No aspect of American trade is talked about more and understood less than the trade deficit. It has been cited as conclusive proof of unfair trade barriers abroad and a lack of competitiveness among U.S. industries at home. It has been blamed for destroying jobs and dragging down economic growth. None of these charges are true.
Understanding the Trade Deficit
The most important economic truth to grasp about the U.S. trade deficit is that it has virtually nothing to do with trade policy. A nation’s trade deficit is determined by the flow of investment funds into or out of the country. And those flows are determined by how much the people of a nation save and invest — two variables that are only marginally affected by trade policy.
An understanding of the trade deficit begins with the balance of payments, the broadest accounting of a nation’s international transactions. By definition, the balance of payments always equals zero — that is, what a country buys or gives away in the global market must equal what it sells or receives — because of the exchange nature of trade. People, whether trading across a street or across an ocean, will generally not give up something without receiving something of comparable value in return. The double‐entry nature of international bookkeeping means that, for a nation as a whole, the value of what it gives to the rest of the world will be matched by the value of what it receives.
The balance of payments accounts capture two sides of an equation: the current account and the capital account. The current account side of the ledger covers the flow of goods, services, investment income, and uncompensated transfers such as foreign aid and remittances across borders by private citizens. Within the current account, the trade balance includes goods and services only, and the merchandise trade balance reflects goods only. On the other side, the capital account includes the buying and selling of investment assets such as real estate, stocks, bonds, and government securities.
If a country runs a capital account surplus of $100 billion, it will run a current account deficit of $100 billion to balance its payments. As economist Douglas Irwin explains, “If a country is buying more goods and services from the rest of the world than it is selling, the country must also be selling more assets to the rest of the world than it is buying.”
The necessary balance between the current account and the capital account implies a direct connection between the trade balance on the one hand and the savings and investment balance on the 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 foreign investment. In other words, it must run a capital account deficit. The money sent abroad as investment will return to the country as payments for its exports, which will be in excess of what the country imports, creating a corresponding trade surplus. A nation that invests more than it saves — the United States, for example — must import capital from abroad. In other words, it must run a capital account surplus. The imported capital allows the nation’s citizens to consume more goods and services than they produce, importing the difference through a trade deficit.
The transmission belt that links the capital and current accounts is the exchange rate. As more net investment flows into the United States, demand rises for the dollars needed to buy U.S. assets. As the dollar grows stronger relative to other currencies, U.S. goods and services become more expensive to foreign consumers, reducing demand, while imports become more affordable to Americans. Falling exports and rising imports adjust the trade balance until it matches the net inflow of capital. In effect, foreign investors will outbid foreign consumers for limited U.S. dollars until the investors satisfy their demand for U.S. assets. Of course, most day‐to‐day currency transactions are not directly related to trade, but demand for U.S. goods, services, and assets affects demand for the dollars needed to buy them, thus influencing the value of the dollar in global currency markets.
Germany in the early 1990s offers a case study of how this mechanism works. West Germans routinely ran large current account (and trade) surpluses in the 1980s, but between 1990 and 1991 Germany’s current account flipped from a surplus of 3.2 percent of gross domestic product to a deficit of 1.0 percent. The reason for the reversal was not that German manufacturers suddenly lost their legendary efficiency, or that Germany’s trading partners imposed new and unfair trade barriers on the night of December 31, 1990. What caused the switch was the huge increase in domestic investment needed to rebuild formerly communist eastern Germany. An increase in domestic investment repatriated a huge amount of German savings that had been flowing abroad, thus reducing the amount of German marks in the foreign currency markets and raising their value relative to other currencies. The stronger mark, in turn, raised the price of German exports and lowered the price of imports, evaporating Germany’s trade surplus.
