A trade war could wreck it all.

A TRADE WAR COULD WRECK IT ALL

THE U.S. ECONOMY has been experiencing the strongest and possibly longest expansion on record, with more than eight million new jobs since President Reagan took office. The stock market has nearly doubled any previous record, and interest rates are the lowest in nine years. The Congressional Budget Office just lowered its estimates of budget deficits for 1987-1990 by a total of $411 billion. Yet there is a stubborn sense of despair among those who write about the economy. This American locomotive of world commerce is said to be "uncompetitive," afflicted with some mysterious disorder.

After three years of waiting like vultures for assorted crises that failed to occur, critics of Reaganomics have turned in desperation to the trade deficit. The U.S. is said to have "lost jobs" to foreign competitors, though the U.S. has added far more jobs than all other industrial countries combined. The 23 per cent increase in U.S. industrial production over the past three years compares quite favorably with the 19 per cent increase in Japanese production and the 12 per cent increase in European production.

Why then is it so easy to incite concern about the trade deficit? Partly because appearances deceive. Some of the most powerful U.S. industries--electrical machinery, chemicals, printing--are not as visible as those that produce consumer goods. South Korea's emphasis on consumer goods, by contrast, makes its economy seem gigantic and threatening, though it is really no larger than the economy of Los Angeles. Moreover, we only read news reports about merchandise trade, as if traded services (on which we run a surplus) and assets had no value. And we forget that about half of our "merchandise" trade deficit is accounted for by imported oil, natural gas, and electric power, where lower prices are not yet reflected in the trade data. Only 29 per cent of U.S. imports are consumer goods, yet concern about these dominates the economic news.

This phenomenon of a merchandise trade deficit brings us to the first and most important point of confusion. Those who worry about the trade deficit and advocate protection of U.S. products to reduce imports argue, in effect, for less trade. But a foreign exporter who trades goods to U.S. buyers in return for dollars has only two options for how to employ those dollars, both of them beneficial to the United States. He can use those dollars to buy U.S. goods, or he can use them to buy U.S. assets (stocks, bonds, or real estate)--that is, to invest in the United States. nHe can also trade the dollars for another currency, but the effect is the same, since whoever ends up with the dollars has the same two options.)

Currently a large number of foreign holders of dollars are taking the option of buying U.S. assets (investing) rather than U.S. goods. In large part this is a tribute to the current strength of the American economy, as well as a warning about the weakness of a number of foreign economies. It is not a defect in U.S. policy that citizens of other countries would rather build factories and hotels in the United States, or buy shares in American corporations, than do the same in their own countries. But in order to get dollars to invest in the U.S. foreigners must sell their wares for dollars. The fact that the U.S. is a desirable place to invest means that the inflow of investments is almost necessarily matched by a merchandise trade deficit. To a very substantial degree, the investment surplus drives the trade deficit, and not vice versa. We are now hearing complaints that, because of all this foreign investment, the U.S. has become a "net debtor." But foreign investment creates jobs (in 1984 alone, direct Japanese investment created eighty thousand jobs here), while being a net creditor a few years back just earned us a lot of bad foreign loans.

Historically, the real volume of U.S. imports always rises with economic growth and only falls during recessions, which means a trade deficit is often a sign of prosperity. U.S. exports likewise rise with foreign prosperity and decline when other economies either cannot afford to buy (Latin America), or do not need U.S. machines and technology because they are not investing much in their own overtaxed economies (Europe). Stuart Tucker of the Overseas Development Council estimates that depression in Third World countries has cost the U.S. nearly 1.4 million jobs in export-related businesses. Restricting Third World imports is not going to help those countries get back on their feet. On the contrary, U.S. imports provide other nations with the dollars to buy our exports, or to pay interest on loans that have already financed, say, the purchase of U.S. grain by Poland or U.S. tractors by Argentina. They have our goods and we have their paper. To restrict their exports is to refuse repayment.

This is the flip side of the problem. Just as the merchandise-deficit/investment-surplus equation indicates the relative strength of the U.S. economy, it indicates the relative weakness of many foreign economies--and their vulnerability to U.S. protectionism. For the United States to turn protectionist against debt-burdened developing countries, such as Brazil or South Korea, would be suicidal. The dollars we spend on Mexican oil, Brazilian shoes, or Korean video recorders come back to the U.S. in interest payments. U.S. import quotas would deny the LDCs (less developed countries) the means of repaying even the interest owed to the stockholders and depositors of U.S. banks. Loans would become gifts, and the world financial system might well collapse in bank runs and panic. For the U.S. to turn protectionist against solvent but weak economies such as Japanhs would have the same effect, as a weaker Japanese economy cut back on purchases from debtor countries, such as Mexico or the Philippines.

