America’s Maligned and Misunderstood Trade Deficit

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America's annual trade deficit, already large by historicalstandards, could reach a new record in 1998, fueling protectionistsentiment in Congress. Political fallout from the trade deficitnumbers could impede efforts to reduce barriers to trade in theUnited States and abroad.

Contrary to popular conception, the trade deficit is not causedby unfair trade practices abroad or declining industrialcompetitiveness at home. Trade deficits reflect the flow of capitalacross international borders, flows that are determined by nationalrates of savings and investment. This renders trade policy anineffective tool for reducing a nation's trade deficit.

A survey of America's major trading partners reveals norelationship between bilateral trade balances and openness to U.S.exports. For example, the U.S. runs a bilateral surplus withBrazil, which is relatively protectionist, while we run deficitswith Canada and Mexico, which are almost totally open to U.S.exports thanks to the North American Free Trade Agreement.

There is no connection between trade deficits and industrialdecline. From 1992 and 1997, the U.S. trade deficit almost tripled,while at the same time U.S. industrial production increased by 24percent and manufacturing output by 27 percent. Trade deficits donot cost jobs. In fact rising trade deficits correlate with fallingunemployment rates. Far from being a drag on economic growth, theU.S. economy has actually grown faster in years in which the tradedeficit has been rising than in years in which the deficit hasshrunk. Trade deficits may even be good news for the economybecause they signal global investor confidence in the United Statesand rising purchasing power among domestic consumers.

What matters to the economy is not the difference betweenimports and exports but the extent to which Americans are free tobenefit from the efficiencies, opportunities and consumer choicecreated in an economy open to world trade.

Introduction

One of the most politically volatile consequences of thefinancial and economic turmoil in the Pacific Rim will be a risingU.S. trade deficit in 1998. Plunging growth rates in the regionwill mean less demand for U.S. exports, while falling foreigncurrency values will make Asia's exports to the United States moreaffordable, spurring demand by American consumers. The result,widely predicted by economists, will be a mercantilist's nightmare:a growing gap between the value of the goods and services we importand the value of what we export. The U.S. merchandise trade deficitin 1998 could approach $250 billion, breaking the record of $198.7billion just set in 1997.(1) If the past is any guide, thegrowing trade gap will fuel anguish in the news media andprotectionist sentiments in Congress.

Whenever the government announces a record, or just a rising,deficit, the media routinely declare the "bad news" that the tradegap has "worsened"--no matter how good the accompanying economicnews may be on inflation, employment, and growth. Media reportswere typically gloomy in February when the Commerce Departmentreported a $114 billion trade deficit for 1997, the largest tradegap since 1988. On February 19, the day of the report, Dan Ratherannounced on CBS News that "the government says the 1997U.S. trade deficit was the worst in nine years."(2) The same day, Lou Dobbs, hostof CNN's Moneyline program, said, "We begin tonight withtoday's troubling report on trade, a report that showed thenation's trade deficit soared by 24 percent in December."(3) The next day, the WallStreet Journal added darkly that "1998 could shape up to be aneven more dismal year for trade than 1997."(4)

No aspect of international trade is talked about more andunderstood less than America's perennial trade deficit. Critics offree trade, and most Americans for that matter, believe the tradedeficit is prima facie evidence that American companies are failingto compete in global markets or that U.S. exporters face "unfair"trade barriers abroad, or both. The obvious implication is that, ifother nations were to open their markets as wide as we havesupposedly opened ours, or if American companies became morecompetitive against foreign rivals, we could export more relativeto imports, thus reducing the trade deficit.

The popular thinking on trade deficits is simple, appealing--andwrong. Trade deficits are not determined by the microeconomics oftrade policy or industrial competitiveness. They reflect underlyingmacroeconomic factors, specifically investment flows and,ultimately, the national rates of savings and investment thatdetermine those flows. The recent experience of the United Statesand its trading partners confirms this conclusion.

Understanding the trade deficit has profound implications forour national debate about trade. We cannot reduce the U.S. tradedeficit by restricting imports to the American market or bypersuading or bullying other governments to lower barriers to theirmarkets. We cannot reduce the trade deficit throughgovernment-directed industrial policy, managed trade, or exportsubsidies aimed at boosting national "competitiveness" (however onedefines the concept). And, contrary to the headlines, tradedeficits are not necessarily bad news for the U.S. economy. Theymay even be good news.

Current Accounts, Current Controversies

Americans have run an annual trade deficit in goods and serviceswith the rest of world in every year since 1976. That unbrokenstring of deficits has colored much of the trade debate in theUnited States in the last two decades.

Beginning in the early 1980s, annual U.S. trade deficits reachedunprecedented levels. After decades of postwar surpluses, the U.S.trade deficit topped $100 billion in 1984 and peaked at a record$153 billion in fiscal year 1987. The trade deficit shrank to a lowof $31 billion in 1991, but it has grown again to more than $100billion a year since 1994, (5) reaching $113.7 billion in1997. (The $198.7 billion deficit in goods last year was offset byan $85 billion surplus in services.)(6)

Throughout the 1980s and 1990s, trade deficits have spawnedworry about "unfair" foreign trade barriers, lost jobs, andAmerica's ability to compete in the global marketplace. Indeed, thetrade deficit was partly to blame for a wave of angst in the late1980s over American "decline." Best-selling books such as PaulKennedy's The Rise and Fall of the Great Powers and ClydePrestowitz's Trading Places: How We Allowed Japan to Take theLead caught the mood of the time.

