The U.S. Trade Deficit: A Sign of Good Times

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Before discussing the cause of the U.S. trade deficit, let mespend a moment on two alleged causes that in reality have no directconnection to the deficit.

One alleged cause is a lack of "competitiveness." The immediateproblem with this explanation is that competitiveness, on anation-to-nation level, is an imprecise term, one almost devoid ofmeaning. What does it mean for a nation's economy to becompetitive? If it means "more productive," then this is justanother term for "wealthier." It makes no sense in theory or inpractice why a nation's trade deficit should shrink as the overallproductivity of its workers rises. Indeed, the opposite effect maybe more plausible.

A second, empirical problem with this explanation is that, byalmost every measure of productivity and wealth, the U.S. economyis performing well at the end of the 1990s at a time when the tradedeficit is reaching record levels. Compared to the other majordeveloped economies, our economy is growing faster, productivity isrising more briskly, and innovative new products and services, frommedical drugs to Internet communications, are being developed morerapidly here than anywhere else. Yet we run persistently large andgrowing trade deficits.

The other alleged cause of the trade deficit is unfair tradebarriers abroad. But this theory also runs aground on the rocks ofreality. The rest of the world is more open to U.S. exports todaythan it was 30 years ago, thanks to two more rounds of GATTnegotiations as well as unilateral trade liberalization abroad. Yetour overall trade deficit is also larger.

Bilateral trade deficits also fail to show a cause-and-effectlink to foreign trade barriers. The United States runs bilateraltrade deficits with Mexico and Canada, two countries that arealmost completely open to exports from the United States. Yet werun a trade surplus with Brazil, country that still maintainssignificant barriers to U.S. exports.

We run a far bigger deficit with Japan today than 30 years ago,even though Japan's economy is much more open today. And U.S.exports to member states of the European Community face a commonexternal tariff, yet we run our largest bilateral surplus with theNetherlands and our third largest bilateral deficit with Germany.Clearly, trade barriers or some half-baked measure ofcompetitiveness cannot account for these differences.

The Savings-Investment Gap

The fundamental cause of the trade deficit in the United Statestoday is the gap between what we save as a nation and the level ofdomestic investment. To cover this shortfall of savings, we offerinvestment opportunities to foreigners, using the surplus ofincoming capital to pay for the import of goods and services overand above what we export. The result is a trade deficit (or moreprecisely, a current account deficit). For a nation such as Japan,where the level of savings exceeds investment, capital flowsoverseas. This allows foreigners to buy more exported goods andservices from the country exporting capital than they import to thecountry, resulting in a trade surplus.

So the variables in the trade-deficit equation are notindustrial competitiveness or trade policies, but how much a nationsaves and invests. If a nation's rate of savings rises or ifinvestment falls (as it usually does during a recession), its tradedeficit will shrink. Conversely, if savings fall or investmentrises (as it typically does during an expansion), the trade deficitwill grow.

For this reason, trade deficits tend to be pro-cyclical, risingand falling with the general health of the economy. Simply put,the U.S. trade deficit is not the cause of bad things in oureconomy; it is the result of good things, chief among them risinginvestment.

The fundamental reason why the U.S. trade deficit has grown sorapidly in the 1990s has been a dramatic increase in domesticinvestment. Since 1992, annual real private investment in plant andequipment in the United States has risen 81 percent, from $557.9billion to an annual pace of slightly more than $1 trillion so farin 1999. Real, price-adjusted investment in computers andperipheral equipment during that same period has increased morethan 10-fold.

As evidence, consider the relationship between America'seconomic performance and the trade deficit since 1973. As Figure 1indicates, the U.S. trade balance typically peaks in the directionof a surplus during recessions, and bottoms out in the negative (ordeficit) direction in the midst of economic expansions.

The Trade Deficit and Economic Performance

A survey of the U.S. economy since 1973, when the era offloating exchange rates and free capital flows began, only confirmsthat rising trade deficits generally accompany periods of risinginvestment and expansion for the U.S. economy.

View trade deficitcomparison table

View table ofEconomic Indicators and the Trade Deficit, 1973-98

In the 26 years surveyed, America's current account deficit as apercentage of GDP grew larger (or, in the parlance of the typicalnews report, "worsened") in 15 of them and shrank (or "improved")in 11. By almost any measure, America's economy has performedbetter in years in which the trade deficit rose compared to yearsin which it shrank.

During years of rising deficits, the growth of real grossdomestic product averaged 3.2 percent per year, compared to 2.3percent during years of shrinking deficits. In other words, oureconomy typically grows about 40 percent faster in years in whichthe trade deficit grows compared to years in which it shrinks.

On the issue of jobs, the story is much the same. During yearsof "worsening" trade deficits, the unemployment rate has, onaverage fallen by 0.4 percentage points. During years of"improving" deficits, the unemployment rate has, on average,risen by 0.4 percentage points.

In the politically sensitive sector of manufacturing, the tradedeficit again proves to be a companion of better times. Duringyears of rising deficits, manufacturing output grew an average of4.5 percent a year. During years of shrinking deficits the averagegrowth rate of manufacturing output was 1.4 percent - less thanone-third the rate of growth during years of rising deficits. As tomanufacturing jobs, those years in which the trade deficit grew sawfactory employment increase by an average of 13,100workers per year. Those years of shrinking deficits wereaccompanied by an average annual loss of manufacturingjobs of 116,700.

Focusing on motor vehicles and parts - long a symbol of Americanindustrial might - domestic output grew by an average of 8.6percent during years of rising deficits while employment grew by anaverage of 21,900. During years when the deficit shrank, domesticoutput of motor vehicles and parts fell by an average of 3.4percent annually and employment fell an average of 25,000 peryear.

Americans on the margins of poverty also appear to fare somewhatbetter when the trade deficit expands. In years when the deficitgrew, the poverty rate in America fell an average of 0.1 percentagepoints a year. In years when it shrank, the poverty rate rose by anaverage of 0.3 points. In terms of real people, years of"improving" trade deficits saw the number of Americans living belowthe poverty line increase by an average of 907,000 people a year,compared to an 81,000 increase during years of "worsening"deficits.

The only major economic indicator out of sync was the stockmarket. On average, the New York Stock Exchange Composite Indexrose 8.7 percent during years of rising deficits, lagging behindthe 12.3 percent rise in years of shrinking deficits. Perhaps itshould be Wall Street, not organized labor, that should becomplaining most loudly about the trade deficit.

Conclusion

Of course, none of this evidence argues that the trade deficitis the cause of economic blessings. What it does indicate is thatrising trade deficits are often caused by the same underlyingfactor, namely rising domestic investment, that drives a number ofother economic indicators - employment, production, poverty rates -in a positive direction.

Without a trade deficit, Americans could not import the capitalwe need to finance our rising level of investment in plants and newequipment, including the latest computer technology. The sameappreciating dollar that expands the trade deficit helps keep a lidon inflation while lower import prices raise the real wages of thevast majority of American workers.

When the underlying causes of the trade deficit are understood,it should become clear that the biggest threat to our economy isnot the deficit itself, but what politicians might do in amisguided mission to shrink it.

Daniel Griswold

Committee on Commerce, Science, and Transportation
United States Senate