Unfortunately, when protectionist fever strikes, the victims tend to be precisely those relatively small trading partners that have little leverage on American policymakers and can be most easily damaged by a trade war. Yet such countries are frequently significant importers of American goods (particularly U.S. farm products). The recent textile-protection bill vetoed by President Reagan was a clear example. Many of the textile exporters that would have been most seriously damaged were LDCs. Many, or most, are voracious importers, even of U.S. goods; many are net importers, if services are counted. Most ironically, most of them are significant importers of U.S. textiles and textile-related products, such as textile machinery and textile fibers. Hence, this bill would have done tremendous damage to the American textile industry, an industry we cannot afford to lose.

In 1984, real imports increased by 8 to 20 per cent in South Korea, Singapore, Hong Kong, Taiwan, and Mainland China, placing them among the fastest-growing importers in the world. Indeed, imports in Hong Kong and Singapore were as large as their entire GDP (gross domestic product), and amounted to about half of GDP in Taiwan and South Korea. Hong Kong has run virtually continuous trade deficits for 140 years. South Korea had a long string of trade deficits with the U.S. until the last three years, and still has a trade deficit with the world (it would be happy to buy oil from us if we had any to sell). Japan imports as much in textiles ($6 billion) as it exports. U.S. imports from Communist China, mostly textiles, were up 17 per cent in the first seven months of 1985, according to the U.S. Information Service; but U.S. exports to China, mostly machinery and transportation equipment, were up by 43 per cent. China's trade deficit last year was almost $15 billion, sizable for a poor country.

With the threat of increased U.S. protectionism, businessmen in Asian countries naturally began to cut back on their productive capacity--that is, to cut back on imports of machines, cotton, and synthetic fibers, much of which had previously been bought from the United States. This Asian retrenchment also contributed to declining world prices for many other U.S. products, including farm products and oil. The Journal of Commerce reported, last October 25, that Taiwan's capital investment had fallen 5.5 per cent, creating a "fall in imports, particularly of capital equipment." Capital equipment is a major U.S. export. The same source noted, on October 16, that Hong Kong's falling exports had resulted in cutbacks in imports: "Decreases in purchases from the United States were noted in electrical machinery and appliances (down 32 per cent), nonmetallic mineral manufactures (51 per cent), and textile fibers (66 per cent)." The Hong Kong economy grew by only 0.8 per cent last year, with a 6 per cent drop in exports to the United States and a 10 per cent drop in imports from the United States.

On October 5, the London Economist observed that South Korea's exports to the United States had dropped by 26 per cent in the first seven months of last year. South Korea had spent $453 million on U.S. cotton the year before, but will not be needing more if the U.S. won't buy the resulting cloth or shirts.

Despite the veto of the textile bill, the Reagan Administration reportedly proposes to keep textile imports from Asia at their 1985 level for three years, although 1985 was a disastrous year for Asia. It is sadly ironic that the U.S. worries so much about competing with countries whose economies are stagnant or sinking. Aside from Japan and Taiwan, most Asian countries have a trade deficit, if interest payments and other services are included, so they must reduce imports if U.S. protectionism restricts their exports.

Economies weakened by actual or expected protection do not need to import as much as before, and could not afford to do so in any case. It is not even a matter of "retaliation," but of the raw necessity to sell before buying. Some Asian countries are already hugely in debt to the International Monetary Fund or to Western investors ($45 billion in loans to South Korea), and those debts must be financed with trade. Nobody will loan more money to finance increased Asian imports from either the U.S. or LDCs in the face of discriminatory restrictions on Asian exports.

These Asian countries process materials purchased from LDCs, so protectionist cutbacks in Asian production could contribute to an international debt crisis. The LDCs would lose important markets in which they now earn dollars that they can pay to the United States. Investments of U.S. citizens in the Asia-Pacific region, which amounted to $75 billion in 1984, would also be jeopardized by a trade war. Zero-sum thinking might imply that the U.S. gains from Asian distress, but that is a dangerously provincial error.

None of this is to deny that American textile producers have very real problems. They do. The prices of American textile products on world markets have fallen sharply in the past few years, too sharply for the industryhs continued health. But the price problem is caused not by foreign competition but by American money. Total exports from the U.S. fell 3 per cent last year, but the decline was entirely in price. Volume was actually up, but U.S. export prices fell. After nearly two decades of inflation, a tight-money policy has been sharply deflating international commodity prices. During an inflation, commodity prices, such as those for copper, steel, and petroleum--and also basic textiles--rise more than average prices; during a deflation they fall more. What all these commodities have in common is that their prices are expressed in dollars, so that apparent glut in commodities is equivalent to a shortage of U.S. money. Goods are cheap not because of a glut caused by foreign producers, but because cash has become more valuable. The dollar shortage can be fixed by having the Federal Reserve provide more bank reserves at lower interest rates, but too much fixing is inflationary. So with policymakers hesitant to lower U.S. interest rates, commodity producers push for protection.

