U.S. Trade Deficit

   

A short review of the March U.S. trade data and a lot of speculation about the arc of the Sino-American economic relationship in light of the non-negotiability of Made in China 2025.

Conventional wisdom among economists is that the China shock ended a decade ago. That is largely because the U.S. bilateral deficit with China has been fairly stable since 2007 (measured as a share of U.S. GDP) while China’s current account surplus fell significantly as a share of its GDP from 2007 to 2017. Neil Irwin of the New York Times wrote in late March: “globalization, at least in the form we have known it, leveled off a decade ago.” I have a slightly more nuanced view—I would argue that the China shock continued, albeit in a more modest form, through the North Atlantic financial crisis and didn’t really “end” in aggregate until 2010 or so. More importantly, there are significant differences across different types of goods: the China shock for consumer goods (apparel, furniture, toys, home electronics, and the like) was mostly over by 2006; the China shock for capital goods lasted until at least 2012—and I would even argue that in some sectors the China shock is still ongoing. The “China shock” of course is short-hand for the impact of rising Chinese imports on U.S. (and European) manufacturing employment in the period immediately following China’s WTO accession. There was a China shock for commodities too. But that shock was positive—first prices rose, and then volumes rose to meet rising Chinese demand. Soybean farmers in Iowa view China differently than manufacturing workers in Ohio. I want to focus on the manufactured side as that is the real source of concern—and, be warned, I will make use of bilateral data. Purists who view all bilateral data with disdain can skip to the aggregate numbers at the end. I do think there is value in using the bilateral data to compare the pattern of U.S. trade with China and the pattern of U.S. trade with the world. China is big enough to influence the overall pattern of trade, and China’s exchange rate hasn’t always moved with the United States' other large trading partners. That said, there is no doubt that the bilateral balance with China overstates China's impact on U.S. manufacturing and understates the impact of the rest of the Asian electronics supply chain.* The U.S. is more likely to displace Korea, Taiwan, and Japan as a source for high-end electronic components than to displace China as a location for final assembly. Some definitions. For “manufactures” I mean the NAICS definition and data, using all the codes in the 300s, minus refined petroleum. For some purposes I will also use the end-use data for capital goods and autos, and compare the trend of capital goods and autos with the trend for consumer goods. NAICS manufactures is a slightly broader concept than capital and consumer goods, as it includes the “manufactures” in the industrial supplies end-use category. And when I look at the Chinese data, “manufactures” is defined as Chinese total trade net of trade in what China calls “primary” products. I generally include Hong Kong with China, as it is clear that many U.S. exports to Hong Kong end up in China (except when I was a bit lazy with the end use data, and for services I don't think the adjustment adds much as most service exports to Hong Kong aren't directly reexported to China). Adding in Hong Kong somewhat reduces (I think correctly) the bilateral deficit with China.** And everything is in nominal terms and has been scaled to GDP. Scaled real numbers are hard to do, and there shouldn't be a big gap between nominal and real in manufactures. What does the data show? (1) The manufactured deficit (as a share of U.S. GDP) peaks in 2012 (though you can argue it essentially is flat from 2010 on), with an inflection point in late 2006 or early 2007.   The rise in the overall deficit has mostly been driven by imports as the scale of U.S. exports of manufactures remains modest relative to imports of manufactures. In practice, very few of the manufactured components that China imports for reexport come from the U.S., in part because many U.S. semiconductor design firms use Asian "fabs." The rise in imports from China from 2002 on also doesn’t—contrary to a common argument—just reflect a reallocation of final production to China from elsewhere in Asia. If you take China out of the data on manufactured trade, imports from the world are flat from 2002 to 2007—the period when imports from China rise strongly.*** The overall numbers on manufacturing trade tells a story that is very consistent with the findings of Autor, Dorn, and Hanson. It is hard to see how a shift in importing from say Korea to importing from China would have an adverse impact on employment and wages in manufacturing-intensive regions of the U.S.. (2) The China shock ends at different points in time for different types of products. The rise in Chinese exports of consumer goods to the U.S. after China’s WTO accession was fast and furious. It also was largely complete by 2006. That’s the bulk of the China shock. (One small note: cell phones are a consumer good, computers are a capital good). The rise in capital goods imports by contrast continued through the global crisis. It only really slowed after 2012. And in some specific product categories it has continued. Many of the proposed Section 301 tariffs would hit parts used in the production of capital goods, e.g. the sectors where the impact of the China shock is likely ongoing (and where there is more likely to be U.S. production capacity). **** (3) Magnitudes are important. The China shock was a swing in the trade balance with China and East Asia of a little more than a percentage point of GDP—and after 2006, the impact of the China shock was balanced by the recovery in U.S. exports to the world that followed the dollar’s 2003 depreciation (with a lag).  