Not all trade is equal

In the back-and-forth dispute over trade statistics between the Trump administration and representatives of Canada's governing Liberal Party, an important shift in rhetoric was attempted by Canadian foreign affairs minister Chrystia Freeland:

Foreign Affairs Minister Chrystia Freeland is taking aim at a core assumption of Donald Trump's upcoming review of American trading partners[.] ... [Freeland stated that] the U.S. has a trade surplus with Canada, not the other way around.

"Canada is the single largest client of the United States and when you look at our overall trading relationship, counting goods and services, the U.S. runs a slight trade surplus with Canada," said Freeland.

"So I am really confident that the U.S. administration understands and will continue to understand that this is a relationship which is win-win and we're going hard on both sides of the border to keep it that way."

The operative word in the quote is "services."  Yes, in recent years, the trade balance in both goods and services between the two nations has slightly benefited the U.S.  But not all trade is equal, and this is the critical point that Trump has long understood.

Much of the debate over the U.S. trade balance since Trump's candidacy to lead the GOP in 2015 has revolved around the U.S. trade in goods.  Since NAFTA came into force, the U.S. has run up an astonishing $1.1-trillion and growing trade deficit in goods with Canada in inflation-adjusted terms.

Each year, the U.S. continues to have immense trade deficits in goods with the rest of the world.  Last year, the value reached a staggering $800 billion.  The question remains: do service exports offset goods imports?  Or in other words, does a dollar of service exports offset a dollar of goods imports?

The data are clear, and the answer is no.

Since 1970, the U.S. trade balance in services started off small and negative (-0.3% of GDP) and has progressively grown into a modestly reliable surplus ranging between 1.0% and 1.5% of GDP.  In contrast, over the same period of time, the trade balance in goods began in slightly positive territory (+0.2% of GDP), held its ground around a balance between imports and exports up until the mid-1970s, and has subsequently collapsed in near free-fall form to a consistent trade deficit in goods between 4% and 6% of GDP.

Thus, over the past half-century, not only has trade become a much more important component of the U.S. economy, but the nature of U.S. trade has shifted from a slight net exporter of goods and net importer of services into a significant net exporter of services and a large net importer of goods.  The overall trade deficit has exploded over this same time frame since, the increasing net exports of services have failed to keep up with the rising net imports of goods.

Consequently, during the last 50 years, an increasing trade surplus in services correlates strongly with lower, not higher, economic growth, while an improving U.S. trade balance in goods displays a high correlation with higher, not lower, rates of GDP expansion.

Critics of this analysis may raise concerns that the overall trade deficit was increasing since 1970, and since that is the overriding factor behind lower rates of economic growth that were progressively taking place in the United States during this time frame, the individual correlations for the components of the trade balance (i.e., goods versus services) are of less significance.

Perhaps this is so, albeit unlikely, but the analyses neatly cut off the two main branches on which the unrestricted free-traders have hung their arguments in recent years: (1) that trade deficits do not matter and (2) that increasing goods imports can be offset by increasing services exports.  The data leave no room for both of these claims to be true.  In fact, the more comprehensive analyses we, and others, have conducted and discussed over the past few years suggest that neither claim is true.

In other words, trade deficits do harm economic growth, potentially in an effectively 1:1 relationship such that every 1% of GDP trade deficit reduces net GDP growth by 1%, and, in general, exporting a dollar of goods leads to far greater economic rewards for the exporting nation than exporting a dollar of services.  The latter conclusion should not be surprising, given that the production of merchandise often relies upon a more extensive network of suppliers and materials than does a similar end value of services.  Over time, as the West's economies have transitioned from the production of goods to services, economic growth has slowed in line with these expectations.

Trading partners will try to reframe the debate, but the Trump administration needs to stay focused on the simple yet undeniable fact that high rates of economic growth cannot be maintained in large, modern economies unless the nation makes goods and is a net exporter of them.  For all the talk of being in the 21st-century service economy, the wheels of growth still revolve around good old-fashioned "stuff."