June 27, 2017

Can the US Have Balanced Trade with Mexico under a Renegotiated NAFTA?


Widespread discontent regarding America’s large trade deficits with Mexico is clearly the main force behind the U.S. Government’s desire to renegotiate the North American Free Trade Agreement (NAFTA). As President Trump said repeatedly during the campaign, 

       "Mexico is killing us on trade."

He reiterated that point in a recent tweet:
“The U.S. has a 60 billion dollar trade deficit with Mexico. It has been a one-sided deal from the beginning of NAFTA with massive numbers of jobs and companies lost.” [1]

Can NAFTA be renegotiated in a way that restores a better balance in trade between Mexico and the United States? 


The Director Emeritus of the Peterson Institute for International Economics, Dr. C. Fred Bergsten, recently issued a policy brief that explores this issue in considerable detail.[2]  

His note is most interesting and useful in terms of what it does and does not say about prospects for balancing U.S. trade deficits with Mexico and Canada.  It clearly reveals the challenges facing those responsible for renegotiating the agreement. Unfortunately, however, his note says nothing about what is certainly biggest barrier to more balanced trade within NAFTA – the U.S. dollar’s massive overvaluation.


Bergsten's Policy Analysis and Recommendations


Dr. Bergsten rightly notes that neither price-based measures such as tariffs of various types nor quantity-based measures such as “voluntary export restraints” (VERs) can restore balanced trade for America. While they might provide specific products such as steel and aluminum some welcome short-term relief from unfair trade practices including dumping and state subsidization, in the longer term, such measures would simply shift our imports of the protected products, along with our trade deficits, to other higher-cost countries not subject to these measures. 

Turning to other policy options, Dr. Bergsten notes that exchange rate initiatives in the past such as the Plaza Accord of 1985 have enjoyed some success, but goes on to say: 
The most likely contemporary counterpart [to the Plaza Accord of 1985] within the NAFTA context itself would be for the member countries to agree to avoid any misalignment among their currencies (or even to push the Mexican peso and Canadian dollar to overvalued levels that would reduce their surpluses with the United States and further increase their global deficits).  (my emphasis)

Clearly, neither Mexico nor Canada would accept such a solution. Furthermore, Dr. Bergsten rightly notes that neither Mexico nor Canada has been or is a currency manipulator. Consequently, policy alternatives such as the Countervailing Currency Intervention (CCI) approach that he and Joe Gagnon advocate in their new book would be of no use in this context. [3]

He concludes that the best approach for balancing U.S. trade with Mexico is “to strengthen the Mexican economy and thus boost its imports from the United States … “. However, he does not mention that strengthening the Mexican economy would almost certainly boost Mexican exports to the United States by even more, leading to larger, not smaller, trade deficits. In fact, except for the post-2008 crash period, this has been the pattern since NAFTA went into effect in 1994 (see graph below). 



So where does this leave us? No tariffs. No quantity-managed trade. No countervailing currency intervention. No exchange rate agreement that would force Mexico and Canada to run even larger global trade deficits.


The Missing Analysis and the Needed Policy Recommendation


The key factor missing from Dr. Bergsten’s analysis and thus from his recommendations is the U.S. dollar’s massive overvaluation. For years, this has been the largest single cause of America’s trade deficits, not only with Mexico, but with the entire world. But just how overvalued is the dollar?

Adjusting data from Bill Cline’s latest exchange rate report[4] so that America’s current account target becomes a true-zero balance shows that the dollar is currently overvalued by 25.5 percent. This is four times the misalignment of the Mexican peso – which, incidentally, is overvalued, not undervalued according to Cline’s data. Mexico’s large, low-wage labor force plus decades of experience with building and running modern factories that make excellent use of this labor have contributed significantly to America’s deficits. But the dollar’s sharp overvaluation is the single biggest cause of America’s exceptionally large trade deficits with Mexico.

If the American people want a NAFTA that is based on more nearly balanced trade, the dollar’s exchange rate must be moved closer to its trade-balancing equilibrium exchange rate. 


Exchange Rate Distortions and the S - I = X - M   --   It is Only an Accounting Identity


As Dr. Bergsten notes, many economists argue that trade deficits are caused by an excess of domestic absorption (consumption, government, and investment expenditures) over domestic output (GDP) -- a relationship captured by the classic accounting identity S - I = X - M. 

