Order Code RL32059
CRS Report for Congress
Received through the CRS Web
Trade, Trade Barriers, and Trade Deficits:
Implications for U.S. Economic Welfare
Updated June 8, 2005
Craig K. Elwell
Specialist in Macroeconomics
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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Trade, Trade Barriers, and Trade Deficits:
Implications for U.S. Economic Welfare
Summary
This report provides an overview of the economics of international trade that
may be helpful for consideration of many recurring international economic policy
issues. It is intended as a general explanation of mainstream economic principles that
may be considered in gauging the economic significance of trade issues as well as
the trade-offs inherent in many policy choices. A fundamental tenet of economics
is that international trade is a means to a higher standard of living for all trading
nations. The post-war era has seen a rapid expansion of trade and the United States
has been a major participant in this process both as a trading nation and as a leader
in the steady lowering of barriers to trade worldwide. The significant benefit of trade
does not come without disruption and cost, however. Gaining the benefit of trade
and also treating equitably those hurt by trade is often a difficult public policy issue.
There is recurring congressional concern about the effect of trade on U.S.
economic welfare. Current issues include bilateral and multilateral trade
liberalization initiatives, steel dumping, export controls, and the rapidly growing
trade deficit. This report provides a brief overview of the economic arguments for
free trade, common arguments for trade barriers, and the cause and economic
significance of persistent large trade deficits. A central theme is that the economic
benefit of specialization and trade is a fundamental aspect of economic life whether
for the individual, region, or nation. This benefit is mutual, enriching each trader;
moreover, the gain from trade can accrue to a trading partner even if that partner is
less efficient in the production of all tradable goods. Trade can also lead to economic
gains by allowing a fuller use of economies of scale and by inducing productive
innovation. Trade is, however, a disruptive force as well, advancing the economic
position of relatively efficient activities, but diminishing that of relatively less
efficient activities. This process will often place significant economic and social
costs on workers and industries in adversely affected activities.
Arguments for trade barriers come in many forms but none is generally accepted
by economists. Trade barriers are often seen as a redress to the social and economic
costs of trade or as a way of enhancing economic advantage. In most cases, however,
economists argue protection from trade imposes costs on the economy that exceed
the benefits obtained. These costs can arise from inefficient resource allocation,
intractable implementation, and foreign retaliation.
The trade deficit is not a necessary aspect of trade, nor is it caused by foreign
trade barriers. A trade deficit is rooted in macroeconomic behavior at home and
abroad. The deficit is a means for the nation to spend beyond current production,
with a like sized inflow of borrowed foreign capital that funds the added spending.
Spending beyond current production, particularly on investment, can confer
significant benefits. But, borrowing will entail some level of cost as debts are repaid.
The report will be updated infrequently with changes in economic knowledge
and with current trade data.

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Contents
The Growing Importance of Trade to the U.S. Economy . . . . . . . . . . . . . . . . . . . 1
Why Do Countries Trade? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Specialization, Comparative Advantage, and Gains from Trade . . . . . . . . . . 2
Other Sources of Gains from Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Measuring the Gains from Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
The Economic Effect of Trade Barriers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Common Arguments for Trade Barriers . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Jobs Are Destroyed by Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Worker Wages Are Hurt by Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
National Security Is Threatened by Trade . . . . . . . . . . . . . . . . . . . . . . 12
Special Industries with Unique and Substantial Economic
Potential Will not Mature without Protection from Trade . . . . . 12
Unfair Competition Undermines the Benefits of Trade . . . . . . . . . . . . 14
The Trade Deficit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
A Saving — Investment Imbalance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
The Benefits and Costs of Foreign Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Reducing the Trade Deficit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

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Trade, Trade Barriers, and Trade Deficits:
Implications for U.S. Economic Welfare
The Growing Importance of Trade to
the U.S. Economy
The American economy has experienced steady and substantial growth of
international trade since the end of World War II. Total trade (the combined value
of exports and imports) as a share of gross domestic product (GDP) has risen from
around 10% in the 1950s to about 25% in 2004. Even this large increase may
understate the rising impact of trade on the economy because of the large share of
services output, much of which is non-tradable, in U.S. GDP. For example, looking
at merchandise exports as a share of total tradeable output for the U.S. we see growth
from near 4% in 1950 to over 40% in 2004. For the United States, however,
international trade is still much less important than in other industrial economies,
where, as in most European countries, trade often exceeds 50% of GDP.1
The rising integration of the American economy with the world economy has
been facilitated by technical advances that have reduced the natural barriers of time
and space that separate national economies. Integration has also been facilitated by
recurrent multi-national policy actions that have steadily lowered various man-made
barriers to international exchange. The United States has always played a leading
role in pursuing these trade liberalization initiatives. As natural and man-made
barriers have fallen, the considerable economic advantages of trade have induced
large increases in the international exchange of goods, and a mutual gain in the
economic well being of trading nations.
