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US mulls economic stimulus but must sort out trade imbalances first

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Trillions of dollars in economic stimulus programs are being discussed on America's election campaign trails, and the U.S. clearly needs these programs to rev up growth and employment creation.

But the stimulus should be executed to meet these objectives without creating excessive trade deficits and increasing the country's large ($7.5 trillion) net foreign liabilities.

As things now stand, architects of these programs seem to be ignoring the fact that they are operating in a highly open American economy, where the external sector represents nearly one-third of GDP. I hope that is just a temporary oversight, because a large stimulus to domestic demand at a time of near-stagnation and slowing growth of our main trading partners would boost our imports and their exports. The ensuing increases in our trade deficits would erode the beneficial impact of the economic stimulus, while increasing our foreign debt and putting pressures on whatever is left of our manufacturing industries.

In order to avoid that outcome, Washington would be well advised to coordinate any future stimulus with similar measures in export-driven economies, which are running huge structural trade surpluses with the U.S. and the rest of the world. Multilateral and bilateral channels exist for such policy co-ordinations. They should be used to implement trade adjustment rules requiring that these stagnant and slow-growing trade-surplus economies have to stimulate their domestic demand.

The U.S. may wish to catch up quickly on such consultations. The existing large trade imbalances are destabilizing the world economy. They are also one of the causes of America's slow growth.

Fight the freeloading

Germany, for example, has the world's largest trade surplus ($320 billion or 9.2 percent of GDP), where the U.S. is bleeding with a bilateral trade deficit currently running at an annual rate of $65 billion. But that is only part of the story.

By refusing to adjust – i.e., to generate more growth from domestic demand – Germany is depressing the European economy it already gravely damaged with its austerity edicts enforced through market-frightening warnings about debt-ridden countries. These policies are killing the market for one-fifth of American exports. So, the damage to the U.S. economy is much larger than the trade deficit with Germany. At the moment, America's trade deficit with Europe is running at an annual rate of $159.6 billion.

Undeterred, the Germans are staying on-message. Berlin keeps pushing France, Italy and Spain (one-half of the euro area economy) to toe the line on the (fiscal) "stability pact" instead of trying to stimulate their moribund economies.

The implied subtext to that message may well be this: Don't worry … Uncle Sam will do the stimulus … Do as we do – keep pushing exports.

East Asia is another area that would greatly benefit from huge leakages of America's turbo-charged domestic demand. In the first seven months of this year, the three largest economies of that region – China, Japan and South Korea (23 percent of world output) – accounted for nearly two-thirds of a U.S. trade deficit that is expected to exceed $700 billion by the end of 2016.

Trade policies should be front and center

So, here are a number of points investors may wish to keep in mind.

First, the U.S. economy is still suffering from sequels to the Great Recession.

The deterioration of the quantity and quality of our human and physical capital – and the ensuing decline of our productivity growth – have brought down the economy's potential (and non-inflationary) growth rate to 1.6 percent from more than 3 percent in the 18 years prior to the onset of the last financial crisis. The production engine, therefore, has to be rebuilt before stepping up on the gas pedal. There is a need to increase labor supply and to augment and rejuvenate the productive capital stock.

Second, the next stimulus package should be coordinated with a similar action of our main trade partners.

It bears repeating that going it alone would be unwise in the extreme. Just think of what would happen if the U.S. unloaded a stimulus aiming at a 4 percent growth rate (as the program floated last week intends) in an economic system where physical limits to growth -- set by the amount of labor, physical capital and total factor productivity -- are currently estimated at only 1.6 percent.

You can easily imagine that – owing to these limited production capacities – the soaring domestic demand would boost imports and upward pressures on costs and prices. We would then be looking at runaway trade deficits, increasing foreign debt, falling dollar, sharply rising inflation and a prelude to a recession of ex-ante unknowable amplitude and duration.

Third, that means that trade consultations must insist on an orderly and symmetric international trade adjustment.

Countries running large and systematic trade surpluses should stop living off the rest of the world. Enforcing the rules of trade adjustment through existing multilateral and bilateral forums does not mean a trade war. But a clear determination to stop tolerating damaging trade practices could help.

That won't work? You may be surprised. Europeans are now scrambling to increase and pull together their defense budgets after one of our presidential candidates told them that the heavily indebted U.S. will no longer carry the financial burden of their protection.

East Asians also know that they have to generate more growth from their domestic demand and to open up their markets. Washington has plenty of leverage (see the paragraph above about East Asia's trade surpluses with the U.S.) to remind them - loudly, if necessary - of the rules of international trade.

Fourth, the Fed has to be part of an effective policy mix to raise the actual and the potential growth rate of the U.S. economy. At the moment, that policy mix does not exist, and, most probably, it won't emerge until sometime in the spring of next year.

That means that the Fed has to continue to hold the economy together until it gets the necessary information to coordinate its action with fiscal and structural policies determined by the new legislative and executive authorities. Anybody who cares, and knows, how to look at the Fed's balance sheet and money market operations can clearly see that that's what the Fed is doing.

Investment thoughts

Economic strategists advising presidential candidates should bear in mind that they are operating within an open economic system where foreign trade policies must remain center stage. Whatever these strategists propose to do – or actually try to do once they assume office – to stimulate the economy should be appropriately coordinated with our main trade partners to maximize America's non-inflationary growth and employment creation. Going it alone is an unwise option.

Meanwhile, the Fed will continue to mind the store all alone until next spring. The Fed's highly accommodative policies will remain in place, barring an unlikely flare-up of sustained price inflation and a significant acceleration of economic growth in the months ahead.

A reasonable and constructive economic dialog with Germans and East Asians should be possible and mutually beneficial. That should be obvious to everybody involved. Fears of "crazy people" running around Washington hell-bent on fueling trade wars may strike some as an attractive figure of speech, but investors should know that this is partisan rhetoric and arrant nonsense.

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