Order Code RL31032
CRS Report for Congress
Received through the CRS Web
The U.S. Trade Deficit:
Causes, Consequences, and Cures
Updated June 7, 2005
Craig Elwell
Specialist in Macroeconomics
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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The U.S. Trade Deficit:
Causes, Consequences, and Cures
Summary
The U.S. trade deficit has risen more or less steadily since 1992. This imbalance
reached $665.5 billion in 2004, an increase of nearly $135 billion over the 2003
deficit, and a rise of about $630 billion since 1992. The deficit’s growth in 2004 was
for the most part the consequence of a sharp acceleration of import purchases, up
nearly $240 billion, in a fast growing economy. Exports had been falling since 2000,
but in response to a cheaper dollar and faster growth abroad, increased about $40
billion in 2003 and about $120 billion in 2004. Together this has resulted in the trade
deficit reaching another record size in 2004. The $3.9 billion deficit in the investment
income component in 2002 was followed by a $33.3 billion surplus in 2003 and a
$24.1 billion surplus in 2004. Surpluses in investment income are good news, but the
large and growing size of U.S. foreign indebtedness suggests the longer term trend
will be toward larger investment income deficits.
The size of the U.S. trade deficit is ultimately rooted in macroeconomic
conditions at home and abroad. U.S. saving falls short of what is sought to finance
U.S. investment. Many foreign economies are in the opposite circumstances, with
domestic saving exceeding domestic opportunities for investment. This difference of
wants will tend to be reconciled by international capital flows. The shortfall in
domestic saving relative to investment tends to draw an inflow of relatively abundant
foreign savings seeking to maximize returns and, in turn, the saving inflow makes a
higher level of investment possible. For the United States, a net financial inflow also
leads to a like-sized net inflow of foreign goods — a trade deficit. Absent the
prospect of any major change in the underlying domestic and foreign macroeconomic
determinants, most forecasts predict the continued widening of the U.S. trade deficit
in 2004. But the rate of increase of the deficit is expected to slow as foreign investors
slow the growth of their dollar asset holdings.
The benefit of the trade deficit is that it allows the United States to spend now
beyond current income. In recent years that spending has largely been for investment
in productive capital. The cost of the trade deficit is a deterioration of the U.S.
investment-income balance, as the payment on what we have borrowed from
foreigners grows with our rising indebtedness. Borrowing from abroad allows the
United States to live better today, but the payback must mean some decrement to the
rate of advance of U.S. living standards in the future. U.S. trade deficits do not now
substantially raise the risk of economic instability, but they do impose burdens on
trade sensitive sectors of the economy.
Policy action to reduce the overall trade deficit is problematic. Standard trade
policy tools (e.g., tariffs, quotas, and subsidies) do not work. Macroeconomic policy
tools can work, but recent and prospective government budget deficits will reduce
domestic saving and most likely tend to increase the trade deficit. Most economists
believe that, in time, the trade deficit will most likely correct itself, without crisis,
under the pressures of normal market forces. But the risk of a more calamitous
outcome can not be completely discounted. This report will be updated annually.

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Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Trade Performance in 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Goods Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Services Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Investment Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Why the Trade Deficit Widens . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
A Saving-Investment Imbalance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
International Capital Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Interest Rates and International Capital Flows . . . . . . . . . . . . . . . . . . . 5
Other Factors That Influence International Capital Flows . . . . . . . . . . . 6
Recent Patterns of U.S. Saving and Investment Behavior . . . . . . . . . . . . . . . 7
Sustainability of the Trade Deficit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Borrower’s Constraint . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Lender’s Constraint . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Special Considerations for the United States . . . . . . . . . . . . . . . . . . . . . . . . 12
Prospects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Is the Trade Deficit a Problem? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Intertemporal Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Debt Service Burden . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Instability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Effects on Total Output and Employment . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Effects on Particular Sectors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Trade Policy Responses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Macroeconomic Policy Responses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
The Effect of Tax Cuts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
The Effect of Economic Policy Abroad . . . . . . . . . . . . . . . . . . . . . . . . 22
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
List of Tables
Table 1. U.S. Current Account and Components . . . . . . . . . . . . . . . . . . . . . . . . . 2
Table 2. U.S. Saving-Investment Balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

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The U.S. Trade Deficit:
Causes, Consequences, and Cures
Introduction
International trade continues to grow in importance for the world economy as
well as the U.S. economy, enhancing economic well-being generally, but also
imposing costs on trade sensitive sectors of national economies. The importance of
trade has been well-recognized by Congress, which in recent years has paid close
attention to many dimensions of U.S. international trade performance. This report
examines the trade deficit, paying special attention to why it continues to widen, why
it may be a problem, and what can be done to correct it.
Trade Performance in 2003
The U.S. trade deficit as reflected in the current account balance1 reached $665.5
billion in 2004, up from $530.7 billion in 2003. As a percentage of GDP the 2004
trade deficit stands at 5.7%, exceeding the previous record share of 4.8% set in 2003.
The trade deficit rose slowly and, more or less, steadily from a small surplus in 1991(a
recession year) to about $135 billion in 1997. Then, as the pace of the economic
expansion rapidly accelerated, the trade deficit posted particularly large increases over
the next three years, reaching $413.4 billion in 2000. With recession in 2001, the
trade deficit fell moderately to $386 billion. With the commencement of economic
recovery in 2001 the trade deficit again began to expand along with the steady
improvement in the pace of economic growth.2 The cumulative increase in the trade
deficit since 1997 is $530 billion. Table 1 shows the anatomy of recent trade trends.
Goods Trade
Goods trade is the largest component of the current account, and what has
happened in this area has been the principal force pushing the current account deficit
higher in recent years including 2004. The deficit in goods trade increased about $67
billion over the 2002 goods deficit to stand at $547.6 billion. Since 1992, the goods
trade deficit has increased nearly $500 billion. Over this period both exports and
imports generally rose, but import growth out paced export growth. In 2001, in
1 The balance on current account is the nation’s most comprehensive measure of
international transactions, reflecting exports and imports of good and services, investment
income (earnings and payments), and unilateral transfers.
2 Trade balance data for the full year 2004 are not yet available, but through three quarters
the trade deficit on current account has been running at an annual rate of near $650 billion.

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CRS-2
response to slack demand across the world economy, U.S. goods exports had fallen,
but the U.S. recession in 2001 also led to an even larger curtailment in the U.S.
demand for imports, causing the goods deficit (and the current account deficit) to fall.
In 2002, weak world demand continued to push U.S. exports down, but even a tepid
U.S. economic recovery in 2002 was enough to cause goods imports to increase, and
the goods deficit (and the current account deficit) was once again on the rise. In 2003,
goods exports return to the upward track, increasing about $40 billion in response to
the stimulating effects of a weaker dollar and faster growth abroad. But accelerating
U.S. economic growth in 2003 also accelerates the inflow of imports by about$100
billion, causing the goods deficit to increase by about $66 billion.
Table 1. U.S. Current Account and Components
(BOP basis, billions of dollars, annual rate)
1997
1998
1999
2000
2001
2002
2003
Current account
-143.5
-220.5
-331.5
-435.4
-393.8
-480.8
-530.7
balance
Goods balance
-196.7
-246.9
-345.6
-499.5
-427.2
-482.9
-547.6
Exports
679.7
670.2
684.4
773.5
718.7
681.9
716.4
Imports
876.4
917.2
1029.9
1222.4
1145.9
1164.7
1,282.0
Services balance
91.9
82.7
80.6
81.0
69.4
64.8
51.0
Exports
258.2
263.6
271.8
296.2
288.9
292.2
319.8
Imports
166.9
181.0
191.3
215.2
219.5
227.4
262.3
Investment income
3.2
-7.0
-18.4
-13.7
10.7
-3.9
33.3
Transfers (net)
-41.9
-44.0
-48.0
-53.2
-46.6
-58.7
-67.4
Source: U.S. Department of Commerce (Bureau of Economic Analysis) and Global Insight
Services Trade
The U.S. surplus in services trade decreased in 2003 to $51.0 billion from $64.8
billion in 2002. In contrast to goods, services trade had shown a slowly rising surplus
through the mid-1990s. That trend ended in 1997, however, with the services surplus
peaking at $91.9 billion. In 1998, the surplus fell to about $83 billion, but steadied
near that level through 2000. Service exports grew over $30 billion in this period, but
with the dual effects of very rapid economic growth in the United States and the
continued strength of the dollar, services imports moved apace. From 2001 through
2002, the services surplus resumed its decline, falling about $15 billion. The decline
in this period reflected the continued increase of service imports despite recession and
slow growth in the United States. It also damped export sales stemming from
economic weakness in other economies and the continued negative impact of the
strong dollar (the dollar had begun to depreciate in 2002, but given the typical lags,
the positive effect of that depreciation was unlikely to have been significant in 2002).
Despite a continued weakening of the dollar in 2003, the quickening of the pace of
U.S. economic growth was sufficient to induce an $30 billion (or 13%) increase in
service imports. Service exports in 2003 also moved up about $13 billion or 4%, but