Ballpark math based on a change of that magnitude would generate a swing in the number of jobs supported by manufactures of about a million jobs (using the estimates for jobs supported by exports as a proxy for jobs in import competing sectors: see here and here). That is close to the numbers that emerge from the much more sophisticated work of Autor, Dorn, and Hanson (reassuring for me). Their 2 million number includes the indirect job losses—the loss of a factory has a local multiplier, so to speak, that amplifies the regional shock. One other point: the China shock was so severe in the first part of the 2000s in part because it overlapped with the (lagged) impact of the dollar's 2000-2003 strength. By contrast, from 2006 to 2008 the improvement in U.S. trade with the rest of the world exceeded the ongoing deterioration in the balance with China.   (4) The China shock lasts a lot longer in the Chinese data than in the U.S. data. China’s exports of manufactures continued to rise relative to the GDP of China’s trading partners through 2015—and China’s total surplus in manufactures similarly peaked relative to the GDP of China’s trading partners in 2015. A portion of the rise in China's manufacturing surplus is a function of higher commodity prices in the years immediately after the global crisis—higher oil (and metal) prices allowed the oil (and metal) exporters to afford more imports of all kinds, and a lot of those imports came from China. One implication of this: a growing share of China’s aggregate impact on the U.S. over time has come from competition for export market share in third party markets, not from imports. It is one reason why U.S. exports of manufactures (as a share of U.S. GDP) haven't increased over the last twenty years. Higher end U.S. capital goods often compete both with high-end products from countries like Germany and Japan and with lower end Chinese products. Think of construction equipment, or diesel locomotives for moving freight. In the future, think of aircraft… (5) Services haven’t provided a significant offset if you exclude tourism and education. There is often talk of how U.S. the has a comparative advantage in services. That's certainly true for many sectors. But it also true that many services are hard to trade across time zones and legal and linguistic frontiers. U.S. exports to China of services other than education and tourism (which require the physical movement of people) are around 0.1 percent of U.S. GDP, while imports are about half that. Putting a graph of services trade on the same scale needed for consumer and capital goods illustrates the relative size of trade in goods and trade in services. Of course the bilateral data can also mislead, and that’s almost certainly the case here. U.S. firms don’t export that many services to markets that are much more open either. They prefer to export intangibles to their subsidiaries in low tax jurisdictions, and then reexport those “services” at a higher price from places like Ireland and Switzerland and Bermuda. This both shifts taxable profits out of the U.S. to low (or zero) tax jurisdictions and services exports toward Europe and the Caribbean. But I would caution that just because the U.S. economy is now dominated by the production of services doesn’t mean that “services” trade with China necessarily offers a huge opportunity: relatively few U.S. firms would provide services in China using U.S. workers. I personally suspect that largest opportunities for increasing the number of jobs supported by U.S. exports to China would come from reforms that raised China’s propensity to import capital goods—or at least policy changes that scaled back China’s plans to displace existing imports of capital goods with Chinese production. U.S. exports of manufactures have lagged the growth in China's GDP from 2006 on, in part because of Chinese import-substituting policies. Obviously there is some disagreement here on the relative priority to be placed on goods versus services —but the conclusion matters. The U.S. isn’t going to get everything it wants in a negotiation with China. The Trump Administration will have to set some priorities. (5) Trade with China isn’t the only thing that matters. Right now the trade data is dominated by the lagged impact of the 2014 "dollar" shock. Since 2014 there has been a negative “dollar” shock roughly equal in magnitude (over a percent of GDP) to the China shock of the early 2000s (the overall increase in the manufacturing trade deficit from 02 to 05 was a bit bigger than the increase in the trade deficit with China, so the current dollar shock isn't quite as big as combined China and dollar shock of the early 2000s).   