Why Do Countries Trade?2
Trade occurs because it is mutually enriching, with a positive economic effect
like that caused by technological change, whereby economic efficiency is increased,
allowing greater output and consumption from the same endowment of productive
resources. One can think of international trade as a productive process, with our
exports as the inputs and our imports as the output. But, most importantly, it is a
more efficient productive process that provides American consumers with goods and
services they want at a lower cost than can domestic producers. The notion “exports
are good and imports are bad,” often colors public policy debates about international
1 See International Monetary Fund, World Economic Outlook, June 2003.
2 For a fuller discussion, see N. Gregory Mankiw, Principles of Economics (New York:
Dryden Press, 1997), pp. 45-57.

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CRS-2
trade. As the cited analogy suggests, from a macroeconomic perspective both exports
and imports are “good.” The benefit of free trade is attached to the product received,
not in the product given. We want imports, and exports are how we pay for them.
We are exchanging something of value to acquire something of greater value to us.
And what we gain from such exchange is increased by anything that allows us to
exchange a smaller volume of exports for any given volume of imports (i.e., by a
reduction in the export cost of imports).
Like technological change and other market forces, international trade creates
wealth by inducing a reallocation of the economy’s scarce resources (capital and
labor) into relatively more efficient activities and away from less efficient activities.
In the case of international trade, however, the more efficient activities are located
beyond the nations borders. Such reallocation can be characterized as a process of
“creative destruction” generating a net economic gain to the overall economy, but
also being disruptive and costly to workers in adversely affected industries. These
displaced workers will likely bear significant adjustment costs and many may find
work only at a lower wage. While economic analysis almost always indicates that
the economy-wide gains from trade exceed the costs, the perennially tough policy
issue is how to secure those gains for the wider community while dealing equitably
with those who are hurt by the process.
Specialization, Comparative Advantage,
and Gains from Trade
The importance of the gains from trade is clearly evident in our individual
economic behavior. Rather than build our own automobile, provide our own medical
services, or produce our own food, we find it far more efficient to specialize in the
production of some good or service we are good at and trade these (indirectly with
the use of money) for most other goods or services that we want. Such specialization
and trade clearly allow each of us to consume far more than we could if we tried to
be completely self-sufficient. The same is true for a country, albeit to a less
extensive degree in most cases (i.e., U.S. imports of goods and services amount to
about 15% of GDP).
Economics also tells us that the gains from specialization and trade are mutual,
occurring even if the trading parties have an absolute advantage or disadvantage in
the efficiency with which they produce all tradable goods. All that is required is a
difference in relative efficiency, that is, a difference among countries in the rate at
which the output of one good must be curtailed to expand production of another
good. (In other words, a difference in opportunity costs exists). If these rates are
different, then each country has a comparative advantage in the production of one
of the goods, creating the potential for gains from trade. In this circumstance, each
country can improve its economic well-being by producing what it does (relatively)
best and trading for the rest. A nation does not compete with its trading partners, it
engages in mutually beneficial exchange with them. Therefore business metaphors
such as “competitiveness” that are relevant to the individual firm are unlikely to be
useful in understanding the “two-way” nature of trade and significance of the mutual
gains from trade.

