Was it really horrible deal?

By Hyeongwoo Kim

In the midst of elevated tension on the Korean Peninsula, South Korea and the United States held a special session of a Joint Committee under the Korea-U.S. Free Trade Agreement (KORUS FTA) in Seoul on Aug. 22, 2017. This meeting was requested by U.S. Trade Representative (USTR) Robert Lighthizer in July to consider matters affecting the operation of the KORUS FTA, including possible revisions of the KORUS FTA to deal with the significant trade imbalance between the two countries.

Lighthizer had just ended the inaugural round of the North American Free Trade Agreement (NAFTA) re-negotiation with Canada and Mexico in Washington on August 20, so he was unable to come to Korea, but he appeared in a video conference before the session in Seoul.

He proposed the same argument from his earlier statement in July, "Since KORUS went into effect (in March 2012), our trade deficit in goods (with Korea) has doubled from $13.2 billion (in 2011) to $27.6 billion (in 2016), ...This is quite different from what the previous administration sold to the American people … We can and must do better." This sounds like a reasonable complaint, although the trade deficit with Korea corresponds to a mere 3.7 percent of the U.S. total deficit in goods.

Trump's assertion that the KORUS FTA was a horrible deal is based on this kind of "common sense" argument, which states that the trade rule is flawed because, under this rule, the U.S. must buy more from Korea than it sells. I do not agree with such conclusions.

First, it should be noted that countries trade not only goods but also services. Why does the Trump administration talk mostly about trade balance in goods but not services? Not surprisingly, America has been consistently enjoying a substantial trade surplus in services. That is, the U.S. total trade surplus in services has grown substantially from $192.0 billion in 2011 to $247.7 billion in 2016.

The U.S. trade with Korea is not an exception. Based on the Bank of Korea's recent report, Korea recorded a $14.3 billion trade deficit in services with the U.S. in 2016, which corresponds to 5.4% of the U.S. total trade surplus in services. If trade imbalance is an issue by itself, do we need to fix this problem?

In fact, America's current trade statistics, trade deficit in goods and trade surplus in services, are largely explained by David Ricardo's classical theory of comparative advantage proposed in the early 19th century, which demonstrates that gains from trade exist even when one country, say the U.S., is more efficient at producing every good than other countries. Instead of producing all goods and services as in autarky, countries may specialize in the good they can produce relatively more efficiently. Then, they export goods they are good at producing while importing other goods from trading partner countries, which can be beneficial to all countries that engage in trade.

In "The Rise of the Service Economy" (American Economic Review, vol. 102, 2540-69, 2012), two prominent macroeconomists Francisco Buera and Joseph Kaboski proposed an economic model, motivated by the rising importance of the services sector and the rapid growth in the skill premium in wages from the post-1950 U.S. economy. This implies that the U.S. economy has a comparative advantage in the service sector generating higher wages in the sector, while it has a comparative disadvantage in the manufacturing sector.

Acknowledging this, it is not surprising to see the current trade pattern of the U.S. with the rest of the world. That is, the U.S. is running a trade deficit in goods (comparative disadvantage) but has a surplus in service (comparative advantage) not just with Korea but also with most other countries. The theory of comparative advantage implies that FTAs can be beneficial to all countries in this situation. Without an FTA, prices of manufacturing goods will rise rapidly if the U.S. must make all goods using more expensive domestic labor. And the U.S. service sector will be likely to shrink with no FTA deals.

Having said that, I do not agree with Mr. Trump's claim that this five-year-old agreement with South Korea is a horrible deal. The current trade patterns between the two countries are well explained by economic theories, and the KORUS FTA is likely to be mutually beneficial.

Furthermore, it should be noted that Korea's military equipment expenditures from the U.S. has dramatically increased to around $5 billion on average each year since the beginning of the KORUS FTA. Recall that this type of expenditures does not normally enter in the trade balance. Should it be included, the trade imbalance between Korea and the U.S. would become even smaller.

What about the foreign direct investment (FDI)? Based on a recent report of the Institute for International Trade, the foreign direct investment (FDI) from South Korea into the U.S. reached $51.2 billion, creating over 47,000 jobs in the U.S., while it was $20.2 billion from the U.S. to South Korea during the five-year period with the KORUS FTA.

The media reports that South Korean and U.S. officials failed to reach any agreement on Tuesday on possible revisions of the KORUS FTA. South Korean Trade Minister Kim Hyun-chong said they made it clear that the U.S. trade deficit with South Korea was not the result of the KORUS FTA and proposed a joint study to examine the effects of the agreement.

The Trump administration's common sense approach can be appealing but lacks fact checks. There's no evidence that the trade deficit was caused by a bad trade deal nor the KORUS FTA was not beneficial to the U.S. As Mr. Kim suggested, it would be necessary to formulate a task force to objectively investigate the effects of the KORUS FTA.

Dr. Kim Hyeongwoo is a professor of economics at Auburn University. He received his Ph.D. from The Ohio State University and his B.A. and M.A. from Seoul National University. He has published over 25 SSCI journal articles since 2009 in the areas of macroeconomics, financial economics and economic forecasting. He can be reached at gmmkim@gmail.com.