Why Protectionism Cannot Cure the Trade Deficit
The causal link between investment flows, exchange rates, and the balance of trade explains why protectionism cannot cure a trade deficit. In his 1997 book, One World, Ready or Not, Washington journalist William Greider proposes an “emergency tariff” of 10 or 15 percent to reduce the U.S. trade deficit. If Congress were to implement that awful idea, American imports would probably decline as intended. But fewer imports would mean fewer dollars flowing into the international currency markets, raising the value of the dollar relative to other currencies. The stronger dollar would make U.S. exports more expensive for foreign consumers and imports more attractive to Americans. Exports would fall and imports would rise until the trade balance matched the savings and investment balance.
Without a change in aggregate levels of savings and investment, the trade deficit would remain largely unaffected. All the new tariff barriers would accomplish would be to reduce the volume of both imports and exports, leaving Americans poorer by depriving them of additional gains from the specialization that accompanies expanding international trade.
Government export subsidies would be equally ineffective in reducing the trade deficit. Partly in response to the Asian financial crisis, President Clinton proposed in his 1999 federal budget an increase in subsidies to U.S. exporters through the Export‐Import Bank. By allowing certain exporters to lower their prices on sales abroad, the subsidies would stimulate foreign demand, but the greater demand for dollars needed to buy U.S. goods would bid up the dollar’s value in foreign exchange markets. The stronger dollar, in turn, would raise the effective price of U.S. exports generally, offsetting any price advantage gained by the subsidies. Total exports, and hence the trade deficit, would remain unchanged. Subsidies only divert exports from less favored to more favored sectors.
In theory, trade policy can indirectly affect the trade deficit by influencing a nation’s level of savings and investment. For example, a higher tariff would presumably raise government revenue through additional customs duties, thus reducing the budget deficit (or increasing the surplus) and reducing the need to borrow from abroad — resulting in a smaller trade deficit. But a tariff can also stimulate investment in the protected industry, increasing demand for foreign capital and leading to a larger trade deficit. After surveying the various theories, Labor Department economist Robert C. Shelburne concluded, “Trade policy is likely to have a marginal impact on savings or investment and thus only a marginal impact on the trade balance.”
Another temptation is to intervene by intentionally devaluing the national currency in the foreign exchange market. A nation’s central bank can put downward pressure on the value of its own currency by creating an excess amount of that currency and using the excess to purchase foreign currencies. A falling currency can stimulate exports and dampen demand for imports, thus reducing a trade deficit. However, a cheaper currency also means that asset values in that country drop in foreign currency terms, attracting foreign investment flows that increase the capital account (and the corresponding current account deficit). And eventually the weaker currency feeds back into the domestic economy in the form of higher overall prices, that is, inflation. In the long run, higher domestic prices will offset any price advantage gained in the international marketplace by a “competitive devaluation.”
Proven Trade‐Deficit Cutter: A Recession
One way to reduce the trade deficit would be for Americans to save more. A larger pool of national savings would reduce demand for foreign capital; with less foreign capital flowing into the country, the gap between what we buy from abroad and what we sell would shrink.
A related way to cut the trade deficit is for the government to borrow less. Reducing the government deficit (a form of “dissaving”) releases more funds for domestic investment, reducing the demand for foreign capital. That explains the “twin deficits” phenomenon of the 1980s, when huge federal budget deficits claimed a rising share of national savings, requiring the importation of savings from abroad to meet domestic demand for investment. The inflow of foreign capital prompted by the budget deficit allowed Americans to buy even more goods and services than they sold in the international marketplace. As the federal budget deficit declined in the late 1980s, so too did America’s trade deficit.
Another, less appealing way to reduce the trade deficit is to reduce investment. That occurs more or less naturally during times of recession, when business confidence falls and companies cut back on expansion plans. As Americans consume and invest less, demand for imports and foreign capital falls along with the trade deficit. That explains why the smallest U.S. trade deficit since the early 1980s occurred in 1991, in the midst of the most recent recession. In fact, the U.S. current account balance tends to shrink during times of recession and grow during economic expansions. If the trade deficit really is one of our nation’s most pressing problems, the surest and swiftest way to tackle it would be to engineer a deep recession.