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CRS-3
This principle of comparative advantage would explain, for example, why the
$200 per hour attorney, despite being able to type very fast and accurately, would still
find it more efficient to employ a secretary for $25 an hour to do that job. The
income gained from using the time he would spend typing to practice law would
likely more than compensate for the cost of the secretary. (The opportunity cost of
the attorney typing for one hour exceeds the cost of the using a secretary for that
task.) Similarly, the secretary gains by spending more time typing and less time
attempting to practice law. (The pay from typing exceeds the opportunity cost of not
practicing law.)
Differences in comparative advantage will arise between countries because of
differences in the relative abundance or scarcity of the factors of production.
Comparative advantage will be found in those activities that make intensive use of
the abundant productive resource. For example, compared to many other countries
the United States, with a relative abundance of high-skilled labor, will find that
specialization in the production of goods that use high-skilled labor intensively will,
with trade, raise national income. In contrast, China, which has a relative abundance
of low-skilled labor and relative scarcity of high-skilled labor, would find that
specialization in the production of goods that use low-skilled workers intensively
would, with trade, raise that country’s real income. (Differences in productive
technology among countries could also create differences in relative efficiency and
form a basis for trade.)
Comparative advantage can emerge in the production of intermediate products
as well as final products. With some increasingly fragmentable production processes,
it may be more efficient to produce a particular component in one country, another
component in a second country, and assemble the final product in a third country.
We also may find that comparative advantage will vary over the life cycle of a
product. At the stage of innovation and product development where high-skilled
workers and specialized capital are required, an economy with an abundant
endowment of such resources like the United States would be the more efficient
location for production. At a later stage in the product’s life, with greatly expanded
sales, a settled technology, the capability for standardized production, and a falling
price, production would be more efficient in an economy with an abundance of low-
wage labor such as in China.
It is important to highlight that the gains from trade will most often arise from
there being differences between the trading partners, not just economic differences
but social, political, geographical, or demographic differences can be of significance
as well.3 This explains why many economists do not find useful the sports metaphor
commonly used in trade policy discussions — the need for a “level playing field”
among trading partners. If each person, region, or country were alike in every way
there would be little to gain from trading. This observation may be particularly
important when considering the merits of U.S. trade with poorer, less economically
advanced countries, who will very often have sharply different economic, cultural,
3 The exception would be a difference caused by a man-made barrier to trade, such as a
tariff. In this case, removal of the “difference” through elimination of the tariff would
increase the gains from trade and economic well-being.

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CRS-4
and other characteristics. Economic theory indicates that using these differences to
generate trade will be an important means by which a rich or poor nation can improve
its economic well-being.
Other Sources of Gains from Trade
Trade is also enriching to the extent it allows countries to take greater advantage
of economies of scale. The longer a production run, the lower unit production costs
may be. Many products require huge initial investments in research and development
as well as large investments in a highly specialized physical plant and equipment.
The ability to reach a larger world market through international trade can greatly
reduce average production costs and the final price consumers must pay for the
product.
In addition, open markets and international trade can increase the flexibility of
an economy. Trade can enhance an economy’s ability to respond quickly and
efficiently to rapidly changing economic conditions in the global market place by
improving access to foreign markets, resources, and technologies.
Further, trade can increase the competitive pressures in the market place,
pushing firms to cut waste, keep prices down, improve quality, and raise productivity.
Such pressure can also be an effective check against the use of monopoly power and
in general a clear benefit to the nation’s consumers.
Finally, trade can accelerate the pace of technical advance and boost the level
of productivity. By raising the expected rate of return to successful innovation and
spreading research and development costs more widely, trade can propel a higher
pace of innovation. With more competitive pressure firms must quickly adopt new
practices, or risk business failure. Greater international trade can also enhance the
exchange of technical knowledge among countries as human and physical capital
may move more freely. Economic theory suggests that these inducements will
increase an economy’s rate of growth, causing, not just a one-time boost to
economic welfare, but a persistent increase in income that gets steadily larger as time
passes.4
Measuring the Gains from Trade
Through these several forces, economists reason that free international trade
will raise the efficiency of the world economy and improve the living standard of
most trading nations. Moreover, these gains are permanent, accruing to the economy
each year, and making their full significance better measured by a cumulative gain
over the stretch of decades. In the postwar era international trade worldwide has
4 Another possible benefit of more open trade for the United States can arise because our
level of trade barriers is already very low relative to most other trading partners. Therefore,
a removal of those barriers would likely have a stronger positive effect on the demand for
our exports than it will on our demand for imports. This can cause a rise in the relative price
of our exports. A rising export price will increase the import purchasing power of any
given volume of U.S. exports and increases the gains from trade to the United States.

