Order Code RL30534
CRS Report for Congress
Received through the CRS Web
America’s Growing Current Account Deficit:
Its Cause and What It Means
for the Economy
Updated April 19, 2001
Marc Labonte
Economist
Government and Finance Division
Gail E. Makinen
Specialist in Economic Policy
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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America’s Growing Current Account Deficit: Its Cause
and What It Means for the Economy
Summary
The U.S. current account deficit, popularly known as the trade deficit, is on
the rise.1 Over the current economic expansion it has grown from 0.2% of GDP in
1991 to a record high of 4.4% of GDP in 2000, which exceeded the previous high of
2.8% reached in 1986. This growth was particularly rapid over the period 1998-
2000. During 1997, the trade deficit was a modest 1.4% of GDP.
Four major reasons have been given for the growth of the deficit: the inflow of
foreign capital motivated by either profit or safety, the dumping of foreign goods in
the American market, recessions or slower growth in the economies of major U.S.
trading partners, and barriers imposed against U.S. goods and services by foreign
countries. A compelling case can be made that the dominant cause of the deficit and
its growth is the inflow of foreign capital. The movement in the foreign exchange
value of the dollar is incompatible with the other given or suggested causes.
The inflow of foreign capital (and the related trade deficit) has a number of
discernable effects on the U.S. economy. First, as a component of aggregate demand,
a growing trade deficit reduces the growth of domestic demand as American spending
is diverted from domestic goods to foreign substitutes. Second, because it represents
foreign saving coming to the United States, it reduces American interest rates and
encourages the growth of interest-sensitive domestic spending by businesses on such
things as plant and equipment and by households on housing, automobiles, and
appliances. On balance, however, the net effect on spending is negative. There is a
third and indirect effect which must also be considered. Lower interest rates in the
U.S. encourages higher equity or stock market prices. Since equities are a major part
of the financial wealth of households, higher equity prices are thought to be an
important determinant of consumer spending and, thus, a positive influence on
aggregate demand. In fact, this may play a large role in the current economic
expansion. Fourth, the inflow of foreign capital enables the United States to put in
place a larger capital stock than would otherwise be the case. Finally, while the
expansions of the 1980s and 1990s have demonstrated that a large trade deficit is no
barrier to the attainment of full employment, they do affect the type of jobs that are
created in the United States.
Over the longer run, a growing foreign ownership of the American capital stock
means that a growing fraction of U.S. income growth will have to be transferred
abroad. And this is increasingly evident in U.S. data. Over the period 1979-1984,
U.S. net earnings abroad averaged $33.4 billion per year. In 2000, the U.S. paid net
to foreigners about $8 billion for a shift of about $41 billion.
1 For purposes of this report, the current account deficit is measured by the excess of imports
over exports in 1996 dollars as reported in the National Income and Product Accounts. In the
text, it will be referred to as the trade deficit.

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Contents
The Growing Trade Deficit and Its Importance to Congress . . . . . . . . . . . . . . . . 1
What Has Caused the Growth in the Trade Deficit? . . . . . . . . . . . . . . . . . . . . . . 1
A. The Movement of Capital to the United States . . . . . . . . . . . . . . . . . . . 1
B. Foreign Goods Are Dumped in the American Market . . . . . . . . . . . . . . 2
C. Recessions or Slow Growth Abroad Are Reducing U.S. Exports . . . . . . 2
D. Trade Barriers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Some Additional Thoughts on the Nature of Capital Movements . . . . . . . . . . . . 4
How Does the Purchase of U.S. Assets by Foreigners Affect the Economy? . . . 5
1. Aggregate Demand or Spending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2. The U.S. Capital Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
3. The Nature of Job Creation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
The Trade Deficits of the 1980s and 1990s: Are They Different? . . . . . . . . . . . . 7
Can the U.S. Continue to Run Such Large Trade Deficits? . . . . . . . . . . . . . . . . . 7
Policy Options for Eliminating the Trade Deficit . . . . . . . . . . . . . . . . . . . . . . . 10
Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
List of Figures
Figure 1. Real Dollar Exchange Rate, 1987-2001
(Market Basket of 26 Currencies) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