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CRS-3
this was not enough to stop the services surplus from falling another $6 billion. The
prospects of improved economic growth abroad and a weaker dollar are forces likely
to continue stimulating service exports.
Investment Income
Another telling aspect of trade in this period has been the steady fall and eventual
turn to deficit in 1997 of the current account’s investment income component. This
pattern was interrupted in 2001 with the investment income balance posting a surplus
of $10.5 billion, reflecting the depressing effect of the U.S. recession on earnings from
foreign-held U.S. assets. In 2002, this balance was back in deficit, with the imbalance
standing at $3.4 billion. This swing reflected continued economic weakness in the
rest of the world economy causing receipts from U.S. foreign investments to fall $34
billion in 2001. Low interest rates and tepid U.S. economic growth kept payments to
foreigners, more or less, level. In 2003, the investment income balance shifted back
to surplus, tallying a positive balance of $33.3 billion. This change was almost entirely
the result of increased returns from U.S. held foreign direct investment assets, as
payments on foreign held U.S. assets were only slightly above the 2002 level.
The investment income sub-balance had been in continuous surplus from the end
of World War II through 1997, but the magnitude of those surpluses was in fairly
steady decline in recent years. Unlike other components of the current account
balance, the deterioration of the investment income balance is a direct consequence
of America’s long string of large trade deficits and the attendant accumulation of debt
obligations to foreigners. This is a consequence that acts to exacerbate the deficit
trend in the current account. Most importantly, the deterioration of the investment
income balance over the last two decades is a measure of the growing economic cost
of America’s persistent large trade deficits and the associated accumulation of foreign
debt. Yet, despite our heavy foreign indebtedness, the deficit is relatively small. The
recent back and forth in this balance between surplus and deficit has been largely the
consequence of changes in asset valuations driven by the short-run impact of the
business cycle and exchange rate movements. In the long-run it seems very likely that
the United States’ large and still growing stock of net foreign indebtedness will come
to dominate movement of this balance and lead to steadily larger deficits in the
investment income balance.3
Why the Trade Deficit Widens
A rising current account deficit (or a falling surplus) over the course of a brisk
economic expansion is not a remarkable event for the U.S. economy. In the 1960s,
3 The level and composition of the United States’ net indebtedness to foreigners is found in
the annual tally of the nation’s net international investment position (NIIP) by the U.S.
Department of Commerce and published in the June Survey of Current Business. In 2003,
the NIIP was a deficit of $2.4 trillion and the United States had received a capital inflow of
$856 billion. At the peak of the business cycle in 2000, the capital inflow was over $1
trillion. The capital inflow is composed of several different types of assets including bank
accounts, stocks, bonds, and real property. For more detail on cross-border capital flows,
see CRS Report RL32462, Foreign Investment in U.S. Securities, by James Jackson.

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CRS-4
brisk economic growth steadily eroded a small current account surplus. In the 1970s,
modest deficits occurred with each economic expansion. However, in the 1980s and
1990s, the size of the trade deficits increased greatly. Cyclical factors certainly at
times played some role in this phenomenon, particularly in recent years with the
United States growing rapidly relative to most major trading partners. Trend forces
are also at work, however, inclining the U.S. economy toward generating large trade
deficits in all but recession conditions. The next section will examine in more depth
the fundamental determinants of the trade balance.
The trade deficit widens as the economy expands, not because of trade barriers
abroad, not because of foreign dumping of exports, and not because of any inherent
inferiority of the U.S. goods on the world market, but primarily because of underlying
macroeconomic conditions at home and abroad. In effect, the U.S. economy spends
more than it produces, and this excess of demand is met by a net inflow of foreign
goods and services leading to the U.S. trade deficit.4 Of course, the U.S. trade deficit
is only possible if there are foreign economies that produce more than is absorbed by
their current spending and are able export the surplus. Trade deficits and trade
surpluses are jointly determined. International capital flows will allow a mutually
favorable reconciliation of these domestic spending-production imbalances. These
imbalances will be sensitive to the short-run effects of the business cycle (at home and
abroad) as well as long-term effects of trends in spending and production. But, these
imbalances will not be efficiently changed by trade policies that try to directly alter the
levels of exports or imports such as tariffs, subsidies, or quotas.
A Saving-Investment Imbalance
National spending-production imbalances are most usefully analyzed from the
standpoint of national saving and investment behavior. Saving is just the flip side of
the same phenomenon (an excess of spending essentially translates into a deficiency
of savings) but has the advantage of more clearly rooting the phenomenon in the
transactions on international asset markets that are the key to understanding aggregate
trade imbalances.
International Capital Flows. A large and fluid trade in assets is one of the
central attributes of the current world trading system, growing from flows totaling
only a few billion dollars in 1970 to about $1.5 trillion in 2000. The United States has
been a major participant in international asset markets receiving inflows of $856
billion in 2003 and as much as $1 trillion at the last business cycle peak in 2000.5
With fluid world capital markets, domestic saving-investment imbalances
involve equivalent transfers at two levels: an initiating transfer of real purchasing
4 It is useful to remember that “income”/”spending” are the flip side of “production”/
“output”. Any given value of production generates an equal value of income. Thus the
income the economy earns can support spending sufficient to purchase the economy’s
current output. With international trade, however, it is possible for there to be a divergence
of spending and production through the borrowing and lending of current income and output
between nations.
5 See CRS Report RL32462, Foreign Investment in U.S. Securities, by James Jackson.

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CRS-5
power through asset market transactions; and an induced corresponding transfer of
real output through goods market transactions.
It is an economic identity that the amount of investment undertaken by an
economy will be equal to the amount of saving — that is, the portion of current
income not used for consumption — that is available to finance investment. But for
a nation this identity can be satisfied through the use of both domestic and foreign
saving, or domestic and foreign investment. Therefore, a saving investment imbalance
is a relationship between domestic saving and investment and one that can only occur
if foreign saving or investment are available to satisfy the overall saving investment
identity.6
International capital flows from lender to borrower are the means by which the
saving of one country can finance the investment of another. If international capital
flows did not exist, domestic investment could be no larger or smaller than domestic
saving.
In a relatively open world economy with reasonably fluid and well functioning
international asset markets, it is possible for domestic saving-investment imbalances
to be reconciled by international capital flows. With a willing lender and a willing
borrower, flows of capital from one nation to another can achieve overall saving-
investment balance for both nations. These asset market transactions will change the
demand for and supply of national currencies needed to purchase foreign assets,
causing changes in exchange rates, which, in turn, induce an equivalent sized net flow
of goods (i.e. trade deficits and trade surpluses) between economies.
Interest Rates and International Capital Flows. Differences in the level
interest rates between economies are the basic equilabrating mechanism that works
to induce saving (income) flows between countries as investors seek out higher rates
of return. A nation with a “surplus” of domestic saving over domestic investment
opportunities will tend to have relatively low domestic interest rates because the
domestic supply of loanable funds (i.e. saving) exceeds the domestic demand for
loanable funds (i.e. investment) pushing down interest rates (i.e. the price of loanable
funds). As a result this economy will also likely see some portion of domestic saving
flow outward, attracted by more profitable investment opportunities abroad. This net
outflow of purchasing power, which generally can only be used to purchase goods (or
assets) denominated in the country’s currency, will, through changes in exchange
rates, induce a like-sized net outflow of real goods and services — a trade surplus.
Japan is an example of a nation that in recent decades has produced large net outflows
of saving to the United States and other nations.

Conversely, another nation that finds its domestic saving falling short of desired
domestic investment will tend to have relatively high domestic interest rates because
the domestic demand for loanable funds exceeds the domestic supply of loanable
6 Saving in a macroeconomic framework is the portion of current income that is left after
households, businesses, and government pay for their current consumption. A household
that diverts some amount of current income to a bank, mutual fund, or government bond is
saving. Similarly the tax revenue that the government has left after paying for its spending
is (public) saving.

