A Rookie mistake made by “Oldie” Columnist

Until recently I did not know the existence and the meaning of the word “ rookie”. Then I read, by accident, the article entitled “Trump Trade Chief Makes a Rookie Mistake” by Noah Smith, whom I follow on twitter and who is, as I discovered recently, also a Bloomberg View columnist and a former assistant professor of Finance at Stony Brook University. The person mentioned in his article is Mr. Peter Navarro, who holds a PhD in Economics from Harvard University and is a Professor of Economics and Public Policy at the Paul Merage School of Business, and who was recently appointed as the Chief of the new National Trade Council. This is information I found on Wikipedia, and I don’t know anything more about these two distinguished gentlemen.

So, it is with complete neutrality that I read and now write about this article, in which Mr. Smith responds to the following short statement made by Mr. Navarro: “when net exports are negative, that is, when a country runs a trade deficit by importing more than it exports, this subtracts from growth.” Here I would emphasize the word “growth” because we see here that the point of discussion is about the relationship between trade deficit and growth which is expressed always in volume terms. Mr. N. Smith writes that this statement is wrong and presents several arguments and examples of why it is wrong.  For that he works from the following equation, one of the three fundamental identities in national accounting.  I call those identities the “3 eyes” which every economist, or those who study economics, should be equipped with.

GDP=Consumption+ Investment+ Government Spending +Export- Import

Then he tries to explain why the value of imports has a negative sign by citing some examples. Most probably, he was trying to explain the important national accounting terms “economic territory” ”resident /non-resident/”, “the rest of the world” in simple language. He concludes: “In other words, imports don’t count negatively in GDP. They amount to zero. This means that a higher trade deficit does not have to make US poorer…” To prove this he imagines that consumption and investment remain the same, but exports increase by $1 billion, and imports increase by $3 billion. In this case the trade deficit goes up by $2 billion, but GDP increases by $1 billion, i.e. the impact on growth is positive, as he calculates. (In his remark the last 2 sentences have “!” mark). In order to show that Mr. Navarro has made a mistake, he uses this equation,  which could be he written in the following form, to show more conceptually and clearly the meaning of this equation to readers:

GDP+Import=Consumption+Investment+Government Spending+Export

As we see here, we are talking about aggregate supply (the left hand side of the equation is domestic and external supply) and aggregate demand (the right hand side of the equation consists from domestic and external demand. Simple and beautiful equation, Isn’t it? This is the first “oldie” mistake made by Mr. Noah Smith when he discovers a rookie mistake made by Mr. Peter Navarro. Why?

1. As I emphasized in the beginning of my article, we are going to talk about how

GDP growth changes when the trade deficit or surplus changes, i.e. whether or not a trade deficit subtracts from growth.  Since we are talking about changes in growth we have to calculate how the trade deficit contributed to the growth rate of a given year or quarter in comparison with a base year or previous period.  [In other words, growth is always estimated in volume or real terms. This is an internationally accepted rule that should be followed by every economics student, professor, or columnist].

2. The contribution of each component in the same equation , including net export, to growth in simple form could be calculated by using the following formula:

ΔGDP_t/GDP_t-1=ΔC_t/GDP_t-1Δi_t/GDP_t-1+ΔX_t/GDP_t-1

The starting point of this formula is the very same equation Mr. Noah Smith has put in his article.

3. As we see here, if we are talking about additions to or subtractions from growth due to a trade deficit we must use this formula and calculate how each of the components’ own change contributes to overall growth change. This is quite different from the calculations mentioned by Mr. Smith, and also from Mr. Navarro’s strict statement.

Now let us briefly consider some cases in which a trade deficit or surplus can contribute to growth.

Case 1. A country runs a trade deficit and its GDP is increased.  Trade deficit decreases in comparison to the base or previous year/quarter. In this case contribution by net export to growth would be positive, as we can see from the formula.

Case 2. Country runs trade deficit but this deficit is increased and GDP is also up. In this case contribution to growth by net export is negative (with minus) and it will be subtracted from overall growth rate.