The swing though has been less visible (and less politically charged) because it has come exclusively from a fall in exports.***** Basically, with a stronger dollar, U.S. based manufactures have lost market share to manufactures in Japan and Europe. The data on manufacturing trade obviously leaves out trade in services. But far more significant is the omission of trade in commodities. With the rebound in the manufacturing deficit after the dollar’s 2014-2015 appreciation, the bulk of swing in the overall trade balance from 2007 and 2017 comes from a single commodity: oil. And I think it is important to recognize that this particular pattern of adjustment has meant that the manufacturing sector hasn't directly benefited from the overall improvement in the trade balance, though no doubt it has benefited from increased domestic demand for the machinery and steel needed to drill wells and build pipelines.   */ A value-added adjustment would reallocate a portion of China’s contribution to the overall U.S. deficit to China’s neighbors in East Asia. That’s a consistent distortion that should be internalized, though the scale of the reallocation varies over time (Chinese value-added has increased over time). There is an argument that the China shock is really an East Asian supply chain plus China shock. **/ This adjustment also reduces the pace of the post-WTO growth in U.S. exports to China, as some of the initial growth reflected a shift from exporting through Hong Kong to exporting directly to China. ***/ The argument for reallocation compares imports from Asia today to imports at their 2000 peak (rather than from China's WTO accession in 2002). But I don’t think that’s right—it confuses two separate trends. U.S. imports globally fell when investment fell after the .com boom/bust. And then when the U.S. started to recover, imports went up, with the bulk of the rise coming from China. Total imports of manufactures rose 1.5 percentage points of GDP from end 2002 to end 2007, while imports from China rose 1 percentage point. ****/ Formal models that have attempted to refine Autor, Dorn, and Hansen by say adjusting imports to reflect trade broken down by value-added generally find a strong China shock impact during the period before the global crisis, and much smaller (or zero) impact after the crisis. That doesn't surprise me. The impact of the China shock on capital goods in the post-crisis period would be much smaller than the impact of the initial shock to both capital and consumer goods, and very difficult to disentangle from the overall recovery that followed the huge Lehman shock. Job market dynamics were essentially driven by the recovery in domestic demand over this period. And more generally, much of the impact of China's emergence as a capital goods exporter has come from a loss of U.S. market share in third party markets and thus won't be identified in studies that focus on the impact of Chinese imports on the local job market in manufacturing intensive parts of the country. *****/ The greater impact of currency moves on exports than on imports is consistent with most formal economic modelling. See the Federal Reserves' international transactions model. However, formal modelling would have predicted a bigger rise in imports after the dollar’s fall than was actually observed. I suspect that is because the dollar shock is correlated with a commodity shock, and a shock to the level of real investment in commodity production (investment tends to be capital goods intensive and thus trade intensive).

There are growing calls for a global coalition of U.S. allies to pressure China to change some of its most egregious commercial practices. That makes some sense, even if it is much easier said than done. It is relatively simply to get agreement that China should change many of its policies. But China doesn’t typically respond to peer pressure alone. It is relatively hard to get agreement on what to do if China doesn’t change voluntarily.* And I have no doubt that China’s domestic market is rigged against fair competition in a way that is unique among the world’s biggest economies. Barriers at the border make it hard to export into China. Competing inside China is difficult, if not impossible, without a joint venture partner, and getting all the needed approvals certainly seems easier if you agree to a certain amount of technology transfer. And even a well-connected joint venture partner doesn’t always assure long-term success, particularly if the political winds change. Ask Hyundai. This isn’t just based on anecdotal evidence either. Imports of manufactured goods for China’s own use (manufactured imports net of the “processing trade”) peaked back in 2003. Such imports are now fairly low relative to China’s GDP. When it comes to manufactures, China exports, but doesn’t import (much). But, well, right now those bad commercial practices are not creating all that a big a current account surplus. China’s current account surplus is well below that of the Eurozone. Or that of Japan. Or those of Asia’s NIEs (who are no longer that newly industrialized, but names seem to stick). After the global crisis China has limited the global impact of its rigged domestic market through a rather massive (off budget) fiscal stimulus and a big credit boom. That stimulus hasn’t translated into a ton of demand for the manufactured goods produced in Japan, Europe, or the U.S.