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CRS-6
funds. As a result this economy will likely attract an inflow of foreign saving, attracted
by the higher rate of return, and that inflow will help support domestic investment.
Such a nation becomes a net importer of foreign saving (income), able to use the
borrowed purchasing power to acquire foreign output, and leading to a like sized net
inflow of foreign output — a trade deficit. That deficit augments the output available
to the domestic economy, allowing the nation to invest beyond the level of domestic
savings.
Both asset market transactions and goods market transactions influence the
demand and supply of dollars on foreign exchange markets. In most circumstances,
however, there is a strong expectation that asset market transactions will tend to be
dominant and ultimately dictate the exchange rate’s actual direction of movement.
This dominance is the result of asset market transactions occurring on a scale and at
a speed that greatly exceeds what occurs with goods market transactions. Electronic
exchange makes most asset transfers nearly instantaneous and we see that in most
years U.S. international asset transactions were two to three times as large as what
would be needed to simply finance that year’s trade deficit. The telling sign that asset
transactions have been the determining force is that the dollar appreciated as the trade
deficit grew. If goods market transactions were the determining force, the increase of
the trade deficit would tend to depreciate the dollar, as rising U.S. imports cause more
dollars to be exchanged for foreign currency, increasing the supply of dollars on the
foreign exchange market, and pushing the dollar down.
Other Factors That Influence International Capital Flows. While
relative levels of interest rates between countries and expected return are likely to be
a strong and prevalent force directing capital flows among economies, other factors
will also influence these flows at certain times. For instance, the size of the stock of
assets in a particular currency in investor portfolios can cause a change in investor
preferences. We know that prudent investment practice counsels that one’s portfolio
should have an appropriate degree of diversification, across asset types, including the
currency in which they are denominated. Diversification spreads risk across a wider
spectrum of assets and reduces over exposure to any one asset. Therefore, even
though dollar assets may still offer a high relative return, if the accumulation has been
large, at some point foreign investors, considering both risk and reward, will decide
that their portfolio’s share of dollar denominated assets is large enough. To improve
the diversity of their portfolios, investors will slow or halt their purchase of such
assets. Given that well over $8 trillion in U.S. assets are now in foreign investor
portfolios, diversification may be an increasingly important factor governing the
behavior of international investors towards dollar assets.
There is also likely to be a significant safe-haven effect behind some capital
flows. This is really just another manifestation of the balancing of risk and reward by
foreign investors. Some investors may be willing to give up a significant amount of
return if an economy offers them a particularly low risk repository for their funds. In
recent decades the United States, with a long history of stable government, steady
economic growth, and large and efficient financial markets can be expected to draw
foreign capital for this reason. The size of this effect is not easy to determine, but the
disproportionate share of essentially no risk U.S. Treasury securities in foreign
holdings suggests the magnitude of safe-haven motivated flows is probably substantial
and must exert a bias towards capital inflows and upward pressure on the dollar.

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CRS-7
We also know that governments will, with varying frequency, buy or sell assets
on the international capital market. Such official purchases are seldom motivated by
the factors of return and risk that typically propel private investors. Government
official purchases can serve two objectives. One, the accumulation of a reserve of
foreign exchange denominated in readily exchangeable currencies, such as the dollar,
to afford a store of international liquidity that can be used for coping with periodic
currency crises arising out of often volatile private capital flows. This is most often
a devise used by developing economies that periodically need to finance short-run
balance of payments deficits and can not fully depend on borrowing on international
capital markets to offer timely finance of these deficits. Also the Asian financial
crisis in the late 1990s heightened the importance for many developing economies of
having an ample store of such international liquidity.
Two, official purchases are used to counter the impact of capital flows that would
otherwise lead to unwanted changes in the countries exchange rate. The United States
and most other industrial nations, while most often allowing the value of their
currencies to float on the foreign exchange market, have at times undertaken such
intervention. This, however, is a common practice for many east Asian economies
who buy and sell foreign assets to influence their currencies exchange rate relative to
the dollar and other major currencies to maintain the price attractiveness of their
exports. Among the large industrial economies in recent years, Japan has been a
highly visible practitioner of accumulating international assets so as to slow the rise
of the yen relative to the dollar, accumulating dollar denominated foreign exchange
reserves in 2003 of about $117. Among emerging economies, China has undertaken
large scale accumulation of dollar assets to fix the value of the renminbi relative to the
dollar, accumulating $202 dollar assets in 2003. In most cases, however government
exchange rate intervention is unlikely to be substantial enough to change the direction
in which private investors are pushing the dollar. It has likely slowed the fall of the
dollar since early 2002, but not stopped it.
Recent Patterns of U.S. Saving and Investment Behavior
A domestic saving-investment imbalance can occur as a result of either
investment rising relative to saving or saving falling relative to investment (see Table
2). In the 1980s, the saving rate and the investment rate both declined, but the saving
rate fell substantially faster, inducing capital inflows and a rising trade deficit. The
fall of the saving rate in this period was rooted in two occurrences. The first was a
substantial fall in the public saving rate caused by the run up of large federal budget
deficits (which amounts to negative saving or dis-saving). The second occurrence was
the decline of the household component of the private saving rate. In the late 1980s
this imbalance narrowed due to increased public saving (i.e., smaller deficits) and a
sharp decline in the investment rate in response to a decelerating economy headed for
recession.
After recovery from the 1991 recession, the U.S. saving-investment imbalance
began to increase steadily, but the form of the imbalance changed. The rates of saving
and investment both rose, but the investment rate climbed faster. The turnaround in
the overall saving rate in the 1990s was the consequence of a sharp change in the
public saving rate, where the steady move by the federal government from budget
deficits to budget surpluses increased the public saving rate from -2.5% (i.e, dis-

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CRS-8
saving) in 1992 to 5.2% in 2000. Dampening the rise of the overall saving rate,
however, was the continued decline in the household saving rate, falling from about
6.5% in 1992 to 0.0% in 2000. The rise of the overall saving rate in the 1990s did not
bring that rate up to the magnitude that prevailed in the 1950s, 1960s, or 1970s, and
fell well short of the 1990s’ briskly ascending rate of domestic investment. The
predictable consequence of a widening savings-investment imbalance was a rising
inflow of foreign savings to close that gap, and in turn, an ever larger trade deficit. A
substantial decrease in the rate of investment during the 2001 recession narrowed this
gap and the trade deficit in that year. With economic recovery and expansion in 2002,
2003, and 2004 the investment-saving gap widened again and so did the trade deficit.
In this instance, the widening was not caused by an acceleration of investment
spending, but by a decline in the economy’s overall saving rate caused by a fall in the
government saving rate.
Two questions may come to mind. One, why has the household saving rate
collapsed over the last 20 years? Other factors unchanged, a higher rate of household
savings would have likely meant the generation of smaller trade deficits. Two, why
did U.S. investment spending boom in the 1990s? Other factors unchanged, a rate of
investment at the lower level typical of other expansions would have also led to
smaller trade deficits. The fall of the household saving rate has been the object of
much economic research, but the reasons for the decline remain problematic. No
single theory can fully account for the phenomenon, but three have considerable
plausibility. First, capital gains on real estate, stocks, and other investments,
particularly in the 1990s, have greatly increased household wealth. Economic theory
predicts that a rise in wealth reduces the need to save and increases the tendency to
spend. Second, increased government outlays for Medicare and Social Security
transfer income from a relatively high saving segment of the population to a relatively
low saving segment. Third, more streamlined credit market vehicles, such as credit
cards and home equity loans, have removed constraints on household liquidity and
prompted increased spending (and reduced saving).7
Table 2. U.S. Saving-Investment Balance
(percent of GDP)
Ann.
Ann.
Avg.
Avg.
1998
1999
2000
2001
2002
2003
2004
1975 to
1983 to
1982
1990
Saving
19.7
17.1
17.3
18.6
18.2
16.5
14.7
13.5
13.8
Investment
20.3
19.5
21.2
21.8
21.8
19.1
18.4
18.2
19.2
Neta
lending(+) or
-0.6
-2.4
-2.9
-3.2
-3.6
-2.6
-3.7
-4.7
-5.4
borrowing(-)
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
a. Net lending, in concept, should equal the size of the current account balance. Statistical discrepancies prevent
a precise matching, however.
7 See CRS Report RS20224, The Collapse of Household Saving: Why Has it Happened and
What Are its Implications?, by Brian Cashell and Gail Makinen.

