they’d otherwise be. (Yeah, penalize the people who are prudent – way to go!)

  • Posted by black swan

    DC, no one’s forcing you to invest your money in this country. Think of the buying power you would have had here in the US, if you had converted your savings to euro bonds a year ago. If you really believe the USD will continue to fall, then get your investment capital out of the country. Here’s a great luxury condo deal in Miami that you could have bought for $.50 on the dollar. Now imagine far lower price you would have paid for one of these, if you had put your money into Euros last year. As you can see from the video the Canadians are doing fine here. Enjoy the video and thank the Fed for this high-end affordable housing.

  • Posted by Keypoints

    Dave Chiang,

    What do you say about today’s AP article: “Bush, Clinton, Bush … Clinton?”;_ylt=AlZykXZEQyxwRGuRJE8chyyyFz4D

  • Posted by qingdao

    RebEconomist: thank you for the gracious invitation, but in a world of hammers, I choose not to volunteer to be the next nail.There is a world of political scientists in usa who write about these things; most of it unintelligable. The short answer is: it’s a contact (contract?) sport. The head of the party in Shanghai was arrested for “corruption” and a few days later shot. Another provincial leader was arrested for having a mistress.

  • Posted by JG
  • Posted by Dave Chiang


    I would have invested my large pension 401K fund in foreign bonds or stocks if I were given the option by my employer.

  • Posted by HZ

    Yes on Apr 27. Looks like FT hasn’t updated their site for a while.

    Now what is interesting is that Libor US$ hasn’t budged since the Fed cut:
    So cost of money for banks has not really come down at the wholesale level.

  • Posted by JG

    HZ oh ok

    The libor is hard to move it’s not very helpful for the ARMs resets too.

  • Posted by Twofish

    To qingdao: Correction the head of the Shanghai Party has not been shot. He has been demoted from all posts and expelled from the party. The head of the Chinese food and drug administration was shot, but he was charged with the crime of homicide in that prosecutors argued that his corrupt approval of a drug directly led to the deaths of eight people.

    One of the reason that China has developed “rule of law” is that it protects leaders if they get in trouble. I don’t think that Chen Liangyu will be shot because he hasn’t done anything that would allow for a capital crime.

    To DC: Anyone that losing unacceptably large amounts of money because of an interest rate or currency shift simply is not managing their finances prudently. In fixed income investing, interest rate risk is *the* biggest thing that you have to worry about, since interest rates have a far bigger impact on returns than credit risk. In forex, currency risk is also something you constantly have to think about. If someone is making bets about the direction of interest rates or currencies a year from now, they are making a bet, which is fine, but they don’t really have much room to portray themselves as “prudent” if the bet doesn’t work out. They are speculating……..

  • Posted by Nicole

    We can learn that both US and China are getting richer for years of the trade.That means the trade is right.
    Trade is so important to the globally-integrated economy. The U.S. is the number one trading country in the world, and China is our third largest trading partner.
    The need to achieve a “balance” that they look at their economy as a whole and accommodate the interests of import-sensitive industries as well as those U.S. manufacturers that rely on imports to stay competitive worldwide.
    As the number one trading nation in the world, America needs to keep balance foremost in mind.
    Boosting U.S. exports to China is the right step to narrow the trade gap.If the U.S. government allows more high-tech products to be exported to China, the trade imbalance could easily be improved. Demand for many US products in China are very strong.Welcome to AmeriChinaB2B( ) to begin your business trip of China.

  • Posted by Twofish

    vorpal: The US cannot afford the amount of oil it purchases because we are in a huge trade deficit. As the price goes up, we will be the first major industrial country to feel the bite. Germany and Japan, both wholly dependent on imported oil, are still in better shape because they have trade surpluses.

    The US trade deficit is still a few percentage of GDP. Also if it is one thing that people should have learned from the 1980’s, is that deficit=bad, surplus=good is wrong. There are cases in which surpluses reflect defects in the underlying economy, which was the case in Japan-1980 and it is the case in China today. China is generating massive amounts of wealth which its financial system cannot invest well internally, and this is why there is such pressure to export money from China.

    vorpal: The US has racked up a huge bill, and is dependent on more credit to get by.

