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Social Issues
The Trade Deficit and the Fallacy of Composition
By Bob Powell, 5/04/05

Use your browser to search for "Updated". Especially see the chart on when the GDP crosses the cumulative trade deficit in the "What's Happening" section below.

Jump to the sections on:
The "Fallacy of Composition"
The greatly misunderstood concept of 'comparative advantage'
What to do about the 'trade' deficit

A presentation, "The Problem is Bigger than the Loss of Manufacturing" (Powerpoint, 1280K, links active in SlideShow mode, PDF w/links, 471K, PDF w/notes, 433K: Updated and expanded 8/28/07), contains updated charts on the U.S. 'trade' deficit and Colorado jobs through of July 2007 plus a summary of the main points on what to do about 'trade', taxes, and health insurance.

See also the very short handout on The Coming Economic Collapse from 'Trade' and Offshoring. 7/17/07.

Preface. The Impact of an Exponentially-Increasing Trade Deficit:
We're Between a Rock and a Hard Place

The U.S. economy will collapse. Repeat. The U.S. economy, and probably the world economy, will collapse because of the United States' exponentially-increasing trade deficit.

Updated chart:

Trade Deficit thru 2006 with Trend: An excellent fit to an exponential function. Perfect fit = 1.000

That's overall and it's increasing rapidly with China, too. See the chart below.

The rest of the world will, within the next few years if not sooner (it's already happening), decide to stop taking U.S. dollars for their goods. As in Iraq, there are no good choices, only bad choices, remaining.

The Rock: The Federal Reserve Doesn't Raise Interest Rates

If the Federal Reserve doesn't raise interest rates to maintain the U.S.'s ability to attract funds to maintain borrowing, it will not be able to finance its trade and fiscal deficits. Not raising interest rates will allow the dollar to fall relative to other currencies and cause inflation as the prices of imported goods rise because the US dollar is worth less.

This will be good for U.S. exports to some extent, but it takes a long time to renew an ability to manufacture goods we no longer produce. This is described by Louis Uchitelle in the New York Times on 12/24/06: Goodbye, Production (and Maybe Innovation) ... it's NOT a "maybe."

A sharp rise in prices (inflation) will over the short term be economically devastating. The economy is now greatly supported by consumer spending, which will be severely impacted by sharply increased prices, especially as the housing bubble, which has allowed many to borrow against home equity and maintain spending, is collapsing.

The U.S. economy will collapse.

The Hard Place: The Federal Reserve Raises Interest Rates

If the Federal Reserve raises interest rates significantly, it will slow the economy. Many consumers will be unable to maintain large and growing consumer debt and bankruptcies will rise. Many more homeowners with variable rate mortgages will face foreclosure. Less consumer spending and higher interest rates will lead to less business activity and associated layoffs.

The U.S. economy will collapse.

Selling Off America

As the trade deficit grows, the U.S. has been selling companies, buildings, ports, and toll roads to take back some of the dollars from foreign hands to stave off the collapse of the dollar. For information on what's been sold, see Economy In Crisis.

What happens? The profits from these enterprises are not retained in the U.S. They are not recirculated in the U.S. (economic multipliers are reduced), which leads to less economic activity. See How a Regional Economy Works.

This growing trade deficit is the root of the controversy over selling U.S. ports to a UAE company. That wasn't, and still isn't, about "good foreign direct investment in the U.S."

Updated 7/27/07: The U.S. has done so much of this that the Bureau of Economic Analysis reports that U.S. net international investment at the end of 2006 was -$2.54 trillion: the amount by which foreign investments in the U.S. exceeds the value of U.S. investments abroad. That's about 45% of the accumulated "trade deficit" ($5.7 trillion in 2006) ... that's a lot of "investing." But substitute "selling off America" for "investing" to better describe what's happening.

By 2014 the U.S. would have to use its entire annual output to retrieve the dollars in foreign hands and buy back the companies, roads, and ports sold to those in other countries.

(See Buffett's chart below showing increasing foreign holdings of U.S. assets.)

A Systems Thinking Perspective on "Trade," Offshoring, & The Fallacy of Composition

This page covers:

  • Trade Data and Trends
  • The Fallacy of Composition
  • Trade Dynamics

The greatly misunderstood concept of 'comparative advantage'

It must be noted that the issue of "trade" and the "trade deficit" is about more than simple "trade." "Trade" is the "exchange of one thing for another," not the "transfer of the factors of production." Because of this, the logic of "comparative advantage" does not apply. This is an important point because "free trade" advocates rest their arguments on the premise that "comparative advantage" applies. It does not. Instead, "absolute advantage" applies.

