Monday, October 23, 2017

The Importance of NAFTA

With Canada, Mexico and the United States renegotiating the 1994 North American Free Trade Act (NAFTA), a look at the trade balance between the three nations is in order, particularly trade between Canada and the United States and Mexico and the United States.  For the purposes of this posting, I am sourcing the trade data from the United States Census Bureau with the Canadian trade data sourced here and the Mexican trade data sourced here.

Let's start with Canada.  According to the Office of the United States Trade Representative, we find the following:

- United States exports to Canada are up 165 percent from 1993 (pre-NAFTA).

- United States exports to Canada make up 18.3 percent of America's overall exports (2015)

- two-way trade in goods with Canada totalled an estimated $544 billion in 2016, making Canada the largest goods trading partner with the United States. 

- in 2016, the U.S. goods trade deficit with Canada was $12.1 billion and the services trade surplus was $24.6 billion resulting in an overall trade surplus of $12.5 billion for the United States.   

- the U.S. Department of Commerce estimates that American exports of goods and services to Canada supported an estimated 1.6 million jobs in the United States in 2015 (latest data available)

- the top exports to Canada include vehicles, machinery, electrical machinery, mineral fuel and plastics.

- the top imports from Canada include vehicles, mineral fuels, machinery, special other items and plastics. 

Here is a graph showing what has happened to the net value (exports minus imports) of American goods exported to Canada since NAFTA was signed:


As you can see, the Great Recession had a profound impact on the American long-term trade deficit with Canada and, in fact, at just under $11 billion, the trade deficit with Canada in 2016 was the smallest since before NAFTA was signed.  In fact, in April 2016, the United States ran a trade surplus of $1.13 billion with Canada, the largest monthly trade surplus by a wide margin since prior to 1985. 
   
Now, let's look at Mexico.  Again, according to the Office of the United States Trade Representative, we find the following:

- United States exports to Mexico are up 455 percent from 1993 (pre-NAFTA).

- United States exports to Mexico make up 15.9 percent of America's overall exports (2015).

- two-way trade in goods with Mexico totalled an estimated $525.1 billion in 2016, with Mexico being America's second largest export market and second largest supplier of goods imports in 2016.

- in 2016, the U.S. goods trade deficit with Mexico was $63.2 billion and the services trade surplus was $7.6 billion resulting in an overall trade deficit of $55.6 billion for the United States.

- the U.S. Department of Commerce estimates that American exports of goods and services to Mexico supported an estimated 1.2 million jobs in the United States in 2015 (latest data available).

- top exports to Mexico included machinery, electrical machinery, vehicles, mineral fuels and plastics.

- Mexico is the third largest market for U.S. exports of agricultural products.

- top imports from Mexico include vehicles, electrical machinery, machinery, optical and medical instruments and furniture and bedding.

- Mexico is the largest supplier of agricultural products imported into the United States.

Here is a graph showing what has happened to the net value (exports minus imports) of Mexican goods imported into the United States since NAFTA was signed:


As you can see, the Great Recession put an end to the substantial growth rate of the U.S. - Mexico trade deficit; since 2007 when the deficit peaked at nearly $75 billion, the deficit has ranged from a low of $47.7 billion in 2009 to a high of $64.5 billion in 2011.

By way of comparison and to put the data for Canada and Mexico into perspective, let's look at trade with China.  Again, according to the Office of the United States Trade Representative,  we find the following:

- United States exports to China are up 504 percent and imports are up 353 percent from 2001 (pre-WTO Accession).

- U.S exports to China make up 8.0 percent of America's overall exports (2015).

- two-way trade in goods with China totalled an estimated $578.6 billion in 2016 with China being America's America's third largest export market and largest supplier of goods in 2016.

- in 2016, the U.S. goods trade deficit with China was $347 billion and the services trade surplus was $37.4 billion resulting in an overall trade deficit of $309.6 for the United States.

- the U.S. Department of Commerce estimates that American exports of goods and services to China supported an estimated 911,000 jobs in the United States in 2015 (latest data available).

While there have been some trade imbalances, trade disagreements and unintended consequences to the implementation of the NAFTA deal, overall and particularly in the case of Canada, the trade situation between the three nations readjusted during and after the Great Recession with the trade deficit with Canada shrinking markedly and the significant annual growth rate of the trade deficit with Mexico levelling off.  In any case, it is quite clear that the United States is not suffering from its trade relationship with Canada and Mexico to the same degree that it is experiencing trade imbalance with China whose trade surplus with the United States is 5.5 times that of Mexico.  My suspicion is that trade with China will be next on Washington's agenda.   


