Review of:

Catherine Mann, Is the US Trade Deficit Sustainable?

Washington, D.C.: Institute for International Economics,1999.

by Diana Thorburn

December 17, 1999

Catherine Mann attempts to answer one of the most critical and complex questions in US politics and international economics: “Is the US trade deficit sustainable?” While Mann’s objective is to analyze the “sustainability” of the US trade deficit, vis-à-vis four areas, international trade and finance, increasing global economic integration, competitiveness and trade policy, and the global economy, her discussion ends up answering many other related and important questions. She does this through an assessment of “external and internal forces,” their confluence, and the analysis of relevant empirical data.

That the trade imbalance may not be sustainable is brought into question by the experience of the past. Mann points out the similarities between the current US economic situation, and that of the mid-1980s, when there was an expansion of the US economy followed by a large devaluation of the US currency. Mann asks what, if any, are the differences between the present state of the US economy with its large external imbalance, and the experience of the eighties. She describes the US’ position in the world economy in the late 1990s—robust growth, low unemployment and inflation in a context of financial crises in the rest of the world—and estimates that the US can run its present level of current account deficits for two to three more years, before there is a 1980s-type devaluation.

The book is not just about answering the question posed in the title, however. Mann situates the US in the world economy, and discusses the most pertinent features of the contemporary global economic situation, and its policy implications. The discussion serves not only to create a context within which the title question can better be understood, but also aptly treats other issues relevant to US interaction with the world economy, and the inferences of this interface for American workers, consumers and policy makers. Mann very effectively begins each chapter with pithy quotes from influential people or publications that are relevant to the specific topic. These serve to remind the reader of the debate surrounding the issues, and provide useful reference points with which one can evaluate Mann’s arguments and recommendations.

Mann first tackles the conundrum posed by the development of a federal budget surplus while the trade deficit has worsened. The two were, until recently, known as the ‘twin deficits’, and were thought to be inextricably linked. The two deficits were called ‘twins’ and linked to each other because they appeared to move together when plotted over time, and because there appeared to be economic relationships common to the two deficits. It was believed that common forces were driving both deficits, principally the expansionary fiscal policy of the 1980s mixed with tight monetary policy. Imports rose as the dollar appreciated, worsening the current account imbalance. The prevailing knowledge then had been that the current account deficit would be eliminated by balancing the federal budget, but this has not proven true, as the federal budget now has a surplus, while the current account deficit has only grown larger.

The present situation questions whether the twinning of the two deficits may have been incorrect to begin with, or if their twinning was correct until new and unpredictable external factors, principally the weak or negative growth of US trading partners, changed the dynamics of the linkage. These unforeseeable external factors would be the US’ growing economy allowing it to import more, while its trading partners’ economies not growing at the same rate. This has resulted in the lack of concomitant demand for US exports in the rest of the world, while US demands for imports has increased considerably. That is, the ‘untwinning’ of the current account and the fiscal deficits occurred because, on the external side, the robustness of the US economy has not been matched overseas. There is a domestic dimension that also attributes to the diversion between the original pair: the diversion can be accounted for by the fall in the savings rate and increased consumption as a result of the healthy economy.

Mann then moves on the question of US comparative advantage as a factor in the large trade deficit. She makes the case that the US has a comparative advantage in services, particularly in financial assets as the US market for government bonds is very mature. The US, since 1975, has had a positive trade balance in services, while the negative trade balance is due to increased imports of capital and consumer goods. Hence increasing exports of services would assist greatly in improving the current external imbalances. This would require, however, further liberalisation of services in world trade. Again Mann makes the point of the advantages of liberalised trade and globalization for US prosperity.

Mann’s focus on globalization and its role in the growth of the US economy and on the current account deficit brings her to evaluate the impact of trade on the American worker. This is an extremely pertinent question in the wake of the recent protests at the World Trade Organization conference in Seattle. Those protests were premised on the polemical notion that trade hurts the American worker. Mann’s analysis focuses not on how specifically changes in the trade balance and changes in export and import flows affect the American worker.

This issue is extremely sensitive in both the US (and European) domestic political arena. The popular understanding of the relationship between trade and the labour market is that increased trade results in loss of jobs in the US, and/or exerts downward pressure on the wage rate. While there is a theoretical relationship between the loss of low-skilled jobs as a result of trade, Mann argues that these losses would also occur were there improvements in technology (implicitly stating that no one would protest improved technology, yet the results are the same as with increased trade). She also argues that, with trade, demand for skilled labour increases, therefore the appropriate policies are not trade barriers, but retraining low-skilled workers for higher skilled jobs; indeed, she states that trade barriers would hurt Americans as a whole.