That is exactly what happened to Mexico in 1995. In the aftershock of the peso crisis, Mexico’s real GDP shrank in 1995 by 6.2 percent. Because of falling domestic demand, fleeing capital, and a plunging peso, Mexico’s overall trade balance flipped from a deficit in 1994 to a surplus in 1995. Mexico’s bilateral balance with the United States did the same, going from a deficit to a surplus. That supposed “trade debacle” for the United States had nothing to do with NAFTA or any other change in trade policy. It was caused by mismanagement on the part of Mexico’s monetary authorities, and the chief victims of that mismanagement were Mexican workers. Perhaps NAFTA critics who believe our bilateral trade deficit with Mexico is such a terrible development would have preferred that the U.S. economy, not the Mexican economy, contract 6.2 percent in one year. Of course, American workers would have suffered, but it would have done wonders for our bilateral trade balance.
An understanding of the all‐important role of investment flows should liberate trade policy from its obsessive focus on the current account balance. The trade deficit is not a function of trade policy, and therefore trade policy cannot be a tool for reducing the trade deficit.
Enduring Myths about the Trade Deficit
Misunderstanding of the U.S. trade deficit has spawned a number of myths about international trade and America’s place in the global economy. Those myths have allowed trade deficits to be used to further a number of anti‐trade and anti‐market positions, including export subsidies, industrial policy, and sanctions against “unfair” trading partners. The following are among the most common and harmful myths surrounding the trade deficit.
Myth: “Unfair Trade Barriers Cause Trade Deficits”
Many Americans are convinced that a bilateral trade deficit proves that the foreign country’s market is relatively closed to U.S. exports compared with the “open” U.S. market. America’s large bilateral deficit with Japan is almost unanimously seen as a problem by U.S. policymakers who share that view, with blame for the deficits placed squarely on “unfair” foreign trade barriers.
A survey of America’s major trading partners challenges that assumption. Countries with which the United States runs large deficits are not characteristically more protectionist toward U.S. exports than are those with which we run a surplus. Canada and Mexico, two countries that are very open to U.S. exports thanks in part to NAFTA, are both among the five countries with which the United States has the largest bilateral trade deficits. On the other side, America’s third largest bilateral trade surplus is with Brazil, a country whose barriers to imports remain relatively high. Americans face a common external tariff when exporting to members of the European Union, yet some EU members (the Netherlands and Belgium) are among the top surplus trade partners, and others (Germany and Italy) are among the top deficit partners. Trade policy cannot explain those differences.
Blaming bilateral deficits exclusively on differences in trade policy once again misses the reality of investment flows. In Japan, high domestic savings rates provide a pool of capital that far exceeds domestic investment opportunities. Japan “exports” capital to the United States, which allows Americans to import more goods from Japan than we export. The main reason that America’s bilateral trade deficit with Japan exploded in the 1980s is that the Japanese government lifted many of its capital controls with the passage of the Foreign Exchange and Foreign Trade Control Law in December 1980. That allowed a tsunami of Japanese savings to flow across the Pacific to the United States, where it could draw a more favorable rate of return.
Despite the common perception, Japan was actually more open to U.S. exports in the 1980s than in the 1960s and 1970s, when American bilateral trade deficits with Japan were much smaller.
The same cannot be said for our bilateral deficit with China. Despite substantial progress in the last 10 years, its barriers to imports remain relatively high. Those barriers partly explain the bilateral surplus China runs with the United States, but the primary explanation is more benign: We like to consume the products China sells. In 1995 the Council of Economic Advisers concluded, “China’s persistent surplus with the United States in part reflects its specialization in inexpensive mass‐market consumer goods. China similarly runs bilateral surpluses with Japan and Europe for this reason.”