In the mid-1980s lawmakers on Capitol Hill responded to thetrade-deficit anxiety with protectionist-leaning proposals. In 1986the House approved by a two-to-one margin an amendment offered byRep. Richard Gephardt (D-Mo.) that would allow the imposition ofimport quotas against countries that were running large bilateraltrade surpluses with the United States. (Japan, Taiwan, and WestGermany were considered the most likely targets at the time.) Theamendment passed the House again in 1987, by a narrow margin,although it was ultimately excluded from the 1988 Omnibus Trade andCompetitiveness Act in favor of the "Super 301" law threateningretaliation against countries engaged in allegedly unfair tradepractices.(7)

In November 1991 Gephardt tried again, proposing an amendmentthat would activate Section 301 sanctions against any nation whosebilateral trade surplus with the United States accounted for morethan 15 percent of the total U.S. trade deficit. "Like the originalGephardt amendment of 1986-88, this proposal exploited two widelyshared beliefs: that nations ought normally to balance their tradebilaterally, and that deficits were caused, in important part, bythe surplus country's barriers to imports," observed trade scholarI. M. Destler.(8)

The trade deficit has continued to haunt U.S. trade policy inthe 1990s. In the debate in the fall of 1997 over renewal offast-track trade authority, opponents of the measure cited thecontinuing overall U.S. trade deficit as evidence that trade harmsthe U.S. economy and destroys jobs. To discredit the North AmericanFree Trade Agreement, and by association all free-trade agreements,opponents of fast-track authority hammered away at the bilateraltrade deficits the United States runs with both of its NAFTApartners, Mexico and Canada.

The deficit with Mexico drew the most fire because America'sbilateral balance with Mexico had been in surplus before 1995. InSeptember 1997 Steve Beckman, an economist for the United AutoWorkers labor union, testified before the Subcommittee on Trade ofthe House Ways and Means Committee that bilateral trade deficitswith Canada and Mexico had created a "trade debacle" costing theU.S. economy more than 400,000 jobs.(9)

Bilateral trade deficits continue to complicate America'scommercial relations with a number of major trading partners, chiefamong them Japan and China. In 1997 the United States recorded a$55.7 billion bilateral trade deficit with Japan and a $49.7billion deficit with China, by far our two largest bilateralimbalances.(10) Thedeficit with China appears even more threatening to some tradecritics because it has grown so rapidly in recent years, more thanquadrupling from $11.5 billion in 1990.(11) Our bilateral deficit withChina has been used to argue against renewal of China's MostFavored Nation status and against admitting it to the World TradeOrganization. America's bilateral trade deficit with Japan hasprobably been the single biggest source of trade friction betweenthe two countries.(12)

If the overall U.S. trade deficit rises in 1998 as predicted, itcould spur a whole new round of attacks on free trade, promptinggovernment intervention to curb imports and spur exports.

Understanding the U.S. Trade Deficit

The trade deficit has been at the heart of one of the oldestdebates in economics. The mercantilist approach to trade thatdominated thinking in the 17th and 18th centuries stressed the needfor nations to accumulate gold. By exporting more than theyimported, nations could hoard the excess money, almost always goldor silver, generated by the trade surplus. A treasury bulging withprecious metals was considered the true sign of a nation's wealthand might. The more metallic money a state possessed, the more ableit would be to wage war if necessary.

Predictably, the obsession with running a positive "balance oftrade" led to all sorts of protectionist measures and exportsubsidies. High tariffs and outright import bans were the ruleamong European nations before 1800.

Back to Smith and Hume

In arguing for free trade, the 18th-century classical liberalsDavid Hume and Adam Smith attacked what Hume called "a strongJealousy with regard to the balance of trade."(13) Hume reasoned that anation's supply of gold was ultimately determined by its capacityto produce wealth, not the other way around. A nation thatattempted to accumulate gold through a trade surplus, by eitherblocking imports or subsidizing exports, would soon find that itsgold stocks were rising in relation to the total goods availablefor sale. That excess of money would cause a general rise in theprice of domestic goods (i.e., inflation), making them lessappealing to foreign buyers. As long as prices kept rising, demandfor exports would fall until the inward flow of gold ceased. AsHume understood two centuries ago, any attempt to manufacture atrade surplus through trade policy was doomed to fail because theflow of money would be self-correcting.

Hume's contemporary and friend Adam Smith also dismissed worriesabout the trade deficit. "Nothing can be more absurd than thiswhole doctrine of the balance of trade," he wrote.(14) What mattered to Smith wasnot the difference between exports and imports but the gains fromspecialization that trade allows. Those productivity gains allow anation's residents to produce goods and services of a higher totalvalue--the only true measure of a nation's economic wealth. Anyinterference in the freedom to trade, no matter what its effect onthe trade balance, diminishes that wealth. "A trade which is forcedby means of bounties [subsidies] and [protected] monopolies may be,and commonly is, disadvantageous to the country in whose favor itis meant to be established. But that trade which, without force orconstraint, is naturally and regularly carried on between any twoplaces, is always advantageous, though not always equally so, toboth."(15) Smith andHume's critique of the balance of trade doctrine remains valid twocenturies later.

