Trade Gap Plunges; Feel Better Now?

Economy: For decades, we've been told that rising trade deficits were a bad thing. Well, guess what? In November, the trade deficit shriveled by 29%. But don't get the party favors out yet.

The common wisdom that trade deficits are a sign of weakness and lost competitiveness is more of a myth. In fact, the opposite is true: Trade deficits tend to climb when the economy is strong, and fall when it's weak.

This is certainly the case now. November's $40.4 billion gap was the smallest in five years and the fourth monthly decline in a row. Both exports and imports fell — a sign of global recession.

So the deficit is shrinking — but don't cue the applause.

Contrary to what some assert, a smaller deficit isn't a "drag" on the economy. Nor is it a sign of economic health.

Just look at recent history. From the end of the recession in 2001 to 2006, a time of solid economic growth in the U.S. economy, the trade deficit surged to record levels.

But, as economist David Malpass of Encima Global has noted, during that time the U.S. created some 9.3 million jobs. Japan, by comparison, created just 360,000 new jobs, and Europe — excluding Spain — created just 1.1 million.

(Like the U.S., Spain ran big deficits. It created 3.6 million new jobs — more than three times the rest of the Euro zone combined.)

This isn't new. As trade economist Dan Griswold of the Cato Institute noted in a 2007 study, there's an inverse relationship between trade deficits and the economy. The faster the economy grows, the greater the trade deficit. And vice versa.

"In those years since 1980 in which the current account (the broadest measure of trade) deficit actually shrank as a share of GDP, real GDP growth averaged 1.9%," Griswold noted. But when the trade gap grew 0.5% or more, he added, real GDP growth averaged 4.1%.

This means the economy grew roughly twice as fast when the trade deficit was getting "worse" than when it was getting "better."

By the way, the last time we ran a trade surplus for a full 12 months was 1991 — a recession year. Anyone who still believes that surpluses are good must be longing for the good old days of the Depression. Thanks to plunging consumer spending and the Smoot-Hawley tariffs, the U.S. ran trade surpluses in nine of the 10 years of the 1930s.

Yes, critics say, but we're falling deeper and deeper into debt as we run up our national credit card to buy goods overseas. We now owe the rest of the world trillions of dollars, thanks to our insatiable hunger for foreign-made things. Where will it all end?

But this too shows a misunderstanding of how things really work.

The mirror-image of a trade deficit isn't debt; it's a capital surplus. That is, dollars that go overseas for foreign goods don't just sit there as "debt." They are either saved, spent on U.S. goods or reinvested here. Mostly it's the latter.

As a 1999 Joint Economic Committee report notes, "a trade deficit will occur when the U.S. economy is offering investors such attractive options that foreigners are investing more in the United States — buying more assets — than Americans are investing abroad."

That's been happening for years.

When dollars come back as investment, we often mistakenly call it "debt." True enough, it's debt if the money buys U.S. Treasurys. But if it's an investment in the stock market, do we really owe someone something?

And if the trade surpluses other countries rack up with us are spent on U.S. real estate, are we worse off? Is that a debt?

And if the money returns as investment in factories and businesses, don't we come out ahead?

The answers are: No, no and yes.

In fact, a lot of that money comes back as direct investment.

This a good thing. As economist Matthew Slaughter of Dartmouth University recently noted, foreign companies in 2005 employed nearly 5.1 million Americans, or roughly 4.4% of the labor force. Compensation per worker for the foreign companies was $66,042, 32% higher than for the average private sector job.

Foreign investments — recycled trade deficits — have made our economy stronger by boosting productivity and lifting demand for labor here. Those investments are made possible by our deficits.

Virtually all economists agree: The more and freer trade, the better. Trade doesn't make us poorer; it makes us richer — a far cry from the misconceptions that pundits have been peddling, and most of the public has been buying, for years.