—but it has generated a lot of demand for commodities. And the commodity exporters in turn do buy a lot of manufactures from Japan, Europe, and even the U.S. The net result is that China—thanks to a combination of loose credit and a loose overall fiscal policy (ask the IMF!)—puts a lot of its huge savings to work domestically. At least for now. (A bit of throat clearing. China’s current account surplus is bigger than officially reported, perhaps by a percentage point of GDP. But even at 2.5 percent of China’s GDP, it is smaller, relative to China’s GDP than the current account surpluses of the United States’ security allies. I do though worry that China’s surplus may be about to head up—export growth has been strong, and China looks intent on a bit of fiscal consolidation that will weigh on growth and imports). U.S. allies generally have much tighter fiscal policies than China. That’s a big reason why they run larger current account surpluses than China. Korea and Taiwan (and neutral Switzerland) also put their finger on the foreign exchange market when needed to keep their currencies weak (Korea rather egregiously in January). As a result, the combined current account surplus of U.S. allies in Europe and Asia is close to $800 billion—well over China’s roughly $200 billion. That sum would be a bit bigger if you added in the surplus of democratic but formally non-aligned European countries like Sweden and Switzerland. There is an important point here. The biggest surpluses globally (and for that matter, the biggest deficits) are now found in advanced economies, and the advanced economies generally have relatively low tariffs. Macroeconomic factors—and currency levels, which themselves are shaped by macroeconomic policy choices—play a much bigger role in determining the overall trade balance than actual trade practices. A China that behaved better commercially would no doubt help many companies. And if China lowered barriers to actual imports, overall trade with China might expand. But better commercial practices on their own aren’t enough to assure a smaller Chinese trade surplus. A China that pared back on its macroeconomic stimulus as it liberalized could also provide less demand to the global economy, especially if a slowdown in China led the yuan to depreciate. Obviously this poses a bit of a dilemma for the United States. If the price of a coalition against China’s commercial practices is a blind eye to macroeconomic policies in the Eurozone, Japan, Korea, and Taiwan that have raised their external surpluses, there isn’t much chance the U.S. aggregate trade deficit will change. China undoubtedly contributes to the United States’ aggregate deficit, but it plays a smaller role (and others in Asia play a bigger role) than its outsized bilateral surplus with the U.S suggests. So long as Asia and Europe’s aggregate surplus remains high, someone in the world will still need to run a large external deficit, and odds are that will still be the United States.*** (The Brits have been punching well above their weight here for a long time, but that may not last all that much longer.) And, well, the latest forecasts tend to point to rising not shrinking surpluses in many of America’s biggest allies. The Eurozones’s external surplus is now expected to rise toward 4.5 percent of its GDP (gulp) in the next few years.**** Higher interest income on its lending to the U.S. alone should be enough to push Japan’s surplus up, even if Japan’s trade surplus stabilizes. Korea has capped won appreciation at 1060 and continues to resist loosening its overly tight fiscal policy. And Taiwan’s surplus shot up in the fourth quarter. This all shouldn’t be a surprise. U.S. imports shot up in the fourth quarter, as did the U.S. trade deficit—and the swing wasn’t against the world’s oil exporters. Globally, things usually line up.   */ Back in the day there were constant calls to build a global coalition to push China to let its currency appreciate. The coalition never really materialized. Many countries wanted the U.S. to do the heavy lifting. Others were confident in their ability to intervene in their own market to protect themselves from China’s undervaluation, and worried that a stronger global norm against either intervention or large external surpluses wouldn’t just hit China. I expect similar divisions would appear today. **/ See the IMF’s blog last year arguing that imbalances are now among the advanced economies, as both the surpluses and deficits of major emerging economies have shrunk (thanks to China’s ability to keep its reported surplus under two percent of GDP; India’s ability to keep its deficit under two percent of GDP; and the end of big surpluses in the oil-exporting economies). ***/ I will explicitly address whether or not the U.S. trade deficit is still too high—and thus whether the large surpluses in many U.S. allies (and the more modest as a share of GDP but still large absolutely surplus in China) pose more than a political problem, in a later post. Suffice to say that the current trade deficit is bigger than I believe is consistent with a stable debt to GDP ratio, especially as the Fed pares back on policy accommodation and U.S. rates rise (relative to U.S. growth). ****/ There is a clear story in the financial account too: from 2014 on, fixed income investors have been fleeing low yields (and a scarcity of bunds) in the Eurozone in droves. In dollar terms, net fixed income outflows from the Eurozone are bigger than the outflow associated with China's out-sized pre-crisis reserve growth (the growth in China's hidden reserves is proxied by the rise in its holdings of portfolio debt). Endnote: In response to a reader request here is the first graph in dollar terms rather than shares of GDP:

