It is often said that the economy is too simple for economists to understand. This is clearly the story with the continuing weakness of the job market and the trade deficit. We are still down more than 3 million jobs from our trend level even with May's strong growth. It should be pretty obvious that losing more than $500 billion a year in demand (at 3.0 percent of GDP) to the trade deficit would be a serious drag on the economy and growth. But for some reason, economists insist on looking elsewhere for the problem.
The basic story should be familiar to anyone who has suffered through an intro economics course. There are four basic sources of demand in the economy: consumption, investment, government spending, and net exports. "Net exports" refers to the excess of exports over imports. If we export more than we import so that net exports are positive, then they add to demand in the economy. This means that in addition to the demand we generate domestically, trade is increasing demand in the economy.
However when we have a trade deficit and we import more than we export, trade is reducing demand in the economy. A portion of the demand being generated domestically is being filled by goods and services that are produced in other countries. From the standpoint of generating demand in the U.S. economy an annual trade deficit of $500 billion has the same impact as consumers taking $500 billion out of their paychecks each year and stuffing it under their mattress.
If the economy were near full employment, then losing this demand would not be a problem. In that case, it would mean that the trade deficit is allowing us to have more consumption, investment, or government services than would be possible if we were only relying on domestic production. But in a context where the economy is below full employment, the loss of demand to imports means that the economy is producing less than its potential and workers are needlessly going unemployed.
For some reason economists are reluctant to discuss the trade deficit as being a source of the economy's weakness. Ever since the economy crashed in 2008 they have hyped weak consumer spending due to the debt overhang from the housing bubble as a main reason for the weak recovery.
This story never made very much sense. After all, even at the worst of the collapse of the housing market we never had much over 11 million underwater homeowners. How much more did we think these homeowners would spend if they weren't underwater, $2,000 a year, $3,000 a year?
Where would they find the money? Is the typical underwater homeowner putting this much into savings each year which they would instead spend on consumption if they weren't underwater? Alternatively, is our counterfactual that the typical underwater homeowner would have otherwise borrowed this much each year, putting themselves deeper in debt, if they were not underwater in their homes?
Even if we want to say that these underwater homeowners would have spent more had their home prices not plummeted, it would not have much impact on the economy. If we take the $3,000 a year figure, and multiply it by 11 million underwater homeowners, this gets us $33 billion in additional consumption spending each year. Assuming second round effects from this spending (the people who get this money then spend much of it), this can get us to $50 billion a year, adding 0.3 percentage points to GDP. This is not trivial, but it hardly makes the difference between a robust recovery and what we have seen. Its economic impact is less than one-tenth as large as the impact of the trade deficit.
There is one final problem with the debt overhang story. Consumption is actually higher as a share of the economy today than it was before the collapse of the housing bubble. In other words, consumption is a larger factor in demand today than it was in the peak years of the housing bubble from 2004-2006. That should be a serious problem for a theory blaming a lack of consumption spending for the weak recovery, but not in economics.
This does not mean that we should not be looking to help the victims of the housing crisis. Unfortunately, the Obama administration was far more interested in rescuing the Wall Street banks than homeowners. Those still hanging on to underwater homes deserve at least as much help as the banks that profited by feeding the bubble.
But assisting these homeowners will not restore the economy to full employment. The key to getting to full employment is reducing the trade deficit. But this is too simple for economists to understand.