America’s Misunderstood Trade Deficit

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Let me begin by thanking Chairwoman Ros-Lehtinen andmembers of the subcommittee for inviting me to testify on thegrowing U.S. trade deficit.

No aspect of American trade is talked about more andunderstood less than the trade deficit. It has been cited asconclusive proof of unfair trade barriers abroad and a lack ofcompetitiveness among U.S. industries at home. It has been blamedfor destroying jobs and dragging down economic growth. None ofthese charges are true.

Understanding the Trade Deficit

The most important economic truth to grasp about theU.S. trade deficit is that it has virtually nothing to do withtrade policy. A nation's trade deficit is determined by the flow ofinvestment funds into or out of the country. And those flows aredetermined by how much the people of a nation save and invest - twovariables that are only marginally affected by trade policy.

An understanding of the trade deficit begins with thebalance of payments, the broadest accounting of a nation'sinternational transactions. By definition, the balance of paymentsalways equals zero - that is, what a country buys or gives away inthe global market must equal what it sells or receives - because ofthe exchange nature of trade. People, whether trading across astreet or across an ocean, will generally not give up somethingwithout receiving something of comparable value in return. Thedouble-entry nature of international bookkeeping means that, for anation as a whole, the value of what it gives to the rest of theworld will be matched by the value of what it receives.

The balance of payments accounts capture two sides ofan equation: the current account and the capital account. Thecurrent account side of the ledger covers the flow of goods,services, investment income, and uncompensated transfers such asforeign aid and remittances across borders by private citizens.Within the current account, the trade balance includes goods andservices only, and the merchandise trade balance reflects goodsonly. On the other side, the capital account includes the buyingand selling of investment assets such as real estate, stocks,bonds, and government securities.

If a country runs a capital account surplus of $100billion, it will run a current account deficit of $100 billion tobalance its payments. As economist Douglas Irwin explains, "If acountry is buying more goods and services from the rest of theworld than it is selling, the country must also be selling moreassets to the rest of the world than it is buying."

The necessary balance between the current account andthe capital account implies a direct connection between the tradebalance on the one hand and the savings and investment balance onthe other. That relationship is captured in the simple formula:

Savings - Investment = Exports -Imports

Thus, a nation that saves more than it invests, suchas Japan, will export its excess savings in the form of net foreigninvestment. In other words, it must run a capital account deficit.The money sent abroad as investment will return to the country aspayments for its exports, which will be in excess of what thecountry imports, creating a corresponding trade surplus. A nationthat invests more than it saves - the United States, for example -must import capital from abroad. In other words, it must run acapital account surplus. The imported capital allows the nation'scitizens to consume more goods and services than they produce,importing the difference through a trade deficit.

The transmission belt that links the capital andcurrent accounts is the exchange rate. As more net investment flowsinto the United States, demand rises for the dollars needed to buyU.S. assets. As the dollar grows stronger relative to othercurrencies, U.S. goods and services become more expensive toforeign consumers, reducing demand, while imports become moreaffordable to Americans. Falling exports and rising imports adjustthe trade balance until it matches the net inflow of capital. Ineffect, foreign investors will outbid foreign consumers for limitedU.S. dollars until the investors satisfy their demand for U.S.assets. Of course, most day-to-day currency transactions are notdirectly related to trade, but demand for U.S. goods, services, andassets affects demand for the dollars needed to buy them, thusinfluencing the value of the dollar in global currency markets.

Germany in the early 1990s offers a case study of howthis mechanism works. West Germans routinely ran large currentaccount (and trade) surpluses in the 1980s, but between 1990 and1991 Germany's current account flipped from a surplus of 3.2percent of gross domestic product to a deficit of 1.0 percent. Thereason for the reversal was not that German manufacturers suddenlylost their legendary efficiency, or that Germany's trading partnersimposed new and unfair trade barriers on the night of December 31,1990. What caused the switch was the huge increase in domesticinvestment needed to rebuild formerly communist eastern Germany. Anincrease in domestic investment repatriated a huge amount of Germansavings that had been flowing abroad, thus reducing the amount ofGerman marks in the foreign currency markets and raising theirvalue relative to other currencies. The stronger mark, in turn,raised the price of German exports and lowered the price ofimports, evaporating Germany's trade surplus.