    And the reason people are willing to extend the US so much credit is that people still believe (I think correctly) that their money is better put in the US than anywhere else.

    vorpal: Moreover, the cost of living is set to increase more rapidly as the price of scarce resources increases (Jeffrey Sachs has a recent article on this.)

    Jeffrey Sachs has been wrong before (disastrously wrong in the case of his plans Russia). Personally, I think that technology will cause standards of living to go up faster than resources cause standards of living to go down. If this is correct, then the nations that will do well are those which have a track record of being able to develop technology rapidly, and the United States leads the world in this.

    But it is not this country versus that country. The US is very good at coming up with new ideas. It’s much less good at implementing those ideas on industrial scales. Japan is better at that. It’s also much less good at actually producing the final widget using cheap labor. China is better at that. But asking what country is “better” is the wrong question. You set up your systems so that you put different functions in different countries, all playing to that countries strengths.

    A lot of that involves finance and social organization. It’s not that US engineers are smarter or more creative than Japanese or Chinese ones, it’s that there are linkages between private equity, venture capital, and the research universities that exist in the United States that don’t quite exist elsewhere. (And even in the US, they exist only in a few cities.) China is trying to replicate Silicon Valley, but that will take about two or three decades.

    vorpal: The US is most vulnerable. Because it depends on imports while it’s ability to pay for them has eroded. The true cost of the imports has been depressed, but it is impossible for this to continue forever.

    But the US has some core strengths, which become more obvious if you look in the past and try to figure out why all of the previous the “US is doomed” predictions failed.

    One is the structure of US university admissions. In the US, you are more likely to get admitted to a high ranking university if you are captain of the football team or president of the debating society whereas in Japan and China, it’s all about how well you score on tests. People who are football team captains tend to have the social and management skills necessary to start and run small/mid sized companies more so than someone that spends 100% of the time on tests.

    The other is the way that the US sees itself. Part of the strength of the US university system is that it takes the brightest people from around the world and turns them into Americans. So China and India are producing upteen million engineers. The US can go through those upteen million engineers, and set things up so that the brightest, most motivated end up in the US.

    This actually contributes to the American character. If you are quiet, obedient, and do what you are told, you are just not going to make it past the US immigration system. The people who get into the US, whether legally or illegally, are motivated passionate people who want to get rich. These are people who tend to start small businesses.

    People say that the US is doomed because Americans are lazy and people are borrowing lots of money to buy useless stuff like McMansions and HDTV’s, but they are not looking at the big picture. This is how the US works.

    You find an empty spot of land. Build a huge giant house with a pool and SUV. You fill it with HDTV’s, credit cards, citizenship papers, and a job that pays a huge amount of money for little work. You surround it with some immigration checkpoints, you broadcast it to the rest of the world and say “come and get this!!!!!” So what happens is that among the millions of scientists, engineers, shopkeepers, farmers etc., etc., all start running through loops to get the prize. They learn English, they figure out all of immigration tricks, etc. etc. Some of them make it. They enjoy the big house and the SUV, and you end up with some of the most motivated people in the world, ending up in the US, who then start the companies and come up with the ideas that pay for the house and SUV.

    Of course, their grandkids and great grandkids are going to end up fat and lazy because they grew up in the nice house rather than having to fight their way in. No problem. Lots of empty space….. Build another house……

    America, the world’s biggest reality game show…..

  • Posted by Twofish

    One more thing. It’s important to look at how America gets its wealth because it could end. One of the fascinating case studies is Argentina in the 20th century, and how things fell apart. If you went back to 1900, there Argentina was this destination for lots of European immigrants, and it has the same sort of advantages that the United States. Lots of open land, open immigration (if you were European), stable government, booming economy.

    What happens is that you have this bad cycle. The economy goes bad. People are more willing to shut the gates. This makes it impossible for new people to get in. This makes the economy worse. The gates shut tighter. Eventually this thing spirals completely down hill, and if anything kills the United States, it will be this.

  • Posted by RebelEconomist


    Yes, Argentina shows the risk. The problem for the US, and I think the UK, is when the majority of people expect an easy ride. Then, in a democracy it becomes politically impossible to align incentives and expenditure to productivity. I see the latest Fed cut as part of this pattern. It becomes numerically, if not politically, difficult to take enough immigrants to maintain properity.

