Trade, FDI, and the Dollar: Explaining the U.S. Trade Deficit
Ten years ago, Peter Drucker offered three reasons why the foundation and structure of the world economy had changed:
- The uncoupling of the primary products and the industrial economies resulting in a decline in the comparative advantages of natural resources.
- The uncoupling of employment and production within the industrial economy due largely to productivity gains associated with technology.
- The partial uncoupling of trade and economic growth, with capital flows replacing trade as the engine of the world economy.1
In the decade since, a fourth factor has been widely recognized: the uncoupling of nations and firms, with firms’ strategic decisions emerging as a critical determinant of international flows of trade and investment.2 Taken together, these factors have undermined — perhaps permanently — the integrity of traditional models of trade and investment. At the very least, they have introduced a new level of complexity into the analysis.
For example, a basic tenet of economic theory is that currency depreciation promotes exports and improves a nation’s trade balance. However, between 1970 — just before the collapse of fixed exchange rates — and early 1995, the U.S. dollar lost more than 70 percent of its value against the yen and 60 percent of its value against the mark,3 yet, in 1994, the United States had a $69 billion merchandise trade deficit with Japan and a $13 billion deficit with Germany.4 In total, the U.S. trade deficit reached a record $170 billion in 1994 despite the dollar’s sporadic decline during the previous two decades. This article attempts to explain these anomalies.
Since currencies began to float more or less freely in 1973, the link between exchange rates and trade flows has become increasingly tenuous. One reason has been the rapid increase in international capital flows. Because capital flows are far more sensitive than trade flows to minor changes in exchange rates — particularly in the short run — countries that attempt to boost exports by weakening their currencies may experience a host of undesirable side effects, including large inflows of foreign direct investment, large outflows of foreign portfolio investment and domestic “flight capital,” and higher domestic interest rates. A second factor has been the growing importance of multinational corporations in dictating international trade patterns. By establishing global production and distribution networks, these firms act to replace exports from their home countries with local production in foreign markets.
1. P. Drucker, “The Changed World Economy,” McKinsey Quarterly, Autumn 1986, pp. 2–26.
2. See, for example:
D. Encarnation, Rivals beyond Trade: America versus Japan in Global Competition (Ithaca, New York: Cornell University Press, 1992);
R. Reich, “Who Is Us?,” Harvard Business Review, volume 88, January–February 1990, pp. 53–64; “Who Is Them?,” Harvard Business Review, volume 89, March–April 1991, pp. 77–88; and
D. Yoffie, ed., Beyond Free Trade: Firms, Governments, and Global Competition (Boston: Harvard Business School Press, 1993).
3. In 1970, these exchange rates were: $1 = ¥360, $1 = DM 3.66, and 1£ = $2.40. By early 1995, the appropriate spot rates were roughly: $1 = ¥95, $1 = DM 1.50, and 1£ = $1.60.
4. International Monetary Fund, Direction of Trade Statistics Yearbook (Washington, D.C.: IMF, 1995).
5. International Monetary Fund, International Financial Statistics Yearbook (Washington, D.C.: IMF, 1995). Figures are f.o.b. and were taken from the balance of payments statement for the United States. This explains the slight discrepancies between these figures and those in Tables 1 and 2.
6. B. Scott and G. Lodge made this point more than a decade ago in:
B. Scott and G. Lodge, eds., U.S. Competitiveness in the World Economy (Boston: Harvard Business School Press, 1985), chapter 1.
7. For these 1993 figures, see:
World Bank, World Development Report 1995 (New York: Oxford University Press, 1995), Table 9.
8. Direction of Trade Statistics Yearbook (1995).
9. For information on U.S. trade in 1992, see:
International Monetary Fund, Direction of Trade Statistics Yearbook (Washington, D.C.: IMF, 1994).
For information on intrafirm trade between U.S. parents and their foreign affiliates in 1992, see:
R.J. Mataloni, Jr., “U.S. Multinational Companies: Operations in 1992,” Survey of Current Business, volume 74, June 1994, pp. 42–63.
For information on intrafirm trade between Japanese parents and their U.S. affiliates in 1992, see:
W.J. Zeile, “Foreign Direct Investment in the United States: 1992 Benchmark Survey Results,” Survey of Current Business, volume 74, July 1994, pp. 154–186. See also Tables 11 and 12 in this paper.