Why Protectionism Cannot Cure the TradeDeficit

The causal link between investment flows, exchangerates, and the balance of trade explains why protectionism cannotcure a trade deficit. In his 1997 book, One World, Ready or Not,Washington journalist William Greider proposes an "emergencytariff" of 10 or 15 percent to reduce the U.S. trade deficit. IfCongress were to implement that awful idea, American imports wouldprobably decline as intended. But fewer imports would mean fewerdollars flowing into the international currency markets, raisingthe value of the dollar relative to other currencies. The strongerdollar would make U.S. exports more expensive for foreign consumersand imports more attractive to Americans. Exports would fall andimports would rise until the trade balance matched the savings andinvestment balance.

Without a change in aggregate levels of savings andinvestment, the trade deficit would remain largely unaffected. Allthe new tariff barriers would accomplish would be to reduce thevolume of both imports and exports, leaving Americans poorer bydepriving them of additional gains from the specialization thataccompanies expanding international trade.

Government export subsidies would be equallyineffective in reducing the trade deficit. Partly in response tothe Asian financial crisis, President Clinton proposed in his 1999federal budget an increase in subsidies to U.S. exporters throughthe Export-Import Bank. By allowing certain exporters to lowertheir prices on sales abroad, the subsidies would stimulate foreigndemand, but the greater demand for dollars needed to buy U.S. goodswould bid up the dollar's value in foreign exchange markets. Thestronger dollar, in turn, would raise the effective price of U.S.exports generally, offsetting any price advantage gained by thesubsidies. Total exports, and hence the trade deficit, would remainunchanged. Subsidies only divert exports from less favored to morefavored sectors.

In theory, trade policy can indirectly affect thetrade deficit by influencing a nation's level of savings andinvestment. For example, a higher tariff would presumably raisegovernment revenue through additional customs duties, thus reducingthe budget deficit (or increasing the surplus) and reducing theneed to borrow from abroad - resulting in a smaller trade deficit.But a tariff can also stimulate investment in the protectedindustry, increasing demand for foreign capital and leading to alarger trade deficit. After surveying the various theories, LaborDepartment economist Robert C. Shelburne concluded, "Trade policyis likely to have a marginal impact on savings or investment andthus only a marginal impact on the trade balance."

Another temptation is to intervene by intentionallydevaluing the national currency in the foreign exchange market. Anation's central bank can put downward pressure on the value of itsown currency by creating an excess amount of that currency andusing the excess to purchase foreign currencies. A falling currencycan stimulate exports and dampen demand for imports, thus reducinga trade deficit. However, a cheaper currency also means that assetvalues in that country drop in foreign currency terms, attractingforeign investment flows that increase the capital account (and thecorresponding current account deficit). And eventually the weakercurrency feeds back into the domestic economy in the form of higheroverall prices, that is, inflation. In the long run, higherdomestic prices will offset any price advantage gained in theinternational marketplace by a "competitive devaluation."

Proven Trade-Deficit Cutter: ARecession

One way to reduce the trade deficit would be forAmericans to save more. A larger pool of national savings wouldreduce demand for foreign capital; with less foreign capitalflowing into the country, the gap between what we buy from abroadand what we sell would shrink.

A related way to cut the trade deficit is for thegovernment to borrow less. Reducing the government deficit (a formof "dissaving") releases more funds for domestic investment,reducing the demand for foreign capital. That explains the "twindeficits" phenomenon of the 1980s, when huge federal budgetdeficits claimed a rising share of national savings, requiring theimportation of savings from abroad to meet domestic demand forinvestment. The inflow of foreign capital prompted by the budgetdeficit allowed Americans to buy even more goods and services thanthey sold in the international marketplace. As the federal budgetdeficit declined in the late 1980s, so too did America's tradedeficit.

Another, less appealing way to reduce the tradedeficit is to reduce investment. That occurs more or less naturallyduring times of recession, when business confidence falls andcompanies cut back on expansion plans. As Americans consume andinvest less, demand for imports and foreign capital falls alongwith the trade deficit. That explains why the smallest U.S. tradedeficit since the early 1980s occurred in 1991, in the midst of themost recent recession. In fact, the U.S. current account balancetends to shrink during times of recession and grow during economicexpansions. If the trade deficit really is one of our nation's mostpressing problems, the surest and swiftest way to tackle it wouldbe to engineer a deep recession.