The Council on Foreign Relations (CFR) and Foreign Affairs offer resources and analysis on President Donald J. Trump’s plan to impose tariffs on steel and aluminum imports. “Donald Trump's decision to impose tariffs on steel and aluminum is the most significant set of U.S. import restrictions in nearly half a century,” concludes Senior Fellow Edward Alden in a blog post. “It will have huge consequences for the global trading order.” “Employment in the U.S. auto industry will suffer from Trump’s tariffs to a vastly greater degree than it could possibly benefit in the U.S. steel industry,” warns Senior Fellow Benn Steil in a new data analysis, with the total expected job loss being “equivalent to almost one-third of the entire U.S. steel industry workforce.” Negotiations for the North American Free Trade Agreement (NAFTA) continue to hang in the balance as upcoming elections in Mexico and the United States threaten to doom any new agreement, writes Senior Fellow Shannon K. O’Neil in Bloomberg View. “If the president is offering the prospects of eliminating the tariffs . . . when NAFTA is renegotiated . . . suddenly the incentive to invest is no longer there,” explains Distinguished Fellow and former U.S. Trade Representative Michael Froman. Listen to the CFR conference call with Froman and Alden. “With Trump imposing tariffs on imported washing machines and solar panels along with steel and aluminum—and soon, perhaps, on foreign automobiles—other countries won’t turn the other cheek,” writes Senior Fellow Max Boot in the Washington Post. President Trump argues that tariffs are necessary to protect U.S. national security, but according to this CFR Backgrounder, many experts argue that the measures could backfire. The current panic that President Trump has generated over a potential World Trade Organization “collapse and impending trade wars might galvanize the organization to set itself on the right course,” argues University of Hamburg professor Amrita Narlikar in Foreign Affairs. CFR Experts On Trade Edward Alden, Bernard L. Schwartz Senior Fellow, @edwardalden Michael Froman, Distinguished Fellow, @MikeFroman Shannon K. O’Neil, Nelson and David Rockefeller Senior Fellow for Latin America Studies, @shannonkoneil Benn Steil, Senior Fellow and Director of International Economics, @BennSteil Thomas J. Bollyky, Senior Fellow for Global Health, Economics, and Development, @TomBollyky To be in touch with a CFR expert, please call 212.434.9888 or email [email protected]. 

It looks like a combination of tax cuts and spending increases will raise the U.S. fiscal deficit by about 2 percentage points of GDP (that’s the number Krugman used; Goldman’s US economics team puts the increase in the fiscal deficit between fiscal 2017 and fiscal 2019 at 1.7 percent of GDP). The IMF’s standard coefficient relating changes in the fiscal balance to changes in the external balance would imply that the U.S. current account deficit will increase by about a percentage point of GDP—so rise to around 4 percent of GDP. There are a few reasons to think that this might be a bit high. The U.S. is globally speaking, a relatively closed economy. Imports have increased at about a quarter of the pace of domestic demand over the course of the recovery from the global (or north Atlantic) crisis. So the external spillovers from a U.S. fiscal stimulus might be smaller than the global norm. * A high portion of the tax cut will go toward buybacks, special dividend payments, and the like, and a high portion of those payments may be saved not spent. This isn’t a fiscal stimulus designed for maximum impact on demand. And, well, the IMF’s coefficients have a whole lot of implicit assumptions baked into them—assumptions that may not hold this time. In most cases a fiscal loosening changes the stance of monetary policy, and those changes in the stance of monetary policy in turn drive some change in the exchange rate. But, if the Fed doesn’t end up tightening more, or if the dollar doesn’t in fact appreciate as the Fed tightens, the impact of the fiscal expansion on the trade deficit may be smaller than the simple application of the IMF’s model would predict. But there are a couple of factors that could work the other way too. The closer the economy is to operating at capacity, the more the demand created by the stimulus may bleed out to the rest of the world. That is arguably what happened in q4 of 2017. Domestic demand growth accelerated, with the contribution from demand to GDP growth rising from around 2.5 percent to above 3.5 percent. But an unusually big chunk of that was spent on imports—over 50 percent. ** If that pattern continues, The