Investment Flows Drive the Deficit

The most important economic truth to grasp about the U.S. tradedeficit is that it has virtually nothing to do with trade policy. Anation's trade deficit is determined by the flow of investmentfunds into or out of the country. And those flows are determined byhow much the people of a nation save and invest--two variables thatare only marginally affected by trade policy.

An understanding of the trade deficit begins with the balance ofpayments, the broadest accounting of a nation's internationaltransactions. By definition, the balance of payments always equalszero--that is, what a country buys or gives away in the globalmarket must equal what it sells or receives--because of theexchange nature of trade.(16) People, whether tradingacross a street or across an ocean, will generally not give upsomething without receiving something of comparable value inreturn. The double-entry nature of international bookkeeping meansthat, for a nation as a whole, the value of what it gives to therest of the world will be matched by the value of what itreceives.

The balance of payments accounts capture two sides of anequation: the current account and the capital account. The currentaccount side of the ledger covers the flow of goods, services,investment income, and uncompensated transfers such as foreign aidand remittances across borders by private citizens. Within thecurrent account, the trade balance includes goods and servicesonly, and the merchandise trade balance reflects goods only. On theother side, the capital account includes the buying and selling ofinvestment assets such as real estate, stocks, bonds, andgovernment securities.

If a country runs a capital account surplus of $100 billion, itwill run a current account deficit of $100 billion to balance itspayments. As economist Douglas Irwin explains, "If a country isbuying more goods and services from the rest of the world than itis selling, the country must also be selling more assets to therest of the world than it is buying."(17)

The necessary balance between the current account and thecapital 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, such as 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 topurchase exports in excess of what the country imports, creating acorresponding trade surplus. A nation that invests more than itsaves--the United States, for example--must import capital fromabroad. In other words, it must run a capital account surplus. Theimported capital allows the nation's citizens to consume more goodsand services than they produce, importing the difference through atrade deficit.

In 1996 Americans invested $1,117 billion privately and another$224 billion through government, for a total of $1,341 billion ingross domestic investment. National savings, however, fell short ofthat amount, requiring Americans to import a net $133 billion incapital.(18) That sameyear Americans paid $1,238 billion to the rest of the world forimports of goods and services, net transfer payments, and income onforeign investments in the United States, while receiving $1,105billion for exports and investment income. The result was a currentaccount deficit of $133 billion, equal to the net inflow of foreigncapital.(19)

The transmission belt that links the capital and currentaccounts is the exchange rate. As more net investment flows into acountry, demand rises for the dollars needed to buy U.S. assets. Asthe dollar grows stronger relative to other currencies, U.S. goodsand services become more expensive to foreign consumers, reducingdemand, while imports become more affordable to Americans. Fallingexports and rising imports adjust the trade balance until itmatches the net inflow of capital. In effect, foreign investorswill outbid foreign consumers for limited U.S. dollars until theinvestors satisfy their demand for U.S. assets. Of course, mostday-to-day currency transactions are not directly related to trade,but demand for U.S. goods, services, and assets affects demand forthe dollars needed to buy them, thus influencing the value of thedollar in global currency markets.

Germany in the early 1990s offers a case study of how thismechanism works. West Germans routinely ran large current account(and trade) surpluses in the 1980s, but between 1990 and 1991Germany's current account flipped from a surplus of 3.2 percent ofgross domestic product to a deficit of 1.0 percent.(20) The reason for the reversalwas not that German manufacturers suddenly lost their legendaryefficiency, or that Germany's trading partners imposed new andunfair trade barriers on the night of December 31, 1990. Whatcaused the switch was the huge increase in domestic investmentneeded to rebuild formerly communist eastern Germany. An increasein domestic investment repatriated a huge amount of German savingsthat had been flowing abroad, thus reducing the amount of Germanmarks in the foreign currency markets and raising their valuerelative to other currencies. The stronger mark, in turn, raisedthe price of German exports and lowered the price of imports,evaporating Germany's trade surplus.

In an October 1997 study for the Economic Strategy Institute,economist Peter Morici attempts to offer an alternative explanationfor the trade deficit. A press release accompanying the studydismisses "the old chestnut that the current account is simply theother side of an immutable accounting identity."(21) As evidence, Morici citesthe effect on the trade deficit caused by the purchase of U.S.assets, in particular Treasury bills, by foreign governments.

Morici's analysis is not a refutation of the accounting identitybut a restatement of it. Whether the transaction involves a privateforeign investor's buying shares in IBM or a foreign government'sbuying T-bills, it still counts as an inflow of foreign capital tothe United States. Indeed, Morici's own regression analysis findsthat changes in the U.S. trade balances are strongly correlatedwith private investment flows. "Overall variations in privatesector behavior appear to be more important than direct measures ofeither U.S. or foreign government policies," he concluded. "Amongprivate variables net foreign private investment (NFPI) seems toexplain more of the variation in the trade and current accountsbalances than the domestic private savings balance."(22) In other words, the oldchestnut still rings true: investment flows drive the tradedeficit.

Why Protectionism Cannot Cure the TradeDeficit

The causal link between investment flows, exchange rates, andthe balance of trade explains why protectionism cannot cure a tradedeficit. 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. tradedeficit.(23) If Congresswere to implement that awful idea, American imports would probablydecline as intended. But fewer imports would mean fewer dollarsflowing into the international currency markets, raising the valueof the dollar relative to other currencies. The stronger dollarwould make U.S. exports more expensive for foreign consumers andimports 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 and investment,the trade deficit would remain largely unaffected. All the newtariff barriers would accomplish would be to reduce the volume ofboth imports and exports, leaving Americans poorer by deprivingthem of additional gains from the specialization that accompaniesexpanding international trade.

