EDITOR’S NOTE: The August 31, 1992, issue of National Review, set out to set the record straight about the Reagan administration’s economic record. We reprint the content of the issue here.
In studying litigation at law school, one learns that pleading in the alternative is not only proper but often the only way the defendant is assured of a comprehensive defense. And never mind that the separate defensive arguments may appear contradictory. The old English case one read at Harvard involved a plaintiff claiming the defendant wrongfully held the plaintiff’s vase. The defendant pleaded that he a) never took it; b) had given it back; and c) was the rightful owner.
It is thus that we must look at our trade deficit–in divergent ways: a) After necessary statistical adjustments, we do not for all practical purposes have a trade deficit; b) our trade deficit reflects a strength, nor a weakness; c) in the long term, it will probably disappear.
The biggest single factor in our trade deficit is oil, and if you take oil and Canada out of the calculations, our trade deficit disappears. It is advisable from a macroeconomic point of view that we make these adjustments because: a) Canada and the Unites States are one trading bloc–soon to be consummated – and one de facto monetary unit; b) oil is traded in dollars–no foreign-exchange transaction is triggered by the supplier’s selling into the United States; c) and suppliers hold most of their reserves in dollars, i.e., the purchase money never leaves the United States. Other countries have to earn dollars to purchase oil. We do not. d) The fact that we purchase foreign oil is irrelevant to any judgment about whether or not our goods are competitive and whether we are relatively efficient – the making of such a judgment being one of the reasons why we keep trade statistics in the first place. e) Eventually, for environmental reasons, other sources of energy such as Canadian and Mexican natural gas will replace substantial amounts of imported oil, so in ignoring oil, we are not being unmindful of the future.
In most countries a chronic trade deficit reflects a problem, i.e., the non-competitiveness of a country’s products: either their exported products don’t measure up in quality or price in the world markets, or imported products are preferred by domestic consumers for the same reasons; or both. In these circumstances, the deficit country can run low on the foreign currency necessary to pay for essential imports–oil,, minerals, and even food–and eventually the deficit country may have to restrict imports, either directly; or indirectly, by devaluing its currency. This will lower the country’s standard of living.
Some countries overcome a trade deficit by the inward flow of foreign currency from so-called “invisibles”–e.g., tourism, insurance premiums, banking services. Indeed, one must look at the entire “current account” (of which trade in only one part) before reaching conclusions about deficits. If there is an overall current-account deficit, it must be matches mathematically by an equivalent positive account in the “capital account,” which records investment flows. A current account deficit is covered in the capital account by the deficit country’s borrowing abroad, receiving investment funds (equity or debt) from abroad, disposing of reserves of foreign currency, or diminishing capital outflows. If the capital-account deficit will also cease. Alternatively, if there is a surplus in the capital account, then there must be a deficit in the current account.
This brings us the proposition that a current-account deficit, or the trade component thereof, is not necessarily a sign of a nation’s weakness. Indeed, during the hundred-year dominance of Britain from Waterloo (1815) to World War I (1914), Britain had a chronic trade deficit despite the captive markets in the Empire for British exports. This was because money poured into the country on both the capital account (countries held sterling bonds; foreigners invested in the UK), and the current account (foreigners purchased British services, such as insurance from Lloyd’s banking from the City of London, engineering from the Midlands). This incoming money was used by the British to buy goods from everywhere, creating the highest standard of living in the world. Imports were good for Britain, not only because consumers benefited, but because the foreign products often forced British products to be competitive. Only as Britain became more protectionist, toward the turn of the century, did she become less competitive.
During this hundred years, Britain also exported its excess capital around the world, which it could do thanks to the capital inflows and the stable, non-inflationary nature of its currency (there was almost no inflation during this hundred years; indeed, most items became cheaper as the Industrial Revolution progressed). This cause Britain to acquire substantial foreign assets, the earnings from which increased the current and capital accounts, allowing the luxury of a large trade deficit. All of this brings us to the Reagan trade deficit. America in the 1980s should be compared to Britain in its glory years, and not a country that shows a trade deficit because its products are not competitive.
