Tuesday, 7 March 2017

Navarro on the trade deficit (updated)

As bizarre as this sounds Peter Navarro, Trump's main trade adviser - Navarro is director of the White House National Trade Council, has written in an article in the Wall Street Journal that
The economic argument that trade deficits matter begins with the observation that growth in real GDP depends on only four factors: consumption, government spending, business investment and net exports (the difference between exports and imports). Reducing a trade deficit through tough, smart negotiations is a way to increase net exports—and boost the rate of economic growth.
Now as a matter of national income accounting this is just plan wrong, as any Econ101 student will be able to tell you. Let us ignore the economics of it for now.

The national income identity that Navarro is using is GDP=C+I+G+NX, where C is consumption, I is investment, G is government spending and NX is net exports which equals exports (X) minus imports (M) so we can write GDP=C+I+G+X-M. Now looking at that equation its looks like reducing M will increase GDP, but this is not so. Why?

To see why think about C. When we consume we consume both New Zealand made goods and foreign made goods, so C includes some imports. The same is true for I and G, both these include a component of imports. But as we are interested Gross Domestic Product we only want to include the New Zealand component of C, I and G, so we minus off imports at the end to remove the foreign components of C, I and G, leaving us with only the New Zealand component. That is, if we don't subtract M in the national income identity, we would overstate our GDP by the value of our imports.

Now think about what happens if we reduce imports and thus increase net exports. We reduce M, which makes it look as though GDP will go up but we also reduce the foreign component of C, I and G by exactly the same amount and thus nothing happens to GDP.

What if net exports could be increased by increasing exports via "smart negotiations"? (Whatever that means.) This would reduce the trade balance and thus the size of any current account deficit. But as the balance of payments must be zero a decrease in a current account deficit also means a decrease in the capital account surplus. There has to be a capital account surplus to get the balance of payments to be zero given a current account deficit. But this reduction the capital account means there is less investment and consumption taking place in the economy. A capital inflow lowers the interest rate and thus simulates domestic investment and consumption A smaller current account means a smaller capital account which implies higher interest rates meaning less investment. So if we could somehow increase X we would decrease I and C.

So again it's not clear GDP goes up.

When you start thinking about economics of reducing imports or increasing exports things get even worse but the national income accounting view of Navarro's statement alone should have you wondering about the standard of thinking on trade in the Trump administration.

Update: Don Boudreaux comments on the Navarro piece here, Tim Worstall comments here, Daniel Ikenson comments here, Phil Levy comments here, Richard A. Epstein comments here and Linette Lopez comments here.

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