In A Systems Thinking Perspective on Manufacturing & Trade Policy, I draw from the following sources to explain.

Lester Thurow in The Future of Capitalism (1996, pp. 69, 70) explains the "theory of comparative advantage" and describes the assumptions required for it to hold:

"The classical theory of comparative advantage is often taught as if everyone benefits from trade. Technically that is not true. The total income of every country that takes advantage of comparative advantage grows, but there will be individuals within each country who lose. What the theory holds is that those who gain from international trade receive enough extra income from their activities that they could compensate those who lose when international trade commences. If that compensation isn't actually paid (and it almost never is), then those who lose are quite rational to oppose international trade.
U.S. Trade Deficit - actual with exponential projection

"But in the classical theory the losses usually will be quite small. First, full employment is assumed to exist. Free trade does not push anyone into unemployment. Second, transition costs are assumed to be zero. There is no region-, industry-, or firm-specific physical or human capital that is destroyed when workers are forced to shift between regions, industries, or firms. Third, returns are assumed to be everywhere equal. Each industry has the same rate of return on human or physical capital. Each firm and industry pays the same wage rate for a worker's being willing to give up an hour of leisure. As a consequence, being forced to shift jobs doesn't change wages very much, if at all."

Paul Craig Roberts notes:

"David Ricardo discovered the principle of comparative advantage in the early 19th century. He recognized that the principle did not hold if all factors of production are internationally mobile. Mobile factors of production would migrate to countries that had the greatest absolute advantages. Those countries would gain and all others would lose. … Today, absolute advantage resides in an abundant supply of cheap and willing labor."

What's happening?

The chart above shows that the trade deficit for 2004, stated as $617.7B, was over 5% of GDP. At that time, projecting along the exponentially-increasing trend (note the confidence in the trend being exponential based on the data was excellent: R-squared = 0.9685), the trade deficit was projected to be at 10% of GDP by 2008.

In line with this trend, the February 2005 deficit was $61.04B, a yearly rate of $732.5B, over 6% of GDP. The actual U.S. trade deficit for all of 2005 was right in line with the exponential trend at $723.6 billion.

A New York Times article [Joseph Kahn, "China Seen Ready to Conciliate U.S. on Trade and Jobs," 9/02/03] described how, in early September 2003, U.S. Treasury Secretary met with Chinese officials in hopes of curbing China's growing trade surplus [... see the black bars in the figure], which was $103B in 2002.

Want to know how that worked out? See the red bars in the figure. The trade deficit in 2005 with China alone was $202B up 25% from 2004's $162B, which was up over 30% from 2003, which was up over 20% from 2002.

China's rising trade surplus with the U.S.

Accumulated Deficit = Debt ... an outflow associated with selling U.S. assets could be shown
The accumulated trade deficit is was 40% of GDP in 2005.  Best fit projections indicated it would be at ~50% of GDP in 2007 and at ~100% of GDP in 2012 (assuming 5% GDP growth from 2005 on).

To me, and many others, this appears to be a serious problem. It's a lot of money to be borrowed from the world. Nothing increases exponentially forever. What can't go on forever will stop; in this case it will stop when the rest of the world decides to stop taking U.S. dollars for their goods.

 

U.S. Trade Debt (Cumulative Deficit) - projection based on the exponential increase shown in the first figure above
 Update 7/27/07:

See the chart below. While the 2007 numbers aren't in, the accumulated trade deficit for 2007 is still projected to be 50% of GDP. The current projection is that it will be at 100% of GDP by 2014, instead of 2012. For some reason the U.S. Census Bureau, Foreign Trade Division, sometime between 11-Mar-05 and 8-Jun-07, lowered the 2005 trade deficit by $9,245B (now $714.4B instead of $723.6B) and lowered 2004 by $5B. That makes about a 2 year difference in the projection.

This chart gives a visual picture of the economic forces developing. As is the case for earthquakes, no one knows exactly, or even approximately, when things will give; one only knows it's inevitable.
At current trends Cumulative Trade Deficit will equal GDP by 2014, but current trends won't continue. The economy will collapse well before that.

Some say the U.S. should just move up the technology chain and concentrate on high tech products, letting others do the manufacturing and lower tech work. Unfortunately, there is no magic wall between the manufacturing and engineering & design jobs. We're losing high-level jobs, too. See the growing trade deficit in Advanced Technology Products below (data from here, but you have to extract the numbers from multiple files). Updated 7/14/08.