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America’s Growing Current Account Deficit:
Its Cause and What It Means for the
Economy
The Growing Trade Deficit
and Its Importance to Congress
A noticeable phenomenon of the 1980s was the growth in the U.S. trade deficit
to record proportions. From a slight surplus in 1981, the trade deficit grew to a
record 2.8% of GDP in 1986. The trade deficit then declined to a low of about 0.2%
of GDP in 1991. It then began to rise, reaching a record high of 4.4% of GDP in
2000. The growth of the deficit was especially rapid over 1998-2000. During 1998,
the deficit was 2.6% of GDP while in 1997 it was only 1.4% of GDP.2
What Has Caused the Growth in the Trade Deficit?
Four major explanations have been offered for the growth in the deficit.
Foreigners’ desire to invest in the United States, the dumping of foreign goods in the
American market, the recession or slow growth in the economies of Asia and the
major trading partners of the United States, and barriers imposed on U.S. goods and
services by foreign countries. While several of these explanations will be shown to
have some possible validity, the capital inflow explanation is the only one consistent
with the movement in the foreign exchange value of the dollar. This explanation for
the growing trade deficit would receive support from most economists.
A. The Movement of Capital to the United States
The key to understanding this explanation for growth in the trade deficit is to
realize that capital comes to a country not in the form of money, but in the form of a
trade deficit. With that in mind, assume that many foreigners, fearful of the security
of their wealth, want to convert it into U.S. assets (or, alternatively, they want to buy
higher-yielding U.S. assets). To do so, they must first buy American dollars. This
will increase the net demand for dollars in the foreign exchange market and, all else
held constant, the dollar should rise in response (or appreciate). The appreciation of
the dollar should raise the price in foreign countries of American goods and services
and reduce the price of foreign goods and services in the United States. As a result,
2 In all of the computations above, exports, imports, the difference between the two, and GDP
are measured in 1996 dollars.

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CRS-2
the total value of American exports should fall and the total value of imports into the
United States should rise.3 The net result should be a rise in the U.S. trade deficit.
In this explanation, the growing trade deficit goes hand-in-hand with an appreciating
dollar.
B. Foreign Goods Are Dumped in the American Market
This explanation implies that foreigners, for whatever reason, offer their goods
at cut rate prices. As a result, Americans switch from buying domestic substitutes to
the now cheaper foreign goods. This shift in domestic demand to imports should
increase the net supply of dollars in the foreign exchange market and, as a result, the
dollar should fall in price or depreciate.4 The net result should be a growing trade
deficit that goes hand-in-hand with a depreciating dollar.
C. Recessions or Slow Growth Abroad Are Reducing U.S.
Exports
Clearly, the economies of a number of Asian countries including Japan as well
as those of the other major trading partners of the U.S. have not matched our high
growth rates. When countries are in recession with falling incomes or their income
growth is slow, their ability to buy goods is reduced (or slowed relative to American
ability to buy their goods). Since some of these goods are made in America, it might
be expected that U.S. exports will be adversely affected. However, this explanation
requires that the growing American trade deficit be linked to a depreciating dollar.
For if foreigners reduce their purchase of American goods and services they will also
reduce their demand for dollars in foreign exchange markets. The reduced demand
for dollars should, all else held constant, cause the price of the dollar to fall; the dollar
should depreciate.5
D. Trade Barriers
On March 31, 2000, the Office of the U.S. Trade Representative issued a 434
page report, that, among other things, detailed various practices foreign governments
use to discriminate against American goods and services of an exportable nature. An
3 This need not be an absolute fall in the value of exports and rise in the value of imports. The
analysis is consistent with a fall in the growth rate of exports and a rise in the growth rate of
imports.
4 Note that the fact that foreign goods are offered at a lower price in the United States is not
dispositive of a conclusion of dumping. The fall in the dollar price of foreign goods is a part
of the adjustment mechanism in A above by which foreign capital comes to the U.S.
5 Explanations B and C cannot, technically speaking, produce a current account or trade
deficit. If there were no capital movements, the exchange rate would depreciate by a sufficient
amount to eliminate the deficit. Thus, the existence and persistence of a current account
deficit is itself evidence that a net capital inflow to the U.S. has occurred.