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CRS-9
The reasons for the investment boom in the late 1990s also remain somewhat
unclear, but three plausible forces have been suggested. First, the wealth induced
spending mentioned just above also provides a stimulus to business investment, as
new plant and equipment is needed to meet the rising demand for output. Second, it
is argued that recent deregulation of industry, liberalization of trade, and massive
integration of ever cheaper and more powerful computers into the production process
have boosted productivity and raised the profitability of investment in the United
States. Third, and perhaps most plausible, pervasive economic weakness abroad, most
recently in Asia, has made the United States a singularly attractive destination for
foreign investment. Even the relatively slow pace of the U.S. economic recovery in
2002 and early 2003, when juxtaposed with generally weaker growth in the rest of the
world made it likely that the trade deficit would expand in 2002 and 2003.
A change of note over the last three years, however, is the shift in the trajectory
of public saving. In 2002, the federal budget moved back into deficit and in 2004 that
budget deficit stands at $371 billion, with the prospect of similar sized budget deficits
persisting into the foreseeable future. This has resulted in the federal government
moving from being a net saver in 2000 at a magnitude equal to about 2.8% of GDP
to being a net dis-saver at a magnitude of about 2.5% of GDP. This fall in
government saving exacerbates the saving-investment imbalance and, other factors
constant, widens the trade deficit.
For that widening of the trade deficit to happen, however, there will also need
to be foreign lenders willing to invest in the United States. If, to take one extreme
position, there are no such investors then any fall in the domestic saving rate will,
through higher interest rates, lead to a like sized fall in the domestic investment rate.
If, at the other extreme, there are legions of investors eager to invest in the United
States, the savings shortfall will be overcome with little dampening of domestic
investment. More realistically, there will likely be willing foreign investors, but that
willingness might have to be gained through the prospect of a higher rate of return.
The higher domestic interest rates must go to attract investors to bridge the domestic
saving shortfall, the more downward pressure there will be on domestic investment.
The macroeconomic forces that generate trade deficits are entirely consistent with
high rates of capacity utilization and employment. Trade deficits, however, can have
negative effects on output and employment in particular sectors. (The output,
employment, and sectoral effects of trade deficits are discussed at greater length in a
latter section of the report.) The United States has regularly been the net recipient of
foreign capital inflows and regularly had trade deficits for the last 25 years. It has also
regularly achieved high rates of economic growth and low rates of unemployment over
this time period.8 This is more understandable if one keeps in mind that while a
deficit in goods and services trade caused by the rise of the exchange rate tends to
have a negative effect on domestic economic activity, there is also a positive effect on
domestic economic activity due to the lower interest rates caused by the like-sized net
8 For a fuller discussion of this analytical framework, see N. Gregory Mankiw, Principles
of Economics (Fort Worth, TX: The Dryden Press, 1997), p. 659; and also, Congressional
Budget Office, Causes and Consequences of the Trade Deficit: An Overview, CBO
Memorandum, Mar. 2000.

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CRS-10
inflow of foreign capital (saving). The trade deficit changes the composition of
domestic output, but not a change in the overall level of output.
It is also true that an overall trade imbalance need not be reflected in the balance
with individual trading partners. Bi-lateral balances will reflect additional forces such
as geographic proximity, scale economies, and comparative advantage, and therefore
some could be in deficit and others in surplus. Similarly, overall trade balance can be
consistent with significant bi-lateral imbalances. For example, even if Unites States
were to eliminate its trade deficit, it would likely have a sizeable trade deficit with
China. Or seen the other way, a reduction of the U.S. trade deficit with China, not
accompanied by a change in the U.S. economy’s overall domestic saving-investment
imbalance, will not lead to a reduction of the overall U.S. trade deficit. If, however,
a decrease in the U.S. trade deficit with China is the result of a reduced inflow of
capital (saving) from China, and there is no like-sized increase in another source of
foreign saving, then the overall U.S. trade deficit will also fall, but so must domestic
investment in the United States to bring it into line with the smaller pool of saving
that would be available to finance domestic investment.
This overall scenario leaves one with three strong impressions. One, U.S. trade
deficits appear to be largely (but not completely) created and propelled by
macroeconomic forces in the domestic economy that influence international flows of
capital. Two, those deficits must be sustained by willing foreign lenders, and
substantial reduction of that willingness, other factors constant, might lead to deficit
reduction on less than the most favorable terms. And three, these forces may not be
easily manipulated by policy.
Sustainability of the Trade Deficit
With little prospect at home or abroad for any dramatic reversal of the forces
determining the trade deficit, it is unlikely that the deficit will shrink any time soon.
In fact, most projections out over the next one to two years see a further widening,
with the current account deficit rising to the $800 to $900 billion range.9
Nevertheless, an ever larger trade deficit is not likely to be sustainable indefinitely.
There are automatic adjustment processes that will work to dampen the willingness
of borrowers to borrow and of lenders to lend, and which can effect a more or less
orderly reduction of the saving-investment imbalance and, in turn, the trade deficit.
Borrower’s Constraint
The central issue for a borrower country like the United States is the “ability to
pay,” that is, the capacity to meet the interest and principal payments on the
accumulated stocks of foreign debt. Such payments must come at the expense of other
forms of national expenditure and, therefore, will not increase without bound. For the
United States, the Net International Investment Position (NIIP) is the measure of our
stock of obligations and GDP is the measure of our ability to pay. Therefore the ratio
NIIP/GDP is a possible proxy of the borrower’s constraint. Because we do not have
9 See forecasts by Global Insight, The U.S. Economy, June, 2004.

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CRS-11
much experience with a rising foreign debt to GDP ratio, it is difficult to judge at what
value this ratio would begin to sharply deter more borrowing. Between 1992 and
2003, this ratio (expressed as a percentage) has risen from 7.3% to 22.5%, a
substantial gain, but that is still below the 25% to 35% common among other high
income countries, well short of the debt burden of most households, and apparently
not high enough to sate our appetite for foreign capital. It remains problematic as to
what value of this ratio would be binding on borrower behavior.
An alternative measure of constraint is the ratio of the current account balance
(CA) to GDP (CA/GDP). This measure lays more stress on the size of the annual
flow of foreign obligations relative to GDP as an initiator of borrower behavior. The
value of CA/GDP for the United States has risen from 0.8% in 1992 to 4.4% in 2000.
Evidence from industrial economies indicates that, on average, when the CA/GDP
ratio exceeds 4.2% the current account begins to narrow.10 This suggests that the
United States may be getting close to a point at which borrowers may begin to slow
their rate of debt accumulation. We must also consider, however, that there are
special attributes of the American economy that would allow it to prudently push
borrowing beyond this benchmark ratio (see below).
Lender’s Constraint
The willingness to lend to a particular destination will be influenced by the risk-
return profile of a borrower’s assets relative to other available assets. A broad array
of alternatives with comparable risk-return prospects would tend to reduce the
willingness to lend to a single borrower. Similarly, a paucity of alternative investment
opportunities would have the opposite effect. One can expect that the array of
alternatives faced would be influenced by the strength of economic conditions across
the globe. In addition, the desire by investors for some degree of portfolio
diversification will tend to limit their willingness to become overly saturated in assets
from one destination. Beyond the willingness to invest is the issue of ability to invest.
The ability to sustain a large or rising outflow of capital will be limited by the size of
the lender economy and its wealth portfolio. Other economies are substantially smaller
than the U.S. economy and may be unable to sustain the magnitude of outflow the
United States can apparently readily absorb. Also limiting cross-border lending is the
observed preference in most economies to hold a high percentage of wealth in home
assets.
The willingness of central banks to accumulate dollar assets will be governed by
different considerations then the standard profit-loss calculation that motivates private
investors and can be sustainable for long periods of time. Nevertheless, there will be
pressures that will work to limit such official purchases. For unless the asset
accumulation is sterilized, the growth of official reserves will be inflationary, and
since the capacity for sterilization is not likely to be infinite, particularly if the
financial markets of the lending country are not well developed and have small
absorptive capacity, the inflationary impulse of official lending may not be avoidable
forever. In general, sustained asset accumulation through official purchases ties the
10 See Catherine L. Mann, Is the Trade Deficit Sustainable (Washington, DC: Institute for
International Economics, 1999), p. 156.

