Insight Line—July 30, 2007

Every month, the U.S. Department of Commerce releases the official balance of trade figures (services excluded), showing the difference between the value of merchandise that enters the country and the value of merchandise that leaves the country. If imports exceed exports, America registers a trade deficit—and Washington and Wall Street worry. If exports are greater than imports, then America has a trade surplus and economists and investors enjoy the moment—as fleeting as it may be. You see, if I understand the U.S. Department of Commerce’s Bureau of Economic Analysis (BEA) accounting methods correctly, as U.S.-based companies continue expanding globally, the merchandise trade deficit probably expands along with them.

But is the persistence of a goods deficit as dire as some in the media, or in Congress, would have investors believe? Or is it a case of a measuring system designed when world trade looked much different from the reality of today?

In measuring trade’s impact to the nation’s gross domestic product account, the BEA’s calculation method stands out as a throwback to a time when world currencies enjoyed the backing of gold or silver. The logic of the time suggested that no nation should continually buy more from other countries than it sold to them. Such trading activities produced an unfavorable balance of trade, implying an outflow of currency—gold or silver—or, essentially, the wealth of a nation. As such, the trade balance relies on a residency point of view; that is, it measures the physical flow of goods and services across a nation’s borders, regardless of the nationality or the ownership of parties on either side of the transaction.

However, such simplistic accounting is arguably lost in the realities of today’s multinational corporations. And nowhere is that more apparent than in the analysis of the trade between U.S. companies and their foreign affiliates.

For example, an automobile made from U.S. manufactured parts, assembled in Canada and then shipped to the United States disproportionately increases the trade deficit. According to the BEA, the exported parts for assembly are an intracompany transfer recorded at cost, while the price of the completed car in the U.S. becomes the recorded import value. In other words, the sum of the parts does not equal the whole. And, considering that Fortune magazine’s latest Global 500 list of the world’s largest corporations² (based on total revenue) contains 161 U.S.-based firms, the problem is both significant and growing in its magnitude.

To be sure, as noted by the BEA in 2002, an accounting change will not eliminate the merchandise trade deficit. Rather, as they suggest, the recognition of intra-company trade brings the data more in line with real world corporate bookkeeping.

All of which leads me to conclude, if investors and politicians are going to worry about the trade deficit let’s at least understand what there is to worry about.