Over the last 16 years, so-called "trade" in Advanced Technology Products has gone from a $38.4B surplus in 1991 to a $53.5B deficit in 2007

Until I saw a chart like this one, thanks to my friend Dave Anderson, I'd thought the increasing deficit was at least somewhat driven by increasing oil imports. Clearly, that's not what's driving the increases. It's offshoring.

What to do about the 'trade' deficit (edited 9/13/10)

There are so many factors affecting trade that achieving a "level playing field" is extremely difficult. Trying to adjust the many factors is just too complicated. There's currency manipulation, competitor countries having national health insurance (removing the cost from industry), tax policies, capital subsidies, transfer pricing manipulation of profits, theft of intellectual property, tax deductions for moving manufacturing and research to China, and lack of labor & environmental standards.

Trying to adjust for each of these by means of import tariffs will mean political battles with virtually every special interest in America, battles which will mostly be lost. Therefore, focus on outcomes by promoting "even trade" or "balanced trade," not "free trade."

Warren Buffett is also concerned with the long-term problems caused by international trade that's "out of balance." He described the problem and what to do in his article in Fortune:

America's Growing Trade Deficit Is Selling The Nation Out From Under Us. Here's A Way To Fix The Problem--And We Need To Do It Now. By Warren E. Buffett Carol J. Loomis, 11/10/03 (alternate link here).

To deal with this out of control situation, he's proposed an Import Certificates mechanism to create balanced trade to deal with what he describes as "a shifting maze of punitive tariffs, export subsidies, quotas, dollar-locked currencies, and the like."

Buffett's Import Certificates mechanism: If a country purchases products or services from the U.S., then it can sell that amount back to the U.S. If it does not want to sell to the U.S., it can sell its Import Certificates to another country that does want to sell to the U.S.

This is a market-based mechanism that would produce the desired outcome: balanced trade. This is necessary because anything out of balance will be, WILL BE, brought back into balance. The more out of balance it's allowed to become, the more severe will be the correction.

When I wrote this article in May 2005, I suggested it would be wise to phase in this policy over a decade or so to mitigate the economic shock. Going "cold turkey" would be ugly; "warm turkey" will be painful, but less so than "cold turkey" and much less than will be the consequences of current policies. That was then; it's too late now (Sept 2010). There's no time left for warm turkey.

Also see: Buffett's Import Certificates Plan Could Pilot the Economy to a Safe Landing By Howard Richman, 1/18/09. This article echoes my view that

"Obama's stimulus package won't accomplish much if it doesn't address the trade deficit". Exactly.

Richman also wrote that "If they don't [pass Buffett's Import Certificates plan], we will continue losing our remaining manufacturing industries and will continue to pile on more and more debt. We could be heading toward a dollar crash." Exactly what's happened and what will happen.

Here's a brilliant article on how it will happen that should scare the living daylights out of you ... it is a must-read:

How Hyperinflation Will Happen In America by Gonzalo Lira, 9/13/10

Below are Buffet's charts from that article on the growing trade deficit and growing foreign holdings of U.S. assets. The growing foreign holdings are a result of those holding an increasing quantity of dollars wanting to hold real assets instead. As he says, this indicates we're selling off America as noted above.

Buffett's Chart in Fortune of the growing U.S. trade deficit

Buffett's Chart of growing foreign holdings of U.S. assets

To those who want to continue current policies, one might ask, "Why do you hate America?"

The Fallacy of Composition and structures responsible for what's happening

To understand what's happening we need to use systems thinking, which is seeking to understand system behavior by examining "the whole," instead of by analyzing the parts.

A key systems principle is that behavior is a result of structure. So when we see exponential growth, we know reinforcing feedback is driving it. Therefore, we want to identify the feedback structure that's responsible. The causal loop structure is shown below and in the presentation slides. When we understand structure, we can understand behavior and design policies to improve behavior.

Unfortunately, human thinking is subject to the Fallacy of Composition: When we act as if what is true for a part is true for the whole. In other words, there are times when individually logical actions are collectively irrational.

To illustrate examples of this fallacy and how system structure determines behavior review three structures:

  • Spectator view of the field
  • Ocean fishing
  • Offshoring

 

Spectators: When a spectator can't see as well as he'd like, he may stand to improve his view. It does, but it also blocks the view of others. They also stand to get a better view. However, when everyone's standing no one can see better than before. Also, the system is less efficient, because standing takes more energy than sitting. In systems thinking, this is called a "fix that fails."

Ocean Fishing: Consider ocean fishing. Every fisherman logically puts out more boats to increase profits. The additional profits provide funds for even more boats and fishing. But as total fishing approaches the sustainable ocean fishing capacity, the effort required per fish caught increases, which reduces profits because all are less efficient. In systems thinking, this is called a "tragedy of the commons," where the commons is the stock of ocean fish. The spectator example above could also be cast as a "tragedy of the commons," where the commons is the shared view of the field.

