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Trade Frictions Result of US Savings Shortfall
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The economic relationship between the United States and China could well be the world's most important bilateral relationship of the 21st century. And it's not going well. The stresses and strains of globalization have added considerable tension to the interplay.

The risks of trade frictions and protectionist actions are mounting. Perhaps more importantly, a corrosive sense of mistrust is building between the United States and China that if left unattended could result in both nations, to say nothing of the broader global economy, squandering enormous opportunities in the years ahead. It's time for a wake-up call before it's too late.

The United States is flirting with protectionism at a time when its need for foreign capital has never been greater. At work is a highly combustible mixture of macro and politics. America's saving shortfall has led to a massive trade deficit, and China happens to account for the biggest portion of that deficit. Meanwhile, a growing sense of angst has gripped the middle-class American workers. This has triggered a classic political blame game, with China being increasingly singled out as the scapegoat. The drumbeat of China bashing is growing louder and louder.

There is a very simple and extremely powerful macro point that is being overlooked in this debate: America no longer has the internal wherewithal to fund the rapid growth of its economy. Suffering from the greatest domestic saving shortfall in modern history, the United States is increasingly dependent on surplus foreign saving to fill the void.

The net national saving rate the combined saving of individuals, businesses, and the government sector after adjusting for depreciation fell into negative territory to the tune of -1.2 percent of national income in late 2005. That means America doesn't save enough even to cover the replacement of its worn-out capital stock. This is a first for the United States in the modern post-World War II era, and I believe a first for any great power over a much longer sweep of world history.

Faced with a shortfall of domestic saving, countries basically have two choices to curtail economic growth or borrow from the rest of the world. The first option just doesn't cut it in the land of abundance.

America, in general, and its consumers, in particular, treat rapid economic growth as an entitlement. That leaves the United States with little choice other than to pursue the second option - drawing heavily on the global saving pool in order to fund economic growth. Once the United States started down the slippery path of consuming beyond its internal means, it got harder and harder to break the habit. Ironically, it has become exceedingly difficult for Washington to accept the consequences of that habit - a nation that has become beholden both to external funding and production. And yet that's exactly how China fits into America's macro equation.

That underscores a key attribute of the savings-short, deficit nation: It is forced to run current account deficits in order to attract the requisite foreign capital. And in the case of the United States, where external funding needs are so massive - now closing in on US$800 billion per year, or about US$3 billion per business day - most of the current account imbalance shows up in the form of a huge trade deficit. In 2005, the trade deficit in goods and services accounted for fully 93 percent of the total current-account gap.

With that external funding imperative come key geopolitical tradeoffs. Thanks to China, America actually got a rather extraordinary deal for its trade deficit dollar in 2005 a net balance of some US$200 billion of low-cost, high-quality Chinese goods that expanded the purchasing power of US consumers. If, however, Washington politicians now choose to close down trade with China by imposing high tariffs or forcing a major Chinese currency revaluation - precisely the intent of legislation proposed by US Senators Schumer and Graham - those actions could easily backfire.

Remove the China supply line, and the trade deficit for a saving-short US economy won't shrink as populist politicians suggest. Instead, due to America's oversized external funding needs, the trade deficit would remain large and merely gravitate to another foreign producer - most likely, one with a higher cost structure. Such a shift in America's external sourcing would amount to the functional equivalent of a tax on the American consumer.

The current political boil raises a critical question: Can a savings-short US select its lenders as well as dictate the terms of its external financing needs? The simple answer to the first part of the question is, "yes" - targeted protectionist actions can, indeed, redirect the sources of external commerce and funding.

Through the Schumer-Graham tariffs, the US could tilt the mix of its trade patterns away from China.

Such actions would do nothing, however, to address the basic problem. As long as the US economy is locked on a sub-par domestic saving path, it is hooked increasingly on the "kindness of strangers" to provide the sustenance of its economic growth - both in terms of foreign-made goods as well as financial capital.

Country-specific protectionist actions would "succeed" only in shifting America's trade deficit and concomitant capital surplus elsewhere in the world.

There's an even darker side to the recent protectionist backlash in the United States - the crass politics of scapegoating. The ongoing angst of middle-class American workers has become a political football -even with the national unemployment rate below 5 percent. It's not hard to figure out why. A US labor market that was once trapped in a jobless recovery is now mired in a wageless recovery - generating an extraordinary stagnation of real wages even in the face of strong productivity growth.

At the same time, the United States is suffering from a record trade deficit, whose largest bilateral piece is with China. That's all it takes for politicians to point the finger at China as being responsible for the trade-related pressures bearing down on beleaguered US workers. With mid-term elections looming in the United States, I suspect this protectionist posturing could well intensify in the months ahead.

But who is really to blame in all this? At the end of the day, America's saving shortfall - the origin of potentially destabilizing capital and trade flows - is a by-product of conscious choices made by the US body politic. The Federal budget deficit, which has accounted for the bulk of the plunge in national saving over the past six years, is made in Washington not in Beijing. The negative personal saving rate is partly an outgrowth of pro-consumption tax policies again, made in Washington. America's elected representatives are the source of resistance to tax reforms, such as a consumption tax, that might address the deficiencies of private saving. Of course, politicians never want to admit that they are the problem.

Instead, they prefer to pin the blame on others in this case, China or Dubai, in the case of the recent political firestorm over its proposed acquisition of East Coast shipping facilities.

Meanwhile, the United States does next to nothing to shoulder its share of the problem a staggering shortfall of domestic savings. Such political posturing is a recipe for serious trouble, in my view.

The author is Chief Economist at Morgan Stanley. This is an excerpt from his speech at the China Development Forum in Beijing on March 19-20.

(China Daily March 23, 2006)

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