Government export subsidies would be equally ineffective inreducing the trade deficit. Partly in response to the Asianfinancial crisis, President Clinton proposed in his 1999 federalbudget an increase in subsidies to U.S. exporters through theExport-Import Bank. By allowing certain exporters to lower theirprices 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 the trade deficitby influencing a nation's level of savings and investment. Forexample, a higher tariff would presumably raise government revenuethrough additional customs duties, thus reducing the budget deficit(or increasing the surplus) and reducing the need to borrow fromabroad--resulting in a smaller trade deficit. But a tariff can alsostimulate investment in the protected industry, increasing demandfor foreign capital and leading to a larger trade deficit. Aftersurveying the various theories, Labor Department economist RobertC. Shelburne concluded, "Trade policy is likely to have a marginalimpact on savings or investment and thus only a marginal impact onthe trade balance."(24)Even Morici concurs, noting that "changes in trade policies havehad minimal effects on aggregate net exports in recentyears."(25)

Another temptation is to intervene by intentionally devaluingthe national currency in the foreign exchange market. A nation'scentral bank can put downward pressure on the value of its owncurrency by creating an excess amount of that currency and usingthe excess to purchase foreign currencies. A falling currency canstimulate exports and dampen demand for imports, thus reducing atrade 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: A Recession

One way to reduce the trade deficit would be for Americans tosave more. A larger pool of national savings would reduce demandfor foreign capital; with less foreign capital flowing into thecountry, the gap between what we buy from abroad and what we sellwould shrink.(26)

A related way to cut the trade deficit is for the government toborrow less. Reducing the government deficit (a form of"dissaving") releases more funds for domestic investment, reducingthe demand for foreign capital. That explains the "twin deficits"phenomenon of the 1980s, when huge federal budget deficits claimeda rising share of national savings, requiring the importation ofsavings from abroad to meet domestic demand for investment. Theinflow of foreign capital prompted by the budget deficit allowedAmericans to buy even more goods and services than they sold in theinternational marketplace. As the federal budget deficit declinedin the late 1980s, so too did America's trade deficit.

Figure 1

The Trade Balance and U.S. Recessions

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Another, less appealing way to reduce the trade deficit is toreduce investment. That occurs more or less naturally during timesof recession, when business confidence falls and companies cut backon expansion plans. As Americans consume and invest less, demandfor imports and foreign capital falls along with the trade deficit.That explains why the smallest U.S. trade deficit since the early1980s occurred in 1991, in the midst of the most recentrecession.(27) In fact,as Figure 1 illustrates, the U.S. current account balance tends toshrink 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. In theaftershock of the peso crisis, Mexico's real GDP shrank in 1995 by6.2 percent. Because of falling domestic demand, fleeing capital,and a plunging peso, Mexico's overall trade balance flipped from adeficit in 1994 to a surplus in 1995. Mexico's bilateral balancewith the United States did the same, going from a deficit to asurplus. That supposed "trade debacle" for the United States hadnothing to do with NAFTA or any other change in trade policy. Itwas caused by mismanagement on the part of Mexico's monetaryauthorities, and the chief victims of that mismanagement wereMexican workers. Perhaps NAFTA critics who believe our bilateraltrade deficit with Mexico is such a terrible development would havepreferred that the U.S. economy, not the Mexican economy, contract6.2 percent in one year. Of course, American workers would havesuffered, but it would have done wonders for our bilateral tradebalance.

An understanding of the all-important role of investment flowsshould liberate trade policy from its obsessive focus on thecurrent account balance. The trade deficit is not a function oftrade policy, and therefore trade policy cannot be a tool forreducing the trade deficit.

Enduring Myths about the Trade Deficit

Misunderstanding of the U.S. trade deficit has spawned a numberof myths about international trade and America's place in theglobal economy. Those myths have allowed trade deficits to be usedto further a number of anti-trade and anti-market positions,including export subsidies, industrial policy, and sanctionsagainst "unfair" trading partners. The following are among the mostcommon and harmful myths surrounding the trade deficit.

Myth: "U.S. Exporters Face Unfair TradeBarriers"

Many Americans are convinced that a bilateral trade deficitproves that the foreign country's market is relatively closed toU.S. exports compared with the "open" U.S. market. America's largebilateral deficit with Japan is almost unanimously seen as aproblem by U.S. policymakers who share that view, with blame forthe deficits placed squarely on "unfair" foreign tradebarriers.

A survey of America's major trading partners challenges thatassumption. Countries with which the United States runs largedeficits are not characteristically more protectionist toward U.S.exports than are those with which we run a surplus. Canada andMexico, two countries that are very open to U.S. exports thanks inpart to NAFTA, are both among the five countries with which theUnited States has the largest bilateral trade deficits. On theother side, America's third largest bilateral trade surplus is withBrazil, a country whose barriers to imports remain relatively high.Americans face a common external tariff when exporting to membersof the European Union, yet some EU members (the Netherlands andBelgium) are among the top surplus trade partners, and others(Germany and Italy) are among the top deficit partners. Tradepolicy cannot explain those differences (Table 1).