Friday, October 20, 2017

Who is the Top of the Global Economy?

While the United States is still the global economic superpower, its self-belief that it still retains the status at the top of the capitalist heap is under threat, particularly in the eyes of the rest of the world as you will see in this posting.

Thanks to the Pew Research Center, we can see how significant the changes in the global economy have become over the past decade and a half, especially since China was admitted to the World Trade Organization on December 11, 2001.  Let's look at the data first.  Here is a graphic showing what has happened to China's GDP since the beginning of 2002:


Here is the year-over-year growth of the Chinese economy over the same time period (in red) compared to that of the United States (in blue):


The difference in the growth rate of the two economies is extremely significant over the past decade and a half with China's economy showing year-over-year growth rate over the fifteen year period averaging 15.9 percent compared to 3.9 percent for the United States.

Now, let's look at how the world views the two economic superpowers.  Pew polled the public from 38 nations in its Spring 2017 Global Attitudes Survey and found that a median of 42 percent of respondents felt that the United States was the world's leading economy compared to 32 percent for China, noting that the other options which included the European Union and Japan received far lower.  That perception varies widely by region as shown on this map which outlines the nations which believe that the United States is leading in blue and those which believe that China is leading in red:


Interestingly, in seven out of ten European Union nations in the study, China is considered to be the global economic leader.  This is part of a trend that began during the Great Recession when Europeans increasingly believed that China was the world's most powerful economy.  Australia, a nation whose major trading partner is China but which has strong ties its long-term ally, the United States, also believes that China is the world's strongest economy by a 58 percent to 29 percent margin.    

Here is a graphic showing the breakdown of how the public in each of the 38 nations polled feels about which nation is the world's economic leader:


In 24 of the 38 nations polled, the public feels that the United States is the world's economic leader whereas in 12 nations, China is seen as the world's economic leader, double the nations that saw China as the leader when the same question was asked between the years 2014 and 2016.   On a year-over-year basis, there have been some significant changes: 

1.) United Kingdom:

- China - 35 percent  in 2016, 46 percent in 2017
- United States - 43 percent in 2016, 31 percent in 2017

2.) Germany:

- China - 30 percent in 2016, 41 percent in 2017
- United States - 34 percent in 2016, 24 percent in 2017

3.) Canada:

- China - 42 percent in 2016, 42 percent in 2017
- United States - 40 percent in 2016, 32 percent in 2017

4.) Mexico:

- China - 17 percent in 2015, 25 percent in 2017
- United States - 60 percent in 2015, 47 percent in 2017

What I found most interesting was the year-over-year changes in the perception of the United States economic leadership from America's geographically closest trade partners, Canada and the United States.  One wonders how much of this change in perception is due to the Trump Administration's threats to kill the decades-old NAFTA trade deal.

As we know, in the global economy, perception quite often becomes reality.  This poll by Pew shows us that the United States reputation as the global economic superpower is under threat from China.  While the current administration in Washington is doing its best to rewrite trade deals to protect its own economic power base, it may find out that reneging on trade deals that have existed for decades hurts the perception of the United States as a world leader more than it benefits America as trade instability rises.


Thursday, October 19, 2017

The Federal Reserve and the New Economic Normal

There is no doubt that the Federal Reserve is puzzled about the "lower than the Fed's comfort zone" inflation rate.  A recent talk by Governor Lael Brainard takes an interesting look at the latest monetary quandary to face the braintrust at the Fed.  In this posting, we'll start by looking at the Fed's "new normal" by defining the concept of a neutral (natural) interest rate and conclude by looking at the dangers to the economy that are posed by the Federal Reserve's policies during this long post-recessional period.

Governor Brainard opens by defining the key aspect of the Federal Reserve's new monetary policy normal:

"A key feature of the new normal is that the neutral interest rate - the level of the federal funds rate that is consistent with the economy growing close to its potential rate, full employment, and stable inflation--appears to be much lower than it was in the decades prior to the crisis."

Please note that, according to the Fed, the neutral interest rate can also be termed the natural interest rate or R* /R-star.

