Blame large budget deficits for manufacturing's decline

Blame large budget deficits for manufacturing's decline
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In many ways, Ross Perot was a forerunner for Donald TrumpDonald John TrumpWinners and losers from the South Carolina debate Five takeaways from the Democratic debate Democrats duke it out in most negative debate so far MORE, a businessman-turned-populist presidential candidate with, shall we say, some eccentric personal characteristics.

Not least of the similarities was each man’s concern about the effect of trade agreements on U.S. manufacturing jobs. Perot, of course, was famous for his prediction that the North American Free Trade Agreement (NAFTA) would cause “a giant sucking sound” of jobs headed south of the border to Mexico.

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Basic economics explains that what’s killing manufacturing jobs is not trade agreements but large, persistent U.S. government deficits. As reported by the Congressional Budget Office on April 9, these large deficits are projected to worsen, increasing the pressure on U.S. manufacturing.

 

Analysis of the government deficit starts with an economic axiom that savings equals investment. Government deficits are negative savings. An economy’s private savings less the government dissaving equals an economy’s investment with international capital flows making up the balance.

On the international side, the inflows and outflows also balance, so if net capital inflows are needed to finance a government deficit, there will be an offsetting trade deficit.

The net of private savings, investment and international flows largely finances government deficits, covering 87 percent of their variability. Small differences in government saving and investment account for the rest.

The international balance may thus be expressed as the difference between private savings and the combination of private investment and the government deficit.

In recent years for the U.S., the burden from international financing of government deficits has fallen especially hard on the manufacturing sector.

Since the 1970s, the U.S. service sector has produced a trade surplus, which has grown to a little over 1 percent of GDP, so the international flows financing government deficits have been offset by trade deficits in the goods sector.

Of course, if manufacturing output goes down as a result of the trade deficit in goods, so will manufacturing employment. For the last 20 years for which we have data, manufacturing output has fallen by 4.4 percent of GDP, from 16.1 percent in 1997 to 11.7 percent in 2016. During the same period, manufacturing employment has fallen from 15.2 percent of all jobs to 10.2 percent.

Much has been made that the decline in manufacturing jobs represents increasing manufacturing productivity or the transition to a service economy, but the demand for manufactured goods, calculated as production from U.S. manufacturers plus imports minus exports, is much more stable.

U.S. demand for goods has declined by 2.8 percent of GDP from 18.5 percent in 1997 to 15.7 percent in 2016. The 1.6-percent difference between the 4.4-percent decline in manufacturing output and the 2.8-percent decline in demand for manufactured goods can be attributed to the rising goods trade deficit.

The goods trade deficit grew by 1.7 percent of GDP from 2.3 percent in 1997 to 4.0 percent in 2016. During the same interval, government deficits increased from 1.6 percent of GDP to 5.0 percent.

Impact on jobs and GDP

In 2016, the average GDP per manufacturing employee was about $124,000, so, with 2016 GDP of $16,716 billion, the 1.6-percent difference between demand and output in the paragraph above translates into $267 billion of lost manufacturing GDP, or 2.2 million lost jobs. (All dollar figures are real 2009 equivalent.)

Since manufacturing jobs produce about $13,500 more GDP than average jobs, the economy could be somewhat larger and incomes somewhat higher with lower government and trade deficits and higher domestic manufacturing output.

Outlook

The April 9 CBO analysis is discouraging with respect to federal government deficits, with increases from 3.5 percent of GDP in 2017 to over 5.0 percent for much of the next 10 years.

If savings and investment hold at their most recent levels, the trade deficit for goods would increase by over 1.0 percent of GDP annually for the next decade, which translates to a further 1.3 million manufacturing jobs lost.

Again, holding savings and investment at their current levels, two alternative deficit scenarios can be examined and compared with the CBO forecast: maintaining the government deficit at its 2017 level of 3.5 percent and eliminating the government deficit over 10 years.

Ironically, it used to be a staple of government budget forecasts to project balance in about 10 years. Today, even that pretense has been abandoned.

More austere budget scenarios produce better results for the manufacturing sector. Holding the government deficit steady at the 2017 level also maintains the goods trade deficit at its current level while eliminating government deficits over 10 years has the potential to produce a goods-trade surplus. Imagine that!

In practice, forecasting future levels for savings, investment and government deficits may be problematic as each varies significantly with the business cycle.

But the net of savings less investment and deficits is much more stable and closely parallels the trade deficit, so ramifications of persistent large government deficits are very threatening for the U.S. manufacturing sector.

Note: Referenced data calculations were done by the author using data from the Federal Reserve of St. Louis' Federal Reserve Economic Data.

Doug Carr is the president of Carr Capital Co., a financial and economic advisory firm. He has taught finance at Quinnipiac University and is the published author of financial markets research. He holds a master's in finance and applied economics from the MIT Sloan School of Management.