Order Code RL30534
Report for Congress
Received through the CRS Web
America’s Growing Current Account Deficit:
Its Cause and What It Means
for the Economy
Updated December 27, 2002
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
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 economic expansion of 1991-2001, it grew from 0.2% of GDP
in 1991 to a record high of 4.3% 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. Curiously, the
deficit continued to rise during 2001- 2002, a period of economic contraction and
recovery.
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, based in part on movements in the
foreign exchange value of the dollar, that the dominant cause of the deficit and its
growth is the inflow of foreign capital.
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 the net effect on spending is negative. A
third and indirect effect is that lower interest rates in the U.S. encourage higher asset
prices, such as stock market prices. Higher asset prices are thought to be an
important determinant of consumer spending and, thus, a positive influence on
aggregate demand. 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 large trade deficits are
no barrier to the attaining 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 2002, the U.S. paid net
to foreigners more than $4 billion for a net shift of nearly $37 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.
Contents
The Growing Trade Deficit and Its Importance to Congress . . . . . . . . . . . . . . . . . 1
What Has Caused the Growth in the Trade Deficit? . . . . . . . . . . . . . . . . . . . . . . . 2
A. The Movement of Capital to the United States . . . . . . . . . . . . . . . . . . . . . 2
B. Foreign Goods Are Dumped in the American Market . . . . . . . . . . . . . . . 2
C. Recessions or Slow Growth Abroad Are Reducing U.S. Exports . . . . . . . 3
D. Trade Barriers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Some Additional Thoughts on the Nature of Capital Movements . . . . . . . . . . . . . 5
How Does the Purchase of U.S. Assets by Foreigners Affect the Economy? . . . . 6
1. Aggregate Demand or Spending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2. The U.S. Capital Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
3. The Nature of Job Creation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
The Trade Deficits of the 1980s, 1990s, and the 2000s: Are They Different? . . . 8
Can the U.S. Continue to Run Such Large Trade Deficits? . . . . . . . . . . . . . . . . . . 9
Policy Options for Eliminating the Trade Deficit . . . . . . . . . . . . . . . . . . . . . . . . 11
Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
List of Figures
Figure 1: Trade Deficit, 1991-2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Figure 2. Real Dollar Exchange Rate, 1987-2002 . . . . . . . . . . . . . . . . . . . . . . . . . 5
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 4.3% of GDP in
2000, the last full year of the 1991-2001 expansion. 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. The advent of the recession in 2001 and the
Figure 1: Trade Deficit, 1991-2002
(as a % of GDP)
6
5
4
P
3
f GD
% o 2
1
0 199119921993199419951996199719981999200020012002
Year
Trade Deficit
Source: Bureau of Economic Analysis
Note: Observation for 2002 is the average for the first three quarters.
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recovery of 2002 did not produce a decline in the trade deficit. Rather it continued
to rise, reaching 5.0% of GDP during the first three quarters of 2002, for which data
are now available.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 foreigners decide to convert some
portion of their wealth into 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 (or appreciate) in response. 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, 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
2 In all of the computations above, exports, imports, the difference between the two, and
GDP are measured in 1996 dollars. All the trade data are taken from the National Income
and Product Accounts.
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.
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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. including the Euro area did
not match the high growth rates enjoyed by the United States in the 1995-2000
period. 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.
The document implies 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 earnings fall. As export
earnings fall in value, in the face of an unchanged value of imports, a trade deficit
will emerge.
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 persistent 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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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.
Summary
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 2. Real Dollar Exchange Rate, 1987-2002
115
110
105
100
95
90
85
801987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Years
Source: Board of Governors of the Federal Reserve System
Some Additional Thoughts on the Nature of Capital
Movements
Although for balance of payments accounting purposes, trade deficits must be
offset by capital movements, not all economists concede that capital movements
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 such factors as
a desire to earn a higher rate of return abroad or a fear of capital loss if it is retained
at home. 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
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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.
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 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
growing trade deficit is a reduction in 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
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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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 assets, including equities,
and this augments the financial wealth of households. Feeling wealthier, households
are supposedly induced 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. However, the contractionary
effect of the growing trade deficit was offset by increases in domestic demand, and
did not prevent the economy from achieving an average growth rate of 4.2% over the
period 1997-2000, when the deficit was growing most rapidly.
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. was 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.9 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. During 2002, the U.S. paid net to foreigners more than $4 billion
a year. This is a net shift of more than $37 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.
9 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.
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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.10 The unemployment rate fell to a three decade low in 2000, at a time
when the trade deficit was at a then record high of 4.3% of GDP. 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.
The Trade Deficits of the 1980s, 1990s, and the
2000s: 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
was not the case in the 1990s. In fact, the opposite occurred. As the federal budget
moved from deficit into surplus, the trade deficit grew absolutely and as a fraction
of GDP. During 2001 and 2002, as the federal budget shifted from surplus to deficit,
the trade deficit grew as a fraction of GDP.11 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, by decreasing national saving, 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. As a result, domestic
investment as a fraction of GDP did not decline as it would have in the face of a
falling domestic saving rate. 2001 and 2002 are a repeat of the 1980s. The shift
from a federal budget surplus to a budget deficit has once again caused the national
saving rate to fall and the story is a repeat of that told above. The rise in the trade
10 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.
