The poor economists. All that work sacrificing time for decent haircuts to shovel seas of data into massive spreadsheet models, and their theories still turn out to be wrong.

Yesterday’s Wall Street Journal article about the trade deficit was notice of yet another failure. The U.S. dollar has been on a decline for over 3 years now, which, according to the most basic tenets of macroeconomics, should mean that our appalling trade deficit should start improving. Thanks to steadfast American consumption, however, the deficit is still on track to exceed last year’s record of $617 billion.

$617 billion. That’s more than the entire GDP of Australia.

This news really irks the econ folks, because, according to their logic, if $6 used to buy us 2 pints of Irish Guinness and now it only buys us 1, we should be smart enough penny-pinchers to switch to good old American Budweiser. So why is the deficit still worsening?

One reason cited by the article is that a large chunk of imports is comprised of related party transactions. This means that a company that has a distributor in the U.S. and a manufacturer in, say, Italy, will still import goods into the U.S. even if the relative costs in Italy go up. This makes sense. Ferrari’s distributors won’t exactly decide to purchase Buicks instead of its own cars just because its Italian manufacturing costs went up by 20%, whereas General Motor’s U.S.-based plant’s costs remained the same.

The problem is that some sourcing decisions are inflexible due to the fact that so many products come from multinationals that have poured billions of dollars of foreign investment into plants all over the world. When they have to start paying the local workers higher relative wages because the exchange rates change such that their €15 per hour salaries suddenly cost a lot more in U.S. dollars than they used to, it is hard for them to switch to sourcing these functions from a relatively lower-cost U.S. operation. If the parties were not related, there would just be a simple contract that the distributor could cancel or choose not to renew. Things aren’t so easy when it’s your own investment that you’re abandoning.

Another consideration to be made is the control that a parent company has on prices between related entities. The sales price of beer from Guinness Manufacturer, Dublin to Guinness Distributor, Chicago is not subject to competition. It is a sale from Guinness (or, more technically, Diageo) to itself. Therefore, Guinness, in theory, can go ahead and decide whatever price it wants to sell the goods to itself. This price is recorded on the customs form at the port of entry into the states, and eventually gets fed into the statistics that the Bureau of Economic Analysis uses to make these eye-popping reports on the trade balance. If the company is smart and has sufficient currency hedges in place, it may have the option to squeeze its manufacturing profits a bit by keeping the intercompany price the same and make up for it in currency gains. This would prevent the U.S.-based customer from necessarily seeing a change in prices, so she would have no reason to alter her Guinness-guzzling habits. Hence the trade deficit would continue…

Now there are a whole bunch of tax regulations that limit how much flexibility companies have with the prices of their related-party transactions. In fact, in both the U.S. and Europe, companies are supposed to price these transactions at the “arm’s-length” or market price for tax purposes. But the U.S. customs folks don’t talk much to the IRS folks, so companies have been known to report different prices on their customs forms than what they report on their tax forms. Plus, in practice many companies only have to make sure they’re OK by year’s end, so within a fiscal year prices may be very different from market prices as long as the company is willing to make a big year-end adjustment on their books. The interim trade deficit numbers that we get from the BEA may therefore be a bit skewed due to these lags. Customs has their own set of rules, but they’re a bit less strict.

These controlled price distortions should only be temporary, however. If the costs of manufacturing in Italy truly are really high compared to those in the U.S. in the long-term, a wise company will eventually relocate its operations to the U.S. This would decrease the amount of imports into the country, as more goods would be sourced domestically, and the trade deficit would improve. But these short-term inflexibilities and price controls may explain the excruciating delay in seeing see the effects of the weak dollar.

Maybe this delay will give those economists a chance to jazz up those boring spreadsheets in preparation for the big day when they know they’ll be right.

Meanwhile at least they’ll be able to spare the 20 minutes for a haircut.

Posted by Michelle Smith on June 1, 2005 08:21 AM

Posted by: Scott Layne at November 3, 2005 04:20 PM