A Note on Trade Deficits and Manufacturing

Some perspective on the eve of trade war

I am supposedly on vacation in an undisclosed location, and for today I want to act like it — especially given that I’ll probably be spending a lot of time later this week reacting to the onset of full-on trade war. So this will be a relatively casual post.

Still, I thought it might be worth saying a bit more about why people like Maury Obstfeld, Jared Bernstein and yours truly are skeptical about the widespread narrative that the dollar’s role as a reserve currency is responsible for U.S. deindustrialization.

It’s not an argument on principle. U.S. trade deficits are surely affected by other countries’ policies, and the size of our manufacturing sector is affected by the size of our trade deficit. It is, instead, a numbers issue. Any way I cut it, the dollar’s reserve currency status is only part of the explanation of U.S. trade deficits. Even more important, trade deficits account for only a small fraction of the decline in manufacturing as a share of our economy.

On the first point: Last year China ran roughly a $1 trillion trade surplus, while the United States ran a roughly equal size trade deficit. So it may seem natural to assume that the first caused the second. But America is only about 40 percent of world GDP ex China, so why are we the sole counterpart to China’s surplus?

Many people assert that the answer is the dollar’s role as the preeminent reserve currency. But as I tried to argue, and Obstfeld explains with much more detail, this story doesn’t hold up when you look at it closely. To explain U.S. trade deficits we need to focus on reasons other than the dollar’s role, such as high productivity growth and relatively favorable demography, that foreigners invest in America.

Beyond that, how central are trade deficits to the relative decline of manufacturing? Most missives about trade and deindustrialization contain some version of this chart, showing the decline in manufacturing as a percentage of total employment:

These missives then simply take it for granted that trade deficits must be responsible for the big decline in this percentage.

But trade deficits are, in fact, responsible for only a fairly small fraction of the long-run decline in the manufacturing share.

How do we know this? Two different ways: international comparisons and bottom-up number-crunching.

International comparisons: In terms of trade, Germany is the anti-America. As we have moved into trade deficit, Germany has moved into massive trade surplus. In fact, Germany’s surpluses are much larger as a share of its own GDP than China’s. Yet Germany has also seen a huge long-term decline in the manufacturing share of employment:

Source: FRED

Data note: FRED offers two different series here, one that only runs up to 2012, another that starts in 2005. I’ve overlapped them, so you can see that they seem consistent.

If Germany’s huge trade surpluses haven’t been enough to avoid a big shift away from manufacturing, even ending U.S. trade deficits (which Trump’s tariffs won’t achieve) wouldn’t make us a manufacturing-centric economy again.

Bottom-up number-crunching: Last year the U.S. ran a manufactures trade deficit of around 4 percent of GDP. Suppose we assume that this deficit subtracted an equal amount from spending on U.S. manufactured goods. In that case what would happen if we somehow eliminated that deficit?

Well, it would raise the share of manufacturing in GDP — currently 10 percent — by less than 4 percentage points, because manufacturing firms buy a lot of services. A rough estimate is that manufacturing value-added would rise by around 60 percent of the change in sales, or 2.5 percentage points, implying that the manufacturing sector would be around a quarter larger than it is.

But look at my first chart above. Manufacturing as a share of employment has fallen about 17 points since 1970. Complete elimination of the trade deficit would undo only around 2.5 points of that decline. So even if tariffs “worked,” which they won’t, they would fall far short of restoring manufacturing to its former glory.

I won’t do the full analysis right now, since as I said I’m supposed to be on vacation, but the difference between the German and U.S. shares of manufacturing in employment is roughly consistent with this calculation.

The fact is that the world needs fewer manufacturing workers than it used to, just as it no longer needs a lot of farmers, and even countries that run big surpluses in manufacturing trade can’t buck that trend. This doesn’t mean that we should abandon efforts to promote manufacturing where that makes sense. But we should do so with a realistic appreciation of the fact that we are going to be mainly a service economy no matter what, and that if we really want to help workers we have to make all jobs better, not dream of a return to an old-time economy.

MUSICAL CODA