There's a perverse additional effect for ocean fishing, because scarcity drives up price, sending exactly the wrong signal to preserve the resource. Many think that market mechanisms always provide appropriate corrections to do what's best for society. This extreme market failure illustrates that this is not true.

 

A libertarian calls me an "Economic Ignoramus" and denies the dynamic I describe above. I explain why he is totally wrong in my response to "The Commons: What Tragedy?" Libertarians are, quite literally, insane.

Another example: Farm Policy Failure.

Offshoring: Let's return to the issue of offshoring and the exponentially increasing trade deficit. When we observe exponential growth we know a reinforcing feedback is responsible. What is it?

The Environment

The world economy is operating in an environment of oversupply compared to demand due to a global glut of economic capacity. This results in extreme price competition and downward pressure on corporate profits (see references below).

The world economy is also operating in a context of an excess of offshore labor supply compared to demand, which produces very low offshore pay. Corporations have found they can tap this low-cost labor supply to increase profits. Each corporation, if it considers profits too low (and corporations logically always want higher profits, no matter what their level), can logically increase offshoring to reduce costs and increase profits.

The Logical Logic that's Irrational

Each company's offshoring adds to total offshoring, which also has the effect of lowering pay in the U.S. (see references below). This in turn reduces U.S. purchasing power and total U.S. market demand, which increases price competition ... leading to pressure for even more offshoring.

So every company logically offshores to cut costs, but when all do, none have lower  costs than others and they are no better off than before in competing in the U.S., the world's largest and most profitable market ... for the time being, until we finally kill off the goose that laid the golden eggs.

In addition, U.S. purchasing power erodes, undermining the whole. As long as offshore pay is lower than in the U.S. and there's a global glut of capacity, the individually logical decisions on the part of corporations will power this "reinforcing feedback." Offshoring increases products & services purchased from offshore and in turn results in an exponentially-increasing trade deficit.

The Structure of Offshoring driving an exponentially-increasing trade deficit

Eventually, as offshoring continues, demand for offshore labor will increase, but there will be a long delay before demand for offshore labor exceeds supply. This will keep offshore wages low for decades, if not a century. If there were to be a world equilibrium of pay, one might expect the equilibrium would be at the weighted mean between U.S. and China pay. Because there are so many Chinese workers compared to U.S. workers and because their pay is so low, the equilibrium would be a very low pay indeed.

Some maintain that as economic conditions improve offshore and pay rises, the world will purchase more goods from the U.S. This won't be true because pay will only rise very slowly and they will also purchase from low-cost sources, not from the U.S.

See how the American Chamber of Commerce and World Bank are opposing an increase in working conditions and pay in China at Are there government & business entities that oppose improving working conditions and wages?

Long before we reach such equilibria, the U.S. economy will collapse due to the exponentially-increasing trade deficit as the rest of the world decides to stop taking U.S. dollars for their goods. In response the Federal Reserve will have to raise interest rates to maintain borrowing, because large and growing government deficits and debt won't allow the U.S. to pay off the loans.

 

This growing trade deficit is the root of the controversy over selling US ports to a UAE company. That wasn't, and still isn't, about "good foreign direct investment in the U.S." (see Buffett's chart above showing increasing foreign holdings of U.S. assets). It's about selling off parts of the US economy (including companies, buildings and toll roads) to take back some of the dollars from foreign hands to stave off the collapse of the dollar.


Summary:

  • This reinforcing feedback will continue long as
    • there's a global glut of supply relative to demand
    • large US-offshore wage disparities exist
    • the US economy doesn't collapse ... exponential increases are unsustainable
  • What's individually logical can be collectively irrational.
  • Note: the issue of "trade" and the "trade deficit" is about more than simple "trade." "Trade" is the "exchange of one thing for another," not the "transfer of the factors of production." Because of this, the logic of "comparative advantage" does not apply.
  • Note: Nations don't "trade" ... companies do. It's not their job to look out for the good of the nation; that's government's job. It's not doing it.
  • Exponential growth is slow at first ... lots of frogs are being boiled ... for now! ... because the trade deficit had been rising relatively slowly  As the rate of trade deficit growth increases, there will be fewer and fewer boiled frogs; they'll be getting more and more concerned and "jumping out of the pot."
  • What to do? See the section above and:

Note, 10/30/05:

I brought this page to the attention of a "free trade" advocate's comment at The Future of American Manufacturing. He'd written: But what on earth is an economist doing asking "What will be our competitive advantages in the emerging global economy?"?

