Forget Trade Deficits: Go for Growth

This article originally appeared in the Financial Times, on February 25, 2005.

The recent London meeting of finance ministers from the Group of Seven leading industrial countries focused attention on the size and implications of the huge US current account deficit, which reached a record Dollars 618bn in 2004, according to figures released this month. In a report on the global economy, the United Nations recently joined the chorus of concerns, noting along the way that the vigorous US economy was one of the main drivers behind the record trade deficit.

Strong growth in the US has stoked demand for imports of not just consumer goods but also the capital machinery, components and raw materials needed by an expanding business sector. Meanwhile, sluggish growth in western Europe and Japan has damped demand for US exports.

The UN study acknowledges what has long been true of the US economy: the trade deficit tends to expand along with the economy and contract when the economy slows. In fact, an analysis of economic data from the last quarter century shows that a growing current account deficit (as a percentage of gross domestic product) is associated with faster, not slower, economic growth, as well as rising manufacturing output and falling unemployment.

Since 1980, the US current account deficit has shrunk as a share of GDP from the previous year in eight different years, it has grown moderately (by half a percentage point of GDP or less) in 10 years and has grown more rapidly in six years. How has the US economy fared under each of those three current account scenarios?

By the most basic measures of economic performance - GDP, manufacturing output and the unemployment rate - the US economy performs better in years when the current account deficit is rising than in years when it is shrinking. And it performs especially well in years when the current account deficit is rising most rapidly.

Consider the most fundamental measure of economic health, the growth of real GDP. In those years since 1980 when the current account deficit declined, real GDP grew a sluggish annual 1.9 per cent on average. When the current account deficit grew moderately, real GDP grew at an annual average of 3 per cent. And when the deficit rose the most rapidly, real GDP grew by a robust average of 4.4 per cent - a rate more than double the growth in years when the deficit was "improving".

The same pattern emerges in the manufacturing sector. It has become the conventional wisdom that a trade deficit hurts manufacturing because imports presumably displace domestic production, but the plain evidence of the past quarter century contradicts that presumption. Manufacturing output actually declined slightly on average in those years in which the current account deficit shrank. In contrast, it grew by 4.1 per cent in years when the current account deficit grew moderately, and by a brisk 5.3 per cent when the deficit grew rapidly.

The pattern also applies in the politically sensitive area of employment. Again, the conventional wisdom holds that a trade deficit destroys jobs by supposedly shipping them overseas. But again, the evidence suggests some thing quite different. In those years of an "improving" current account deficit, the unemployment rate on average jumped by 0.8 percentage points. In years when the deficit moderately "worsened", the unemployment rate fell by an average of 0.2 points, and in years when the deficit grew the most rapidly the unemployment rate fell by an even larger average of 0.7 points.

If a rising trade deficit is responsible for "shipping jobs overseas", how do the critics of trade explain the fact that unemployment rises when the trade deficit shrinks and falls when it expands? The year 2004 fits the pattern comfortably. America's current account deficit expanded by about 0.6 per cent of GDP last year, while economic performance was also moderate to robust. Real GDP grew at an annual rate of 4 per cent and manufacturing output by 5 per cent, while the unemployment rate fell by 0.3 percentage points. In 2004, as in previous years, a rising current account deficit may have been bad news to headline writers, but it accompanied good news for the US economy, its factories and workers.

Those who seek the Holy Grail of a trade surplus should be careful what they wish for. Germany last year racked up a global surplus of almost Dollars 200bn. Not entirely coincidentally, its unemployment rate reached 11.4 per cent in December and the number of unemployed reached a post-unification high of 5m people. The last time America's jobless rate was that high was 1982 - when its own current account deficit was a measly Dollars 5bn.

America's trade deficit is essentially an accounting abstraction. Our attention should focus on what really matters - economic growth, job creation, industrial output, and the free and open markets that promote real growth.