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CRS-5
grown three times as fast as a briskly advancing world output, leaving little doubt that
trade has made an important contribution to the growing prosperity of the United
States and the world economy. Initiatives such as the creation of the European Union,
implementation of Uruguay Round of market openings, and the North American Free
Trade Agreement (NAFTA) all speak to the importance of trade. It is also apparent
that trade has played an important role in the dramatic transformation of the emerging
economies in East Asia.
Many studies have measured the benefits of trade to be sizable, with the overall
gain typically growing with the degree of openness to international trade. For
example, a 1999 study by Frankel and Romer looked at data from 123 countries to
assess the relationship between openness to trade and the growth of real per capita
income. They found that each percentage point increase in openness ( as measured
by the sum of exports and imports as a percentage of GDP) led to a 0.34 % increase
in real per capita income. For the United States between 1960 and 1997, there was
a 12.7% increase in openness to trade and an associated 4.3% increase in real per
capita income, and they expected this gain to increase as the time period is extended
into the future.5 A 2003 study by Catherine Mann looked at the economic
consequences of the globalized production and international trade of information
technology (IT) hardware. It found that increased IT hardware trade between 1995
and 2002 generated a cumulative gain of $230 billion to the U.S. economy.6
The likely sizable benefits derived from trade’s inducement for the
development of new products, provision of an enhanced array of products, and
generation of increased productivity are not easy to measure. Therefore, it is likely
that the full magnitude of the gains from trade are underestimated in most
quantitative studies.
5 Jeffery Frankel and David Romer, Does Trade Cause Growth?, NBER Working Paper No.
5476, June 1999.
6 Catherine L. Mann, Globalization of IT Services and White Collar Jobs: the Next Wave of
Growth, International Economics Policy Briefs, no. pb03-11 (Washington: IIE, Dec. 2003).
For more evidence on the gains from trade, see Edward E. Leamer and James Levinsohm,
“International Trade Theory: The Evidence,” in The Handbook of International Economics,
vol. 3 (Amsterdam: North Holland, 1995), and Douglas A. Irwin, Free Trade Under Fire
(Princeton NJ: Princeton University Press, 2003), pp.29-54.

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CRS-6
The Economic Effect of Trade Barriers7
If international trade is economically enriching, imposing barriers to such
exchanges will prevent the nation from fully realizing the economic gains from trade
and must reduce welfare. Protection of import-competing industries with tariffs,
quotas, and non-tariff barriers can lead to an over-allocation of the nation’s scarce
resources in the protected sectors and an under-allocation of resources in the
unprotected tradeable goods industries. In the terms of the analogy of trade as a more
efficient productive process used above, reducing the flow of imports will also reduce
the flow of exports. Less output requires less input. Clearly, the exporting sector
must lose as the protected import-competing activities gain.
But, more importantly, from this perspective the overall economy that consumed
the imported goods must also lose because the more efficient production process —
international trade — cannot be used to the optimal degree, and, thereby, will have
generally increased the price and reduced the array of goods available to the
consumer. Therefore, the ultimate economic cost of the trade barrier is not a transfer
of well-being between sectors, but a permanent net loss to the whole economy arising
from the barriers distortion toward the less efficient the use of the economy’s scarce
resources.