According to research by Kathryn Holston and Thomas Laubach at the Federal Reserve Bank of Sa Francisco, the natural rate of interest in the United States fell close to zero after the Great Crisis, significantly lower than it was in the decades prior to 2007 - 200.  As shown on this graph, r* or r star, the real short-term interest rate that pertains when the economy is at equilibrium (i.e. unemployment is at the natural state and inflation is at the two percent target) has dropped significantly in recent years as shown on this graph:


In fact, as shown on this graph, R-star has declined into negative territory according to the latest updated estimates of the baseline model designed by Thomas Laubach and John Williams:


The speaker notes that the low level of the neutral interest rate "limits the amount of space available for cutting the federal funds rate to offset adverse developments".  This means that there will likely be more frequent and longer periods when the Fed's interest rate policies are constrained by the lower bound (i.e. zero percent), where unemployment is at elevated levels and where inflation is below the Fed's targets.  This means that future lower bound episodes will be "more challenging in terms of output and employment losses", in other words, the Federal Reserve has now painted itself into a "monetary policy corner" from which there is no easy exit. 

Governor Brainard correctly observes that the Phillips curve which explains the relationship between unemployment and inflation looked like this in the 1960s:


...has slowly flattened as the decades have passed as shown here:


This means that, even in the essentially full employment environment that exists in the United States today, inflation stubbornly remains below the Fed's 2 percent target.  That said, Mr. Brainard is very concerned that the transition to a higher inflation target is "likely to be challenging and could heighten uncertainty" and that the public "may start to doubt that the central bank is still serious about its inflation target" if the Fed were to signal that its 2 percent target should be changed.  

One of the biggest problems with the current low neutral interest rate is related to cross-border spillovers where even small changes in interest rates on 10-year Treasuries leads to high changes in the value of the U.S. dollar.  Prior to the Great Crisis, a 25 basis point increase in the expected interest rate on the 10-year Treasure led to a one percentage point increase in the value of the dollar; now, that same 25 basis point increase leads to a three percentage point increase in the value of the dollar.  As well, cross-border spillovers are amplified on yields since the Great Recession resulted in a low neutral rate environment; for example, news from the European Central Bank that leads to a 10 basis point decrease in Germany's 10-year term premium is associated with a roughly 5 basis point decrease in the U.S. 10-year term premium.  These spillover effects were much smaller prior to the Great Recession.

One of the most telling parts of Governor Brainard's speech is found here (with all bolds being mine):

"Finally, a low neutral rate environment may also be associated with a heightened risk of asset price bubbles, which could exacerbate the tradeoff for monetary policy between achieving the traditional dual-mandate goals and preventing the kinds of imbalances that could contribute to financial instability. Standard asset-valuation models suggest that a persistently low neutral rate, depending on the factors driving it, could lead to higher ratios of asset prices to underlying income flows--for example, higher ratios of prices to earnings for stocks or higher prices of buildings relative to rents. If asset markets were highly efficient and participants had excellent foresight, this would not necessarily lead to imbalances. However, to the extent that financial markets extrapolate price movements, markets may not transition smoothly to asset valuations that reflect underlying fundamentals but may instead evidence periods of overshooting.  Such forces may have played a role in both the stock market boom that ended in the bust of 2001 and the house price bubble that burst in 2007-09.

The risks of such financial imbalances may be greater in the context of the kind of explicit inflation target overshooting policies proposed in the paper. Again, if market participants were perfectly rational, overshooting policies would not likely pose financial stability risks. But the combination of low interest rates and low unemployment that would prevail during the inflation overshooting period could well spark capital markets to overextend, leading to financial imbalances."

Basically, Governor Brainard is clearly (well, as clearly as any central banker ever is) telling us that the "monetary medicine" that has been used by the Federal Reserve and the world's other influential central banks could already be creating the next Great Recession, thanks to a low neutral interest rate, below target inflation and the Fed's seeming inability to see that its policies have created fiscal imbalances that could burst as was the case in 2001 and 2007 to 2009.  The bursting of this latest asset bubble will leave both equity and bond investors holding assets that are worth a fraction of what they paid for them.

The Federal Reserve's "new normal" could prove to be painful when it "unwinds", largely because the Fed has adopted policies that have proven to be ineffective over the past two decades in one of the world's other large economies, Japan.