The Causes and Consequences of the U.S. Trade Deficit

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Mr. Chairman and members of the Senate Finance Committee: Thankyou for allowing me to testify on the causes and consequences ofthe U.S. trade deficit.

The economic turmoil in East Asia has thrust America's tradedeficit back into the news. Perhaps no aspect of American trade istalked about more and understood less than the trade deficit. Ithas been cited as conclusive proof of unfair trade barriers abroador a lack of competitiveness among U.S. industries at home. It hasbeen blamed for destroying jobs and dragging down economic growth.I welcome the opportunity to present a more charitable view of this much abused trade number.

The U.S. trade deficit is the result of a net inflow of capitalto the United States from the rest of the world. Because of ourstable and relatively free domestic market, we remain the world'smost popular destination for foreign investment. We have become anet importer of capital because Americans do not save enough tofinance all the available investment opportunities in our economy.This inflow of capital from abroad allows us to pay for importsover and above what we export.

In other words, the trade deficit is simply a mirror reflection of the larger macroeconomic realitythat investment in the United States exceeds domestic savings. Ifwe want to change the U.S. trade deficit we must change the rate atwhich Americans save and invest.

In a study published by the Cato Institute in April, I addressfour enduring myths about the U.S. trade deficit. Two of themrelate to causes, two to consequences.

The first myth is that the overall U.S. trade deficit is causedby unfair trade barriers abroad. Foreign barriers are certainly aproblem, just as our own barriers to imports remain a problem. Buttrade restrictions do not determine theoverall U.S. trade deficit, nor do they fully account for thedifferences in bilateral trade balances. For example, the UnitedStates runs a large trade surplus with Brazil, a country withrelatively high trade barriers, while we run deficits with Mexicoand Canada, two countries virtually open to U.S. exports.

The second myth is that trade deficits are caused by a lack ofU.S. industrial competitiveness. This myth has been refuted by thestellar performance of the American economy, which today is theenvy of the world. Since 1992, the U.S. trade deficit hastripled. During that same time, U.S.industrial production has surged 24 percentand manufacturing output 27 percent. TheAmerican people sell more goods and services in the globalmarketplace than people of any other country.

A third myth is that trade deficits destroy jobs. Again, theperformance of the U.S. economy in the last decade should lay thatmyth to rest. While the trade deficit has expanded, so haveAmerican payrolls. Indeed, there is a strong correlation betweenrising trade deficits and falling rates of unemployment. The reason is simple: Thesame expanding economy that stimulates demand for labor also raisesdemand for imported goods and capital.

The final myth is that trade deficits are a drag on the U.S.economy. With the slowdown in East Asia, this seems a reasonableclaim. But the drag is not the trade deficit itself, but fallingdemand for our exports in the Far East. A trade deficit thatreflects both rising exports and evenmore rapidly rising imports can be a signof health. That has been the case in the United States for most ofpast two decades. Since 1980, the U.S economy has grown an averageof 3.1 percent in years in which thecurrent account deficit has expanded from the previous year, and anaverage of only 2.0 percent in years inwhich the deficit has shrunk. If trade deficits are bad for growth,why does the U.S. economy grow more than 50 percent faster when thetrade deficit expands?

Frankly, we would have more reason to worry if the U.S. wererunning a trade surplus. In Mexico in 1995 and more recently inSouth Korea and other East Asian countries, trade balances flippedovernight from deficit to surplus because of plunging domesticdemand and the flight of foreign capital. In Japan today, a soaringtrade surplus has been accompanied by recordhigh unemployment. It's no coincidence that America's smallest trade deficit in recent yearsoccurred in 1991 - in the trough of our last recession.

What does all this mean for policy? First, there is noemergency. The trade deficit is not a sign of economic distress,but of rising domestic demand and investment. Second, the tradedeficit is largely immune to changes in trade policy. Imposing newtrade barriers will only make Americans worse off while leaving thetrade deficit virtually unchanged.

In conclusion, I would urge Congress to ignore the trade deficitand focus instead on reducing and eliminating barriers to trade,wherever they exist.

Thank you for letting me speak and I would be glad to answer anyquestions.