I noted that Trade and globalization depend upon absolute, not competitive or comparative, advantage, a very different idea. (Sorry I've had a typo above since I wrote this, saying "depend on comparative", when what I actually wrote below was "absolute".) I referred him to this page.

His response:

I know what the Tragedy of the Commons is. I've written on the subject a number of times myself. You equate offshoring with that. Sorry, TotC is about the overuse of a scare resource because of perverse incentives. Offshoring?? That looks like the use of a different resource for entirely sensible incentives. Don't see, unless you are an economic nationalist, how the two can be compared.

My response:

To see how they're related, see the slides in my presentation at a meeting of the Colorado Springs Manufacturing Task Force: A Systems Thinking Perspective on "Trade" (pdf, 290K). All (this "All" version has the cartoons and the page numbers below are for this file). These structures make explicit how the dynamics play out.

The structure on p. 12 is the Tragedy of the Commons applied to ocean fishing, with which you indicate you're familiar. The problem comes about, not because the incentives in this structure are "perverse" for the individual, they are totally logical and produce the desired results until the scarce resource limit is reached ... then comes the tragedy. In systems our problems are often the result of our successes, not our failures.

The figures from pages 13 to 17 build the structure of offshoring. The titles of the slides explain what's going on as the links are added.

You are correct in that they are different structures ... note that reinforcing (R) and balancing (B) loops are interchanged. However, as long as there's low offshore pay and price competition driven by a global glut of capacity, the reinforcing feedbacks power offshoring and an increasing trade deficit. Reinforcing feedbacks produce exponential behavior ... as shown in one of the figures, the fit of trade deficit numbers to an exponential function is quite good.

What these structures have in common is that, though they are different, they are examples of the fallacy of composition: individually logical decisions producing results that are collectively irrational. That's the comparison; it's not that the structures are the same.

For a guide to Reading Systems Diagrams there's a link to A Brief Introduction to Systems Diagrams that explains the S and O links.

As to whether I'm an "economic nationalist" or not: If there's a choice between being an "economic nationalist" and standing by as our economy crumbles, I'll choose being an "economic nationalist." As I note in my post, I recommend ending "reverse protectionism" and adopting Buffett's balanced trade mechanism ... and we need to end "comparative advantage" arguments that don't apply to the current situation (... absolute advantage is operative).
_____________

References on Global Glut of Supply:

The Chicago Tribune, four-part series: "The economics of glut."
December 15, 2002 through December 18, 2002 at:
http://www.chicagotribune.com/business/chi-021215glut,1,4874700.storygallery?coll=chi%2Dnewsspecials%2Dhed

Overcapacity Stalls New Jobs By LOUIS UCHITELLE, NY Times, October 19, 2003
http://www.nytimes.com/2003/10/19/business/19SOAP.html

References on Wages:

"Using official Bureau of Labor statistics, Johns Hopkins University economist Arnold Packer calculates that employees' share of the value added in the U.S. economy has fallen to its lowest point since records were first kept in 1947 -- and the rate of decline is accelerating."

"Maybe We Could All Deliver Pizza . . .,"
Jodie T. Allen, 3/06/04, The Washington Post,
http://www.washingtonpost.com/wp-dyn/articles/A35469-2004Mar6.html

The recession in the U.S. has been over for more than three years. The economy has been growing at better than a 4% annual clip for the past two. Profits, at least until recently, have been up. Growth in worker productivity has remained strong. ... Yet wages for the typical worker aren't even keeping up with inflation. Wages are growing unusually slowly for this point in the economic cycle, especially given persistently strong growth in productivity ...

Workers' Wages Trail Growth in Economy By DAVID WESSEL
Wall Street Journal - April 21, 2005; Page A2

Past Presentations:

Presentation at the Magellan Center (Longmont) on 11/9/06:
Magellan Center “Big Idea” on Offshoring & “Trade”, A Systems Thinking Perspective (pdf, 1085K)

Presentation to the Colorado Springs Manufacturing Task Force meeting on 5/5/05.

See the slides at this link: A Systems Thinking Perspective on "Trade" (pdf, 290K). All

This article (modified) appears in the Summer 2005 issue of the Magellan Center's Magellan Explorer magazine with the title: "Is Our Trade Deficit Sustainable: A systems Thinking Perspective on Trade" (pdf, 32K) ... in approximately the same format as in the magazine.

[Discussion below updated 4/25/06 & 5/4/06, including additional diagrams and charts. See update of charts on trade and jobs as of 3/07 at Populism, 'Trade' and Jobs].

© 2003 Continuous Improvement Associates

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