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CRS-3
important implication of this document is that if these practices did not exist, U.S.
exports would be larger and the trade deficit would be smaller.
While there is no doubt that U.S. exporters face trade barriers imposed by
foreign governments, there is substantial doubt that these barriers are either
responsible for the trade deficit itself or for the growth in the deficit over the 1990s.
The reason for this conclusion is straightforward. Suppose that trade between the
United States and the rest of the world is balanced: the dollar value of U.S. exports
is equal to the dollar value of U.S. imports. Suppose now that the rest of the world
imposes barriers on U.S. exports (a tariff) such that export revenues fall. As exports
fall in value, in the face of an unchanged value of imports, a trade deficit will emerge.
Individuals who argue in this way are holding constant a vital price: the exchange
value of the dollar. And it is because they do that they draw an incorrect conclusion.
With the decline in foreign spending on American goods comes a decline in the
demand for dollars in the foreign exchange market. As a result, the dollar will fall in
value or depreciate. And depreciation will restore equilibrium to the trade balance.
It will do this in two ways. First, by lowering the price of U.S. goods abroad, it will
encourage some additional spending by foreigners on those goods. Second, by
increasing the price of foreign goods in the United States, Americans will be induced
to spend less on imports. And it is primarily through a reduced spending on imports
that balance will be restored to the trade accounts.6
The net effect of the imposition of trade barriers is not a trade deficit, but
reduced spending by Americans and foreigners on each others goods and services or
on the level of spending on imports and exports.7
If the trade barriers explanation has any relevance to recent U.S. trade statistics,
it implies that dollar depreciation should go hand-in-hand with a reduced level of
trade, not a trade deficit. The data do not agree with this interpretation.
Thus, the behavior of the foreign exchange value of the dollar is an important
piece of evidence in resolving the controversy over the growth in the trade deficit.
The data in figure 1 show than since mid-1995 the dollar has been appreciating. This
is consistent with the “movement of capital to the U.S.” explanation and implies that
the rise in net capital imports is the dominant explanation for the growing trade
deficit. It does not preclude the other explanations from having had some effect on
U.S. foreign trade. The movement in the exchange rate seems to preclude them from
having had a dominant effect.
6 To the extent that there are lags and market imperfections, there may be temporary
imbalances, but in time this adjustment will take place.
7 Interestingly, the effectiveness of trade barriers can be increased without the need for
legislative action. Tariffs, for example, are often “specific” in nature, such as 10 cents per
ounce or $5 dollars per ton, etc. Should prices fall, the real level of protection offered by
specific tariffs will increase as the world discovered during the Great Depression of 1929-33.
This is not true for tariffs that are expressed as a percent of value or that are “ad valorem”
in nature.

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Figure 1. Real Dollar Exchange Rate, 1987-2001
(Market Basket of 26 Currencies)
110
105
100
95
90
85
801987