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CRS-12
monetary policy of the lending country to that of the borrowing country and the
lending countries need to avoid an acceleration of inflation will make it an
unsustainable policy.
Special Considerations for the United States
There are factors unique to the United States that may reduce the constraints on
international lending or borrowing. First, over 90% of the U.S. international
borrowing is denominated in dollars.11 This means that the pressures that other
borrowing countries might face due to fluctuations in the value of debt service burden
caused by volatile exchange rates are largely not an issue for the United States.
Second, a large portion of foreign capital inflows to the United States is in relatively
stable long-term investments. Such investments tend to be less prone to volatility
caused by sudden changes in investor confidence. Third, about 50% of the investment
in the United States by foreigners is in the form of equity (stock) holdings. Equity
holdings tend to carry less strict payment requirements than debt holdings, working
to lower the potential service payments (for a given level of NIIP), and extend the
period over which the nation can prudently run current account deficits. Finally, the
size and importance of the U.S. in global trade and finance puts the United States in
a special position as a borrower. That importance is enhanced by the dollar being the
world economy’s principal reserve currency and therefore a readily held asset as well
as a readily exchanged asset.
Prospects
Where is the trade deficit headed in the period just ahead? In the analytical
framework presented in this report, the answer to that question will hinge on the net
direction of capital flows into and out of the American economy. At present, the
United States is an international borrower receiving a net inflow of foreign capital.
If that net inflow decreases, the trade deficit will also decrease. If the net inflow
increases, the trade deficit will also increase. If the capital inflow remains the same,
so will the trade deficit. So, what direction are capital flows likely to take?
Whether the current capital inflow gets bigger, smaller, or remains the same will
most likely be determined by the resolution of two contenting forces: risk and reward.
If, on balance, foreign investors see further investment in the United States as a far
more riskier undertaking, other factors equal, the capital inflow will ebb and bring the
trade deficit down with it. On the other hand, if the relative rate of return from
investment in U.S. assets grows more attractive the net capital inflow could expand
and bring the trade deficit up with it.
The important risk factor currently is the adequacy of diversification in investor
portfolios. Very large dollar balances have been accumulated in recent years. A
survey by The Economist magazine shows that American assets make up 53% of the
typical foreign investors equity portfolio and 44% of the typical bond portfolio. As
recently as the mid-1990s these percentages where only about 30%. It has also been
estimated that the average investor in recent years has allocated about 80% of his
11 See U.S. Treasury Department, Treasury Bulletin, Apr. 2002.

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CRS-13
increased wealth to dollar assets and would have to continue at this rate or higher to
sustain the U.S. trade deficit for the next few years.12 This is possible, but it is fair to
doubt that it is probable, as standard investment practice increasingly suggests that
investors move away from dollar assets. Such a shift is the most likely cause of the
fall of the dollar since early 2002. In 2002, almost all foreign capital inflows were
from private sources. But in 2004, only about 75% of that inflow was from private
sources. The difference has been a sharp increase in official purchases by foreign
central banks ,rising from about $42 billion in 2000 to about $355 billion in 2004.
Will the private foreign investor continue to move away from dollar assets? Will
foreign central banks continue to increase there holdings of dollar assets?
For the private foreign investor a relatively high rate of return is likely to
continue to be a powerful incentive for holding an asset, and there are reasons to
believe that for the immediate future dollar assets will be the most attractive
alternative on the world market. For one reason, the U.S. economy is expanding at
a quick pace, with real GDP up 4.4% in 2004 as compared to an average rate of
growth of only 2.3% in the economies of its major trading partners. Moreover, the
United States is likely to continue to outpace other major economies in 2005and 2006.
Faster growth usually brings relatively higher interest rates and offer more attractive
rates of return to foreign investors then can be found in the rest of the world at
comparable risk. In addition, for the time period just ahead the upward pressure on
interest rates in the U.S. economy will likely be exacerbated by sizable government
borrowing to finance large federal budget deficits.
Because of these strong but opposing factors, there is likely to be an above
average degree of uncertainty in forecasting the trade deficit’s path. Nevertheless, a
common scenario sees the current account deficit continuing to advance in 2005 and
2006, perhaps exceeding $850 billion. In a common scenario, the trade deficit
stabilizes near this level but begins to fall as a share of GDP. In this view, foreign
investors are willing to continue their accumulation of dollar assets, but at a steadily
slowing rate, as concerns about risk increase and opportunities for alternative
investment destinations broaden. The impacts of past and prospective dollar
depreciation and faster economic growth abroad will likely have a stronger impact on
the goods and services deficit, perhaps even causing it to decline in 2005, but an
accelerating deficit in investment income would likely keep the current account deficit
from doing the same for a while longer.13
Is the Trade Deficit a Problem?
A trade deficit is not necessarily undesirable. It confers benefits and carries some
costs, and the former may exceed the latter. Trade deficits are a vehicle for extending
the gains from trade, where lending and borrowing among nations can lead to a more
efficient allocation of saving and a preferred pattern of consumption over time. Trade
12 The Economist, Sept. 18, 2003.
13 See Global Insight, U.S. Economic Outlook, June 2005; and OECD, Economic Outlook,
June 2005.

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CRS-14
deficits do not necessarily cause slower economic growth or lead to any economy-
wide loss of jobs.
As seen in the 1980s and as was evident in the 1990s, the U.S. unemployment
has fallen to record lows and the economy’s growth rate has accelerated to record
highs even as the trade deficit has risen. That deficit, therefore, does not necessarily
come at the expense of current domestic economic activity. Of course, borrowing
carries a cost as the lender demands that interest be paid on the funds borrowed and
the principal one day be repaid. This “debt service cost” is a burden the borrower
must carry tomorrow for living beyond his means today. One’s evaluation of the
desirability or undesirability of a trade deficit will hinge on the current benefits gained
from that added spending relative to the future debt service burden that is incurred.
Also, reliance on foreign sources of finance often raises concern that trade deficits
carry an elevated risk of instability and disruption to the economy. Finally, trade
deficits have differential effects on different sectors of the economy, often placing
large burdens on exporting and import-competing sectors.
Intertemporal Trade
Gains from trade can arise from intertemporal exchanges. These are exchanges
of current goods and services for claims on future goods and services, that is, an
exchange of goods and services for an asset (i.e. cash in a bank account, stock, or
bond). When the United States (or any trading nation) borrows from abroad to import
materials for a current investment project, it is undertaking intertemporal trade. In
such a transaction, the borrowing nation gains because it can support a higher rate of
investment in capital goods than what current domestic saving alone could finance.
The lending nation gains an asset yielding a higher rate of return than is available in
the home economy. Because of the difference in their preferences for spending over
time, the international asset market allows both parties to the transaction to raise their
economic well-being. The borrower’s economic well-being is raised by being able to
spend more in the current period than current income allows. The lender’s economic
well-being is raised by being able to spend more in some future period. A country that
is a net borrower will also run a trade deficit, while the country that is a net lender will
run a trade surplus. This type of international asset transaction allows a more global
utilization of the world’s saving, a more efficient allocation of investment spending
across nations, and a preferred distribution of spending over time.
Since the early 1980s, the United States has incurred trade deficits of moderate
to large size, using international borrowing to push spending beyond current
production, pursuing desired consumption and productive investment now rather than
later. Similarly, nations like Japan have been able to run trade surpluses, using
international lending opportunities to earn higher returns on their excess national
savings and expanding the prospects for spending in the future. Such net flows have
not grown as fast as gross flows of capital so that external sources of finance still
claim only a small share of the total funding of domestic investment in most industrial
countries. For the United States in 2004, for example, the trade deficit was equal to
5.7% of GDP and about 35% of domestic investment spending. The trend,
nevertheless, has clearly been toward larger external imbalances (surpluses and
deficits).