Table 1
America's Top 10 BilateralDeficits and Surpluses 1997
(billions of U.S. $)

U.S. Deficit U.S. Surplus
Japan -$55.9 Netherlands +$12.5
China -$49.8 Australia +$7.4
Germany -$18.7 Brazil +$6.3
Canada -$17.9 Belgium +$5.5
Mexico -$14.4 Hong Kong +$4.8
Taiwan -$12.2 United Kingdom +$3.8
Italy -$10.4 Argentina +$3.6
Malaysia -$7.2 Egypt +$3.2
Venezuela -$6.8 Chile +$2.1
Nigeria -$5.5 South Korea +$1.9

Source: U.S. Department of Commerce, Bureau of the Census,Foreign Trade Division, at www.census.gov/foreign trade.

Blaming bilateral deficits exclusively on differences in tradepolicy once again misses the reality of investment flows. In Japan,high domestic savings rates provide a pool of capital that farexceeds domestic investment opportunities. Japan "exports" capitalto the United States, which allows Americans to import more goodsfrom Japan than we export. The main reason that America's bilateraltrade deficit with Japan exploded in the 1980s is that the Japanesegovernment lifted many of its capital controls with the passage ofthe Foreign Exchange and Foreign Trade Control Law in December1980. That allowed a tsunami of Japanese savings to flowacross the Pacific to the United States, where it could draw a morefavorable rate of return.

Despite the common perception, Japan was actually more open toU.S. exports in the 1980s than in the 1960s and 1970s, whenAmerican bilateral trade deficits with Japan were much smaller. AsRobert T. Parry, president and chief executive officer of theFederal Reserve Bank of San Francisco, explained:

Of all the U.S. trading partners, Japan continues to be singledout for having the most unfair trading practices. But it's doubtfulthat such policies have been a major cause of U.S. trade deficits.First of all, the Japanese market has become somewhat moreopen--not more closed--over the past decade. Second, Japan's shareof changes in the total U.S. non-oil merchandise trade deficit hasbeen proportional to its U.S. trade share. For example, in 1981,about 9 percent of our exports went to Japan, and about 20 percentof our imports came from Japan. That left us with a bilateraldeficit of $16 billion. If the same shares prevailed in 1992, wewould have had a bilateral deficit of $57 billion--which is in facta little larger than the actual deficit of $51 billion. So I thinkthere's not much evidence to say that restrictive trade practiceshave been the driving force behind changes in the U.S. tradedeficit.(28)

The same cannot be said for our bilateral deficit with China.Despite substantial progress in the last 10 years, its barriers toimports remain relatively high. Those barriers partly explain thebilateral surplus China runs with the United States, but theprimary explanation is more benign: We like to consume the productsChina sells. In 1995 the Council of Economic Advisers concluded,"China's persistent surplus with the United States in part reflectsits specialization in inexpensive mass-market consumer goods. Chinasimilarly runs bilateral surpluses with Japan and Europe for thisreason."(29)

If China were to further open its market, America's bilateraldeficit with China would probably shrink, but our overall tradedeficit--determined by aggregate savings and investment--wouldremain largely unaffected. A rising dollar caused by increaseddemand for U.S. exports to China would lead to larger bilateraldeficits (or smaller surpluses) with other U.S. trading partners.If the United States were to impose higher tariffs aimed at importsfrom China (say, by revoking its Most Favored Nation status), thattoo might reduce the bilateral deficit, but not the overall U.S.trade deficit. Higher tariffs against Chinese imports would merelyshift some of the bilateral trade deficit to other countries whileraising prices for American consumers.

Myth: "America Is Losing ItsCompetitiveness"

In 1992 the Cuomo Commission on Competitiveness labeled thetrade deficit one of America's 10 most urgent economic problems."Because of American industry's declining competitiveness and ouropenness to the global economy, the economic demand spurred by thefederal budget deficits in the early 1980s precipitated a huge flowof imports," the commission concluded in its report, which simplyassumed a connection between trade deficits, openness, andcompetitiveness.(30)

The "competitiveness" myth has gone into remission in recentyears. Since the Cuomo Commission report, the United States hasenjoyed seven consecutive years of healthy, noninflationary growthalong with historically large and rising trade deficits. Meanwhile,Japan and Germany, the two export-driven juggernauts that weresupposed to eclipse the United States as economic powers in the1990s, have struggled with slow growth and rising unemployment.

America's experience in both the 1980s and the 1990s refutes anyconnection between trade deficits and a loss of industrial might.Figure 2 shows that industrial production in the United States hasclimbed steadily in the past two decades during a time ofhistorically large U.S. trade deficits.

Figure 2
The Trade Balance andIndustrial Production

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Between 1980 and 1987, when the U.S. current account deficit wasrising to a peak of 3.6 percent of GDP, U.S. industrial productionrose by 17 percent and total manufacturing output by 23percent.(31) The samestory has repeated itself in the 1990s. Between 1992 and 1997 theannual U.S. trade deficit almost tripled, from $39 billion to $114billion.(32) Meanwhile,since 1992 total industrial production in the United States hassurged by 24 percent and manufacturing production by 27percent.(33) In Japanduring the same period, industrial production has grown by only 8percent, and in Germany growth has been less than 1percent.(34) Americaruns substantial bilateral trade deficits with both countries.

America is the world's number-one trading nation in both importsand exports. Between 1992 and 1997, U.S. exports of goods andservices surged from $617 billion to $932 billion. The reason thetrade deficit has grown is that imports have increased even faster,from $657 billion to $1,046 billion.(35) By any definition, theability of American industry to compete in the world has notsuffered because of a rising trade deficit. The experience of the1980s and 1990s points in quite the opposite direction.