1988

1989

1990

1991

1992 1993
1994 1995 1996
1997 1998
1999 2000 2001
Years
Source: Board of Governors of the Federal Reserve System
Some Additional Thoughts on the Nature of Capital
Movements
It is argued that capital movements do not drive the trade balance, as the above
analysis suggests. Those holding this view argue that cause and effect are the other
way around: the trade balance drives capital movements. And, this fact renders the
above analysis incorrect. What is the nature of this argument and is it relevant to
recent American experience?
The type of capital movement noted in the previous section is referred to in the
literature as an autonomous capital movement or one motivated by fear or a desire to
earn a higher rate of return abroad. As such, they are associated with movements in
the exchange rate of the type presented above. When a country is a net recipient of
an autonomous capital inflow, it’s currency appreciates in value and the net inflow of
capital is represented by a trade deficit.
There is, however, another type of capital movement. It is often referred to in
the literature as an induced capital movement because it is induced by prior
movements in exports and imports. Suppose, for example, that the U.S. grew more
rapidly than its trading partners and thus spent more on imports than the partners
spent on American exports.8 Under normal circumstances this would lead to a
depreciation of the dollar and a closing of the trade imbalance as discussed earlier.
8 Even more to the point, this imbalance could be caused by the imposition of trade barriers
on American goods and services by foreigners.

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This need not be the case. If all of these goods and services were paid for by checks,
foreign banks would acquire a net claim on U.S. banks represented by the trade
deficit. These balances are a capital flow in the same sense as if foreigners had
purchased U.S. bonds or equities. They are, however, an induced capital inflow.
This inflow would not have occurred without the prior trade imbalance in goods and
services.
Is the growing inflow of capital to the United States dominated by an induced
inflow? The answer is likely to be a resounding no. The net inflow is dominated by
autonomous inflows. The reason being that an induced capital inflow should have
very little effect on the exchange rate – it is, in effect, exchange rate neutral. As the
above analysis makes clear, an induced capital inflow prevents the exchange rate from
depreciating to restore equilibrium between the value of exports and imports. Thus,
if induced flows dominate the net inflow, one would expect the growth in the trade
deficit to go hand-in-hand with little movement in the exchange rate. And, from
figure 1, it can be seen that this is not the case. The growth in the trade deficit has
been associated with an overall appreciation in the value of the dollar. And this is the
movement suggested by a net inflow dominated by autonomous capital movements.
This is not to say that induced inflows do not play some role in the overall net inflow
of capital. It is to say that the role is likely to be minor.
How Does the Purchase of U.S. Assets by
Foreigners Affect the Economy?
When foreigners want to hold a larger value of American assets, the resulting
trade deficit (or growth in the trade deficit) has four discernable effects on an
economy:
1. Aggregate Demand or Spending
The direct effect of a trade deficit (or the growth of a trade deficit) is to reduce
aggregate demand (or the growth in demand) for American goods and services. This
is because spending on imports represents a demand by Americans for foreign output.
Since a trade deficit means that that demand is not offset by foreign spending on
American output (U.S. exports), on balance, the net demand for American output
must be lower than it would be without the deficit. Thus, the direct effect of a trade
deficit is a lower level of demand for U.S. output. And, a growing trade deficit
reduces the growth in aggregate demand in the United States.
However, a trade deficit has several indirect effects that tend to expand spending
for American goods and services. First, since the trade deficit is the way foreign
capital or saving comes to the United States, it reduces American interest rates from
what they otherwise would be. And lower interest rates stimulate interest-sensitive
spending by American businesses and households. This includes spending on such
durable goods as plant and equipment, housing, automobiles, and appliances. Second,
lower interest rates tend to increase the prices of equities and this augments the
financial wealth of households. Feeling wealthier, households are supposedly induced