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CRS-15
An aspect of the current pattern of international capital flows of some concern
is that the inflows to the United States are largely outflows of capital from the
developing economies. This is not a pattern that makes economic sense over the long-
term. The United States has a large stock of high quality capital to equip its workers
with and a slow growing but rapidly ageing population. The developing world, in
contrast, tends to have a low ratio of capital to labor and have young, rapidly growing
populations. Economic reasoning would lead one to suspect that investment
opportunities are likely to be greater in the capital poor developing economies and the
need for saving to support future retirees greater in the United States, and that the
United States should be running trade surpluses and be a net lender to the developing
economies, not vice versa.14
Debt Service Burden
With each successive trade deficit the stock of foreign obligations grows. The
current size of this stock is formally measured by the NIIP. In 1981, the United States
was a net creditor with a net accumulation of assets in the rest of the world of $374
billion. But a steady and substantial stream of net foreign borrowing has swung the
NIIP to a net debtor position of about $2.4 trillion 2003, up from about $2.2 trillion
in 2002, and amounting to a cumulative swing since 1981 of nearly $3 trillion over
this period.15
The current annual debt service cost of America’s stock of foreign debt can be
roughly judged from behavior of the investment income component of the current
account balance (see Table 1). That series is a measure of the nation’s net payments
or receipts on past investment and debt. If positive, the United States earned more
than it paid; if negative, the United States paid more than it earned. Over time trend
movement in this measure will be reflective of changes in the stock of net
indebtedness. We see in Table 1 that international investment income in 2002 was
a deficit of about $3.9 billion, down from a surplus of $10.7 billion in 2001, in 2003
the deficit swung into a surplus of $16.6. This shrinking of the investment income
deficit is likely a short-run phenomenon caused by the current dynamics of interest
and dividend payments among the United States and other nations. Over the long-run,
if the trade deficit remains on its current upward trajectory, debt obligations will
continue to grow, and it is quite credible to expect U.S. international debt payments
to reach the $100 billion range before the current account deficit is erased and net
foreign borrowing stops.
A $100 billion transfer of real income to the rest of the world is significant, but
it is not an overwhelming outflow for the world’s largest economy. In the year 2005,
the United States will likely have a GDP valued at over $11 trillion dollars and by
decades end it will likely exceed $13 trillion dollars. For an economy of this size, a
$100 billion foreign debt service burden amounts to slightly less than 1.0% of GDP.
Clearly, insolvency is not lurking just over the horizon, particularly since the economy
14 See Ben S. Bernanke, “The Global Saving Glut and the U.S. Current Account Deficit,”
speech delivered March 10, 2005, The Federal Reserve Board.
15 See U.S. Department of Commerce, Bureau of Economic Analysis, 2003 Yearend Net
International Investment Position, June 30, 2004.

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CRS-16
will be Nevertheless, a debt service payment of this size is significant, particularly if
viewed in the context of the economy’s average annual growth rate of real GDP. For
a mature industrial economy like the United States the long-term growth rate of real
output can optimistically be expected to average as much as 3.0 % per annum. Thus
a yearly debt service burden of about 1.0% of GDP would mean that the rate of growth
of output that is effectively available to the domestic economy is reduced to 2.0%.
That would be a significant erosion of the rate of improvement in the U.S. living
standard. At a 3.0% annual growth rate national income doubles about every 24 years,
whereas at a 2.0% annual rate, doubling occurs every 35 years. Put another way, if the
per-capita GDP in 2002 of $36,6000 grows on average at 3.0% for 24 years, GDP per
capita would equal about $75,000, whereas growing at 2.0% for that same period
would bring per capita GDP to only $59,000 or about 21% less.
The degree of burden actually incurred, however, will depend in part on how the
nation uses what it borrows. If foreign borrowing is used to finance an increase in
domestic consumption (public or private), there is no boost given to future productive
capacity. Therefore, to meet debt service expense, future consumption must be
reduced below what it otherwise would have been. Such a reduction represents the
burden of foreign borrowing. This is not necessarily bad; it all depends on how one
values current versus future consumption. If, on the other hand, foreign saving is used
to increase domestic investment the burden could be slight. We know that investment
spending increases the nation’s capital stock and expands the economy’s capacity to
produce goods and services. The value of this added output may be sufficient to both
pay foreign creditors and also augment domestic spending. In this case, because future
consumption need not fall below what it otherwise would have been, there would be
no true economic burden.
It is difficult to assess to what extent U.S. debt service cost will be attenuated by
the shift in the 1990s to the pattern of supporting rising domestic investment using
foreign borrowing from the pattern of the 1980s of support, more or less exclusively,
added domestic consumption with foreign borrowing. (Keep in mind, however, that
the accelerated rate of investment makes only a small net contribution to the size of
the nation’s huge capital stock. Thus its growth-accelerating effect is commensurately
modest. In the calculations of debt burden done just above a relatively high rate of
long-term growth was assumed. Therefore the possible boost from earlier elevated
rates of investment has probably been accounted for.)
Instability
Trade deficits often raise concern about the potential instability of external
sources of finance. What if foreign investors begin to pull their funds out of the
United States, disrupting domestic capital markets and the wider economy? There are
good reasons to doubt that a sharp turnaround in foreign capital flows is likely.
Recent experience of other countries with the panic of foreign investors has shown
that such behavior most often results from the growing likelihood that they would not
be repaid, that debt service payments were doubtful. This occurred when a country’s
ability to pay debt service was imperiled by persistent weak economic growth or the
rapid consumption of the nation’s foreign exchange reserves in the defense of an
overvalued currency. These are not risk factors that have much relevance to the

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CRS-17
circumstances of the United States, which has strong growth and does not fix its
exchange rate.
In addition, a large proportion of investments made in the United States have
been long-term in nature and not particularly prone to quick changes in commitment.
It is very likely that many foreign investors generally see the U.S. economy as a
bastion of long-run economic strength and will continue to invest for long-term gain.
It is true that a sizeable share of the stock of U.S. foreign debt is in short term assets
that can move quickly. That these types of assets will change direction as relative
yields rise abroad is quite likely and does raise the risk of instability somewhat. But
given the absence of the risk factors noted just above, it is far more likely that such
capital outflows will be part of an orderly adjustment process and not lead to undue
economic instability. The impact of any exodus of foreign capital, if it did occur,
would tend to raise interest rates and dampen credit sensitive activities. It is very
likely that a falling dollar and a shrinking U.S. trade deficit would be more disruptive
to the more export dependent and exchange rate sensitive economies of Europe and
Japan.
For the United States, the pain of such an adjustment would be muted by the
large size of the overall U.S. capital market relative to the scale of the foreign capital
flows. In recent years, the total funds raised in U.S. credit markets have been around
$2,200 billion. Therefore, net borrowing from the rest of the world at around $500
billion to $700 billion represents 25% to 30% of the nations annual flow of credit.
This is a magnitude of significance, but if withdrawn gradually it is not necessarily
overwhelming for the United States.
Effects on Total Output and Employment
Standard economic analysis indicates that a trade deficit does not cause a net loss
of output or jobs in the overall economy. Trade deficits will, however, likely change
the composition of output and employment. This compositional effect occurs because
the forces generating the trade deficit will tend to increase the dollar’s exchange rate,
raising the incentive to substitute some types of foreign output for similar types of
domestic output. But this dampening effect on some domestic industries will tend to
be offset by the positive effects of the trade deficits associated capital inflow on other
parts of the economy. With a trade deficit some import sensitive industries (i.e.
textiles) will have their output and employment decline, but some credit sensitive
industries (i.e. housing) will have their output and employment increase. Recently we
have seen some domestic manufacturing industries harmed by the trade deficit, but we
have also seen a great surge in home-building stimulated by lower interest rates
afforded by the trade deficits attendant inflow of foreign capital.
Also, the Federal Reserve, using monetary policy, can set the overall level of
spending in the economy to a level consistent with full employment.16 While
16 Economies always have some amount of unemployment. Each economy will tend to have
a natural rate of unemployment around which the actual unemployment rate fluctuates. This
natural rate will also represent the rate at which the economy is effectively at full
employment because a lower rate of unemployment would not be sustainable due to the
(continued...)