In the Reagan years, the trade deficit grew because the country became more prosperous, drawing in imports and raising living standards. Investment poured in (and more importantly, ceased flowing out) to take advantage of dropping interest rates (creating capital gains in the bond market, an increase in the value of the dollar, a rise in the stock market, and the availability of loans to acquire companies at reasonable prices). The export performance during the Reagan years was spectacular, more than doubling, with manufacturing and exports both increasing their percentages of U.S. GDP, but the large increase in household incomes sucked in imports ever more rapidly, thus creating the trade deficit.
A High-Class Problem
The Reagan trade deficits were the result of the Reagan prosperity. That’s what is called a high-class problem. But there are those who see it as a problem nonetheless–who cling to the notion that foreign-owned investment in the United States is a threat. These fears were sharpened by dislike of specific investors–oil-rich Arabs and efficient Japanese. The fact is that it takes two things for any country to grow: work and capital, which can include foreign capital. Growth not only creates new jobs, it creates better jobs, making dreams of upward mobility a reality. Just as British capital invested here contributed to pre-1914 U.S. growth, so does Arab, Japanese, German, French, Taiwanese, Korean, et al. Capital add to our present growth.
But what are we to make of the charge that we have become a debtor nation, Uncle Sam with a tin cup seeking handouts? First of all, the value of the assets we hold abroad–IBM, Coca-Cola, Exxon–must be re-calculated to reflect their true value and not their historical cost or an arbitrary value established by the Commerce Department. The fact that Coca-Cola now makes more profit in Japan than it does in the United States is not adequately reflected in the evaluation of Coca-Cola Japan. Moreover, it is only in the last few years that interest and dividends paid abroad have exceeded, slightly, the earning generated by our own foreign assets. Second, when the U.S. borrows abroad, it is in dollars, our own currency, not in a foreign currency as Brazil or Mexico have been forced to do; it makes no material difference if the holder of a U.S. Treasury bill is sitting in Nassau or in Miami. If foreigners stop holding our debt instruments, then they will lose us as a market for their goods. Third, the official figures mix debt and equity, and while both theoretically represent claims on the U.S., lending to the U.S. and investing in equity in the U.S. are different and have different consequences. Much of the $2.5 trillion of foreign holdings in the U.S. represents a rise in our stock and bond markets. We have been a good place for foreigners to invest. We could eliminate the $382-billion difference between our holdings abroad (officially, $2.1 trillion) and foreign holdings were by a brisk sell-off in our markets. The fact is that as long as we have the good sense to maintain a competitive, growing, non-inflationary economy, we will continue to attract foreign lenders and investors, all to the benefit of our economy.
The threat to our economy is not from abroad, it is from Washington D.C. That is where protectionism, high taxes, crippling regulation, and excess spending come from.
And yet people still speak of the threat to American jobs from free trade with foreign countries. Jobs saved by protectionism always cost astronomical amounts: they cause domestic prices to rise, lessen the quality of domestic products, and lessen job creation to the point where, net, fewer jobs are available. A prosperous Mexico and Canada are in our best interests. They buy our products (creating jobs) and invest in our country and in theirs (creating jobs). What those who complain are really saying is that free trade is a threat to our unions–whose members often are our less productive workers. The raison d’etre for unions is more for the union leaders than for the members. In any case, we should not subsidize the maintenance of the unions by protecting union jobs at the expense of other American jobs, at an enormous cost to the consumers, and to the detriment of our industries’ competitiveness.
We came out of the Reagan years in competitive shape, with admittedly a mixed record in protectionism, but with a growing economy. The latter has been derailed by President Bush, but we still seem strong enough to recover despite the recent increases in taxes, regulation, and spending. Trade can bring added growth, and the Reagan years were growth oriented. While we may quarrel over certain aspects of President Reagan’s policies–for example, an undervalued dollar and continued protectionism–he certainly recognized that it was in our best interests that our trading customers be strong. The trade deficit is a political weapon for the demagogues, and we should not allow ourselves to be stampeded into doing something dumb.
–Mr. Galbraith, who served as U.S. ambassador to France from 1981 to 1985, is Advisory Director of firm management at Morgan Stanley International.