Case3. A country has trade surplus in the previous year/quarter and this surplus is decreased in the current period. GDP is up. In this case, contribution to growth is minus! (I should not put! mark here as Mr. Smith likes it).

Case4.Both GDP and trade surplus increased, contribution to growth is positive indeed.

We can continue like this, even GDP is down, contribution to growth would be less by net export with positive or negative signs.

Now let us clarify what Mr. Smith said by taking an example, where export increased by $1 billion, import $3 billion. For this, let us use the real figures from U.S GDP and take Q1, 2015 figures. (Table1)

Table 1

Quarterly

U.S GDP, Expenditure approach, USD in billions

In Q2 2015  GDP equals 4500=3710+917-127 where -127 is net export or the difference between export (575) and import (702).  What happens if we assume, as Mr. Smith suggested, that exports increase by $1 billion and imports by $ 3 billion, with others remaining unchanged?

Then: GDP equals 3710+917+576-705=4498.  The trade deficit has worsened to - $129 billion and GDP has fallen by the same amount. GDP is not increased and growth is negative. However, it is not so important; some misunderstanding and some miscalculation might occur with everybody. What is most important is GDP growth and how it breaks down by its components, in this case by net export. For  illustrative purpose, readers now may look at Table 2 where US GDP growth is broken down into its components, including net export.  By the way, as we can see from Table 1 that the U.S. trade deficit to GDP ratio is really tiny, between (-2,5 and -2,9% and “Trade openness” is not so high for the American economy.

Table 2.

US GDP growth rate, seasonally adjusted, Contributions to growth (%, expenditure approach)

As we can see on Table 2, in the US the contribution to GDP by net exports is tiny. I think the main issue is how to increase this contribution by promoting and developing exports not by trying to decrease “mechanically” imports. Maybe I’m wrong as I am not an expert on U.S economy and trade at all.

So what are my concluding remarks? 

1. Both Mr. Navarro’s original statement (I should say that I don’t know or didn’t read his whole article: what is about etc.)  and Mr. Smith’s correction are wrong; Smith is right to point out Navarro’s error, but unfortunately he explained it in a wrong way. Both of them should have read carefully the clear and short message provided by Mr. Daniel J. Ikenson in his article (“Navarro’s trade views ‘misguided, dangerous’): “the identity is not a GDP growth equation”.
2. When we analyze trade patterns, we always talk about trading gain or loss and measure them in different ways using different methods. In this case, it would also be important to make reference to other indicators such as terms of trade, purchasing power of export and  trading gain/loss index, all of which are analyzed and reported very professionally in the U.S, by the BEA (Bureau of Economic Analysis,). They are professionals.
3. The system of national accounts is a great analytical tool everywhere, in countries of widely varying degrees of development, no matter whether in the USA or Mongolia.  Where your economics degree was earned also doesn’t matter, whether in Harvard, Stony Brook or the Mongolian National University. What matters is how and when to refer to the right institutions and instruments which deal with the subject matter at hand, and listen to what they tell us.
4. The moral of this story is not whether we are looking at simple accounting relationships or at the complicated world when doing economics. They are linked to each other; these accounting relationships help us understand our complicated world and if we don’t understand these simple relationships -- beautiful relationships born from beautiful minds of the last century -- we cannot judge about the complicated world.  At the same time these accounting relationships in themselves tell us little about the world, without rooting their application in real data and real events.  Using both we can work to make better analysis and find ways that we can all, mutually and multi-nationally, benefit from free trade. This is the moral of this story, I dare to think.  Isn’t it or did I make my own rookie or “oldtimer” mistake?

S.Demberel , Economist from Mongolia

PS: Although I don’t know the details of the dispute on US trade policy under Mr. Trump’s administration, but if I were an American economist  I would read again Jonathan Swift’s “Gulliver’s Travels” and think over and over about “Gulliver’s effect”,   about which, among others, Dr. Donald N. McCloskey, then professor of Economics and History at the University of Iowa published an article in Scientific American in September 1995. (I found it also by accident). By the way, I’m from Mongolia, “lilliput” country with great history, sandwiched between two giant neighbors China and Russia, and our trade policies always open to the rest of the world, because we as a nation, benefits from free trade.