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CRS-18
deviations from full employment can occur, a well run monetary policy will minimize
the incidence and duration of such episodes and help keep the total level of
employment high in most years with or without outsourcing, trade deficits, or trade
in general.
Trade deficits are most often a means of augmenting the level of goods and
services available to domestic purchasers, in effect, allowing the nation to spend
beyond current domestic output by means of importing foreign output. Both domestic
and foreign output are used to meet current domestic demand. With strong demand
in an economy operating near or at its productive capacity, and unable to generate a
near-term expansion of that productive capacity sufficient to meet that demand, it is
possible for domestic industries to be working at full capacity, even as there are also
large inflows of similar or related foreign products.
Another reason why more imports do not lead to a reduction of domestic output
and employment is because a very large share of U.S. trade is intraindustry trade in
intermediate products — trade within the same industry due to an internationally
fragmented production process — a final product will often be composed of several
components, some of domestic origin and some of foreign origin.17 With this
structure of production, an increase in the demand for the final product will increase
both domestic output and imported foreign output of necessary components,
regardless the level of capacity utilization. Finally, there may simply be no domestic
counterpart for some goods because product differentiation has led to specialization
across countries in the production of particular goods. (The economic gain from such
specialization arises from economies of scale, not comparative advantage and is
common among high income economies with very similar resource endowments).
16 (...continued)
inducement of higher a rate of inflation. The natural rate is not zero because at any point in
time there will be some people who are changing jobs and other people who normal market
forces have temporarily displaced. More fluid the economy’s labor markets the lower its
natural rate of unemployment is likely to be. For most of the last 30 years the United States
economy’s natural rate was judged to be in the 5.5% to 6.0% range. Since the mid-1990s,
the natural rate has likely fallen to the 4.5% to 5.0% range. Most often an appropriate level
of aggregate spending is that consistent with employment at the natural rate. There is no
theory or evidence to indicate full employment is influenced by the trade deficit.
17 The significance of intraindustry trade varies by industry. For industries that make
sophisticated manufactured goods it tends to be very high with over 90% of trade of this
form. In labor intensive industries, that manufacture less sophisticated products, very little
trade is intraindustry. Intra industry trade is to a great degree a manifestation of a wide
spread move towards more fragmented production processes, or what is called vertical
specialization. It is estimated that about one-third of the growth of world trade since 1970
is the result of this phenomenon and can be expected to be even higher for the trade of an
advanced industrial economy such as the United States. For further examination of the
nature and significance of intraindustry trade, see Paul Krugman and Maurice Obstfeld,
International Economics: Theory and Policy (Reading, MA: Addison Wesely, 1997), pp.
139-142. For further examination of the vertical specialization phenomenon, see David
Hummels, Dana Rapoport, and Kei-Mu Yi, “The Nature and Growth of Vertical
Specialization,” Journal of International Economics, vol. 54 (June 2001) pp. 75-96.

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CRS-19
For these reasons, to a substantial degree the size of the trade deficit during an
economic expansion, as during the 1990s, cannot be taken as a one-for-one measure
of reduced domestic output and the loss of the associated jobs.
Effects on Particular Sectors
While large trade deficits do not necessarily reduce the total level of economic
activity, they can alter the composition of domestic output. There is evidence that
over the last 20 years persistent trade deficits may have caused a reduction in the size
of the domestic manufacturing sector.18 The trade deficit exerts some downward
pressure on the size of the domestic manufacturing sector because the trade inflow
cannot easily augment the full spectrum of goods and services that comprise the
nation’s increase in domestic demand. About 70% of domestic spending is on
services, but because trade is a relatively poor vehicle for acquiring services, only
about 15% of U.S. imports are services. Therefore the trade deficit, largely a net
inflow of manufactured goods, may not meet the augmented domestic demand for
goods and services. In this circumstance relative prices can be expected to change so
as to reallocate some resources out of the domestic manufacturing sector and into the
production of services to help meet the added domestic demand for services. This, in
turn, should induce a greater reliance on the net inflow of foreign manufactured goods
to help meet the added domestic demand for manufactures. The outcome will be
greater real output by the domestic service sector and smaller real output by the
domestic manufacturing sector.19
Recent surges of the trade deficit have clearly had a sharp negative impact on
particular sectors. On the export side, agriculture and commercial aircraft experienced
dampened export sales, mainly due to general weakness in other economies,
particularly in Asia. On the import side, the steel industry and the textile and apparel
industries came under considerable pressure from low price competition from
countries affected by economic crises. Adjustment to such trade effects can be
economically painful for workers in these harmed sectors. Many economists argue
that it is usually more beneficial to the overall economy to encourage adjustment than
it is to protect sectors from the disruptive effects of trade. There are government
programs that provide some amount of trade adjustment assistance, but there are
important questions about the adequacy of these programs.
Looking to the future, trade deficit induced erosion of the U.S. manufacturing
sector may also undercut the country’s ability to make future debt service payments
to foreign creditors. Manufacturing is a major part of the exporting sector and it is
18 See CRS Report RL32350, Deindustrialization of the U.S. Economy: The Roles of Trade,
Productivity, and Recession, by Craig K. Elwell; CRS Report RL32179, Manufacturing
Output, Employment, and Productivity, by Stephen Cooney; and Robert Rowthorn and
Ramana Ramaswamy, “Deindustrialization: Causes and Implications,” Staff Studies for the
World Economic Outlook, IMF, 1997.
19 This argument is not likely undermined by the development of U.S. trade surpluses in
services in this period as tradable services are a small sub-set of the full spectrum of, largely
non-tradable, services in domestic demand.

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CRS-20
that sector which will be the means for paying debt service. A healthy manufacturing
sector is likely to make that task easier.
Policy Responses to Trade Deficits
So long as domestic saving in the United States falls short of domestic
investment and an inflow of foreign saving is available to fill all or part of the gap, the
United States will run a trade deficit. This suggests that the use of trade policy tools
to alter the flow of exports or imports, while imposing efficiency costs on the
domestic economy, would not over time change the domestic investment-saving
imbalance and therefore, would not change the overall size of the trade deficit.20 On
the other hand, macroeconomic policy tools have the potential to alter the saving-
investment balance and the trade balance, but the realistic scope for their use is
limited.
Trade Policy Responses
Trade policy involves actions to directly stimulate or retard the flows of imports
and exports such as the erection or removal of tariffs and subsidies. Such actions will
have significant impacts on the level of trade and economic efficiency (positive or
negative) but will not change the balance of trade. In each instance action aimed at
altering one side of the trade equation tends to induce effects via the exchange rate
that will cause the other side of the equation to change in the same direction and by
an equal amount. For example, using a tariff or quota as a barrier to stem the flow of
imports into the United States would also reduce the demand for foreign exchange
needed by the United States to purchase imports, appreciate the dollar’s exchange rate,
and induce an equivalent curtailment of export sales. With this policy the level of
trade has been reduced along with the economic gains from trade and general
economic well-being, but the trade deficit would be unchanged. Alternatively, getting
our trading partners to remove trade barriers would stimulate export sales, but would
increase the demand for dollars by foreigners, appreciate the dollar exchange rate and
induce an equivalent increase of imports. In this case the level of trade is increased
along with the gains from trade and economic well-being, but the trade deficit would
be unchanged. Finally, an export subsidy would also stimulate export sales but an
exchange rate induced rise of import sales would also leave the trade balance
unchanged. (In the case of the subsidy, economic theory holds that a higher level of
trade does not lead to an increase in economic welfare as the gains from trade are
more than offset by the economic inefficiency of distorting the allocation of resources
towards the export sector.)
Macroeconomic Policy Responses
The mechanics of the saving-investment relationship in an internationally open
economy such as the United States suggests that there are essentially three ways the
20 Similarly, the removal of U.S. trade barriers, while conferring efficiency gains, would
not change the domestic investment-saving imbalance and, therefore, would not widen the
trade deficit.