The United States and other nations have made great progress in the post-war
era in reducing trade barriers. The average tariff among industrial nations has been
reduced from near 50% after WW II to near 5% today.8 Barriers in many developing
economies have also fallen but are still generally higher than those of the industrial
economies. These remaining impediments to trade, nevertheless, have significant
economic costs. A 1994 estimate of the economic cost of existing U.S. barriers in 21
highly protected sectors was $70 billion per year, with economic cost per protected
job ranging from $100,000 to more than $1 million and averaging about $170,000.9
7 Man-made trade barriers come in several forms. Two common manifestations are tariffs
and quotas. Tariffs are a tax on imported goods. Quotas are a limit on the quantity of a good
that can be imported. A variant of the quota is the voluntary export restraint (VER), where
the exporting country imposes the restriction. Other barriers against imports (often called
non-tariff barriers) include local content requirements, national procurement policies, and
unduly protracted health, safety, and customs procedures. The magnitude of the negative
effect on economic welfare will likely vary with the type of barrier used. In general, for a
given level of protection quota-like restrictions carry a greater potential for reducing welfare
than do tariffs. Tariffs, quotas, and non-tariff barriers lead too few of the economy’s
resources being used to produce tradeable goods. An export subsidy can also be used to
give an advantage to a domestic producer over a foreign producer. Export subsidies tend to
have a particularly strong negative effect because in addition to distorting resource
allocation, they reduce the economy’s terms of trade. In contrast to tariffs, export subsidies
lead to an over allocation of the economy’s resources to the production of tradeable goods.
For a fuller discussion of the nature and implications of different forms of trade barriers, see
W. M. Corden, The Theory of Protection (Oxford: Clarendon Press, 1971).
8 OECD, Indicators of Tariff and Non-tariff Barriers, Paris, various issues.
9 See Gary Clyde Hufbauer and Kimberly Ann Eliott, Measuring the Costs of Protection in
(continued...)

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CRS-7
In all 21 cases, the cost of protection was far higher than the workers average annual
earnings and far higher than any likely worker adjustment program would cost.
A 2004 study of eight industrial nations, including the United States, provides
estimates of the extent of integration among these economies and the welfare gains
from further integration.10 On the question of extent of integration, it was found that
despite considerable lowering of trade barriers over the post-world war II sizable
barriers still existed (in 1999), with average product prices differing by a third. On
the welfare gains from further integration, it was found that removal of the remaining
trade barriers among these eight countries would lead to an increase in global GDP
of more than $500 billion (in 1997 dollars) or 2.1% of global GDP. The gain to the
U.S. alone was estimated to be about $77 billion (in 1997 dollars) or about 1% of
GDP. Highlighting the greater gain associated with a multi-lateral lowering of trade
barriers, this study also estimated the gains to each of the eight countries if each
removed their trade barriers unilaterally. In this circumstance, the GDP increase for
the United States is pared to $30 billion or 0.4% of GDP. In general, the welfare
gains to the United States are smaller then those of the other eight countries. This is
thought to occur for three reasons: one, U.S. trade barriers were already lower than
those in the other countries; two, trade represents a comparatively smaller share of
economic activity in the U.S. economy; and three, there are increases in import prices
because of the huge size of the U.S. market, causing some deterioration of the terms
of trade and an associated decrement to economic welfare.
The issue, however, is not just whether to continue removing barriers but
whether to resist the erection of new barriers. During most of the first half of the 20th
century trade barriers grew sharply, reversing the substantial trade liberalization
achieved in the previous century. Therefore, much of the effort towards free trade
in the post-war era has involved reversing protectionist structures erected beginning
at the time of World War I and continuing into the 1930s.
Common Arguments for Trade Barriers
Demands for the preservation or augmentation of trade barriers continues to be
part of the public debate over trade policy. Five of the more common arguments for
trade barriers are evaluated below for their likely economic effects.
Jobs Are Destroyed by Trade. It is asserted that trade has created jobs for
foreign workers at the expense of American workers. It is more accurate to say that
trade both creates and destroys jobs in the economy just as other market forces do.
Economy-wide, trade creates jobs in industries that have comparative advantage and
destroys jobs in industries that have a comparative disadvantage. In the process, the
economy’s composition of employment changes, but according to economic theory
there is no net loss of jobs due to trade. Over the course of the last economic
expansion, from 1992 to 2000, U.S. imports increased nearly 240%. Over that same
9 (...continued)
the United States (Washington: Institute for International Economics, 1994).
