It's worse, way worse, than it sounds.

The trade deficit's deep bite
A $225 billion U.S. trade deficit means we're deeper in the red than 20 years ago and sinking fast. Among the impacts: A lower standard of living for all of us in the years ahead.

By Jim Jubak

It's worse, way worse, than it sounds.

Which is pretty frightening, since it certainly sounds really bad.

On Mar.14, the U.S. Bureau of Economic Analysis announced that the broadest measure of the U.S. trade deficit grew to $225 billion in the fourth quarter of 2005. That marked an increase of 21% from the $185 billion deficit in the third quarter of 2005. And the quarter's results drove the deficit for all of 2005 to $805 billion, a new record.

The current account deficit -- defined by economists as the combined balance on trade in goods and services plus income transfers between the U.S. and the rest of the world -- increased in the fourth quarter to 7% of U.S. gross domestic product (the most common measure of the U.S. national income). For all of 2005, the deficit was 6.4% of GDP.

In 1985, when the G7, then the club of the world's seven largest free-market economies, pushed through a major devaluation of the U.S. dollar in the Plaza Accord, the current account deficit was a mere 3.5% of U.S. gross domestic product. The good news is that the world is a lot more tolerant of a massive U.S. deficit with the rest of the globe than it was 20 years ago. The bad news is that we're running a lot deeper in the red than we were in 1985.

So how can I say that the news is actually worse than it sounds?
First, because if you look at the long trends driving the deficit numbers, they're still picking up steam. The momentum is running very strongly against the United States, and when you're talking about reversing the course of something as big as the U.S. or the global economy, momentum counts.

Second, because the deficit has become so large that there isn't any silver bullet that will let us get out of this hole painlessly and quickly.

And, third, the demographics of an aging world say that our creditors are going to need the money they've lent us not too far down the road in order to support their own retirements.
Depressed yet? Wait, I'm just getting warmed up.

Overseas investors buying U.S. assets
Let's take a look at the most ominous trend in the 2005 numbers.

Unlike the trade deficit, which just measures the difference between what we export in goods and services and what we import, the current account deficit also includes international flows of investment income. That's worked to the benefit of the United States over the decades since World War II because we've built up quite a big portfolio of overseas investments from real estate to ownership stakes in foreign companies to holdings of foreign bonds that pay income to the U.S. owners of those foreign investments. For all of 2005, that income flowing into the U.S. came to a whopping $466 billion, up 24% from 2004.

But for years, overseas investors have been buying our assets faster than U.S. investors buy foreign assets. In 2005, for example, U.S.-owned assets overseas increased by $492 billion, while foreign-owned assets in the U.S. increased by $1,293 billion. (Or $1.29 trillion, if you prefer.)

And as you'd expect, the faster growth in foreign ownership of U.S. assets has gradually increased the amount of income that overseas investors receive from the United States. In the fourth quarter, the income flow actually turned against the U.S. We sent $2.4 billion more in income overseas than we received. That was a shift from the $4.9 billion income surplus in favor of the United States in the third quarter of 2005, and only the second time EVER (or at least since there have been decent records) that income from investments has been in deficit for the United States. In 2004, the surplus from income was more than $30 billion. From 1980 to 1985, the annual average was above $30 billion, and from 1980 to 2004, the smallest annual surplus was $4.3 billion in 1998.

So the shift from surplus to deficit in the fourth quarter is a big deal. It quite probably marks the end of a long period when flows of income into the United States from U.S.-owned assets helped offset deficits in years when U.S. imports exceeded U.S. exports.

Trend is accelerating
A turning point like this is just the beginning of an accelerating trend. It's extremely likely that the income deficit will continue to grow for years to come, because foreign investors are increasing their ownership of U.S. assets -- an increase of $278 billion in the fourth quarter -- faster than U.S. investors are buying overseas assets -- an increase of $43 billion for the quarter.

And ownership of an asset today creates a stream of income for a lot of tomorrows.
A shift from an income surplus of $30 billion to the income deficit of the $10 billion or so some economists project for 2006 isn't much help if you're trying to balance an annual current account deficit north of $800 billion. But it becomes positively devastating if you add this trend to other trends now working to push the current account deficit higher in the years ahead.