U.S. would get stuck with the debt while the United States’ big trading partners would get the stimulus. A poorly timed fiscal expansion thus could end up making China, Korea, Japan, Germany, and the other big exporting economies great. Aside from trade there is an “income” channel. Or more specifically, a “higher interest rate on a big stock of external debt” channel. The U.S. now has a large stock of external debt, so a higher nominal interest rate in the U.S. mechanically leads to higher interest payments on that external debt (interest payments are big part of the income balance in the current account, along with the dividend income on foreign direct investment). The United States’ external debt has quietly increased to about 50 percent of GDP, so a 1 percentage point increase in the nominal interest rate translates into half a percentage point of GDP increase in the amount of interest the U.S. will need to pay to the world. *** This swing is easy to forecast even if the change will come slowly: effectively, the central banks of the world’s biggest (former?) currency manipulators stand to gain over time as they rollover their maturing treasuries into higher-yielding bonds, raising the cash return on their excess reserves. There are many ironies here of course. But the most important, perhaps, is that Trump’s trade goals will likely be set back by his biggest policy success: the tax bill. Had Congress been unable to agree on a large tax cut—or had the Trump administration insisted on a budget-neutral tax plan—there is a strong argument that the trade deficit would now be set to fall. European demand growth is (finally!) strong and the Eurozone’s output gap is falling. With the market looking forward to the end of the ECB’s asset purchases and speculating about the beginning of a tightening cycle, the euro is rising. The combination of China’s stimulus in 2016, the controls put on in 2017, and the euro’s rise against the dollar has led China’s currency to strengthen against the dollar. While Korea continues to resist calls to expand its system of social insurance and bring its fiscal surplus down [PDF], the won—and many other Asian currencies—are now facing pressure to appreciate. With a bit of U.S. pressure on key countries to limit their intervention (both through the front door and through the back door), currencies like the Korean won, the new Taiwan dollar, and the Thai baht could all rise—supporting global adjustment. Canada’s dollar is rising, and the U.S. trades a lot with Canada. A deal on NAFTA would likely lead the Mexican peso to rise too. Basically, many of the conditions were in place for some of the deterioration in the non-petrol balance that occurred after the dollar rose in 2014 to reverse. But that would have required patience on the part of the Trump Administration—and refraining from policies that juice U.S. demand just as the rest of the world is starting to look better.   Very wonky endnote: I wanted to do the very rough math needed to plug the demand stimulus into a standard partial equilibrium model for the U.S. trade balance (something akin to the Fed’s international transactions model). Such models have their critics (they don’t model savings and investment, they are partial equilibrium not general equilibrium models, etc.) but I have generally found them a useful guide for thinking about the trade balance. Let’s stipulate that U.S. demand growth would be expected to contribute about 2.5 percentage points of GDP to U.S. growth in the absence of a major shift in fiscal policy in the next couple of years (that’s the average pace of increase in the last 12 quarters of data, though it arguably is a bit stronger than what the U.S. should be able to generate over the long-term. And let’s stipulate that growth in U.S. trading partners will be between 3 and 3.5 percent (roughly, the IMF’s forecast for global growth). The Fed puts the income elasticity of U.S. imports at around 2—so 2.5 percent demand growth should translate into a 5 percent increase in import volumes. And the income elasticity of U.S. exports is more like 1.5, so 3 percent growth abroad translates into a 4.5 percent increase in export volumes. Exports are a bit smaller than imports as a share of GDP (17 versus 20 percent of GDP or so), so all things equal the expected differential in volume growth would lead the real trade deficit to widen a bit. Now throw in the stimulus. Krugman estimates that a 2 percentage point of GDP fiscal impulse over the next two years would boost growth by about half that (or 1 percentage point). Technically, I should turn that into an estimated demand impulse—as U.S. demand growth, not overall U.S. growth, is what drives imports. So to be overly precise, let’s assume that the impetus to domestic demand is more like 1.25 percentage points of GDP over two years. If all that came in a single year, import volume would be expected to grow by 7.5 percent. In practice, the impulse is likely to be spread over the next two years. No matter: absent an acceleration in global growth, the additional impulse to U.S. demand would clearly be expected to raise the U.S. trade deficit (very roughly, an additional 2.5 percentage points of import growth over two years versus baseline means about 50 basis points of GDP in