That is exactly what happened to Mexico in 1995. Inthe aftershock of the peso crisis, Mexico's real GDP shrank in 1995by 6.2 percent. Because of falling domestic demand, fleeingcapital, and a plunging peso, Mexico's overall trade balanceflipped from a deficit in 1994 to a surplus in 1995. Mexico'sbilateral balance with the United States did the same, going from adeficit to a surplus. That supposed "trade debacle" for the UnitedStates had nothing to do with NAFTA or any other change in tradepolicy. It was caused by mismanagement on the part of Mexico'smonetary authorities, and the chief victims of that mismanagementwere Mexican workers. Perhaps NAFTA critics who believe ourbilateral trade deficit with Mexico is such a terrible developmentwould have preferred that the U.S. economy, not the Mexicaneconomy, contract 6.2 percent in one year. Of course, Americanworkers would have suffered, but it would have done wonders for ourbilateral trade balance.

An understanding of the all-important role ofinvestment flows should liberate trade policy from its obsessivefocus on the current account balance. The trade deficit is not afunction of trade policy, and therefore trade policy cannot be atool for reducing the trade deficit.

Enduring Myths about the TradeDeficit

Misunderstanding of the U.S. trade deficit hasspawned a number of myths about international trade and America'splace in the global economy. Those myths have allowed tradedeficits to be used to further a number of anti-trade andanti-market positions, including export subsidies, industrialpolicy, and sanctions against "unfair" trading partners. Thefollowing are among the most common and harmful myths surroundingthe trade deficit.

Myth: "Unfair Trade Barriers Cause TradeDeficits"

Many Americans are convinced that a bilateral tradedeficit proves that the foreign country's market is relativelyclosed to U.S. exports compared with the "open" U.S. market.America's large bilateral deficit with Japan is almost unanimouslyseen as a problem by U.S. policymakers who share that view, withblame for the deficits placed squarely on "unfair" foreign tradebarriers.

A survey of America's major trading partnerschallenges that assumption. Countries with which the United Statesruns large deficits are not characteristically more protectionisttoward U.S. exports than are those with which we run a surplus.Canada and Mexico, two countries that are very open to U.S. exportsthanks in part to NAFTA, are both among the five countries withwhich the United States has the largest bilateral trade deficits.On the other side, America's third largest bilateral trade surplusis with Brazil, a country whose barriers to imports remainrelatively high. Americans face a common external tariff whenexporting to members of the European Union, yet some EU members(the Netherlands and Belgium) are among the top surplus tradepartners, and others (Germany and Italy) are among the top deficitpartners. Trade policy cannot explain those differences.

Blaming bilateral deficits exclusively on differencesin trade policy once again misses the reality of investment flows.In Japan, high domestic savings rates provide a pool of capitalthat far exceeds domestic investment opportunities. Japan "exports"capital to the United States, which allows Americans to import moregoods from Japan than we export. The main reason that America'sbilateral trade deficit with Japan exploded in the 1980s is thatthe Japanese government lifted many of its capital controls withthe passage of the Foreign Exchange and Foreign Trade Control Lawin December 1980. That allowed a tsunami of Japanese savings toflow across the Pacific to the United States, where it could draw amore favorable rate of return.

Despite the common perception, Japan was actuallymore open to U.S. exports in the 1980s than in the 1960s and 1970s,when American bilateral trade deficits with Japan were muchsmaller.

The same cannot be said for our bilateral deficitwith China. Despite substantial progress in the last 10 years, itsbarriers to imports remain relatively high. Those barriers partlyexplain the bilateral surplus China runs with the United States,but the primary explanation is more benign: We like to consume theproducts China sells. In 1995 the Council of Economic Advisersconcluded, "China's persistent surplus with the United States inpart reflects its specialization in inexpensive mass-marketconsumer goods. China similarly runs bilateral surpluses with Japanand Europe for this reason."

If China were to further open its market, America'sbilateral deficit with China would probably shrink, but our overalltrade deficit - determined by aggregate savings and investment -would remain largely unaffected. A rising dollar caused byincreased demand for U.S. exports to China would lead to largerbilateral deficits (or smaller surpluses) with other U.S. tradingpartners. If the United States were to impose higher tariffs aimedat imports from China (say, by revoking its Normal Trade Relationsstatus), that too might reduce the bilateral deficit, but not theoverall U.S. trade deficit. Higher tariffs against Chinese importswould merely shift some of the bilateral trade deficit to othercountries while raising prices for American consumers.