If China were to further open its market, America’s bilateral deficit with China would probably shrink, but our overall trade deficit — determined by aggregate savings and investment — would remain largely unaffected. A rising dollar caused by increased demand for U.S. exports to China would lead to larger bilateral deficits (or smaller surpluses) with other U.S. trading partners. If the United States were to impose higher tariffs aimed at imports from China (say, by revoking its Normal Trade Relations status), that too might reduce the bilateral deficit, but not the overall U.S. trade deficit. Higher tariffs against Chinese imports would merely shift some of the bilateral trade deficit to other countries while raising prices for American consumers.
Myth: “America Is Losing Its Competitiveness”
In 1992 the Cuomo Commission on Competitiveness labeled the trade deficit one of America’s 10 most urgent economic problems. “Because of American industry’s declining competitiveness and our openness to the global economy, the economic demand spurred by the federal budget deficits in the early 1980s precipitated a huge 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 in recent years. Since the Cuomo Commission report, the United States has enjoyed seven consecutive years of healthy, noninflationary growth along with historically large and rising trade deficits. Meanwhile, Japan and Germany, the two export‐driven juggernauts that were supposed to eclipse the United States as economic powers in the 1990s, have struggled with slow growth and rising unemployment.
America’s experience in both the 1980s and the 1990s refutes any connection between trade deficits and a loss of industrial might. Industrial production in the United States has climbed steadily in the past two decades during a time of historically large U.S. trade deficits.
Between 1980 and 1987, when the U.S. current account deficit was rising to a peak of 3.6 percent of GDP, U.S. industrial production rose by 17 percent and total manufacturing output by 23 percent. The same story has repeated itself in the 1990s. Between 1992 and 1997 the annual U.S. trade deficit almost tripled, from $39 billion to $114 billion. Meanwhile, since 1992 total industrial production in the United States has surged by 24 percent and manufacturing production by 27 percent. In Japan during the same period, industrial production has grown by only 8 percent, and in Germany growth has been less than 1 percent. America runs substantial bilateral trade deficits with both countries.
America is the world’s number‐one trading nation in both imports and exports. Between 1992 and 1997, U.S. exports of goods and services surged from $617 billion to $932 billion. The reason the trade deficit has grown is that imports have increased even faster, from $657 billion to $1,046 billion. By any definition, the ability of American industry to compete in the world has not suffered because of a rising trade deficit. The experience of the 1980s and 1990s points in quite the opposite direction.
Myth: “Trade Deficits Mean Lost Jobs”
A study by the Institute for Policy Studies in January 1998 predicts that the larger trade deficit caused by the East Asian financial meltdown will cost the U.S. economy more than 1 million jobs. Columnist Patrick Buchanan, when running unsuccessfully for the Republican presidential nomination in 1996, offered his own, back‐of‐the‐envelope estimate of jobs lost because of the trade gap: “Our merchandise trade deficit was $175 billion (in 1995). For every $1 billion, you get 20,000 jobs. That’s 3.5 million American workers who would have had good manufacturing jobs if we simply had a trade balance.” Both estimates are based on a fundamental misunderstanding of the relationship between trade and aggregate employment in the United States.
The total number of jobs in the United States is largely determined by fundamental macroeconomic factors such as labor‐supply growth and monetary policy. Trade with other nations does not reduce the number of jobs, but it does quicken the pace at which production shifts from one sector to another. Trade, like new technology, lowers demand for some jobs while raising demand for others. Trade allows the United States to produce more Boeing jetliners, pharmaceuticals, software, and financial services for export, but trade also means we produce fewer shoes, T‐shirts, Happy Meal toys, and computer memory chips. Meanwhile, total output and total employment keep growing.
In reality, larger trade deficits correlate positively with falling unemployment. When the trade deficit expands, as it did in the 1980s, unemployment falls. When the deficit shrinks, as it did during the 1990–91 recession, the unemployment rate rises. As the trade deficit has expanded in the 1990s, the unemployment rate has fallen steadily. The unemployment rate fell in all but 2 of the most recent 14 years in which the trade deficit grew larger than it had been the previous year (1976–78, 1982–87, 1992–94, 1996–97). As an expanding economy creates jobs, it also creates demand for imports and for capital from abroad.