10 Scott Bradford and Robert Z. Lawrence, Has Globalization Gone Far Enough? The Cost
of Fragmented Markets (Washington: Institute for International Economics, 2004).

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CRS-8
period total employment grew by 22 million jobs and the unemployment rate fell
from 7.5% to 4.0% (the lowest unemployment rate in more than 30 years.)11 Foreign
outsourcing by American firms, which has been the object of much recent attention,
is a form of importing and also creates and destroys jobs, leaving the overall level of
employment unchanged.12
There are two complementary reasons for increased international trade not
leading to any net job loss. First, the Federal Reserve, using monetary policy, can set
the overall level of spending in the economy to a level consistent with full
employment.13 While 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. To give some perspective on the relation between
“job loss”and total employment, as well as the potential significance of foreign
outsourcing in this dynamic process, consider that in any quarter of 2000, at the peak
of the last economic expansion, with total employment at about 111 million, gross
job losses tallied between 8.5 and 9.0 million. Nevertheless, the economy at that time
was operating at the lowest rate of unemployment in 40 years. Over the whole course
of that expansion, gross job loss actually rose as the unemployment rate steadily fell.
But with adequate economy-wide spending, it was possible to create job gains that
more than offset job losses. In the far weaker labor market of 2003, gross job losses
per quarter measured 7.2 to 7.8 million. Gross job gains in 2003 were at about the
same as losses leaving total employment steady. In either time period gross job
losses occurred on a scale far greater than that attributed to foreign outsourcing
alone.14
11 These data can be found in the most recent annual report of the Presidents Council of
Economic Advisers. Since the end of the recession in late 2001, the labor market has
responded slowly, with the unemployment rate continuing to rise even as economic growth
strengthened. Relatively weak aggregate spending, caused by a number of recent economic
shocks, is the most likely cause of poor employment growth. For a fuller discussion, see
CRS Report RL32047, The “Jobless Recovery” From the 2001 Recession: A Comparison
to Earlier Recoveries and Possible Explanations, by Mark Labonte and Linda Levine.
12 See CRS Report RL32484, Foreign Outsourcing: Economic Implications and Policy
Responses, by Craig K. Elwell and CRS Report RL32350, Deindustrialzation of the U.S.
Economy: The Roles of Trade, Productivity, and Recession, by Craig K.Elwell.
13 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
inducement of a higher 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. The 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 U.S.
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.
14 U.S. Department of Labor, Bureau of Labor Statistics, Business Employment Dynamics,
various issues.

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CRS-9
Second, against the economic backdrop of adequate aggregate spending, any
increase in the purchase of imports will tend to generate an equal increase in the sale
of the country’s exports of goods or assets. This outcome follows from the
fundamental economic requirement that imports must be paid for and exports are the
only means for making that payment. The export sold does not have to be a currently
produced good or service, it can also be the sale of an asset such as a deposits in a
bank account, shares of stock, bonds, or real property, but in the end when tallied
across transactions in goods and assets, a nation’s trade is always in balance in the
sense that any imbalance in goods trade must be offset by a compensating imbalance
in asset trade. Both types of export sales will have a positive effect on domestic
output and employment, countering across the whole economy the negative effect of
increased imports. In short, the U.S. deficit in trade is offset by the surplus in capital
flows.
There is no denying that with international trade there will be short-run hardship
for some, but economists maintain the whole economy’s living standard is raised by
such exchange. They view these adverse effects as qualitatively the same as those
induced by purely domestic disruptions such as shifting consumer demand or
technological change. In that context, economists argue that easing adjustment of
those harmed is economically more fruitful than protection given the net economic
benefit of trade to the total economy.
Worker Wages Are Hurt by Trade. Many people believe that imports from
countries with low wages has put downward pressure on the wages of Americans.