The great danger is that protection usually accelerates a deflation. Your corner drugstore has certain roughly fixed costs, such as rent and interest, which it must cover, regardless of the volume of business. If the store's business shrinks--as import- and export-related businesses shrink under protection--its need for ready cash to meet fixed costs may force it to slash prices. The value the store places on cash has gone up, the value it places on goods has gone down. Exporters and importers behave the same way when protection depresses trade. This is the sort of thing that, if severe enough, causes depressions, with everyone liquidating commodities and real estate at distress prices in order to raise cash.

One of the cruelest ironies is that in a protection-induced or -exacerbated deflation, the prices of protected goods often fall further than average prices. Some free-market economists criticize protection for unfairly favoring some sectors of the economy over others. The truth is, protection almost always hurts everyone and often hurts the protected more than most.

Looking at each industry separately, it might seem that depressed world commodity prices--for copper, say, or for cloth--could be increased by keeping out "cheap" imports. That might be true for one or two industries, but cannot be true for them all because consumers cannot afford to pay more for everything, especially in a deflationary environment in which consumer incomes are not rising.

If protection makes distressed farmers and miners pay extra for shirts, then they must spend less on other things. Budgets are not unlimited, and artificially high prices reduce disposable income. Gary Hufbauer of Georgetown University estimates that existing protection in textiles and apparel--the equivalent of a 30 per cent tariff--already raises consumer prices by $27 billion. That has to reduce potential sales of other goods. Forcing a few prices up by reducing import supplies and competition thus forces other prices further down. Moreover, protectionism almost always spreads, through logrolling. Last year's vetoed "textile" bill had already grown to include fishing tacke, dolls, artificial flowers, copper, and shoes. This year, congressional Democrats are stressing the "generic" approach--namely, quotas and tariffs on almost everything. Forcing many prices up, through broad import quotas or tariffs, will actually force all prices down, as world trade implodes.

From this we can see why protection is often especially damaging to the protected. Protection forces the prices of protected domestic goods down through its effects on other countries, particularly the big debtors, whose need for cash compels them to cut their own imports and dump exports in shrunken markets. Countries that used to produce, say, shirts for the U.S. market suddenly find they have an excess of workers, machines, and inventories, but no excess of dollars to pay their bills. The inevitable result is a global "going-out-of-business sale," which depresses the price of shirts outside the protected U.S. market. Textile machinery is unloaded cheap by bankrupt firms, making it easier for new rivals to permanently undercut U.S. producers who paid full price for their equipment.

Although the U.S. price of shirts would be higher than the world price, owing to quotas or tariffs, it would nonetheless be forced lower than it was before the trade war began. Adding a 20 per cent tariff to the import price doesn't help much if it results in results in import prices falling by 30 per cent. Foreign and domestic producers would both find they had to cut prices further in smaller world markets, in order to acquire cash to pay their creditors. Throughout U.S. history, the immediate effect of increased protectionism has always been deflation--falling prices--particularly for the goods intended to be "protected" (which have always included textiles). Wholesale prices fell with the big tariffs of 1816, 1860, 1890, and, of course, 1930. Textile-industry ads ask, "What about 1922?" The answer is that average tariff rates nearly doubled in 1921, not 1922, rising from 16.4 to 29.5 per cent. Commodity prices fell 58 per cent in 1921, textile prices 74 per cent, though a big increase in the Fed's discount rate was largely to blame. Smoot-Hawley tariffs averaged 46 per cent from 1929 to 1931, and the 39 per cent drop in "protected" textile prices again exceeded the 25 per cent drop in overall commodity prices. The textile industry has always been the main victim of textile protection. Farm products were also "protected" from imports, and we recall what happened to farm prices after 1929. The farmers' former foreign customers could not buy because they could not sell.

U.S. imports always expand rapidly when the U.S. economy is expanding rapidly; U.S. exports likewise grow when the economies of our trading partners are doing well. The only sensible way to help U.S. producers is to encourage exports, mostly be encouraging foreign economic growth. Maintaining the U.S. recovery is one key to foreign growth; exporting American economic policies--urging our trading partners to cut taxes and tariffs and chop away quotas and regulations--is another.

Reducing imports, the protectionist solution for the trade deficit, would require a recession, for only during a recession do imports fall. And indeed, import quotas could produce a recession by raising costs at home and bankrupting debtor countries abroad. But the function of an economy is not merely to balance arbitrary trade figures. When we are contemplating sure-fire policies for creating a global depression, such as protectionism or higher tax rates, there should be a bette reason than some abstract journalistic anxiety about a trade or budget "crisis."