Is the U.S. Trade Deficit Really Bad News?

If the past is any guide, the widening trade gap will be reported almost universally as grim news. Critics of free trade will wave the deficit numbers as a rallying call to get tough with "unfair" trading partners.

But are trade deficits necessarily bad for the U.S. economy? The answer is no. Trade deficits are not a sign of unfair trade practices, or a lack of American "competitiveness." Trade deficits are caused by factors in the macroeconomy that are not directly related to trade.

To understand why, journalists should borrow a technique from investigative reporting and "follow the money."

When Americans buy imports, foreigners must do something with the dollars they earn. They can either use the dollars to buy American exports or to invest in American assets, such as Treasury bills, stocks, real estate and factories.

If the amount of investment capital entering the U.S. exceeds the amount flowing out, the extra dollars entering the country can then be used by Americans to buy imports over and above the amount we could buy merely from what we earn by selling exports.

So, a current account deficit is simply the mirror image of a capital account surplus.

In the global economy, some countries, such as the United States, are net importers of capital and thus run a trade deficit. Others, such as Japan, are net capital exporters because domestic savings exceed domestic investment. The excess savings these capital exporters send abroad returns to their home market to purchase exports, creating a trade surplus.

One reason for a trade deficit can be that the deficit country is growing faster than its trading partners. Faster growth attracts investment dollars, which, along with rising incomes, allow the deficit country to buy more imports on the global market.

In slower-growing countries, demand for imports falls and capital flows outward to greener pastures. This largely explains our rising trade deficit with Asian Pacific nations, including Japan.

It also explains why trade deficits have tended to expand in times of relative prosperity, and to contract in times of recession. It is no coincidence that the smallest American merchandise trade deficit since 1982, $74 billion in 1991, occurred during the period's only recession.

Germany switched from a current account surplus of $50 billion in 1990 to a deficit of $20 billion in 1991. This had nothing to do with a change in trade policy or a sudden loss of competitiveness.

In 1991, Germans began to invest heavily in the former East Germany rather than spend their savings abroad, leaving foreigners with fewer deutsche marks with which to buy German exports.

Conversely, Mexico flipped from a trade deficit in 1994 to a surplus in 1995 as domestic investment fell in the wake of the peso crisis. Again, the reversal had nothing to do with trade policy or competitiveness, and everything to do with investment flows.

If a trade deficit is determined solely by rates of savings and investment, then the U.S. trade deficit will be impervious to a get-tough trade policy. Slapping higher tariffs on imports will only deprive foreigners of the dollars they would have earned by selling in the U.S. market.

This, in turn, will reduce the supply of dollars on the international currency market, raise the value of the dollar relative to other currencies and make dollar-priced U.S. exports more expensive for foreign buyers, thus reducing demand for our exports. Eventually the volume of exports will fall along with imports, and the trade deficit will remain largely unchanged.

Nations do not trade with each other; people do. America's trade deficit with the rest of the world is only the sum of the individual choices made by American citizens. Those choices, to buy an import or to sell an export, only take place if both parties to the transaction believe it will make them better off. In this way, the "balance of trade" is always positive.