Myth: "Trade Deficits Mean Lost Jobs"

A study by the Institute for Policy Studies in January 1998predicts that the larger trade deficit caused by the East Asianfinancial meltdown will cost the U.S. economy more than 1 millionjobs. Columnist Patrick Buchanan, when running unsuccessfully forthe Republican presidential nomination in 1996, offered his own,back-of-the-envelope estimate of jobs lost because of the tradegap: "Our merchandise trade deficit was $175 billion (in 1995). Forevery $1 billion, you get 20,000 jobs. That's 3.5 million Americanworkers who would have had good manufacturing jobs if we simply hada trade balance."(36)Both estimates are based on a fundamental misunderstanding of therelationship between trade and aggregate employment in the UnitedStates.

The total number of jobs in the United States is largelydetermined 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 correlate positively withfalling unemployment. Figure 3 illustrates how closely theunemployment rate corresponds with changes in the U.S. tradedeficit. When the trade deficit expands, as it did in the 1980s,unemployment falls. When the deficit shrinks, as it did during the1990-91 recession, the unemployment rate rises. As the tradedeficit has expanded in the 1990s, the unemployment rate has fallensteadily. The unemployment rate fell in all but 2 of the mostrecent 14 years in which the trade deficit grew larger than it hadbeen the previous year (1976-78, 1982-87, 1992-94,1996-97).(37) As anexpanding economy creates jobs, it also creates demand for importsand for capital from abroad.

Figure 3
The Trade Balance andUnemployment

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There is no reason to believe that eliminating the trade deficitwould create any gain in manufacturing jobs, never mind 3.5million. With the U.S. economy already operating at a low level ofunemployment, it is not clear where 3.5 million new manufacturingworkers would come from. And as we have already seen, a protectivetariff to close the trade deficit would only succeed in reducingexports as well as imports, thus eliminating manufacturing jobs inthe export sector. If Buchanan's calculations had any meaning, weshould expect to see a fall in manufacturing employment duringperiods of rising trade deficits. Recent economic trends tell adifferent story. Since 1993 the U.S. merchandise trade deficit hasgrown from $132 billion to $198 billion.(38) In that same period thenumber of Americans employed in manufacturing has grown from18,075,000 to 18,678,000--an increase of more than 600,000.(39)

If anything, rising trade deficits signal more jobs, notfewer.

Myth: "The Trade Deficit Is a Drag on EconomicGrowth"

The Asian financial crisis is expected to shave a few tenths ofa percentage point off the rate of growth of U.S. GDP in 1998, butto blame slower U.S. growth on an expanded trade deficit is toconfuse cause and effect.

The real drag on U.S. economic growth is falling demand in EastAsia for U.S. exports. At the same time, falling currency values inEast Asia make the region's exports to the United States moreattractive, leading to a larger U.S. trade deficit. A growing tradedeficit is not the cause of slower U.S. growth; instead,slower growth and a bigger trade deficit are both effectsof East Asia's economic slowdown.

In his study, Morici claims that "persistent trade deficitsreduce long-term economic growth by shifting labor and capital fromhigh-R&D to low-R&D activities."(40) That claim is based partlyon the fact that research and development expenditures, and wages,tend to be higher in trade-related (that is, exporting andimport-competing) sectors than in non-trade-related sectors of theeconomy. The proper lesson to be drawn is not that trade deficitsare bad for economic growth but that trade is good for growth. Inother words, the true measure of the effect of trade on the economyis not exports minus imports but exports plusimports.

Far from being a drag, a trade deficit can be a good sign for aneconomy when it reflects growing demand for imports. When aneconomy expands, consumers are able to afford more goods, bothdomestic 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 current accountdeficit has shrunk from the previous year as a percentage of GDP,the average growth rate of the U.S. economy has been 2.0 percent.In the 11 years in which the current account has grown larger as apercent of GDP (i.e. "worsened"), the average growth rate of GDPhas been 3.1 percent.(41) Those who maintain that thetrade deficit is a drag on growth need to explain why our economygrows 50 percent faster in years in which the deficit expands.

Without a trade deficit, Americans would need to financedomestic investment exclusively from domestic savings. To bringinvestment in line with savings, domestic interest rates would needto rise, reducing investment and economic growth. As the Council ofEconomic Advisers recently concluded, the trade deficit has been a"safety valve" for the expanding U.S. economy. "Imports of goodshave kept inflation low, while imports of capital have keptinterest rates low, helping to sustain rapid income growth. In thestrongly expanding full-employment economy that the United Statesnow enjoys, it should be easier for Americans to see that tradedeficits do not necessarily reduce output and employment."(42)

The United States ran trade deficits throughout much of the 19thcentury during a period of dynamic growth and expansion. Fromindependence until the 1880s, America was a net importer of capitalfrom the rest of the world, in particular Great Britain. Foreigninvestors provided the capital to build the railroads and canalsAmerica needed for a continentwide economy. "In the 19th century,especially after the cotton boom of the 1830s, it was the currentaccount that went into the red in order to balance the heavy inflowof funds to finance American enterprise. The United States had moreprofitable investment opportunities than it had domestic savings tofinance them. The British, Germans, Dutch, and French stepped inand made themselves (and our American forebears) richer."(43)

Today Americans run trade deficits with the rest of the worldfor much the same reason: America's relatively free and unregulatedeconomy offers attractive investment opportunities. Attempts toreduce the trade deficit through government intervention wouldreduce our economic efficiency, slowing investment and growth.