Myth: "America Is Losing ItsCompetitiveness"

In 1992 the Cuomo Commission on Competitivenesslabeled the trade deficit one of America's 10 most urgent economicproblems. "Because of American industry's declining competitivenessand our openness to the global economy, the economic demand spurredby the federal budget deficits in the early 1980s precipitated ahuge flow of imports," the commission concluded in its report,which simply assumed a connection between trade deficits, openness,and competitiveness.

The "competitiveness" myth has gone into remission inrecent years. Since the Cuomo Commission report, the United Stateshas enjoyed seven consecutive years of healthy, noninflationarygrowth along with historically large and rising trade deficits.Meanwhile, Japan and Germany, the two export-driven juggernautsthat were supposed to eclipse the United States as economic powersin the 1990s, have struggled with slow growth and risingunemployment.

America's experience in both the 1980s and the 1990srefutes any connection between trade deficits and a loss ofindustrial might. Industrial production in the United States hasclimbed steadily in the past two decades during a time ofhistorically large U.S. trade deficits.

Between 1980 and 1987, when the U.S. current accountdeficit was rising to a peak of 3.6 percent of GDP, U.S. industrialproduction rose by 17 percent and total manufacturing output by 23percent. The same story has repeated itself in the 1990s. Between1992 and 1997 the annual U.S. trade deficit almost tripled, from$39 billion to $114 billion. Meanwhile, since 1992 total industrialproduction in the United States has surged by 24 percent andmanufacturing production by 27 percent. In Japan during the sameperiod, industrial production has grown by only 8 percent, and inGermany growth has been less than 1 percent. America runssubstantial bilateral trade deficits with both countries.

America is the world's number-one trading nation inboth imports and exports. Between 1992 and 1997, U.S. exports ofgoods and services surged from $617 billion to $932 billion. Thereason the trade deficit has grown is that imports have increasedeven faster, from $657 billion to $1,046 billion. By anydefinition, the ability of American industry to compete in theworld has not suffered because of a rising trade deficit. Theexperience of the 1980s and 1990s points in quite the oppositedirection.

Myth: "Trade Deficits Mean LostJobs"

A study by the Institute for Policy Studies inJanuary 1998 predicts that the larger trade deficit caused by theEast Asian financial meltdown will cost the U.S. economy more than1 million jobs. Columnist Patrick Buchanan, when runningunsuccessfully for the Republican presidential nomination in 1996,offered his own, back-of-the-envelope estimate of jobs lost becauseof the trade gap: "Our merchandise trade deficit was $175 billion(in 1995). For every $1 billion, you get 20,000 jobs. That's 3.5million American workers who would have had good manufacturing jobsif we simply had a trade balance." Both estimates are based on afundamental misunderstanding of the relationship between trade andaggregate employment in the United States.

The total number of jobs in the United States islargely determined by fundamental macroeconomic factors such aslabor-supply growth and monetary policy. Trade with other nationsdoes not reduce the number of jobs, but it does quicken the pace atwhich production shifts from one sector to another. Trade, like newtechnology, lowers demand for some jobs while raising demand forothers. Trade allows the United States to produce more Boeingjetliners, pharmaceuticals, software, and financial services forexport, but trade also means we produce fewer shoes, T-shirts,Happy Meal toys, and computer memory chips. Meanwhile, total outputand total employment keep growing.

In reality, larger trade deficits correlatepositively with falling unemployment. When the trade deficitexpands, as it did in the 1980s, unemployment falls. When thedeficit shrinks, as it did during the 1990-91 recession, theunemployment rate rises. As the trade deficit has expanded in the1990s, the unemployment rate has fallen steadily. The unemploymentrate fell in all but 2 of the most recent 14 years in which thetrade deficit grew larger than it had been the previous year(1976-78, 1982-87, 1992-94, 1996-97). As an expanding economycreates jobs, it also creates demand for imports and for capitalfrom abroad.