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to save less and spend a higher proportion of their disposable income. It has been
argued that such consumer spending has played an important role in the continuation
of the current economic expansion. Overall, the general consensus is that a trade
deficit, on balance is contractionary. Thus, the overall effect of a growing trade
deficit is to slow the growth of aggregate spending in the United States.9
2. The U.S. Capital Stock
An important attribute of a growing economy is a growing net per capita capital
stock. How much that stock can grow is basically determined by the net saving rate
of a country or how much of its gross saving is left after being used to replace the
capital that is depreciated or used up in the process of producing output. The net
national saving rate of the United States has been falling over the post-World War II
period and is now low — averaging about 6% of GDP over the last 4 years (versus
about 11% during the decade of the 1960s and nearly 9% over the decade of the
1970s). With a trade deficit during the 1990s that averaged nearly 2% of GDP, the
U.S. is able to add to its net capital stock at a much faster rate than without this net
inflow of foreign capital. Of course, a portion of the net capital stock is now foreign
owned and the rewards to that capital will accrue to foreigners. This will require that
a rising portion of U.S. output be transferred abroad.10 And, in fact, this is occurring.
Before the large trade deficits that began in the mid-1980s, the U.S. received a net
income from its foreign capital holdings that averaged about $33.4 billion during the
peak years 1979-1984. By 2000, the U.S. paid net to foreigners about $8 billion a
year. This is a net shift of about $41 billion a year.
3. The Nature of Job Creation
From the discussion above it can be seen that a growing net inflow of capital
usually implies a rise in the amount spent on imports and a fall (either absolute or
relative) in the amount spent on exports. This translates into a decline in jobs that are
or would be created in the import competing and export sectors of the economy. This
is offset to a degree by jobs that are preserved or created in the interest sensitive
sectors of the economy. This change in the employment mix should be distinguished
from the total employment in the economy. During both the long expansion of the
1980s and the 1990s, the U.S. managed to achieve full employment, if not overfull
employment.11 Thus, the large and, at times, growing trade deficits of those two
decades have not been a barrier to achieving full employment in the United States.
9 While a trade deficit can produce a slowing in the growth rate of aggregate demand, it is
doubtful if it could produce an actual contraction in aggregate demand in the United States.
10 However, some of the rewards of foreign investment will accrue to American workers,
enabling them to enjoy a higher standard of living than they otherwise would.
11 Macro economists define full employment relative to a stable rate of inflation. Thus, the
full employment rate of unemployment is the unemployment rate compatible with a stable rate
of inflation. Empirical estimation including data for the 1990s places that rate in a 5% to 6%
range. Estimates using data through the 1980s would produce a similar range.

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The Trade Deficits of the 1980s and 1990s: Are They
Different?
The growth in the trade deficit during the 1980s closely paralleled the growth in
the federal budget deficit giving rise to the so-called "twin deficit" theory. This is not
the case in the 1990s. In fact, the opposite has occurred. As the federal budget has
moved from deficit into surplus, the trade deficit has grown absolutely and as a
fraction of GDP. What does this mean? It basically means that trade deficits can have
several causes. In the 1980s, the prevailing view was that the growth in the federal
budget deficit put upward pressure on U.S. interest rates. Other things constant
abroad, this led foreigners to desire to buy American assets and, in the process of
doing so, the dollar appreciated and the resulting trade deficit represented the net
inflow of capital to the United States.
The 1990s present a more complicated picture. The rise in the productivity of
U.S. capital, not widely experienced abroad, is believed to have raised desired
investment in the United States. Since domestic saving was insufficient to
accommodate domestic investment, foreign capital was drawn in to the country.
Additionally, financial turmoil in Asia and Russia caused foreign saving to flee to the
safety of the United States, making higher domestic investment possible. Through the
same process the dollar appreciated and the trade deficit grew to reflect the enlarged
net inflow of capital to the United States.
In both cases, the growth in the trade deficit resulted from a desire to purchase
American assets. In that sense, the proximate cause of the trade deficit is the same.
The motivation for doing so, or the ultimate cause, however, may have been different:
in the 1980s it was higher yields that resulted from American fiscal decisions while in
the 1990s it was a desire to participate in the enhanced productivity of the American
economy and because of the safety of U.S. assets.12
Can the U.S. Continue to Run Such Large Trade
Deficits?
Since the trade deficit arises primarily because foreigners desire to purchase
American assets, there is no economic reason why it cannot continue indefinitely. The
consequence is a growing foreign ownership of the capital stock of the United States
and a rising fraction of U.S. income that must be diverted overseas in the form of
interest and dividends to foreigners.
A trade deficit is sustainable as long as the capital lent to the U.S. generates
enough growth to service the borrowing costs the loan generates in the future.
12 For a more extensive discussion of this subject, see U.S. Library of Congress.
Congressional Research Service. Why the Budget Deficit and the Trade Deficit Haven’t
Been Moving Together. CRS Report 97-985E by Gail Makinen.