    But all is not lost yet. My response to this threat would be to make public childcare and education the clear priority for expenditure, to help the existing population to become as productive as possible and to break the link between poverty and opportunity, and in the longer run, create a more informed electorate. To raise the money, I would tax oil consumption in the US, and property in the UK.

  • Posted by bsetser

    2fish — i don’t think the current edifice of globalization was something that was built up over the past ten years. the striking thing about its dominant feature (EM financing of the US) is that it isn’t at all institutionalized. It sort of just happened — as ASia decided to follow the $ down and the oil exporters began to build up surpluses. There isn’t any institution that plays a formal role supporting the system, tho i would argue that China’s central bank effectively acts as the key wheel in the system (in part by holding the rmb down and punishing those who let their currencies appreciate by more).

    and the current edifice hasn’t generated large benefits for a majority of the US and European participants in the system — real median wages are flat, and i don’t really think you are better off in real terms if the market value of your home goes up. you are still living in the same space and realizing the gains requires downsizing and living in a smaller space. the gains have been captured by a relatively narrow segment of the population. so the current edifice doesn’t really command strong democratic support in the US and Europe.

    Chinese real wages are certainly rising — tho labor’s share of total national income is falling, as wage growth has lagged GDP growth. But i am not sure that a system based on investing a decent chunk of china’s savings in money losing assets (domestically, through the misallocation of capital and NPLs and extenrally by buying depreciating $) really would command majority support in China.

    This all suggests to me that the current edifice is has been built on very shaky ground. that is what worries me.

  • Posted by Twofish

    bsetser: and the current edifice hasn’t generated large benefits for a majority of the US and European participants in the system — real median wages are flat

    I do wonder if there is an “escalator effect” going on here, in that real median wages are flat whereas people are moving up. Something that is a bit surprising is the question of why people haven’t been complaining more than they are if things are so stagnant, and thinking in terms of wages as an escalator might explain things.

    bsetser: the gains have been captured by a relatively narrow segment of the population. so the current edifice doesn’t really command strong democratic support in the US and Europe.

    Walking on the street and looking around, I really don’t think that the gains have been captured by a relatively narrow segment of the population. I’m sure that this is because I spend my time in Texas and New York rather than Ohio and Michigan, but there are areas were globalization has lifted the standard of living of just about everyone in those areas.

    Again, the fact that none of the major candidates have have made globalization an issue is pretty significant. It may be that the power elite has got everyone brainwashed, but that doesn’t explain why that brainwashing was more effective in 1992 than in 2008. I think it is more likely that people are looking at their own lives and their own wages, and aren’t seeing things badly impacted by globalization.

    bsetser: But i am not sure that a system based on investing a decent chunk of china’s savings in money losing assets (domestically, through the misallocation of capital and NPLs and extenrally by buying depreciating $) really would command majority support in China.

    Most people don’t care about the details. They just care that they get their stuff. If you see a 10% drop in wages or if their bank account disappears, people notice that really quick. If people are seeing a 10% rise in wages, the fact that another 10% is going elsewhere is irrelevant. Same with bank accounts. Very few people care about whether the PBC loses $300 billion in currency reserves. However misplace $1 in someone’s bank account and they notice.

  • Posted by Ames Tiedeman

    The U.S. Trade Deficit is a huge problem. We will either end up being owned by foreigners or we will simply fade away. Both prospects are quite un-
    American. Some basic facts: The U.S. has not had a trade surplus with the world since 1974. We have not had a trade surplus with Japan since April of 1976. We stopped having trade surpluses with Eurpoe in 1983. Fifteen years ago we did not have a trade deficit with China. Now we have a 250 Billion a year deficit with the People’s Republic. A nation that does not make anything is a worthless nation. Worse, the longer we go without making the needed investments in our manufacturing infrastructure, the more knowledge we lose. We will either forget how to manufacture or we will simply not be good at it. Our creative energy fades away if we do not use it. Also, it is innate to want to make things. Kids play in sand boxes, youg men build tree forts. This is human nature. All of this is being taken away from the American people by idiots in Washington who do not know how to make trade deals. I may write a book on this topic.