10. T. Liesner, One Hundred Years of Economic Statistics (New York: Facts on File, 1989), Table US 16.
11. There are at least two sides to this debate. The first views the U.S. trade deficit as a consequence of declining U.S. competitiveness, particularly in the manufacturing sector. For examples of this approach, see:
M. Blaine, “America’s Competitiveness Paradox,” Business & the Contemporary World, volume 7, 1995, pp. 28–56;
M. Dertouzos, R. Lester, and R. Solow, Made in America: Regaining the Productive Edge (New York: HarperCollins Publishers, 1990);
J. Hart, “A Comparative Analysis of the Sources of America’s Relative Economic Decline,” in M. Bernstein and D. Adler, eds., Understanding American Economic Decline (Cambridge: Cambridge University Press, 1994);
R. Hayes and S. Wheelwright, Restoring Our Competitive Edge: Competing through Manufacturing (New York: John Wiley, 1984); and Scott and Lodge (1985).
The other side of the debate considers basic macroeconomic factors (such as the overvalued dollar, the U.S. budget deficit, and the gap between domestic saving and investment) as the primary cause of the trade deficit. For example, see:
W. Cline, United States External Adjustments and the World Economy (Washington, D.C.: Institute for International Economics, 1989);
R. Dornbusch, “External Balance Correction: Depreciation or Protection?,” Brookings Papers on Economic Activities, no. 1, 1987, pp. 249–269;
P. Krugman, R. Baldwin, B. Bosworth, and P. Hooper, “The Persistence of the U.S. Trade Deficit: Comments and Discussion,” Brookings Papers on Economic Activities, no. 1, 1987, pp. 1–55; and
M. Miller, J. Grant, and G. Thiessen, “Plans to Solve the Problem of the Twin U.S. Deficits,” Canadian Public Policy, volume 15, supplement, February 1989, pp. S58–70.
12. See Economic Report to the President (Washington, D.C.: U.S. Government Printing Office, 1996), Table B–99.
13. A more formal derivation of the equation begins with the basic macroeconomic identity. We know that:
C + G + I + (X – M) = Y = C + S + (TX – TR)
where C is consumption, G is government purchases, I is investment, Y is GNP, TX is taxes paid to government, and TR is transfer payments made by government. By rearranging terms, we find:
[(G + TR) – TX] + (I – S) = – (X – M)
The left side of this equation is the excess of total government spending over tax revenue — or net public borrowing — plus net private borrowing; the right side is the trade deficit.
14. Economic Report to the President (1996), p. 251. See pages 250–259 for the council’s full analysis of the causes and consequences of the U.S. trade deficit.
15. These trends are clearly visible in: Economic Report to the President (1996), Table B-99.
16. For an analysis of the pressures on the federal budget in the future, see:
P. Peterson, Facing Up: How to Restore the Economy from Crushing Debt and Restore the American Dream (New York: Simon & Schuster, 1993).
17. For trends in U.S. saving, see:
Economic Report to the President (1996), Table B-28.
18. Unfortunately, more recent comparable data is unavailable. Tables detailing GDP by industry (formerly Tables B-11 and B-12) were not included in the 1996 Economic Report to the President and seem unlikely to return. This change offers compelling evidence of the perceived unimportance of the source of domestic product (i.e., manufacturing versus services) in Washington.
19. Note that the source for constructing Table 9 differs from the source for Tables 3 and 4. As a result, the product classifications and their respective percentages of U.S. exports and imports may vary slightly between tables.
20. Economic Report to the President (Washington, D.C.: U.S. Government Printing Office, 1994), Table B-106.
21. Economic Report to the President (1996), Table B-102.
22. T. Sekimoto, “Agenda for Global Trade,” Keidanren Review on the Japanese Economy, special issue, May 1995, p. 5.
23. This conclusion is based on an informal study on the origin of various household and consumer products that I conducted in early 1995. I selected a wide range of product categories and surveyed the stores of five large national and regional mass merchandisers to determine the national origin of these products. China was the primary source for footwear and toys in all stores and a major source of clothing and small appliances. Other Asian nations were the primary source for most electronic products, but Chinese goods were also represented. Conspicuously absent in most of these categories were American-made products.