11 The relationship between the budget and trade deficits is fraught with much
misunderstanding. Largely this is because budget deficits or surpluses can be created by
Congressional actions that affect taxes and expenditures and they can also be created
because the budget responds to the economy. In recessions, for example, tax revenue tends
to fall and expenditures rise. If the budget was near balance at the peak of the business
cycle, it will move into deficit in a downturn even if there are no legislative changes
affecting tax rates and/or expenditures. To clear up this ambiguity, the position of the
budget in this discussion is relative to what would prevail if the economy were at full
employment. In the literature, this is referred to as the structural budget deficit or surplus.
Thus, in the discussion in this section, a shift from budget deficit or surplus or the reverse,
must be understood as a shift in the full employment measure of the budget. They are not
shifts caused by changes in the economy. The structural shifts are frequently referred to as
a change in fiscal regime.
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deficit occurred despite the decline in private investment as a fraction of GDP during
2001 and 2002.
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 the desired
level of 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 and the early 2000s it was lower national saving that resulted
from a shift in American fiscal regimes while in the 1990s it was primarily a desire
to participate in the enhanced productivity of the American economy through
investment (capital formation).12
Can the U.S. Continue to Run Such Large Trade
Deficits?
Many observers have questioned whether the record-high trade deficit is
sustainable. This report assumes that unsustainable means that the trade balance will
shift back to surplus. Basically, the trade deficit is sustainable as long as foreigners
are willing to continue to lend to Americans. The consequence is a growing foreign
ownership of the U.S. capital stock and a rising fraction of U.S. income that must be
diverted overseas in the form of interest and dividends to foreigners.
An assessment of whether American investments will continue to be attractive
to foreigners in the future is beyond the scope of this report. As long as American
investments yield a higher (risk-adjusted) rate of return than foreign assets, foreigners
would presumably continue to find U.S. assets attractive. There are two hypothetical
reasons why future U.S. investments might not be as attractive as they were in the
past: if the U.S. was suffering from an investment bubble or a consumption boom
during the trade deficit years. Do either of these explanations describe the U.S.
economy in the late 1990s?
Many observers have made the case that the U.S. stock market experienced a
bubble in the late 1990s. By traditional rule of thumb measurements, valuations were
much higher than in the past. They take the subsequent sharp decline in stock prices
from 2001-2002 to confirm the bubble hypothesis. While investors may not be able
to enjoy the high rates of return of the late 1990s again in the future, this does not
mean that investments in U.S. assets could not be profitable in the future. Whether
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 Marc Labonte and Gail Makinen.
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foreigners would be willing to lend to the U.S. again in the future depends on how
high a rate of return foreigners would demand in return – the unusually high rates of
return enjoyed in the late 1990s or rates more in line with the historical average.
The consumption boom explanation of the late 1990s seems less compelling.
Investment as a percentage of GDP rose in the last half of the 1990s, perhaps spurred
by increases in the growth rate of productivity. Analysts point to the decline of the
household saving rate as evidence a consumption boom was underway, but the
increase in the public saving rate (the budget surplus) made up for most of the
decline. Some analysts argued that the 1980s trade deficit was fueling a consumption
boom since it was strongly influenced by the government budget deficit and most
government spending is dedicated to consumption rather than investment.
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 is worth noting that today’s trade deficits have a consequence for future trade
balances. The future debt service that is generated by foreign investment in the
United States today represents a capital outflow from the U.S. that would cause a
trade surplus, all else equal. Each year that the U.S. trade balance is in deficit would
increase this debt service, and hence, the capital outflow. This explains why U.S. net
earnings abroad fell from an average of $33.4 billion year from 1979-1984 to a net
payout of more than $4 billion in 2002. Thus, for the U.S. to run trade deficits in the
future, the U.S. would need to borrow more abroad than it is paying back in debt
service. For this reason, two leading international economists used the debt owed to
foreigners as a percentage of GDP as a rule of thumb guide to the sustainability of the
trade deficit. 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% of GDP per year, U.S. debt to foreigners 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 smaller debt to GDP ratios, between 20-80% of GDP. They take this to be an
indication that the U.S. trade deficit is unsustainable at its current size.14
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,
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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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. 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.
Given the traditional role the U.S. has played as an investment safe haven,
however, sudden capital outflows seem unlikely.
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
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.15
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
15 See U.S. Library of Congress, Does the U.S. Economic Downturn Threaten World
Economic Stability? by Marc Labonte and Gail Makinen, CRS report RL31287.
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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.16 However, there is a more direct way for the government to increase the
national saving rate – it can return to a policy of structural 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.17
Conclusions
The U.S. trade deficit is made possible by the net purchase of U.S. assets
(stocks, bonds, real estate, etc.) by foreigners.18 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 1997-2002.
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
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. But 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. If the large trade deficit made sudden shifts in foreign capital flows
more likely, the large trade deficit represents a legitimate policy concern.
Since the trade deficit represents a shortfall between domestic saving and
domestic investment, economic theory suggests that policies to increase the national
16 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.
17 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.
18 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 to be the dominant factor
given the size and persistence of the trade deficit.
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saving rate are most likely to succeed in reducing the trade deficit. Reducing the
government’s (structural) budget deficit is the most straightforward way to raise the
national saving rate.