Unless we find life on Mars — nay, an advanced civilization on Mars who we can trade goods with — there is one central fact that cannot be escaped when talking about global trade. That is, there cannot be a global trade surplus or a global trade deficit. The second thing to recognize is that while some bi-lateral situations can exist forever, where country A runs a trade deficit with country B, eventually country A will have to run a trade surplus with country C, or it will simply run out of money.
A core problem right now is that every country in the world wants to be a net exporter, and no country really wants to be a net importer. For years now, the U.S. has been the world’s consumer of last resort and has run massive trade deficits. Over time, this has turned the U.S. from the world’s largest creditor nation into the world’s biggest debtor — by a very large margin.
The biggest of these deficits has been with China, but we also tend to run persistent trade deficits with OPEC and Japan, as well. China has been the largest trade surplus country, followed by Japan and Germany. Europe as a whole has been more or less in balance, with the South of Europe running persistent deficits and Northern Europe running trade surpluses.
With the recent crisis in Greece, it is clear that they and the other Southern European countries, most notably Spain and Italy, are going to have to sharply reduce their current account deficits. The ideal way for them to do so would be for them to devalue their currency. That would make imports more expensive and their exports cheaper.
But since they are locked into the Euro, as is Germany, the decline in the value of the Euro is going to have no effect on the relative prices of things between Germany and Greece. If the Greek deficit goes down, then either the German surplus with them (and the rest of the PIIGS) has to go down, or the overall European surplus with the rest of the world has to go up.
Until this point, while there were some pretty big surpluses and deficits in individual countries in Europe, they more or less netted out. Since the entire Euro area has seen a devaluation, it seems likely that the overall European surplus, mostly meaning Germany (but also places like the Netherlands and Norway) will go up. If the European surplus rises, then either some of the deficit countries (read: the U.S.) will have to run larger deficits, or other surplus countries will have to see their surpluses shrink.
Running a trade surplus is a good way to generate economic growth and employment, and thus every country wants to do so. Remember the old formula for GDP: GDP = C + I + G + (X – M). If you increase X (exports) or decrease M (imports), your GDP increases.
The Greece Situation
Now consider Greece for a minute. Because they have to cut their budget shortfall dramatically, their G (government) is going down sharply. They are also raising taxes sharply, which will cut into both C (consumption) and I (investment). If they can’t either reduce their imports or increase their exports, they are in for a world of hurt.
But most of their “exports” are within the Euro zone. I put exports in quotation marks since the principal export industry in Greece is tourism, and the vast majority of tourists to Greece come from other European countries. The world market for olives, olive oil and wine that — let’s be kind and say “is an acquired taste” (Retsina) — simply is not all that big.
To make that stay on Mikonos more affordable to other Europeans, it means that the price in Euros is going to have to fall, not simply having the Drachma be worth fewer Euros. Most estimates are that Greece needs to see its unit labor costs fall by 20% to be competitive with the rest of Europe. If that means that wages are going to have to fall by 20% (on top of the higher taxes), then domestic consumer demand has to simply collapse.
The adjustment has to come from somewhere. The impact does not have to be directly on a bi-lateral basis, although with the Euro sliding, it means that the Yuan, which is pegged to the dollar, has already be revalued upwards on a trade-weighted basis. China sells more to Europe than it does to the U.S. With aggregate demand in all of Europe — but particularly in Southern Europe — about to plunge, there will be fewer exports from China to Europe.
More significantly from the point of view of the U.S. is that European goods, many of which compete directly with U.S. goods in markets like China, will have a big advantage. If China is looking to buy a new electrical generator, Siemens (SI) is going to be in a much better position than will General Electric (GE) to get the order. Germany also tends to compete directly with Japan in many goods, and so Japan might end up running smaller trade surpluses.
The U.S. and the Global Deficit
The U.S., however, simply cannot afford to increase its share of the global deficit. We already account for over a third of the entire world’s trade deficits. We have already played that role too long. While the sharp decline in oil prices that has accompanied the crisis in Europe will help offset some of the effect, in effect causing the oil exporting countries to run either smaller surpluses or larger deficits, the sharp rise in the dollar means that the U.S will bear at least some of the adjustment in the form of higher trade deficits.
However, as a matter of accounting identity, the trade deficit has to be matched on a dollar-for-dollar (or euro-for-euro) basis with an increase in the capital account. In other words, if you buy something and don’t pay for it with other goods, then you either go into debt or have to sell off assets.
While most of the debt is in the form of T-notes, to get a sense of what it means and its scale, try thinking about it in terms of the stock market. Last month the U.S ran a trade deficit of $41 billion. That is the equivalent of selling off Colgate-Palmolive (CL) just to fund one month’s trade gap, and then if it stays at that level, selling off Target (TGT) next month. Over the course of a year, the current rate would be the equivalent of selling off Wal-Mart (WMT), Johnson & Johnson (JNJ) and Intel (INTC). How much longer can that go on until we have nothing left?
At the core, though, eventually the biggest imbalance in the world economy is going to have to be rectified. The U.S. trade deficit will have to fall, and the Chinese surplus will have to decline. That does not have to happen on a bi-lateral basis, but that would be the most direct route.
However, the current situation in Europe seems to be postponing this desperately needed adjustment even longer. China needs to be consuming more of its production internally, and thus raising the living standards of its people. The U.S. needs to be consuming less and exporting more. The strong dollar will work in the wrong direction, by making imported products that much cheaper. While that would be good news if inflation were a real problem, that is not the case today.
The tables below are from http://mpettis.com/2010/05/don%e2%80%99t-misread-the-trade-implications-of-the-euro-crisis-for-china/ and are based on CIA estimates for 2009. The article is well worth reading as well.
Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.