There is no reason to believe that eliminating the trade deficit would create any gain in manufacturing jobs, never mind 3.5 million. With the U.S. economy already operating at a low level of unemployment, it is not clear where 3.5 million new manufacturing workers would come from. And as we have already seen, a protective tariff to close the trade deficit would only succeed in reducing exports as well as imports, thus eliminating manufacturing jobs in the export sector. If Buchanan’s calculations had any meaning, we should expect to see a fall in manufacturing employment during periods of rising trade deficits. Recent economic trends tell a different story. Since 1993 the U.S. merchandise trade deficit has grown from $132 billion to $198 billion. In that same period the number of Americans employed in manufacturing has grown from 18,075,000 to 18,678,000 — an increase of more than 600,000.
If anything, rising trade deficits signal more jobs, not fewer.
Myth: “The Trade Deficit Is a Drag on Economic Growth”
The Asian financial crisis is expected to shave a few tenths of a percentage point off the rate of growth of U.S. GDP in 1998, but to blame slower U.S. growth on an expanded trade deficit is to confuse cause and effect. The current drag on our economy is not the widening trade deficit, but plunging demand for our exports in the Pacific Rim of Asia. The growing trade deficit and the emerging signs of our own economic slowdown are two symptoms of the same cause — the economic turmoil across the Pacific.
Far from being a drag, a trade deficit can be a good sign 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 capital and increased demand for imports tends to widen the trade deficit. That explains why every recent U.S. economic expansion has been accompanied by an expanding trade deficit.
Since 1980, in the six years in which the current account deficit 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 a percentage of GDP (i.e., “worsened”), the average growth rate of GDP has been 3.1 percent.41 Those who maintain that the trade deficit is a drag on growth need to explain why our economy grows 50 percent faster in years in which the deficit expands.
Contrary to mercantilist assumptions, a growing trade surplus can be a symptom of economic weakness. In Mexico in 1995 and more recently in South Korea and other East Asian countries, trade balances flipped overnight from deficit to surplus because of plunging domestic demand and the flight of foreign capital. In Japan today, a soaring trade surplus has been accompanied by record high unemployment.
Without a trade deficit, Americans would need to finance domestic investment exclusively from domestic savings. To bring investment in line with savings, domestic interest rates would need to rise, reducing investment and economic growth. As the Council of Economic Advisers recently concluded, the trade deficit has been a “safety valve” for the expanding U.S. economy. “Imports of goods have kept inflation low, while imports of capital have kept interest rates low, helping to sustain rapid income growth. In the strongly expanding full‐employment economy that the United States now enjoys, it should be easier for Americans to see that trade deficits do not necessarily reduce output and employment.”
Misunderstanding of the trade deficit threatens to undermine the freedom to trade by encouraging faulty and damaging “solutions” to a problem that does not exist. Any attempt to fix the trade deficit through protectionism, export subsidies, or currency manipulation is bound to fail because none of those tools of intervention addresses the underlying causes of the trade deficit. The trade deficit will respond only to changes in a nation’s net flow of foreign investment, which in turn is determined by its underlying rates of savings and investment.
If the aim of Congress is to eliminate the trade deficit, then we must either increase national savings or reduce investment. The surest and swiftest way of reducing investment, and thus the demand for foreign capital, would be for the United States to enter a recession. It’s no coincidence that America’s smallest trade deficit in recent years — that is, the last time our country came closest to “restoring the balance” in trade — occurred in 1991, in the middle of our last recession.
When it comes to the U.S. trade deficit, there is no emergency. The current trade deficit is not a sign of economic distress, but of rising domestic demand and investment. Any quick fix by Congress is likely to do far more harm than good. Imposing new trade barriers against imports will only make Americans worse off while leaving the trade deficit virtually unchanged. I would urge Congress to ignore the trade deficit and 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 any questions.