I started out to write a blog earlier this week about the Federal Reserve and their balance sheet and discovered that I was spending way too much time trying to explain myself rather than just writing. This is when it dawned on me that many people probably have little to no idea how financial “stuff” works. Exactly what is a bond and how does it work? What does the Federal Reserve do, and why do I care? What is the difference between a mutual fund and an ETF (exchange traded fund)?
With that in mind I decided to embark upon a series of blogs that will attempt to explain many financial concepts. If you have an idea or concept in mind that you particularly want addressed, please feel free to leave me a comment below or drop me an email with the request. For now, I thought I would like to start with a concept that even the President seems not to quite comprehend but is quite relevant currently – trade deficits. This is particularly timely as it was announced this week that our trade deficit is at record levels despite tariffs.
I recently watched an informal news conference Trump did from the Oval Office. During the question and answer time one reporter asked about a trade deal with China. Trump’s answer included a line that took me aback. In attempting to explain the current negotiations with China, Trump stated: “Our country lost $800 billion last year with trade. Eight hundred billion.”
On the face of it, this sounds quite scary! We lost HOW MUCH?! We need to stop this! Immediately! But wait a minute…. Lost how? Did we really “lose” here? What the President was referring to is our trade deficit. Let me explain what a trade deficit is and how we are not, in fact, “losing” when we have a trade deficit with another country.
Let us start with the basics. The U.S. manufactures many things – Fords, Budweiser beer, Jack Daniels whiskey, Harley Davidson motorcycles and so on. At the same time, other countries manufacture things we want – BMW’s, Apple iPhones, Nike sneakers, Moet champagne and so on. We send Budweiser beer to Europe while they send Moet champagne here. This is international trade. At the end of the day, the government scorekeepers add up how much we shipped overseas and subtract from that what we spent buying goods shipped to us from other countries. If we shipped and sold more Budweiser or Harley Davidsons than we spent on Moet or Mercedes, we have a trade surplus. If we bought more foreign goods than foreign nations bought from us, we have a trade deficit.
So, with that concept in mind, a trade deficit simply means we bought more goods from foreign manufacturers than we shipped and sold overseas. Does that mean that we “lost”? After all, if we want champagne more than we want Budweiser, is that a negative thing? Let me explain this another way. If I fill up my gas tank and pay cash for the gas, I now have a trade deficit with the gas station. I have sent more money to their side of the ledger than I have received from them. But here’s the rub. I got a benefit for that $25 “trade deficit”. I received the benefit of a tank of gas. Am I worse off for having spent the money? No, of course not!
This is exactly how trade deficits work in the real world. If we send more money overseas than we take in, we have a trade deficit, but we have (presumably) received some benefit from this bargain. We have more Samsung Galaxy phones and Nikes and BMWs than we did before. This is not necessarily a bad thing. Where I think people – including the President – seem to miss the boat is conflating a deficit with “bad for America”. Just because we buy more goods or services from a country than they buy from us does not equal “bad for America”. In fact, we must have received some benefit from this relationship like my tankful of gas, or we would not have made those purchases. We wanted those Nikes or BMWs or Samsung Galaxy phones.
Our biggest trade debt is with – no surprise here – China. We mainly import consumer electronics, clothing and machinery from China. The first two should be no surprise. Think Apple iPhones or Nike shoes. Even the President’s family isn’t immune from outsourcing to China as first daughter Ivanka, until the middle of last year, ran a now shuttered clothing line that was manufactured in China. Why don’t U.S. companies keep all manufacturing here at home? Cost is obviously one answer. It is much cheaper, even with shipping, to have an iPhone made in China than here at home. With minimum wages going up throughout states, either by law or by pressure from other companies, these labor-intensive jobs are likely to remain offshore.
Let’s dig a little deeper into how we rack up a trade deficit, even on goods that are made here. One of the key items traded in the NAFTA zone – Canada, the U.S. and Mexico – is auto parts. The Ford Escape is assembled in Kentucky making it an American-made car. However, 55% of the parts that go into the car, including the entire engine, come from Mexico or Canada. The engine that we purchase from Canada counts in the calculation of what is bought and sold between countries. That is, when we purchase engines without shipping something of equal or greater value back to Canada, we have incurred a trade deficit. So, the Ford Escape is assembled and resold mainly in the U.S. with Canadian engines and we end up with a trade deficit. But did we lose on this deal or not? Presumably, if Ford could source engines as cheaply here in the U.S., they would. Using Canadian engines is apparently saving Ford on the cost of building the Escape and allowing consumers to more easily afford this vehicle. That would seem to be a benefit to everyone involved – Canadian and American.
The bigger issue and thornier question concern the outsourcing of manufacturing to foreign countries at the expense of American jobs. I don’t pretend to have any easy answers here. From an economic standpoint, I would argue that we should outsource some manufacturing overseas to countries with cheaper labor. I do have a problem with using child labor at $1 a day, even if that wage is high for that country. There is no one single answer to the question of whether we should outsource or not. In the end, if we are getting the products we want at prices we want, outsourcing to other countries can be mutually beneficial. I would love to hear your thoughts and ideas below.
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