There's an old cartoon that shows a U.S. map, with tugboats towing away several states. The caption goes something like this: 'The trade deficit' Oh, that's just for economists to talk about. It doesn't mean anything.?
Twenty years later, economists are still talking about the trade deficit, which encompasses interest payments on debt and earnings on overseas investments as well as goods and services. To many, the trade deficit is a useful economic indicator and provides insight to the direction of foreign exchange rates, interest rates and even world economic growth. It hit a record $666 billion in 2004, almost 26 percent larger than the $531 billion imbalance the United States racked up in 2003, and could soon amount to 6 percent of the U.S. gross domestic product (GDP). Many economists consider trade deficits above 4 percent of GDP dangerously high.
"About 70 percent of our trade is in manufacturing goods, which have had a strong decline," according to Christian E. Weller, senior economist at the Center for American Progress. "The problem is the areas we have been pinning our hopes on, services and advanced technology products, have also lost ground rather than gained over the last few years."
To pay for the trade deficit, we need to borrow money overseas, and that debt must be repaid at some point.
"We're already paying interest on that debt, about 2 percent of GDP, and that debt will continue to be a drag on our economic growth, notes Weller.
The trade deficit is calculated by stacking up the value of all cars, electronic gadgets, tourism, payments for banking services, among others, that enter the country against those that leave. These days, it's mostly goods coming in and money going out.
But the picture is complex, showing a range of sometimes counterintuitive effects.
- The trade deficit largely reflects a hunger for imports. The healthier the U.S. economy becomes, the more U.S. consumers spend on goods from Japan, South Korea, and the eurozone.
- When the value of the dollar falls " which it has been by almost 30 percent against the euro during the past two years " imports become more expensive because a dollar buys less. At least for now, Americans are still buying foreign goods. Many economists believe the dollar must drop much further for the trade gap to narrow.
- Major exporters to the United States would rather see the dollar rise, not fall. A stronger dollar could mean even more U.S. sales. And foreign investors, including central banks, hold lots of dollar-denominated stocks and bonds as well as greenbacks themselves. A rising dollar makes those holdings worth more.
So what does this mean to you as an investor?
Today's situation represents a global imbalance, one that ultimately will correct itself. If the ballooning trade deficit shakes the confidence of foreign investors, they could begin to look for other places to park their cash, the dollar could drop further, and interest rates might have to rise more rapidly to lure investors. This does not bode well for the stock market.
However, if the government makes promised cuts in its other deficit " the federal budget " the demand for investment could ease, thus reducing pressure on interest rates. Whether the dollar remains strong or continues to weaken, the global nature of markets may make it wise to have some investment dollars in international investments. While foreign investing does involve political and currency risk, it also provides a way to take advantage of economic cycles on a global level.
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