Look at oil, for example. In 2005, the United States imported $176 billion in crude oil at an average cost per imported barrel of $46.78, according to the Census Bureau. Our trade deficit with OPEC (the Organization of the Petroleum Exporting Countries) came to $92 billion. That's less than half our huge deficit with China in 2005 of $202 billion, but it's still a significant part of the $805 billion record deficit in 2005.

And there's certainly a good chance that the price of that oil -- and hence the size of the U.S. trade and current account deficits -- will climb in the years ahead. On the same day that the fourth-quarter current account numbers hit the news, the president of OPEC said the organization's new price target was between the upper $50s and the lower $60s per barrel. That's a huge jump from the last announced price target of $22 to $28 a barrel.

There's an unfortunately long list of similar trends that are working to continue to push the U.S. current account deficit higher. The size of the U.S. surplus in agricultural products has been falling as U.S. consumers eat more specialty and out-of-season products from around the world. Higher U.S. interest rates will increase the income flowing to the overseas owners of U.S. financial assets. And so on…

But you get the idea.

No magic fix
It would be comforting to believe that this huge problem can be fixed by a single, simple act. That's why our politicians are so fond of "solutions" such as forcing China to revalue its currency, the yuan, so that Chinese goods become more expensive. Or of rhetorical solutions such as "The U.S. can grow its way out of this problem by making U.S. exports more competitive."

Well, when you're running an $800 billion current account deficit, "it don't work like that." In many categories, Chinese goods are so much cheaper than the alternatives and so embedded in the global supply chain that making the yuan more expensive would, for some painfully long period, just increase the profits of Chinese manufacturers and the size of the U.S. trade deficit with China.

And our chances of growing our way out of this mess? Since U.S. exports make up such a small percentage of the U.S. economy, exports would have to grow by 70%, Paul Ashworth of Capital Economics has estimated, to eliminate the deficit.
A slew of solutions
In truth, it's going to take the combination of a lot of different "solutions" to get us out of this fix.
Yes, we should work to increase U.S. productivity, because that will drive U.S. exports higher -- and because high U.S. productivity growth, relative to the rest of the developed world, will continue to attract the overseas investments that we'll need to finance our deficit while we dig ourselves out of this hole

Yes, we should put pressure on China to take down barriers in its markets that prevent U.S. companies in fields such as financial services from doing more business in China. And we should demand that the Chinese adopt adequate rules protecting intellectual property. Add that to some appreciation in the yuan, and the trade deficit with China will shrink. Gradually.

Yes, we should do everything we can to encourage economic growth in the rest of the world. The U.S. can't continue to pull the global economy -- even with strong assists from China and India.

Yes, U.S. consumers have to spend less and save more. The odds are that it will take a painful slowdown in the U.S. economy to produce the "spend less" result. Higher U.S. interest rates would go a long way toward creating that spend-less environment and encourage U.S. consumers to save more as well. Part of the U.S. savings "problem" is a result of the negative real interest rates that Alan Greenspan engineered to keep the economy from deflating after the popping of the tech stock bubble in 2000. But certainly, no rational economist expects people to save when banks pay 1% and inflation is 2%.

Yes, those of us who live in the U.S. are looking at a reduction in our standard of living. We've used borrowed money to live beyond our means, and the bill is coming due.

And most of all, we need to follow the first law of holes: When you find yourself in one, stop digging. We need to adopt policies on energy, government budget deficits, health care and education that won't put us even further in hock while we're trying to work our way out of this deficit.
We don't have an endless amount of time to take these steps. Japan, a major funding source for the U.S. current account deficit, is one of the most rapidly aging societies in the world. Japanese savers will need to keep more and more of their money at home to pay the costs of that aging. The Chinese, another society of savers, have only a relatively small window of opportunity for putting aside the money they'll need to pay for their own retirements and health care in a society virtually without pensions or health insurance.

All this may sound very abstract to you. Global problems do seem far away from the everyday tasks of getting the kids to school or paying the doctor.

So in my next column, I'll talk about how the U.S. trade deficit and the budget deficit in Washington have already put the squeeze on your future.