There is no doubt that international trade can have strong effects, good and bad, on
the wages of American workers. The plight of the worker adversely affected by
imports comes quickly to mind. But it is also true that workers in export industries
benefit from trade. Moreover, all workers are consumers and benefit from the
expanded market choices and lower prices that trade brings. Yet concurrent with the
large expansion of trade over the last 25 years, real wages (i.e., inflation adjusted
wages) of American workers grew more slowly than in the earlier post-war period,
and the inequality of wages between the skilled and less skilled worker rose sharply.
Was trade the force behind this deteriorating wage performance?
The effect of trade on wages in the U.S. economy has been the focus of
numerous studies over the last 10 years, and the conclusions that may be drawn from
these efforts are as follows:
! As regards the slow growth of the average real wage from the mid-
1970s to the late 1990s, increased trade is not seen as being the
cause of that sluggish performance, rather the identified reason was
slow productivity growth. Labor’s share of the economic pie was not
getting smaller; the economic pie just was not growing as fast.15
When productivity accelerated in the late-1990s average real wages
also increased at a faster pace. That the level of wages is most often
reflective of the level of worker productivity also explains why
15 This conclusion is also confirmed by the absence of any deterioration in labor’s share of
national income, which has remained at about 70% throughout the post-World War II era.

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higher wage American workers are not necessarily at a disadvantage
to lower wage foreign workers. The critical comparison is of unit
labor costs, not of the level of wages. The high productivity that is
the basis of a high wage means that unit labor costs can be lower in
the high-wage economy than in the low-wage economy because
productivity in low-wage economies is commensurately low as well.
! As regards trade and increased wage inequality, the research
indicates that trade was a contributing factor, but a minor one,
accounting for perhaps 10% to 20% of the observed increase in wage
inequality. It would seem then that from the standpoint of the
economy as a whole, trade with low-wage economies has not
triggered a “race to the bottom.”
A likely important reason for the small effect of trade on wages for the U.S.
economy was that trade with low-wage countries was still relatively small, amounting
to less than 2% of GDP in 2000. In fact, among U.S. trade partners the average wage
level in manufacturing relative to the U.S. manufacturing wage level grew from 60%
in 1975 to 76% of the U.S. level in 2000.16 This has occurred because many trading
partners who were once low-wage economies have, with open trade and steady
economic growth, become high-wage economies. As the once poor have moved up
the income ladder, they have also withdrawn from the production of goods that use
low-skill and low-wage labor intensively and these products are then imported from
the newer emerging economies. China has picked up this task, as other East Asian
economies have withdrawn, and, in turn, as these economies did when Japan shifted
away from this type of production. So U.S. trade with low-wage economies is not
rising to a significant degree; rather, it is shifting location.
Economies of scale are also a factor that likely helps hold up industrial wages
in the face of low-wage foreign competition. Scale effects are thought to be a
significant force in many industries and, when present, would tend to increase worker
productivity and decrease unit labor costs. It is also possible that the increase of
competition itself spurs companies to higher levels of efficiency that also lowers unit
labor costs and helps preserve a higher wage level.
Another reason for the small impact of trade on wages in the United States is
that as the once low-wage economies transform to high-wage economies, two events
occur: one, they tend to produce less of the goods typically produced by low-wage
workers; and two, they tend to increase there demand for the products produced by
low-wage workers. The two effects exert upward pressure on the wages of these
workers, including any producing similar products in the United States. This
outcome is consistent with the evidence that for the United States the relative price
of unskilled, labor-intensive, import competing goods rose in the 1980s and 1990s.17
16 U.S. Department of Labor, Bureau of Labor Statistics, “A Perspective on U.S. and Foreign
Compensation Costs in Manufacturing,” Monthly Labor Review, vol. 125, no. 6 (June 2002),
pp. 36-49.
17 Jagdish Bhagwati and Vivek Dehejia, “Freer Trade and Wages — Is Marx Striking
(continued...)

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CRS-11
Of course, it cannot be ruled out that if trade with relatively low-wage
economies does grow in importance, the negative effects on U.S. worker wages of
such trade would grow in significance. Yet, there is probably an upper bound to this
effect, for it is possible that in the future with only relatively moderate differences
between home and foreign production costs, complete specialization would occur.