Continuing on the topic of trade, the book then assesses the role of trade in prospects for sustainable long-run growth. The discussion focuses on how the current dynamics of US trade with the rest of the world have rendered the optimal situation of growth with low inflation. The recent phase of US economic growth has not resulted in the expected inflation that normally accompanies such growth; indeed, inflation has fallen. While there are new factors involved that explain the lack of correlation between these two theoretically and, up to now empirically linked variables, the correlation has not permanently been eliminated. That is, there has not been inflation with the current phase of US economic growth because the appreciation of the US dollar kept import prices down, and slow growth overseas has kept commodity prices low. Slow overseas growth has also put downward pressure on export prices. None of these situations is permanent, however, and inflation will resume the expected upward path with time, but it will not return fully to the original pattern, as we know it from the Phillips Curve. Globalization has resulted in greater competition at the international level, and hence pricing, productivity growth, and research and development spending has assumed much higher profiles in terms of what variables production decisions are based on. The growth phase has also seen new investment in plant and equipment, and greater prospects for hiring without running into capacity constraints.

In this discussion, Mann emphasizes once again that globalization and increased trade have changed some of the fundamental dynamics of the US economy, in ways that have been good for US workers and consumers, and that these gains should be made clear to Americans.

In her analysis of unfair trade practices and the external deficit, Mann takes on the argument that the US trade deficit is in some measure owed to trade barriers in other countries. She rejects this argument, as her data shows that few bilateral deficits can be attributed to this explanation. Furthermore, altering bilateral trade balances is a much less optimal policy than would be changing business profitability or the household savings rate. Where trade negotiations can have a meaningful effect is at the multilateral level, specifically in the services industry, a point that Mann has made in other contexts in her work. Mann tackles this argument in an effort to preclude the erection of trade barriers in response to demands for such policies by those who believe that bilateral trade relationships are the cause of the trade deficit. Mann counters this position in two ways: first, that bilateral trade barriers are few and exert minimal effect on the trade deficit, and two, that other policy actions comprise much more optimal strategies for reducing the deficit than do bilateral trade negotiations.

The new global economy has challenged conventional wisdom all around, and Mann continues to address the new developments brought on by globalization in her book as she deals with the apparent inconsistency between the notion of US competitiveness and the trade deficit. That the US can be the most indebted country in the world at the same time as it is the most competitive is confounding to most people, economists or not. Mann tackles this paradox, stating that these two issues are, in the main, discrete, and that the trade deficit is not a good measure of international competitiveness. At the same time, however, Mann does contend that the trade deficit has implications for the US competitiveness, and that the imbalances reflected in the trade deficit could augur inauspiciously for US competitiveness. To avoid this, Mann advocates that the US keep abreast of the changing demands of a global economy viz. education and training, research and development, and particularly improvements in technology and productivity.

Up to now, Mann has described and analysed how the international economy has provided unprecedented benefits for US consumers, who are enjoying extremely high levels of consumption, as a result of the confluence of many of the different factors that Mann has addressed. However, the trade deficit in the face of high consumption begs the question, is the US living beyond its means?

Mann’s answer is that, in some regards, yes, the US as a whole is spending beyond its means. However, much of this spending has gone into purchases that will bring returns in the long run as the economy will continue to grow. Nevertheless, the current spending patterns, to be maintained, rely on the foreign savings and national wealth to continue growing; these are not definite prospects, and hence other policies should be targeted, such as increasing household savings rates, and trade negotiations to liberalize trade in services. Moreover, when economic growth slows, households will borrow more to maintain present high consumption levels, adding adversely to the trade deficit.

The last topic Mann treats before arriving at the original question posed in the book, is the role of capital markets in the trade balance. Capital transactions today are largely independent of trade transactions, and far exceed trade transactions, though they are both driven by the fundamental, perennial economic forces of relative prices, income, savings and investment. For Americans this means that “trade” does not only mean imports and exports of tangible goods and services, but also the movement of financial wealth. This implies, however, that stability in terms of policies and expectations is crucial to reaping gains and avoiding crises. While the US is in a better position than most countries because the US dollar is practically a universal currency, and because asset markets are deep, crises in asset markets can have negative consequences for imbalanced goods markets.

In the concluding chapter of the book, Mann directly answers the question that the book’s title asks, “Is the US external deficit sustainable?” The rest of the book, in a sense, built up to this question and her answer, preparing the reader, as it were, by providing a backdrop to the US economy and its relationship to the world economy.