Although a shortfall of savings versus investment can cause a trade deficit, as happened when Thailand was investing heavily in modernizing its industrial sector during the 1980s and 1990s, this simple accounting identity does not prove that low domestic savings (I > S) cause external trade deficits (M>X). 

Nevertheless, some people wrongly believe that they do, then go on to claim that the trade deficit can only be eliminated by saving more and spending less -- the infamous austerity prescription. At a time when America’s biggest problem is insufficient demand for made-in-America products, austerity would be the recipe for a deflationary disaster in America that would risk another Great Recession, or worse.

Those who look only at the S - I = X - M relationship miss the very important point that this is a reduced-form equation that hides the most important variable of all: GDP.  If we assume for simplicity that government expenditures are classified under either C or I, the full GDP expenditure equation is:


GDP = C + I + X - M 

With the full identity equation, we can easily demonstrate that trade deficits are not necessarily caused by excessive domestic expenditures, but are rather the result of the dollar’s overvaluation. In the process, we can also demonstrate that, even when the overvalued dollar is accepted as the primary force causing trade deficits, exchange rate overvaluation also drives the variables in the simple S I = X M equation in ways that maintain the accounting identity.

1. On the real side of the economy, when the dollar is overvalued:
  • Demand for U.S. exports goes down >> lower U.S. demand for made-in-America goods >> GDP declines.
  • U.S. demand for imports goes up >> lower U.S. demand for made-in-America goods >> GDP declines.
2. When GDP growth declines:
  • Wages & household incomes go down.
  • Borrowing goes up to maintain current living standards despite lower GDP (a rational decision if the economy is expected to improve) >> lower savings rate.
3. On the financial side of the economy, when the dollar is overvalued:
  • Demand for dollars and dollar-based assets goes up >> more foreign capital inflows >> more dollar overvaluation.
4. More capital inflow >> more money and credit available in the United States >> lower interest rates.

5. More capital inflow + more and cheaper credit >> higher asset prices >> wealth effect >> more incentive to borrow against assets such as homes & less incentive to save >> lower savings rate >> S-I = X-M. 

The S-I = X-M identity still holds, but low savings are the result, not the cause, of trade deficits -- which for America today are driven in the first instance by an overvalued exchange rate.  (For more on the difference between identity and causality, see CPA’s recent note, Do Savings Rates Cause Trade Deficits? [5]


Conclusion


Once we recognize that the overvalued dollar, not a low domestic savings rate, is the fundamental cause of America’s trade deficits with Mexico today, the policy prescription changes dramatically.

Instead of recommending a high-risk austerity approach, we can recommend fixing the exchange rate – a task easily handled at low risk by the Market Access Charge (MAC).

More nearly balanced trade within NAFTA is clearly a very high-priority goal for the American people and their representatives in Washington, and implementing the MAC as soon as possible is essential if America is to achieve such balance. 

I hope that this message came through loud and clear in the NAFTA hearings in June, and that this note will help stimulate action to implement the MAC, the policy most able to promote balance trade within a renegotiated NAFTA.

Notes:
1. @realDonaldTrump, Jan 26, 2017. https://twitter.com/realDonaldTrump/status/824616644370714627
2. Trade Balances and the NAFTA Renegotiation, PIIE, June 2017. (https://piie.com/system/files/documents/pb17-23.pdfhttps://piie.com/system/files/documents/pb17-23.pdf)
3. C. Fred Bergsten and Joseph E. Gagnon. 2017. Currency Conflict and Trade Policy: A New Strategy for the United States. Washington: Peterson Institute for International Economics. (https://piie.com/bookstore/currency-conflict-and-trade-policy-new-strategy-united-statehttps://piie.com/bookstore/currency-conflict-and-trade-policy-new-strategy-united-states).
4. William R. Cline. May 2017. Estimates of Fundamental Equilibrium Exchange Rates. Washington: PIIE, Policy Brief 17-19 (https://piie.com/system/files/documents/pb17-19.pdf)
5. Do Savings Rates Cause Trade Deficits?     (http://www.prosperousamerica.org/do_savings_rates_cause_trade_deficits)



America Needs a Competitive Dollar - Now!

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