If it's you, then spend less, save more...

THERE is a lot of grumbling that free trade is eroding economic health in the US, writes Nathan Lewis of New World Economics in this article first posted at Forbes.

There is some merit to these arguments; also, the US economy hasn't been very healthy for a long time. Recently, there has been talk about new tariffs on steel. This has been supported by Wilber Ross, now US Secretary of Commerce, who, in 2002, assembled the International Steel Group from assets of several bankrupt steel companies.

In 2005, Ross sold ISG to India's Mittal Steel Company, for $4.5 billion. Media reports at the time estimated that this sale price was over twelve times Ross' investment. (The fact that president George W.Bush slapped new tariffs on steel, immediately after Ross' purchases, certainly helped.)

There are a lot of issues surrounding trade – for example, the tendency of trade agreements to come attached with globalist institutions that erode national sovereignty. The European Coal and Steel Community (1951) not only allowed trade in coal and steel, it introduced a whole new supranational government structure, including three branches of government and a parliamentary body, that later grew into the European Union. This sort of thing should be avoided with extreme prejudice.

Today's environment of floating fiat currencies introduces new problems. The devaluation of the Mexican Peso in 1995, shortly after the passage of the North American Free Trade Agreement in 1994, caused all sorts of hardship for US competitors that cannot be attributed to any meaningful "comparative advantage".

Nevertheless, we will try to isolate some of these sub-issues by asking: would free trade be acceptable if the United States ran a trade surplus?

A trade surplus would not help the US steel industry very much. Nor would it help any domestic manufacturers of the sort of thing you buy at WalMart. But, other US manufacturers (and service providers) would also be selling an equivalent, or greater, amount of goods and services to foreigners. This could be things like agricultural products, capital goods, software, and a wide variety of services including banking or information technology.

I think most people would feel that this is acceptable. The easiest way for us to acquire beach chairs is to sell complicated barcode scanning systems, and then take the beach chairs in trade. At present, gross exports of goods and services are about 80% of gross imports. The 20% difference is the "trade deficit".

Today, gross exports of goods and services are greater than at any time before 2007 – around 12% of GDP. We don't seem to have any trouble selling our wares to foreigners. We are selling more to foreigners than ever. In the 1960s, when the US had a trade surplus, total exports were about 5% of GDP. Imports, of course, were less than this.

If the amount we sell to foreigners has been steadily rising, why can't we manage to run a trade surplus? The reason has to do with the nature of trade, investment, and savings. Domestic capital creation – basically, the combination of the private savings rate and corporate profits – in the US is low. Much of this new capital is then dissipated on consumer lending, government budget deficits, and capital-related taxes. To fund new investment, capital must be imported. This appears as the trade deficit.

Thus, if we want to have a trade surplus, we should generate more capital domestically, and squander less, to finance domestic opportunities and leave some left for net foreign investment. This means more gross consumer saving and less consumer lending; plus, smaller government budget deficits.

Just as, on a personal level, "higher savings" means less purchasing of goods and services (relative to income), and more acquisition of real and financial assets, so too the analogous behavior, on an aggregate national level, would mean fewer imports and more net acquisition of foreign assets.

Sometimes people ask me: are trade balances driven "by the goods side," or "by the investment side"? Actually, they are intertwined. Let's take an example: What if the price of oil doubles? Since demand is slow to change, this would mean a big jump in the cost of oil imports. Certainly, that has nothing to do with domestic savings, right?

Let's imagine the US as one aggregate entity trading with the Rest of the World. If higher spending on oil imports is offset by less spending on other imports, leaving total spending (and the savings rate) unchanged, then we can see that total imports do not rise, and the trade deficit is unchanged. Alternately, if the US spends more on oil imports, but other imports do not change thus leading to higher total spending and higher total imports, the higher overall spending is effectively financed by a decrease in the savings rate, and the trade deficit would increase.

What about the other side? The Rest of the World gets more Dollars for its oil. What does the ROW do with these extra Dollars?

In the first instance, they probably appear as a bank balance in an account at a US bank – a financial asset. If these extra Dollars are then spent on goods and services, then US exports increase, the "trade deficit" does not change, and the ROW's savings rate is unchanged. However, if they are left as a bank asset, or used to acquire other assets such as Treasury bonds, then the ROW effectively "saves" the new income, US exports do not increase, and the "trade deficit" expands. We can see that decisions about savings and investment do indeed drive the trade account, even in this example.

We should not be too unhappy by the fact that foreigners invest in our economy – that the US runs a trade deficit. In the midst of low capital creation today, this finances investment and thus helps create jobs and prosperity that would not otherwise occur. It would be better if we could generate lots of capital internally, but in the absence of such a happy condition, capital imports probably allow a healthier economy than would otherwise be the case.

To put it a little more bluntly – what if foreigners were banned from all future purchases of Treasury bonds? The trade deficit might shrink, but you can imagine some of the other consequences.

If we had big pro-business reforms in the US, like a 15% corporate tax and other such advantages, then the US would be a better place to invest. How would the US steel industry be doing if it had low taxes and efficient regulation (effective but not burdensome) regarding environmental issues, worker safety, healthcare, legal liability, or a dozen other things handicapping the industry today?

This kind of business-friendly environment could lead to new investment in steel, and could thus drive an even larger "trade deficit", as domestic capital is insufficient to finance all the available opportunities. This was the case during most of the nineteenth century, as European capital flowed to the US, some of it financing the original growth of America's steel giants. During the 1990s, high-growth Asian economies like Korea and Thailand had high savings rates and capital creation, but so many domestic opportunities that they still imported capital and ran a "trade deficit."

Whenever I look into issues surrounding trade, I come to the conclusion that most concerns would be resolved by a combination of a business-friendly environment, Stable Money, and high levels of capital creation. In other words, the Magic Formula: Low Taxes and Stable Money.

There are still some issues regarding "globalism" that merit attention, but I think that most people would be happy with the overall result.