Mann first defines sustainability as “a stable state or stable path where the external balance generates no economic forces of its own to change its trajectory. A sustainable external balance is one in which the feedback relationships between the external balance and the exchange rates and interest rates are relatively weak in comparison to other macroeconomic forces that affect these asset prices.” This definition cannot have meaning without context, however, and so Mann looks at sustainability from three perspectives, that of the borrower (the US), that of the lender (foreign creditors), and from the political perspective.

An important point to make is that implicit in Mann’s definition of sustainability is a reduction in the trade deficit. That is, she foresees a continued trade imbalance on the deficit side, but this imbalance will only continue to generate positive effects if there is movement towards reducing it. Otherwise, it appears that Mann is saying in her extrapolation from the data and events of the mid-1980s, her analysis of current data, and the consideration of other important factors such as the composition of trade and investment flows and the rest of the world economy, a depreciation of the US dollar must take place, and the current account imbalances will generate negative effects for US workers and consumers.

From the US perspective, defining sustainability requires evaluating a number of questions, such as: do imbalances mean for the US what they mean for other countries, given the US’ unique position in the world economy? An example of why this question is important is that while large trade imbalances have proved economically disastrous for other countries in the past, those economies do not enjoy the US’ influence and position in the world economy, with such a powerful currency and such a large and strong economy. These questions are relevant, because for the borrower, the US, future claims on the resources of the country depend on whether the imbalance is sustainable or not. That is, will the deficit and the interest payments on it grow so large that they impact negatively on future consumption? Or can consumption levels be maintained, or increase, at the same time as the debt burden can be maintained as required? This is what sustainability means for the US.

From the investors’ perspective, one must ask, how long are investors willing to hold on to US debt? Perhaps were it any other country, investors may not want to hold on to debt for a long time, but again the US is a special case, as US assets are considered valuable for financial asset portfolios. But if investors were to become doubtful of the US’ ability to repay its loans, and decided to cash in, and the US were suddenly required to repay not only interest but principal, this could create adverse shocks for the US economy. Furthermore, should the deficit grow, will investors be willing to lend more to the US?

Finally, from the political perspective, Mann evaluates the sustainability of the trade deficit with respect to the voting public. Can a political representative maintain support with a trade imbalance such as this? Particularly when populist campaigns focus on the deficit and propose protectionist measures as a solution? How long can the present situation be sustained before the electorate has had enough and votes in policy makers who promise to change the situation (or at least promise to try to change it)?

Mann then assesses the sustainability of the trade deficit, and the “special-ness” of the US economy, with three different tests, using the same basic data in three different but possible scenarios.

In the first scenario, Mann keeps the value of the US dollar stable, with US and world growth rates as they are currently projected (US growth slowing a bit and the rest of the world picking up a bit), and looks to the year 2010. This case suggests that the trade deficit is sustainable for about three years, before the US consumer starts to feel the effects of growth rates not matching the debt burden. At this point the political sustainability may also come to an end. The investor, in this scenario, probably would be willing to take up the US assets that would become available to sustain the deficit, as growth resumes overseas, and US additions to financial portfolios are sought.

Mann conditions this tentative conclusion of unsustainability on the borrower side by introducing the features of the US’ “special-ness”. She thus concludes further that the calculations used to arrive at this conclusion may lose relevance in light of the fact that most of the US debt is in US dollars, that US assets enjoy particular attractiveness in international financial markets, and that a depreciation of the dollar is unlikely. Nevertheless, even if in two or three years the predictions of unsustainability do not prove true, they will in the longer run.

The second scenario posits a substantial depreciation of the dollar, a likely scenario should the trade deficit prove unsustainable. Should this happen, the trade deficit will not improve, and the sustainability problem will be postponed but not eliminated. US growth would slow, the rest of the world’s growth would increase, and the deficit would return to its original level in about five years, given a 25% depreciation. Further, inflation would increase, and productivity would decrease.

The third scenario envisions structural change having taken place, where the US dollar remains at high value, and economic reforms have increased both world rates of growth and US growth rates, via the liberalization and deregulation of world trade in services. This has been Mann’s prescription throughout the book. In fact, this scenario, in conjunction with education and training for American workers, would yield positive results for all the controversial issues she raises in the book, such as trade’s impact on the wages of low-skilled workers.

Finally, Mann raises the question of the implications of the new European currency, the euro, for the trade deficit. Primarily, the effects of the euro will be felt on the side of investor sustainability, as euro assets may become more attractive and compete with US assets. Should this happen, this will lower the sustainability limits for the present external imbalance.