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Borrowing can be used in two ways – for investment or for consumption. In fact,
there was a private investment spending boom in the late 1990s at the same time the
trade deficit was growing. If markets work efficiently and individuals are rational,
then one would expect that investment would yield high enough returns overall to
service these debts in the future. Alternatively, a few economists fear that much
investment was driven by an unsustainable, speculative “asset bubble” in the late
1990s. For example, they believe that the stock market reached valuations that could
not be justified by realistic predictions of future profits. If this were the case, future
debt service could be difficult.
Unfortunately, if the trade deficit is primarily used for consumption, servicing
excessive borrowing for consumption is unlikely to be as sustainable in the future.
This was one reason that the 1980s trade deficit was a cause for concern among
economists – it was strongly influenced by the budget deficit, and most government
spending is dedicated to consumption not investment. Since the budget is now in
surplus, one cause for concern has been eliminated. But the behavior of households
today offers another cause of concern to some economists. The household saving rate
has been declining throughout the decade. In 2000 it became negative – overall,
households were net borrowers. Although the (negative) household saving rate is
much smaller than the trade deficit, to the extent that foreign capital enables this
borrowing to occur, it may make the trade deficit unsustainable.
It is difficult to disentangle from the data useful information on whether most
foreign capital is being directed towards consumption or investment. It is impossible
to predict what proportion of investment will be profitable and what proportion is
being driven by a bubble because admitting the existence of a bubble requires the
relaxation of the assumptions that markets work efficiently and investors are rational.
Without these assumptions, any empirical measurement becomes impossible. In fact,
these assumptions are so canonical to mainstream finance theory that the theory is
largely unwilling to admit the possible existence of a bubble. Thus, accurate and
meaningful analysis of the sustainability of the trade deficit on these grounds is
impossible.
Some economists have tried to calculate rough rule-of-thumb estimates of the
sustainability of trade deficits. Two leading international economists used the debt
owed to foreigners as a percentage of GDP as such a rule-of-thumb estimate. They
found that in 1999 this measure was about 20% of GDP, the highest it has been in
U.S. history since the 19th century.13 Were trade deficits to continue at over 4% a
year, this measure would reach 90% of GDP in a few decades. Although the yearly
debt burden that this implies is relatively small, many countries that have experienced
financial crises in the post-war period had debt to smaller GDP ratios, between 20-
80% of GDP. They take this to be an indication that the U.S. trade deficit is
unsustainable at this size.14
13 By contrast, total financial capital was 425% of GDP in 1999.
14 Maurice Obstfeld and Kenneth Rogoff, Perspectives on OECD Economic Integration:
Implications for U.S. Current Account Adjustment, working paper presented at Federal
Reserve Bank of Kansas City Jackson Hole Symposium, August 2000, p. 24.