There is no reason to believe that eliminating thetrade deficit would create any gain in manufacturing jobs, nevermind 3.5 million. With the U.S. economy already operating at a lowlevel of unemployment, it is not clear where 3.5 million newmanufacturing workers would come from. And as we have already seen,a protective tariff to close the trade deficit would only succeedin reducing exports as well as imports, thus eliminatingmanufacturing jobs in the export sector. If Buchanan's calculationshad any meaning, we should expect to see a fall in manufacturingemployment during periods of rising trade deficits. Recent economictrends tell a different story. Since 1993 the U.S. merchandisetrade deficit has grown from $132 billion to $198 billion. In thatsame period the number of Americans employed in manufacturing hasgrown from 18,075,000 to 18,678,000 - an increase of more than600,000.

If anything, rising trade deficits signal more jobs,not fewer.

Myth: "The Trade Deficit Is a Drag onEconomic Growth"

The Asian financial crisis is expected to shave a fewtenths of a percentage point off the rate of growth of U.S. GDP in1998, but to blame slower U.S. growth on an expanded trade deficitis to confuse cause and effect. The current drag on our economy isnot the widening trade deficit, but plunging demand for our exportsin the Pacific Rim of Asia. The growing trade deficit and theemerging signs of our own economic slowdown are two symptoms of thesame cause - the economic turmoil across the Pacific.

Far from being a drag, a trade deficit can be a goodsign for an economy when it reflects growing demand for imports.When an economy expands, consumers are able to afford more goods,both domestic and imported. Returns on investment also increase,attracting foreign capital. The combination of inflowing capitaland increased demand for imports tends to widen the trade deficit.That explains why every recent U.S. economic expansion has beenaccompanied by an expanding trade deficit.

Since 1980, in the six years in which the currentaccount deficit has shrunk from the previous year as a percentageof GDP, the average growth rate of the U.S. economy has been 2.0percent. In the 11 years in which the current account has grownlarger as a percentage of GDP (i.e., "worsened"), the averagegrowth rate of GDP has been 3.1 percent.41 Those who maintain thatthe trade deficit is a drag on growth need to explain why oureconomy grows 50 percent faster in years in which the deficitexpands.

Contrary to mercantilist assumptions, a growing tradesurplus can be a symptom of economic weakness. In Mexico in 1995and more recently in South Korea and other East Asian countries,trade balances flipped overnight from deficit to surplus because ofplunging domestic demand and the flight of foreign capital. InJapan today, a soaring trade surplus has been accompanied by recordhigh unemployment.

Without a trade deficit, Americans would need tofinance domestic investment exclusively from domestic savings. Tobring investment in line with savings, domestic interest rateswould need to rise, reducing investment and economic growth. As theCouncil of Economic Advisers recently concluded, the trade deficithas been a "safety valve" for the expanding U.S. economy. "Importsof goods have kept inflation low, while imports of capital havekept interest rates low, helping to sustain rapid income growth. Inthe strongly expanding full-employment economy that the UnitedStates now enjoys, it should be easier for Americans to see thattrade deficits do not necessarily reduce output andemployment."

Conclusion

Misunderstanding of the trade deficit threatens toundermine the freedom to trade by encouraging faulty and damaging"solutions" to a problem that does not exist. Any attempt to fixthe trade deficit through protectionism, export subsidies, orcurrency manipulation is bound to fail because none of those toolsof intervention addresses the underlying causes of the tradedeficit. The trade deficit will respond only to changes in anation's net flow of foreign investment, which in turn isdetermined by its underlying rates of savings and investment.

If the aim of Congress is to eliminate the tradedeficit, then we must either increase national savings or reduceinvestment. The surest and swiftest way of reducing investment, andthus the demand for foreign capital, would be for the United Statesto enter a recession. It's no coincidence that America's smallesttrade deficit in recent years - that is, the last time our countrycame closest to "restoring the balance" in trade - occurred in1991, in the middle of our last recession.

When it comes to the U.S. trade deficit, there is noemergency. The current trade deficit is not a sign of economicdistress, but of rising domestic demand and investment. Any quickfix by Congress is likely to do far more harm than good. Imposingnew trade barriers against imports will only make Americans worseoff while leaving the trade deficit virtually unchanged. I wouldurge Congress to ignore the trade deficit and focus instead onreducing and eliminating barriers to trade, wherever theyexist.

Thank you for letting me speak and I would be glad toanswer any questions.

Thank you.

Daniel Griswold

Subcommittee on International Economic Policy and Trade
Committee on International Relations
United States House of Representatives