24. International Monetary Fund, Balance of Payments Statistics Year-book, Part 2 (Washington, D.C.: IMF, 1993), Tables C-2 through C-7.
25. For a detailed and somewhat sanguine analysis of U.S. productivity in general and of the service sector in particular, see:
W. Baumol, S.A. Batey Blackman, and E. Wolff, Productivity and American Leadership: The Long View (Cambridge, Massachusetts: MIT Press, 1989).
26. Krugman notes that the two decades since 1970 have seen the lowest productivity growth of the century. See:
P. Krugman, The Age of Diminished Expectations: U.S. Economic Policy in the 1990s (Cambridge, Massachusetts: MIT Press, 1990), chapter 1.
For trends in U.S. productivity growth, see also:
Economic Report to the President (1994), Tables B-47 and B-48.
27. In 1992, average hourly earnings in manufacturing were $11.46, while average earnings in all private industry groups were $10.58. For trends in real wages and earnings, see:
Economic Report to the President (1994), Table B-45.
28. D. Sanger, “President Imposes Trade Sanctions on Chinese Goods,” New York Times, 5 February 1995, p. 1.
29. For a few examples of this approach, see:
Hayes and Wheelwright (1984);
Scott and Lodge (1985);
L. Thurow, “Revitalizing American Industry: Managing in a Competitive World Economy,” California Management Review, volume 27, Fall 1984, pp. 9–41; and
R. Vernon, “Can U.S. Manufacturing Come Back?,” Harvard Business Review, volume 64, July–August 1986, pp. 98–106.
30. Encarnation (1992), p. xi.
31. For information on U.S. trade in 1992, see:
Direction of Trade Statistics Yearbook (1994).
For information on “intrafirm” trade between U.S. parents and their foreign affiliates in 1992, see:
For information on intrafirm trade between foreign parents and their U.S. affiliates in 1992, see:
32. The factors influencing the location of foreign production and investment are an integral part of the theory of the multinational enterprise. See:
P. Buckley and M. Casson, The Future of the Multinational Enterprise (London: Macmillan Press, 1976);
P. Buckley and M. Casson, Multinational Enterprises in the World Economy: Essays in Honour of John Dunning (Aldershot, United Kingdom: Edward Elgar Publishing Ltd., 1992), particularly chapters 3 and 4;
A. L. Calvet, “A Synthesis of Foreign Direct Investment Theories and Theories of the Multinational Firm,” Journal of International Business Studies, volume 12, 1981, pp. 43–59;
J. Dunning, “Trade, Location of Economic Activity, and the MNE: A Search for an Eclectic Approach,” in B. Ohlin, P.O. Hesselborn, and P.M. Wijkman, eds., The International Allocation of Economic Activity (London: Macmillan, 1977);
J. Dunning, Explaining International Production (London: Unwin Hyman, 1988); and
A. Rugman, ed., New Theories of the Multinational Enterprise (Beckenham, United Kingdom: Croom Helm Ltd., 1982).
33. “Global” strategies were particularly popular in the 1980s. For some of the more notable discussions of these strategies, see:
C. Bartlett and S. Ghoshal, Managing across Borders: The Transnational Solution (Boston: Harvard Business School Press, 1989);
T. Hout, M. Porter, and E. Rudden, “How Global Companies Win Out,” Harvard Business Review, volume 60, September–October 1982, pp. 98–108;
B. Kogut, “Designing Global Strategies: Comparative and Competitive Value-Added Chains,” Sloan Management Review, volume 26, Summer 1985, pp. 15–28;
B. Kogut, “Designing Global Strategies: Profiting from Operational Flexibility,” Sloan Management Review, volume 27, Fall 1985, pp. 27–38;
M. Porter, “Changing Patterns of International Competition,” California Management Review, volume 28, Winter 1986, pp. 9–40; and
C.K. Prahalad and Y. Doz, The Multinational Mission: Balancing Local Demands and Global Vision (New York: Free Press, 1987).
34. For an important early study of the shift of U.S. manufacturers to low wage locations, see:
J.M. Finger, “Tariff Provisions for Offshore Assembly and the Exports of Developing Countries,” The Economic Journal, volume 85, June 1975, pp. 365–371.
