Frames Matter

Yeah, I know I've been on an economic kick lately, but it's either that or intestinal bacteria. OK, now that we've cleared that up, on with the numbers and cents.

There has been the usual wailing and gnashing of teeth over the record Current Account Deficit (otherwise known as the trade deficit). First I'm going to point you to another fine piece by David Nicklaus:

Fortunately, there is another way of viewing the trade deficit. Instead of being a sign of weakness in our goods- and services-producing industries, it's a sign of strength in our capital markets.

By definition, the current account deficit must be matched by a capital account surplus, which means foreigners invest more here than we invest abroad. If foreign investors simply view the U.S. as a great opportunity, their enthusiasm may be driving the trade equation.

Bill Poole, president of the St. Louis Federal Reserve Bank, explored this line of thinking Wednesday in a speech at Lindenwood University.

"It may be that the trade deficit is driven by ... investors seeking the best combination of risk and return in the international capital market," he said. "The mechanism creating this outcome is that capital inflows keep the dollar stronger than it otherwise would be, tending to boost imports and suppress exports."

That does make the trade deficit sound less scary. But, the alarmists would argue, the U.S. is in a vulnerable position. Foreigners can simply pull their money out, cause the dollar to plummet and throw us into recession.

Poole thinks that is highly unlikely. "For the United States, unlike almost every other country in the world, a hard-landing process is inherently self-limiting," he said.

That's because our external debts are denominated in dollars. A decline in the dollar's value has no effect on our debts - we still owe the same amount in dollars as we did before - and it makes our overseas assets, denominated in foreign currencies, more valuable.

"To the extent that the foreign exchange value of the dollar declines, the effect on the values of U.S. and foreign asset holdings works not as an accelerator of crisis, but as part of a self-correcting mechanism," Poole said. "The composition of the U.S. international investment account, therefore, contributes to stability rather than to instability."

His view is that the trade deficit will be reduced in a "slow and orderly" way and that the adjustment "may not begin for quite some time."

The real question is if that's the better way to look at the issue ("I'm not overweight, I'm undertall") but since I've been hearing just how bad the trade gap is for a very long time now, and it doesn't seem to have a noticable effect, I'm going to go with looking it as a sign of capital market strength. I recall reading something similar in regards to when Britannia ruled the world -- at least in the economic sense -- and how having the world currency provided certain capital benefits, but I'm too lazy to go track it down.

In addition to the main thrust of the article, a couple of things caught my attention. First, is the use of absolute dollar numbers when comparing ecomonic events that occur at different times. This can be misleading. The best way to compare such figures is to use non-dimensionalized figures, in other words divide dollars by dollars, which removes the effects of inflation and gives a real apples to apples comparison. So in this case, you should divide the gap by either the size of all trade, or by GNP, just as you would divide the budget deficit by either the total budget or the GNP to give meaningful figures. Whenever somebody just gives you absolute numbers and then makes a comparison, even if only implied (e.g. worst deficit ever), take it with a grain of salt.

Secondly, buried in the piece was this interesting fact: Even with record trade deficits, the economy has grown at a rate of 3 percent or better for 10 straight quarters, the longest such streak in more than two decades. What's this, the "Bush" economy beats the "Clinton" economy. Gee, that's not something you hear from the press, mired in a loss of advertising revenues that has gone from glitch to downturn to slump to permanent loss.