For the economy to correct its external imbalances, US policy makers will have to make far-reaching changes to the present import-export profile, changes that could entail difficult adjustments domestically the longer they are put off. Changes will also have to be made in the US domestic savings rate, and the liberalization of global trade in services. Furthermore, the depressions, and financial crises in the rest of the world will have to be remedied so that the US can regain buoyant trading partners so that US exports can resume growth.

In sum, Catherine Mann’s principal conclusions are based on the fact that the globalization of the US economy causes trade and domestic policy to converge, so that good policies in the new millennium will balance both domestic and external needs and objectives. These conclusions are:

(1) International trade has been good for the US economy in stimulating growth without inflation.

(2) Globalization and its benefits must be sold to the American people, and they ought to be better equipped to take full advantage of the US advantage in the global economy.

(3) Without rectification of the financial crises in US trading partners, the current account deficit will continue and become unsustainable in 2-3 years.

(4) Should the external imbalance become unsustainable, a depreciation without domestic structural changes will not rectify the imbalance, and may augur an increase in inflation

(5) The liberalization of trade in services is the critical factor to reduce the trade deficit.

(6) Household savings levels are too low, and consumption levels are too high; should the stock market boom ebb, household debt levels will rise as households borrow to maintain high consumption levels.

(7) Growth in the rest of the world’s economies will precipitate a narrowing of the current account gap, as investors would diversify their portfolios to other countries that at present are not attractive for investment.

The political aspect of this issue is a crucial consideration to the question of what policy will work best to maintain sustainability (and reduce the deficit). The policies likely to be implemented should the electorate demand a change in the present set of policies, are likely to be protectionist trade policies that will not be beneficial to US consumers. Other policies, such as a currency depreciation, will not in the medium or long term solve the problem. Mann posits that political sustainability has already been reached, at least initially, though one can foresee that it will really come to a head when the deficit is no longer economically sustainable and consumption is forced down.

Mann’s book makes a timely and relevant contribution to the understanding of the question about the US trade imbalance, and the conundrums related to it. But the book also provides a description and assessment of the bigger picture of the US and the world economy, and how the current state of globalization and world capitalism is manifesting itself. The US trade deficit is a product of the new global economy, and its sustainability or unsustainability are dependent not only on domestic policy actions, but also on policies and developments in the rest of the world. Certainly there are initiatives that the US can do independently of the rest of the world, such as raise the domestic savings rate, and concentrate on education and training for the future. But there are policies and developments that the US has only partial control over, or none at all. These include liberalisation in the trade of services, a policy that would require the collaboration of all WTO members.

Growth in the rest of the world’s depressed economies is also necessary for sustainability, but besides financial and technical aid transfers towards economic reform and rehabilitation in the rest of the world, much of the rebounding necessary in other countries depends on the domestic political economy, which is sovereign to that country. Where the US has even less influence is in the future attractiveness of the euro, which could have negative effects on the sustainability of the US current account, as investors may become less willing to buy or keep US financial assets.

Another important contribution of this book is its methodology. By maintaining a consistent focus on both the external and domestic factors, and also on their interaction, Catherine Mann’s methodology appropriately reflects the new context of economic forces and their dynamics, effects and outcomes. Treating any of these discretely would not portray the entire picture necessary to understand contemporary developments in the world economy in general, nor the question of external balances in particular, and hence would not render viable or realistic policy prescriptions. Having seen the aptness of the application of this approach, one cannot see how future analyses of domestic or international economic phenomena could be otherwise carried out.

The points raised in the book, and the conclusions drawn, bring one to reflect on the possibility of the various scenarios. The possible scenarios as presented by Mann bring into question the sustainability of the capitalist world economy, as well as the implications of US economic weakness on global political stability. Suppose that growth does not pick up in the rest of the world? And, bearing in mind that the US is at present the global hegemon, in large part due to the strength of its economy, suppose the US continues to become more and more indebted, causing the external imbalance to become unsustainable and rendering the US economically weak—what will this mean for global peace and security? Clearly these questions are way beyond the scope of the book, and it is no fault of Mann’s for not addressing them, but they are important in the larger scheme of things. Indeed the clarity of Mann’s analysis, and the disaggregation of the causal factors critical to the present situation perhaps present the necessary details for intervention to preclude such a scenario. If this is the case, then whose responsibility is it to take the requisite measures proposed? The audience of this book, and the receptiveness of that audience, would thus become very important. The response to Catherine Mann’s arguments should thus be greatly anticipated.