35. For a detailed breakdown of U.S. FDI by industry in 1992, see:
36. To some extent, the relatively low level of manufactured exports from the U.S. affiliates of foreign corporations — and the relatively high level of exports from foreign affiliates in the wholesale industry — may be an artifact of the way the Department of Commerce collects data on foreign investment in the United States. Affiliates are classified by their primary activity. Therefore, some affiliates — particularly Japanese affiliates in the auto industry — are classified as wholesalers even though they may also perform a significant amount of manufacturing or assembly.
37. For a detailed breakdown of Japanese investment in the United States in 1992, see:
38. The basket of currencies that constitute the SDR has changed over time. Since January 1991, these currencies have been the dollar, mark, yen, franc, and pound. The IMF notes that the weights of these five currencies broadly reflects their relative importance in international trade and finance. For a detailed discussion of the SDR, see:
International Monetary Fund, International Financial Statistics Yearbook (Washington, D.C.: IMF, 1993), p. xi.
39. International Monetary Fund, International Financial Statistics Yearbook (1994).
40. Figures for the dollar per SDR exchange rate are from the appropriate series in:
International Financial Statistics Yearbook (1994).
41. The strength of the U.S. economy is based on its annual rate of real GDP growth in:
Economic Report to the President (1994), Table B-5.
42. For example, the average annual returns of Japanese firms in the auto, electronics, and machinery industries declined markedly after 1985 as the yen began to appreciate against the dollar. This suggests that firms in these export-dependent industries were slow to raise the foreign prices of these products and instead accepted a decline in their profit margins. For a discussion of Japanese export behavior and strategies, see:
M. Blaine, “Profitability and Competitiveness: Lessons from Japanese and American Firms in the 1980s,” California Management Review, volume 36, Fall 1993, pp. 48–74; and
S. Cohen, Cowboys and Samurai: Why the United States Is Losing the Battle with the Japanese and Why It Matters (New York: HarperBusiness, 1991), chapters 8 and 9.
Conversely, a study of the behavior of U.S. exporters found that most exporters were unwilling to accept reductions in their profit margins to remain competitive in foreign markets as the dollar appreciated in the early 1980s. See:
V. Hatter, Behavior of U.S. Export Prices and Profit Margins, 1981–1986 (Washington, D.C.: Office of Trade and Investment Analysis, International Trade Administration, U.S. Department of Commerce, 1988).
43. For an analysis of global sourcing strategies, see:
M. Kotahe, Global Sourcing Strategies: R&D, Manufacturing, and Marketing Interfaces (New York: Quorum Books, 1992).
44. S.E. Baragas and J.H. Lowe, “Direct Investment Positions on a Historical-Cost Basis, 1993: Country and Industry Detail,” Survey of Current Business, volume 74, June 1994, pp. 76–77.
45. Ibid., p. 73.
46. For an excellent historical survey of the gold standard and its operations, see:
A.G. Ford, “International Financial Policy and the Gold Standard, 1870–1914,” and
D.E. Moggridge, “The Gold Standard and National Financial Policies, 1913–1939,” both in:
P. Mathias and S. Pollard, eds., The Cambridge Economic History of Europe, Volume VIII, The Industrial Economies: The Development of Economic and Social Policies (Cambridge: Cambridge University Press, 1989), pp. 197–249 and pp. 250–314 respectively.
47. Sekimoto (1995), pp. 5–6.
48. For a summary of the policies that several Asian nations used to achieve rapid growth and increase exports, see:
World Bank, The East Asian Miracle: Economic Growth and Public Policy (New York: Oxford University Press, 1993), particularly chapters 3 and 6.
For an analysis of industrial policies in Japan, Korea, and Taiwan, see: Office of Technology Assessment, Competing Economies: America, Europe, and the Pacific Rim, OTA-ITE-498 (Washington, D.C.: U.S. Government Printing Office, 1991), chapters 6 and 7 respectively.
49. See: R. Forsyth, “The Appeal of Gold,” Barron’s, 19 February 1996, pp 31–34.
For an interesting analysis of the relative virtues of various exchange rate regimes, see:
Economic Report to the President (Washington, D.C.: U.S. Government Printing Office, 1993), pp. 282–308.