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US trade deficits are killing growth and profits

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Far be it from me to maliciously dwell on the fact that America's running of the world economy last year cost it nearly an entire percentage point of its GDP growth. That would be grossly out of turn at the time when the globalists – led by U.S. government officials -- are having a field day of sorts during the IMF spring jamboree in Washington D.C.

But I cannot reconcile myself with the fact that those systematically running huge trade surpluses between 3 percent and 20 percent of their GDPs are feted as exemplary economic macro-managers and free traders. They should be loudly called out as free riders on Uncle Sam's coattails. Yes, the countries falling in this category are currently amassing a cool $1.3 trillion of net assets, or, if you prefer, beefing up their net global creditor positions.

In the original Bretton Woods international monetary system, these people would be subject to penalties, because the rules set out at that time called for symmetric trade adjustment policies – i.e., both deficit and surplus countries were expected to run roughly balanced external positions. But that sound economic principle of a stable global financial architecture was promptly subverted because, via facti, only deficit countries were forced to adjust as they ran out of money. Surplus countries got a free pass, even though they were (sort of) obliged to stimulate their domestic spending to reduce their trade surpluses and help to balance out the world economy.

That is the process of international trade adjustment that should be upheld and "enforced" by those whom we (the global taxpayers) are generously remunerating to do that job.

Balance the world economy

But let's be fair. Their job has changed. Now, they are there to dispense the free-trade bromides and, as the IMF's managing director said recently, to make money on financial distress in deficit countries.

Also, the IMF's last week rhetorical free-trade overdose was pointed at the U.S. primaries, where Donald Trump, the Republican Party's frontrunner, keeps screaming "they are eating our lunch," and promising, in a typical electoral hyperbole, to wipe out the $19.2 trillion of U.S. national debt in eight years by "negotiating better trade deals."

It remains to be seen whether Donald Trump will ever be able to repeat that bombast from the sanctum of the Oval Office. But it would be enough of his legacy if his outcry were to lead to some repair of the badly damaged international trading system. That would go a long way toward evening out the playing field for American businesses abroad, and it could also slow down the country's hugely deteriorating external debt. At the end of last year, America's net international investment position was estimated at -$7.3 trillion, showing an increase of $225.2 billion in net foreign liabilities in the course of the fourth quarter.

The insulting irony is that we are told that most of this is coming as a result of a strong dollar. No, most of this is coming from the weakness of the world economy caused by free riders. Anybody who has ever done any sound econometric estimates of trade equations knows that price effects (which include exchange rate changes) are much weaker than income effects.

So, yes, there is some negative effect on U.S. exports caused by the dollar's 10 percent trade-weighted appreciation last year, but the real killer is the tanking world economy, i.e., the weakening external demand for U.S. exports.

And you can take this a step further: Businesses in countries refusing to stimulate their domestic demand are forced to export in order to survive. Export to where? To the U.S., of course, where they have a huge and a widely open homogeneous market.

Still want to deride those genuinely worried about America's foreign trade?

Investment is driven by demand

Whatever one might think of that question, or of the existential issues raised in the primaries, it should not surprise anyone that trade problems are being flagged out by a businessman rather than professional politicians talking about, well, the same old thing … the usual stuff ….

And by talking about the American trade problem, that businessman is also lending some credibility to those building the U.S. doomsday scenarios on declining corporate profits. These naysayers probably don't even know that American companies get one-fifth of their profits from their foreign operations.

Now, think of what would happen to profits, and to U.S. equity market valuations, if American companies could operate in a more open, balanced and faster growing world economy, with fewer free riders and more trade surplus countries generating growth from their domestic demand.

But using America's leadership to enforce the rules of orderly trade adjustment policies requires a bit of work and deft diplomacy. It's easier to scream at the Fed to keep doing more QEs.

Meanwhile, the U.S. economy's cyclical problems are becoming deeply entrenched, European-style, structural barriers to growth that will relegate the country to a pitiful – and politically and strategically dangerous – potential economic growth of 1.6 percent that we have now.

Again, please think of it: The physical limits, set by available labor and capital resources, to our noninflationary growth potential are putting us at 1.6 percent, 0.8 percent below last year's GDP growth we consider as utterly and unacceptably low.

But that's the way it is. And if we change nothing to our trade picture, any further Fed stimulus – assuming it can keep revving up our domestic demand – will promptly spill out to the rest of the world, where the usual crowd is waiting for the American trade manna.

How can we relieve these physical limits to growth? The answer is old and well known: We have to expand and make more productive our stock of human and physical capital. And the way to do that is through rising investment.

Profits, or internal sources of finance, are a relatively minor investment driver. In our broad and sophisticated financial system, most projects responding to market demand will eventually get external funding. The key to an investment decision is always the anticipated demand for a particular product or service. Businesses have no need to hire more people, expand a factory floor or add new machines if they can satisfy the current and expected sales from existing production capacities. No amount of profits will change that.

So, demand is always the essential condition for moving from the existing to the desired stock of human and physical capital. Retained earnings can affect the speed of that adjustment, but they rarely, if ever, affect the desired amount of capital stock.

Investment thoughts

In case you are inclined to jump on this as a partisan view of Donald Trump's candidacy, hold your fire. Regular readers of this column know that my concern about America's trade problems much predate Mr. Trump's decision to run for the highest elective office in the land.

But all those worrying about our economy and financial markets should understand the root causes affecting their jobs, paychecks and the real purchasing power of hard-earned savings. The sacrifice of a one percentage point of our annual growth is a clear and eloquent statement of where the problem lies – now and especially in the future.

Briefly, even if (a big if, indeed) the Congress and the White House could agree on a well calibrated policy mix of fiscal, monetary and structural measures, the resulting faster growth of our domestic demand would promptly leak out to support growth, trade surpluses and nest eggs (i.e., net external assets) of those systematically relying on export-driven growth policies (a.k.a., free riders).

That simply means that without a thorough revision of trade rules and international policy coordination, the U.S. will be left holding the bag with a rapidly increasing external debt. And here is how big a problem that is: Only in the course of the fourth quarter, the increase in our foreign debt ($225.2 billion) accounted for 58.2 percent of the total increase of our real GDP in 2015.

Please change the tune and stop yelling at the Fed; try the Congress and the White House instead. That's where the real problem lies, and this election period is a perfect time to do that.

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