Global Policy Forum

By Arthur B. Laffer*

Just because the United States has its largest trade deficit ever doesn't mean that we're living beyond our means. Far from it. In fact, the characterization of the U.S. as a land of chronic overspenders, hellbent on selling themselves into global servitude doesn't make sense at all. And once the over-consumption model is put into question every policy remedy based on the presumption of squander looks pretty weak.

In an era of floating exchange rates the trade deficit (or more appropriately, the current account deficit) is one and the same as the capital surplus. The only way the U.S. can have a trade deficit amounting to 5.6% of GDP is if foreigners invest that amount of their capital in the U.S. It's a matter of simple accounting. But once you realize that the trade deficit is, in fact, the capital surplus you would clearly rather have capital lined up on our borders trying to get into our country than trying to get out. Growth countries, like growth companies, borrow money, and the U.S. is the only growth country of all the developed countries. As a result, we're a capital magnet.

Take a look around. Germany hasn't had a growth spurt since the 1960s when Ludwig Erhard was Bundeskanzler. France still has a mandated maximum workweek of 35 hours, a maximum income tax rate of 58%, a 1.8% annual wealth tax and government spending as a share of GDP greater than 50%. Finland, for goodness sakes, fines speeders a percentage of the speeder's income. Sweden, Denmark and Germany also fine speeders a percentage of their income, only with caps. Japan has had a stock market down by over 70% from its high in 1989 and both company and government unfunded liabilities in Japan are out of sight. Canada's economic policies are kooky and investments in Latin America, the Middle East, Russia, Southeast Asia and Africa are about as safe as running drunk blindfolded across the "I-5" freeway at rush hour.

So what's not to like about the U.S.? Whether you're an American or a foreigner the U.S. is the choice destination for capital. That's why we have such a large trade deficit. The only way foreigners can guarantee a dollar cash flow to invest in the U.S. is if they sell more goods to the U.S. and buy less goods from the U.S. Our trade deficit is not a sign of a structural flaw in the fabric of the U.S. economy but is instead a stark reminder of our privileged status as the most pro-growth, free market, rule of law economy the world has ever known. Why on earth any American would want to change our policies to emulate foreign policies is beyond me.

China has realized the pre-eminence of the U.S. model and since 1979 has reduced the percentage of GDP flowing through its government from about 82% to today's level of about 30%. That is a supply-side tax cut par excellence. China also realizes that the U.S. has the best monetary policy ever. By fixing the value of its currency, the yuan, to the U.S. dollar, it has literally imported Alan Greenspan to China. Talk about outsourcing!

To guarantee the dollar value of the yuan requires that China hold over $500 billion of liquid dollar assets. China doesn't hold those dollars as a favor to us: it holds those dollars to benefit itself. One needs only glance at the financial disaster that ensued when former Argentine President Fernando De la Rúa broke the peso currency bond to the U.S. dollar to understand why China won't break its currency's link to the dollar. It's elementary, my dear Watson.

Now, within this framework of global capital mobility and U.S. pre-eminence there are significant variations in the relative capital attractiveness of the various nations of this world. When foreign economic policies improve, and the foreign attractiveness to capital increases as a result, the first impact is a weakening of the U.S. terms-of-trade (the real exchange rate) followed much later by a fall in the U.S. capital surplus, i.e., trade deficit.

As of late, foreign economic policies have improved. France is a lot better today than it was three years ago. And -- shock of shocks! -- Germany is even considering a real tax cut. Jean- Claude Trichet has shown himself to be a world-class governor of the European Central Bank, following on the heels of the incompetent Wim Duisenberg. Five new entrants to the EU -- Estonia, Latvia, Lithuania, Malta and Slovakia -- have low-rate flat taxes. Junichiro Koizumi of Japan is a lot better than the former prime minister, Yoshiro Mori. Investors on the margin should look more favorably to investments abroad.

But even changes in exchange rates have limits. The dollar under current circumstances can't go to zero or infinity. Without a corresponding rise in domestic dollar prices, U.S. goods and assets become relatively more attractive to foreigners and Americans alike when there is a fall in the foreign-exchange value of the dollar. Sooner or later the dollar would be such a bargain that there would be more buyers than sellers, therefore limiting the dollar's fall. Today, the dollar's value in the foreign exchanges fits nicely within its historical range.

On Jan. 1, 1999, the euro was born and was worth $1.17. In fact, if we look at the synthetic euro prior to 1999, the dollar's low was in 1992 when each euro could buy $1.47. The large dollar appreciation from 1992 to early 2002 saw the dollar peak at 83 cents per euro and our capital surplus (the trade deficit) go from less than 1% of GDP to almost 4% of GDP (and continue on to today's 5.6%). Well, the global economic environment is changing once again as are investors' perceptions of relative attractiveness.

There have been times in the past when the dollar depreciation of the magnitude we've experienced over the last two-plus years would have been a clear harbinger of much higher inflation and interest rates. But such is not the case today. It is true that products which are freely traded in global markets will experience dollar price increases relative to foreign prices by the percentage depreciation of the dollar. But to have these exchange-rate induced price increases lead to higher U.S. inflation would require the Fed to accommodate the higher inflation with faster monetary-base growth. The Fed has not accommodated any higher inflation and as a result markets do not anticipate higher inflation. Nor should they.

Back in the late 1960s and '70s, currency depreciation was associated with domestic monetary creation and a horrendous bout of global inflation. Then, as opposed to now, currency depreciation was directly responsible for inflation, high interest rates, and low growth. We even coined a new word for low growth and high inflation -- stagflation. Aren't you glad we've had an epiphany of Fed policies under the leadership of both Paul Volcker and Alan Greenspan?

The most natural, proper, and economically correct response of the foreign exchange markets is for the U.S. terms of trade to have declined and that's exactly what has happened. As far as I can tell, the decline in the dollar is about over; soon we will see the U.S. capital surplus falling back to more normal levels. When a global economic system works as well as ours does, we should just leave it alone.

About the Author: Mr. Laffer is founder and chairman of Laffer Associates.

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