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Some economists fear that a large trade deficit is symptomatic of wider
economic imbalance. They see it as a leading indicator for future inflation because it
is a proxy for either consumption outpacing production or an investment bubble. In
developing countries, it has often been a leading indicator of financial and/or currency
crisis, although the applicability of this comparison with the U.S. may be limited,
especially since the U.S. has a flexible exchange rate regime. They would see a
tightening of monetary policy as the appropriate response to an excessively large trade
deficit – not because the trade deficit itself is detrimental but to prevent future
inflation from occurring. But in the late 1990s, few other leading indicators warned
of mounting inflationary pressures.
It should be re-emphasized that economic theory does not suggest that a slow
decline in the trade deficit would be troublesome for the overall economy. In fact, it
would be expected to have an expansionary effect on the economy, since the increase
in net exports would have a more stimulative effect on aggregate demand in the short
run than the decrease in investment and interest-sensitive spending. Historical
experience seems to bear this out – the trade deficit declined continually in the late
1980s from 2.8% of GDP in 1986 to near zero in 1990. Yet economic growth was
strong throughout the late 1980s.
A possibly serious short run problem could emerge if foreigners suddenly
decided to reduce the fraction of their saving they send us in the form of a capital
inflow or if they suddenly decided to repatriate part of their liquid capital. The initial
effect could be both a sudden and large depreciation in the value of the dollar as the
supply of dollars on the foreign exchange market would increase and a sudden and
large increase in U.S. interest rates as an important source of saving was withdrawn
from the financial markets. It is doubtful that the direct effects of these shifts in
lending patterns by foreigners could cause a recession. This is because the desire of
foreigners to hold fewer dollar assets would lead via dollar depreciation to a trade
surplus (or smaller deficit). And the move from trade deficit toward trade surplus is
a move that expands aggregate demand. However, the indirect effects, which
typically offset the direct effects only partially, could cause a recession if the change
is sudden.15 Large increases in interest rates could cause problems for the U.S.
economy as they reduce the market value of debt securities, cause prices on the stock
market to fall, and raise questions about the solvency of various debtors. Resources
may not be able to shift quickly enough from interest-sensitive sectors to export
sectors to make this transition fluid.
But is this a scenario that is probable enough that measures should be taken to
avoid it? It is easy to imagine that a recession could cause the current account deficit
and dollar to collapse. It is much harder to imagine a collapsing dollar and current
account deficit causing a recession. It can be done only by making several unlikely
15 The principal indirect effect would be on consumption expenditures. The rise in the fraction
of household disposable income devoted to consumption is thought to be due, in part, to the
rise in the equity wealth of households. A sharp rise in U.S. interest rates could cause a sharp
fall in equities values on stock markets decreasing household wealth and, consequently,
consumption spending.

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assumptions. Adding these assumptions together, it seems safe to say that this threat
is small.
The first assumption that must be made is that foreigners suddenly stop investing
in U.S. assets. This seems highly improbable in the absence of a recession. Foreign
investment opportunities may become relatively more attractive than opportunities in
the U.S. over time, but under normal circumstances that would imply a slow dollar
depreciation which, for the reasons outlined above, could not be economically
disruptive. A sudden drop in U.S. investment, on the other hand, implies a panic that,
although possible, seems hard to imagine. For many years, the United States has been
considered a “safe haven” for investment. This was most starkly illustrated in 1998,
when international financial panic caused investment to temporarily flow out of
developing countries and into the United States. For foreigners to suddenly stop
investing in the U.S., the exact opposite would need to occur: foreigners would
suddenly become afraid to hold U.S. assets and seek out some other country’s assets
instead. But for what country would foreign investors suddenly spurn the United
States when the United States has the broadest, deepest, and most transparent
financial markets in the world?
The second assumption relies on the economic effects of the currency change
working in the opposite way that they usually do. Typically, when a currency
depreciates it has a positive effect on the growth of aggregate demand because the
positive stimulus to export growth exceeds the negative stimulus to investment
spending. For a depreciating currency to have the opposite effect, the negative effect
on investment spending must exceed the positive effect on export growth. If the
depreciation is large enough, this is possible: investors may be able to react to the
change more quickly than exporters. But if this were the case, the effect by definition
would be short lived.
The third assumption is that monetary or fiscal policy either would not be used
to counteract the decline in investment spending or would prove ineffective. It is
unlikely that the decline would be so large that lower interest rates, say, could not
reverse its effect on aggregate spending. It is possible that policymakers would
choose to allow for the decline, but only if they were more concerned with the value
of the dollar than the state of the economy. Lower interest rates would probably
exacerbate the dollar’s slide and policymakers may find this undesirable. However,
in recent history it can be argued that policymakers have tended to show much greater
concern for domestic economic stabilization than for currency stabilization.
The fact that three unlikely events would need to come to pass for a sudden
currency depreciation to cause a recession implies that little weight should be given
to the argument that the current account deficit could cause a recession.
Policy Options for Eliminating the Trade Deficit
If the U.S. government were to adopt a policy to reduce or eliminate the trade
deficit, what policy tools could it use? The discussion above implies that barriers to
trade would not affect the trade deficit – a reduction in imports caused by barriers
would be replaced by an increase in net imports caused by dollar appreciation. Even