Exports Are Good, Imports Are Better

Underlying each of those myths, and much of the misunderstandingabout trade deficits, is the assumption that exports are good andimports are bad. To anyone who accepts that premise, a tradedeficit will by definition be a problem.

Pat Buchanan, during a 1996 campaign stop in Maryland, statedthe case with characteristic bluntness: "This harbor in Baltimoreis one of the biggest and busiest in the nation. There needs to bemore American goods going out. We've got to start exporting moregoods and stop exporting our factories and exporting ourjobs."(44) Even manyadvocates of free trade implicitly agree with Buchanan. In hisstate of the union address in January, President Clinton urgedCongress to pass fast-track trade legislation to "open more newmarkets" for U.S. exports and to "create more new jobs." Imports,in contrast, were painted as a threat. The president warned that,without U.S. aid through the International Monetary Fund, fallingcurrencies in the Far East would mean "the price of their goodswill drop, flooding our market and others with much cheaper goods,which makes it a lot tougher for our people to compete."(45)

By focusing exclusively on the danger of "cheaper goods" and notthe benefits, the president chose to champion the cause of a smallgroup of producers while ignoring the welfare of the large majorityof consumers who will benefit from more affordable imports.

Imports bless Americans in a number of substantial ways. First,imports mean lower prices and wider choice for American consumers.By exerting downward pressure on prices, imports raise the realwages of American workers. Imports create price competition where adomestic monopoly or oligopoly might otherwise exist. They alsospur domestic producers to control costs and raise quality inresponse to foreign competition.

Second, imports of intermediary inputs benefit Americanproducers by keeping final prices down. One reason the U.S.computer industry is so successful and competitive is that it isable to import component parts, such as disk drives and D-RAMchips, at world-market prices. The largest categories of goodsimported to the United States are not consumer goods but capitalgoods and industrial supplies and materials. Together theycomprised more than half of the $803 billion in goods Americansimported in 1996.(46)Restricting imports hurts unprotected producers as well asconsumers.

Third, imports of capital goods make Americans more productive.Higher productivity means a higher standard of living. Withoutimports, Americans would be deprived of the technology and know-howembodied in new, imported machinery.

Exports are not the reason we trade; they are the means by whichwe acquire imports. It is imports, not exports, that allowAmericans to enjoy a higher standard of living. Exports withoutimports are like a job without a paycheck.

Conclusion

Misunderstanding of the trade deficit threatens to undermine thefreedom to trade by encouraging faulty and damaging "solutions" toa problem that does not exist. Any attempt to fix the trade deficitthrough protectionism, export subsidies, or currency manipulationis bound to fail because none of those tools of interventionaddresses the underlying causes of the trade deficit. The tradedeficit will respond only to changes in a nation's net flow offoreign investment, which in turn is determined by its underlyingrates of savings and investment.

America's $114 billion trade deficit in 1997, and the prospectof a larger deficit in 1998, are not a cause for worry. Our tradedeficit reflects the fact that America remains an attractive havenfor international investors. The trade deficit allows Americans tomaintain a level of investment in our future productivity thatwould be impossible if we were required to rely solely on ourcurrent level of domestic savings.

None of the common concerns about the trade deficit holds up toempirical scrutiny. Trade deficits cannot be blamed forunemployment or slower growth, nor are they a sign of unfair tradepractices abroad or declining industrial competitiveness at home.Trade deficits may even signify growing consumer demand andexpanding investment opportunities.

What matters to a nation's economic health is not the differencebetween exports and imports but the degree to which its citizensare free to trade and invest across international borders. Whencitizens are allowed to buy and sell goods, services, andinvestment assets freely in the international marketplace, anation's productive resources will tend to flow to the best andhighest use, raising the nation's overall standard of living.

In the final analysis, nations do not trade with each other;people do. Every international transaction that Americans engage inwill, by definition, leave both parties to the transactionbelieving they are better off than before--otherwise thetransaction would not occur. By this measure, the "balance oftrade" is always positive, benefiting the nation as a whole.


Notes

1. Gordon Platt, "1998 Trade Deficit Predicted to Reach $250 Billion--The Highest Ever," Journal of Commerce, December 4, 1997; and John Maggs, "1997 Trade Deficit Hits 9-Year High," Journal of Commerce, February 20, 1998.

2. Quoted in "Reporters Assume Trade Gap Is Bad News," MediaNomics, (Media Research Center, Alexandria, Va.) February 1998, p. 3.

3. Transcript provided by the Media Research Center, Alexandria, Va.

4. Christina Duff, "U.S. Trade Gap Grew 24% in December: Deficit Could Worsen in '98 As Asia's Ills Spill Over, Some Analysts Warn," Wall Street Journal, February 20, 1998, p. A2.

5. Council of Economic Advisers, Economic Report of the President 1998 (Washington: Government Printing Office, 1998), Table B-103, p. 398.

6. Richard W. Stevenson, "Trade Deficit For 1997 Hit 9-Year High, " New York Times, February 20, 1998, p. C1.

7. I. M. Destler, American Trade Politics (Washington: Institute for International Economics, 1995), pp. 91-95.

8. Ibid., p. 269.

9. Steve Beckman, International Union, United Automobile, Aerospace and Agriculture Implement Workers of America, Statement before the Subcommittee on Trade of the House Committee on Ways and Means, September 11, 1997.

