In September, the trade deficit expanded to $36.5 billion — an increase of $5.7 billion or 18.5% over August. This was a much bigger increase than was expected, as consensus expectations were for a deficit of $31.8 billion. Since the trade deficit is a direct input into the GDP calculations, look for the next iteration of the third quarter GDP numbers to be revised down from the original read of 3.5% growth.

The reason for the growth in the trade deficit is also a bit of a silver lining. It happened because imports rose by $9.3 billion to $168.4 billion, while exports rose by $3.7 billion. The increase in both imports and exports indicates that world trade — which is very important to global growth — is on the mend.

A 5.8% monthly increase is unusual, but is probably a reflection of higher overall demand in the economy, which at this point is a good thing. A 2.6% monthly increase in exports is respectable, but is overshadowed by the big increase in imports.

The month-to-month numbers are in distinct contrast to the year-over-year figures. Relative to September 2008, imports are down 43.7 billion or 20.6%, while exports are down $20.0 billion of 13.2%. Thus on a year-over-year basis, the deficit is down $23.7 billion or 39.4%.

The decline in trade, as shown by the fall in both imports and exports, is both a reflection and a partial cause of the overall worldwide recession. On the other hand, without the decline in the trade deficit year over year, the decline in U.S. GDP would have been sharper than it was.

The first graph, (from shows the history of our imports and exports back to 1994. Note that both imports and exports declined in the last recession as well, but nowhere near as severely. Also note that the blue export line never crosses over the red import line, and that the two lines have been consistently diverging except during recessions. Now they are diverging once again.

This is not a good thing. It is the trade deficit that drives our external indebtedness, not the fiscal deficit. It is what gives China its huge political leverage over us by holding over $1.5 Trillion of our obligations. The chronic trade deficits are a cancer eating away at our economy.

So what was driving the increase in the deficit? Part of it was that we imported more cars from the Toyotas (TM) and Hondas (HMC) of the world as dealers restocked after inventories were depleted due to Cash for Clunkers. However, for the month, the biggest increase in our imports was Industrial Supplies and Materials — a category that includes oil. Oil is a big part of the reason why our trade deficit has been so intractable, and the decline in the price of oil from a year ago is a big part of the reason that we have seen an improvement in the deficit over the last year.

The second graph (also from breaks out the deficit cause by our oil bill, and the deficit caused by everything else. We started making progress on reducing our non-oil deficit towards the end of 2005, and until the last few months, have continued to make steady progress. However, as the price of oil rose, that progress was offset by an ever increasing oil bill.

The net result was that from mid-2005 through the summer of 2008, our trade deficit remained stable at a horrendous level of roughly $60 billion a month. As a percentage of GDP, it exceeded 5.0% in every quarter from the second quarter of 2004 through the second quarter of 2008, and was extremely close to that level through the third quarter of 2008. It was not until oil prices collapsed in the fall of 2008 (along with everything else) that we saw a dramatic improvement in the trade deficit. Now with oil prices on the rebound, the deficit is deteriorating rapidly again.    

There are really only two solutions to solving the chronic deficit problem. The first is that the dollar falls, thus making imports more expensive to U.S. consumers and businesses, and our exports much cheaper to foreign consumers and businesses. Yes, a weak dollar would not be fun next time you decide to vacation in Paris. It also would have the potential to be inflationary. However, right now, there are big deflationary pressures elsewhere in the economy (for example, housing prices and rents), so a little bit of inflation pressure coming from higher import prices is not a huge worry.

Creating export-led jobs is much more important right now. That would help increase Investment’s share of the economy, and decrease the Consumer’s share. Over time it is vitally important that we do this.

One big problem, though, as far as the weak dollar is concerned in curing this cancer — it is not weak against every other currency. Most importantly, it has been absolutely stable against the Yuan, and our deficit with China was $22.1 billion in September, up from $20.1 billion in August.

As a percentage of the total, then, it was 60.5% in September — down from 65.6% in August, but still a huge part of the problem. It is also an issue that a weak dollar does not address (unless China stops pegging to the dollar and moves to say pegging it to a basket of major currencies, I doubt they will go to a full free-float of the Yuan).

The second solution is that we get serious about creating domestic sources of energy to offset the need for us to import so much oil. Since we have already extracted most of our original endowment of oil, “drill baby drill” is looking less and less like the right answer.

However, we have lots and lots of natural gas (NG), thanks to the new Shale plays. Our ability to switch from oil to gas immediately is limited. Butiven the cost differential on a BTU basis right now, there is every incentive in the world already for businesses to make the switch if they can. Strictly on the basis of the amount of energy in them, a barrel of oil should be worth 6x as much as an MCF of natural gas.

Right now, oil is going for $75.86 a barrel while NG is going for $4.42, so if a business has the ability, they could be buying the equivalent of a barrel of oil for just $26.52. That is a big incentive to switch. Over the medium-to-long term, it is easier to make that change. Only relatively minor modifications are needed to switch, say, vehicles to natural gas — it’s not like it is some sort of cutting-edge technology.

However, it is not free, and we do not have the nationwide refilling infrastructure to do so. If this differential persists, I would expect more and more fleet-type vehicles (i.e. city buses and delivery trucks) to switch over. This would obviously be a good thing for the big producers of natural gas like EnCana (ECA) and Chesapeake (CHK).

It would also be a very big improvement environmentally. Natural gas is still a carbon-based fossil fuel, but it has much less of a carbon footprint than does oil or coal.

Increasing our use of renewable energy, such as wind and solar, and using the increased electrical output to power plug in hybrids would also be a big help in this regard. Natural gas is a great complement to them, since the output of renewable sources tends to be highly variable (it gets cloudy or the wind changes speeds). Gas-fired power plants can change their output levels much faster than can coal-fired plants.

We will need to significantly improve our overall power grid for that to happen though, since the best locations for alternative power are far from where the power is needed. New Mexico has lots of sun, and North Dakota has lots of wind, but neither consumes a large percentage of the country’s energy.

The Stimulus Bill made some tentative steps in the right direction, but not on the scale needed. I would argue that large investments in improving the power grid to enable large scale adoption of alternative energy would do more for our national security than increasing our military commitments in certain parts of the world. It would also do a lot more to bring down the unemployment rate, as well as being a big step in solving the chronic trade problem we have.
Read the full analyst report on “TM”
Read the full analyst report on “HMC”
Read the full analyst report on “ECA”
Read the full analyst report on “CHK”
Zacks Investment Research