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CRS-21
trade gap can be reduced. One, the rate of domestic investment falls. Two, the level
of domestic saving rises. Or three, some combination of one and two occurs.
Macroeconomic policy, the use of monetary and fiscal policy tools, can in theory
effect changes in these variables. Monetary policy, by raising domestic interest rates
and braking economic activity, can lower the rate of domestic investment and likely
narrow the trade deficit. (At the extreme, a recession would likely dramatically reduce
the trade deficit as it did in 2001.) Because of its negative effects on economic
growth, decreasing the rate of domestic investment is not generally considered the
most desirable economic course to follow, however.
The second course to a smaller trade deficit, raising the domestic saving rate,
while having considerable economic merit, is a very problematic goal for
macroeconomic policy. As explained above, fiscal decisions on taxing and spending
influence the deficit or surplus position of the federal budget and the rate of public
saving. As seen in the late 1990s, a rise in the U.S. overall saving rate as a
consequence of a rising public saving rate stemmed from the sharp swing of the
federal budget from a deficit of $290 billion in 1992 to a surplus of $236 billion in
2000. But budget deficits have returned and the government saving rate has fallen
accordingly. Given the political nature of budget deliberations, it seems problematic
whether the federal budget can be an exploitable policy tool for reducing the trade
deficit.
Also, keep in mind, that there is less than a one-for-one change in the total saving
rate from a given reduction of the budget deficit. The lower interest rates that come
from the smaller budget deficit will also tend to stimulate some amount of domestic
spending and reduce national saving accordingly. The ultimate effect on the overall
saving rate is likely to be $0.50 to $0.80 for each dollar reduction in the budget deficit.
This also means that a dollar of budget deficit reduction results in less than a dollar
of trade deficit reduction, other factors constant. Therefore, given budget deficits of
about $400 billion, a vanishing of the trade deficit achieved through only a change in
government saving would entail running large budget surpluses.
Can macroeconomic policy lift the low private saving rate? Proposals have been
made to use the tax code to raise incentives for saving by households. Careful analysis
reveals that such proposals most often have uncertain effects on the saving-investment
balance, as they tend to raise both saving and investment.21 Other proposals, such as
individual retirement accounts, may just redistribute saving, raising the household rate
(a little), but lowering the public rate by an offsetting amount.
The Effect of Tax Cuts. Federal budget surpluses of recent years have been
an important source of saving for the U.S. economy. But changes in federal tax and
spending policies have now turned the budget to deficit for the foreseeable future. It
is possible that tax cuts in particular could lead to an increased rate of household
saving, leading to no deterioration of the national saving rate and no increase of the
trade deficit. The more likely outcome, however, is that some portion of the tax cut
will be saved and some portion will be spent. Recent household behavior would
suggest that the proportion spent has been much larger than the proportion saved. To
21 See CRS Report RL30873, Saving in the United States: How Has It Changed and Why Is
It Important?, by Brian Cashell and Gail Makinen.

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CRS-22
the extent that the tax cut is spent by households the national savings rate will fall.
In the framework outlined above, such a large reduction of saving will tend to raise
domestic interest rates and attract more foreign capital (foreign saving) and induce a
substantial increase of the trade deficit. Of course, a rise in the trade deficit can occur
if there is also an available flow of savings from the rest of the world. The less able
the United States is to attract foreign saving the less the trade deficit will rise and the
more domestic investment would be trimmed to accord with a smaller flow of saving.
The Effect of Economic Policy Abroad. Foreign economic policy can help
or hinder efforts by the United States to decrease the size of its trade deficit. As
discussed above, the U.S. trade deficit is a two-way affair, reflecting the behavior of
borrower and lender alike. On the other side of the U.S. inclination to spend beyond
current domestic output by importing the difference is a symmetrical inclination of
one or more foreign nations to spend well short of domestic output and export the
difference. It seems that American spending is as important to these economies as
foreign borrowing is to the United States. The most orderly adjustment to a smaller
U.S. trade deficit is likely to occur if as the United States moves to bring domestic
spending down closer to domestic output, our major trading partners move to bring
domestic spending up closer to their domestic output. In so doing, our efforts to
become less dependent on imports from them is complemented by their efforts to
become less dependent on exports to us. The less willing foreign economies are to
change this current pattern of spending the more protracted and difficult shrinking the
U.S. current account deficit could be. If foreign economic policies work to counter
U.S. policies attempting to raise domestic saving by reducing their domestic saving,
then the dollar depreciation needed to induce a sizable reduction of the U.S. trade
deficit would be larger than if foreign policies were more supportive of the change in
spending patterns.
Without such mutually supporting policies, the dollar might have to fall 40% to
50% to achieve any sizable reduction of the U.S. trade deficit. A depreciation of that
magnitude is risky for two reasons. One, some would argue that the greater the size
of the currency’s fall, the greater the chance that it will fall too far, too fast, sending
a jolt to world financial markets that could possibly precipitate a world recession.
Two, the dollar may not fall evenly against other currencies. Since 2002, the dollar
has fallen over 30% against the euro but only about 15% against the Japanese yen.
This has occurred because Japan has more actively tried to limit the strengthening of
the yen relative to the dollar, accumulating a large stock of dollar assets. If such
behavior becomes wide-spread, then the burden of adjustment of trade flows would
fall heavily on the euro area and raise the risk of major economic collapse there.
Because of their size and degree of economic interaction with the United States,
Japan and the euro zone (particularly Germany) would likely have to play a key role
in assuring the world economy has an orderly adjustment to a weaker dollar and a
much smaller American trade deficit. Yet neither has had a recent history of
economic strength and there are reasons to doubt their willingness to undertake the
actions that would better insure an orderly adjustment to a smaller U.S. trade deficit.
Japan has struggled with poor economic performance for more than a decade and
despite much better performance recently it is unclear that it is willing to overcome
its fears of deflation and move strongly toward a stronger yen and reduced dependence
on exports to support economic activity there. In Europe, structural rigidities continue

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CRS-23
to slow economic growth and a distinct bias towards tight macroeconomic polices
further inhibits economic activity. In addition, there is an evident tendency of the euro
zone to also use exports to support economic activity and therefore an inclination to
avoid significant strengthening of the euro.
Of course, this adjustment process would also be assisted by the appreciation of
other currencies, particularly in other Asian economies that have ‘pegged’ their
currency to the dollar. Much attention has been focused on China and its pegged
currency, but the case for a stronger yuan is more tentative. Unlike Japan, China has
a relatively small trade surplus. And unlike Japan and the euro zone, China does not
have a well developed and stable financial system and as a result probably has limited
ability to successfully contend with currency instability. In general, policies that
improve the investment climate in many developing countries such as improved
macroeconomic stability, increased financial transparency, and better bank regulation
will tend to redirect international lending towards them and away from the United
States. Nevertheless, it would seem quite problematic whether other countries will
follow polices that would greatly increase the prospect for an orderly or quick
shrinking of the U.S. current account deficit.
Conclusion
A trade deficit is not necessarily bad. It is most useful to see it as a vehicle to
achieve an economic end, conferring some benefit at some cost. Whether the trade
deficit is good or bad will hinge on how one weighs the benefit against the cost. The
overriding benefit is the ability to borrow internationally so as to push current
spending beyond current production. Trade deficits in the 1990s have been a means
to help finance an elevated level of domestic investment. Investment augments the
nation’s future productive possibilities and is a boon to long-term economic welfare.
The cost of the trade deficit is the debt service that must be paid on the associated
borrowing from the rest of the world. The U.S. debt service has grown steadily and
will soon reach a size that could impose a significant decrement to the rate of growth
of our living standard. It is a burden that is still well within the U.S. means to pay, but
some might argue it is a burden that needs to be curtailed.
Reducing the trade deficit by policy actions is very problematic, however. It is
clear that standard trade policy tools such as tariffs, quotas, and subsidies will not
change saving or investment behavior and, therefore, will not reduce the trade deficit,
but in many cases will create distortions that reduce national economic welfare.
Macroeconomic policy can affect the saving-investment balance and can change the
trade deficit, but how to do so by raising domestic saving rather tan reducing
domestic investment remains unclear. Recent policy changes have turned the federal
budget from surplus to deficit for the next several years, reducing public saving, and
tending to increase the trade deficit. The trend toward larger trade deficits will be
reinforced by the prospect of sustained economic weakness in Japan and Europe
leading to an increasing stream of capital outflows to the U.S. economy. Generating
a sustained increase in the U.S. economy’s rate of saving by reversing the steadily
sagging rate of household saving would reduce the trade deficit, but how to raise that
rate is uncertain.

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CRS-24
It is very probable that the trade deficit could correct itself without any
inducement by economic policy. There are good reasons to expect that economic
forces will work to sate the demand for foreign borrowing as well as reduce the supply
of foreign funds being offered. A significant acceleration of the rate of growth abroad
relative to that of the United States (raising domestic investment relative to domestic
saving abroad) would likely initiate such a process. A change in relative growth rates
would most likely alter rates of return between the United States and the rest of the
world, redirect a larger share of international investment flows towards destinations
other than the United States, and shrink the U.S. trade deficit. This correction does
not necessarily have to lead to an elimination of the trade deficit. It might only fall
enough to assure a more sustainable rate of accumulation of foreign debt.
Nevertheless, a smaller trade deficit will, lacking an increase in the rate of domestic
saving, likely lead to higher interest rates and a lower rate of domestic investment.
And sustaining that lower rate of investment will still require some net inflow of
foreign saving.

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