extra imports over that period). Now for the part I find much harder: the impact of the dollar. The Fed’s model implied that a 10 percent increase (decrease) in the dollar reduces (raises) U.S. exports by close to 7 percent over 3 years. And a 10 percent increase in the dollar raises imports by about 4 percent over two years. Seems straightforward. But remember the lags—the model implies that the impact of a dollar rise in the second year after the change (quarters 5 through 8) is almost as big as the effect in the first year. For 2018 exports, the three year lag implies changes in the dollar in 2016, and 2017 matter as well as changes in the first quarter of 2018. And for imports, moves in late 2016 and 2017 still matter. A plot of the lagged dollar shows this well—if you look at the trailing three year sum (an imperfect measure of the exchange rate impulse for exports) the dollar is rising not falling. In other words, don’t count on a boost to exports from the dollar’s recent weakening right now. In fact, the average level of the dollar in 2016 was significantly above its average level in 2015—and the dollar’s average level in 2017 was about at its 2016 level. The dollar’s impulse to exports would only really be expected to be positive in 2019. If the dollar stays at its current level the roughly 5 percent depreciation in the broad real dollar from its 2017 average should push up the pace of export growth by about 3.5 percentage points relative to a baseline over 2018, 2019 and 2020 and also do a bit to hold down the pace of import growth. But remember that the baseline includes some lagged impact from the dollar’s strength in late 2016, and thus the depreciation baseline would show a slowdown in export growth. My ballpark math thus suggests that the exchange rate won’t do much to offset the projected widening of the real trade deficit in 2018, but could help stabilize the real trade balance in 2019. Note that this is just the forecast for the real trade balance. The price of oil matters too (still). And the U.S. interest bill is likely to rise along with U.S. interest rates, pushing the current account up even if the trade deficit is constant. Now for a few even wonkier caveats. The Fed’s trade model is based on historical relationships, and those may not hold perfectly. For example, the dollar’s 2003 to 2008 depreciation boosted exports by a bit less than would have been expected based on the models used at the time, while the dollar’s 2014-2016 rise has had more or less the expected negative impact on exports. I personally worry that the positive effect of dollar depreciation on exports is not quite as strong as the negative effect of dollar appreciation. And, well, the dollar’s 2014 to 2016 rise does not seem to have led to the expected increase in imports—which is a bit of a puzzle (an inventory adjustment in 2015 clearly played a role). That creates a bit of risk too: if there is a bit of catchup to forecast, imports might rise by even more than the basic model would suggest. Even with the dollar’s recent depreciation, it is still substantially stronger than it was from 2008 to 2013. Finally, the estimated historical income elasticity is also subject to challenge—there is some evidence that income elasticities have fallen recently. But this still rough math convinced me of two things: 1) The dollar’s current weakening won’t have an impact for a while; 2) The Trump administration should hope that the income elasticity of imports has fallen and the rise in the trade deficit that accompanied the acceleration of demand growth in the fourth quarter is a one-off and not a sign of things to come. * The average spillover to the rest of the world from imports since the end of 2009 has been a little over 20 percent of the increase in U.S. demand. Until the dollar’s 2014 appreciation, that was typically offset by the spillover of growth in the rest of the world to the U.S. ** I am curious how others react to this graph. I added exports to demand—but also plotted the increase of imports against domestic demand. This is an effort to try to capture the different ways trade can impact growth. Ideally, export demand would rise as domestic demand falls. That though clearly wasn’t the case in 2015—hence the slowdown in overall U.S. growth. Conversely, in the fourth quarter of 2017—unlike in q2 or q3—the bulk of the increase in U.S. demand ended up supporting global rather than U.S. output. That’s why overall growth slowed even as demand growth accelerated. *** Tim Duy, among others, has noted that higher rates now have the advantage of giving the U.S. more scope to cut should growth falter in the future. No disagreement from me. I only would note that, for the U.S., the advantages a higher nominal rate path provides for monetary policy have to be balanced against the disadvantages higher rates always pose to a net debtor. The stock of U.S. external debt, measured relative to U.S. GDP, has essentially doubled since the last Fed rate hiking cycle. A return to a world of 4 percent nominal/2 percent real rates thus has a larger mechanical cost to the U.S. than in the past.

The increase in the non-oil trade deficit in December should be getting more attention. It matters more than the year-over-year rise in the 2017 trade deficit.