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if stronger economic growth abroad could reduce the trade deficit – and the analysis
above suggests that it may not – it is doubtful that U.S. policy can do much to boost
growth abroad.16
The discussion above implies that the current trade deficit is primarily a result of
the fact that there are more attractive investment opportunities in the U.S. than can
be accommodated by domestic saving alone. To reduce the trade deficit, one must
reduce this imbalance. Obviously, a policy to reduce profitable investment
opportunities in the U.S. would be counter-productive. Instead, a policy to reduce
the trade deficit must aim to increase the domestic saving rate. The government may
be able to do so by making saving more profitable and increasing the incentives to
save. The government can make saving more profitable by lowering the taxes on
saving. It can increase the incentives to save through the creation and extension of
tax-favored savings accounts. The empirical evidence about the effectiveness of
lower taxes and government saving incentives as policies to increase saving is mixed,
however.17 Nevertheless, there is a more direct way for the government to increase
the national saving rate – it can pursue a policy of increased budget surpluses.
National saving is determined by households, corporations, and the government.
When the government runs a surplus, economic theory holds that it results in more
domestic saving being available for private investment.18
Conclusions
The U.S. trade deficit is made possible by the net purchase of U.S. assets
(stocks, bonds, real estate, etc.) by foreigners.19 This deficit includes the traditional
types of imported goods familiar to American consumers (cars, stereos, cameras,
etc.). Because the trade deficit is a component of aggregate domestic demand and
sudden fluctuations in the deficit can cause sudden changes in income growth and
employment, Congress has been concerned about its growth, especially the sharp
increase during 1997-2000.
An increased desire by foreigners to purchase American assets can affect the
economy in several ways. First, it directly reduces the growth in aggregate demand
since the difference between the value of exports and imports is a component of
demand. This is offset in part by the lower interest rates made possible by the capital
16 See U.S. Library of Congress, Congressional Research Service, Does the U.S. Serve as the
World Economy’s Engine of Growth? by Marc Labonte and Gail Makinen, CRS report
RL30846.
17 For example, see the symposia “Government Incentives for Saving” in the Journal of
Economic Perspectives, v. 10, n. 4, Fall 1996 and “Tax Policy: A Further Look at Supply
Side Effects,” American Economic Review, v. 74, n. 2, May 1984.
18 For more information, see U.S. Library of Congress, Congressional Research Service, What
if the National Debt Were Eliminated? Some Economic Consequences, by Marc Labonte,
CRS report RL30614.
19 This does not preclude the dumping of foreign goods in the American market and recessions
abroad from playing a role. Trade barriers could possibly play a role provided that they
induce capital movements, which is highly unlikely given the size of the trade deficit.

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inflow. As a consequence, it would be difficult for a growing trade deficit to actually
cause aggregate demand to contract in the United States. Second, the inflow of
capital makes possible a larger addition to the net national capital stock than would
be possible from net domestic saving alone. Third, it can affect the composition of
jobs that are created. Moreover, history has shown that the trade deficit is no barrier
to achieving full employment.
Any sudden shifts in foreign preferences for American assets can cause
potentially large changes in the exchange rate and domestic interest rates, both of
which can be disruptive to the orderly growth of output and employment in the United
States.

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