10. Duff.

11. International Monetary Fund, Direction of Trade Statistics Yearbook (Washington: IMF, 1997), p. 453.

12. On March 23, 1998, the U.S. Senate voted to spend $2 million to fund an "Emergency Trade Deficit Review Commission." The commission would study the causes of the U.S. merchandise and current account deficits and recommend policy changes, with special focus on the bilateral deficits with China and Japan. See "Senate Approves Provision Creating Commission on Trade Deficit," Inside U.S. Trade, March 27, 1998, p. 13.

13. David Hume, "Of the Balance of Trade," Essays: Moral, Political and Literary (1777; Indianapolis: Liberty Fund, 1987), p. 309.

14. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776; New York: Random House, 1937), p. 456.

15. Ibid.

16. In the official figures, the balance is not always zero. A government cannot keep track of every single international transaction its citizens engage in, as hard as its customs agents and financial regulators may try. That creates the need for a "Statistical Discrepancy" line in the accounts. In 1996 the statistical discrepancy in the U.S. balance of payments amounted to $46 billion. That may seem like a large amount, but it represents less than 1.5 percent of more than $3.1 trillion in total two-way transactions in 1996. For all practical purposes, the flow of money out of the United States in a given year equals the flow of money in.

17. Douglas A. Irwin, "Three Simple Principles of Trade Policy," American Enterprise Institute, Washington, 1996, p. 19.

18. Council of Economic Advisers, Economic Report of the President 1998, Table B-32, p. 319.

19. Ibid., Table B-24, p. 308.

20. International Monetary Fund, International Financial Statistics Yearbook (Washington: IMF, 1997), p. 142.

21. Economic Strategy Institute, "New ESI Study Finds Causes and Costs of Trade Deficit More Complex Than Traditional Economic Rhetoric," Press release, October 16, 1997.

22. Peter Morici, "The Trade Deficit: Where Does It Come From and What Does It Do?" Economic Strategy Institute, Washington, October 1997, p. 10.

23. William Greider, One World, Ready or Not: The Manic Logic of Global Capitalism (New York: Simon and Schuster, 1997), p. 189.

24. Robert C. Shelburne, "The Macroeconomics of Commercial Policy and the Trade Balance: A Policy Perspective," International Trade Journal 10, no. 1 (Spring 1996): 81.

25. Morici, p. 9.

26. Moving to an investment-based, personally managed retirement system in place of Social Security might be one way to boost private savings.

27. The current account balance in 1991 received an additional boost of about $40 billion in the positive direction because of transfer payments to the U.S. government from its Gulf War allies.

28. Robert T. Parry, "U.S. Trade Deficits and International Competitiveness," Business Economics, January 1994.

29. Council of Economic Advisers, Economic Report of the President 1995 (Washington: Government Printing Office, 1995), p. 236.

30. Cuomo Commission on Competitiveness, America's Agenda: Rebuilding Economic Strength (Armonk, N.Y.: Sharp, 1992), p. 11.

31. Council of Economic Advisers, Economic Report of the President 1998, Table B-51, p. 340.

32. Ibid., Table B-103, p. 398.

33. Ibid., Table B-51, p. 340.

34. Joint Economic Committee of Congress, Economic Indicators, December 1997, p. 35.

35. Ibid.

36. Quoted in Wayne Leighton, "Playing with the Numbers: Why Protectionists Are Wrong about Trade," Issue Analysis, Citizens for a Sound Economy Foundation, Washington, September 18, 1997, p. 1. Buchanan made his remark on CNN on March 3, 1996.

37. See Council of Economic Advisers, Economic Report of the President 1998, Table B-103, for the annual trade deficit figures and Table B-42 for the annual unemployment rates.

38. Ibid., Table 103. The 1998 merchandise trade figure was released February 19, 1998, by the Bureau of Economic Analysis, http://www.census.gov/indicator/www/ustrade.html.

39. Council of Economic Advisers, Economic Report of the President 1998, Table B-46, p. 334.

40. Morici, p. 19.

41. For the current account as a percent of GDP, see International Monetary Fund, International Financial Statistics Yearbook (Washington: IMF, 1997), p. The U.S. current account deficit grew larger as a percent of GDP in 1982 through 1987, in 1992 through 1994, and in 1996, and 1997. It shrank in 1981, in 1988 through 1991, and in 1995. For real GDP growth by year, see Council of Economic Advisers, Economic Report of the President 1998, Table B-4, p. 285.

42. Council of Economic Advisers, Economic Report of the President 1998,p. 249.

43. Mark Thomas, "Who's Afraid of the Big Bad Trade Deficit?" in Second Thoughts: Myths and Morals of U.S. Economic History, ed. D. N. McCloskey (New York: Manhattan Institute, 1993), p. 90.

44. Michael Abramowitz, "Baltimore Port Is Backdrop for Another Buchanan Attack on Trade Policies," Washington Post, March 3, 1996., p. A10.

45. See text of President Clinton's state of the union message, Washington Post, January 28, 1998, p. A24, col. 3.

46. U.S. Department of Commerce, Survey of Current Business 77, no. 12 (December 1997): D-51.

Daniel Griswold

Daniel T. Griswold is associate director of the Cato Institute's Center for Trade Policy Studies.