That is, the United States would no longer produce much of what is imported from
low-wage foreign economies. Since the United States would then no longer have
industries that use low-wage labor intensively, there would be no downward pressure
on domestic wages caused by such trade. To the extent that this pattern of trade
allows for a fuller realization of economies of scale and lowers product prices,
domestic workers’ real wages could be increased. The change in the location of U.S.
imports from low-wage economies noted above suggests that a sizable amount of
such specialization may have already occurred. Reviewing the period 1994 through
2003, the Council of Economic Advisors concludes that for United States the
increase in share of total U.S. imports accounted for by imports of goods from China
has been largely offset by a decrease in the share of goods imports from other Pacific
Rim countries. The value of imports from both sources has increased considerably.
Still, many of the export jobs in non-China Asia are migrating to China, so the
distributional effects of this change fell on workers in China and the Pacific Rim
economies rather than workers in the United States.18
Also we know that industries that export pay wages that are, on average, higher
wages than industries that compete with imports. Therefore, as a rising level of trade
and outsourcing creates jobs in exporting industries, and destroys jobs in import-
competing industries there is a tendency for the average industrial wage to rise. It is
also useful to keep in mind that the U.S. economy is still largely domestic in
orientation, with perhaps as much as two-thirds of the labor force working and
having wages determined in activities largely unaffected by trade.
Economic analyses indicates that it is very unlikely that growing international
trade has had much to do with the slowdown in real wage growth and unlikely that
trade has caused more than a minor share of rising wage inequality. In the United
States, the slower productivity growth evident from the mid-1970s to the mid-1990s
is seen as the principal cause of slow real wage growth in this period. The experience
during the 1992-2000 period shows that despite a rapidly rising level of imports real
hourly earnings in the U.S. manufacturing sector (the sector most strongly effected
17 (...continued)
Again,” in Jagdish Bhagwati and Marvin Kosters, eds., Trade and Wages:Leveling Wages
Down? (Washington: AEI Press, 1995), pp. 36-75.
18 This also suggests any restriction placed on China’s imports to the United States would
not increase domestic output, rather it would increase the output of the Pacific Rim
economies whose exports to the United States would increase as they become a replacement
for restricted Chinese goods. For a discussion of this and other aspects of trade with China,
see The Economic Report of the President (Washington: GPO, 2004), pp. 65-68 and CRS
Report RL32165, China’s Exchange Rate Peg : Economic Issues and Options for U.S. Trade
Policy, by Wayne M. Morrison and Marc Labonte.

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CRS-12
by trade but one with relatively high productivity growth in this period) rose 26%.19
For trade to have reduced the relative wages of lower skilled workers there would
need to be an associated fall in the market price of those import-competing goods that
are produced using lower-skilled workers intensively. This has not occurred.20
A more likely reason for increased wage inequality is the presence of a bias in
recent technological change toward greater use of higher skilled workers economy-
wide, tending to pull up their wages relative to those of the less skilled. Other factors
that are thought to have made minor contributions to wage inequality are
immigration, deunionization, and a falling real minimum wage.21
National Security Is Threatened by Trade. Some industries, or at least
components of some industries, are vital to national security and possibly may need
to be insulated from the vicissitudes of international market forces. This
determination needs to be made on a case-by-case basis since the claim is made by
some who do not meet national security criteria. Such criteria may also vary from
case to case. It is also true that national security could be compromised by the export
of certain dual-use products that, while commercial in nature, could also be used to
produce products that might confer a military advantage to our adversaries.
Controlling such exports is clearly justified from a national security standpoint; but,
it does come at the cost of lost export sales and an economic loss to the nation.
Minimizing the economic welfare loss from such export controls hinges on a well-
focused identification and regular re-evaluation of the sub-set of goods with
significant national security potential that should be subject to control.
Special Industries with Unique and Substantial Economic Potential
Will not Mature without Protection from Trade. In theory, there can be
“special” industries, which, if given government nurturing, including protection from
international trade, will grow to generate large economic returns in the future. But
without this public support these special industries will not emerge or will occur at
too small a scale. While there are many variants of the argument for government
promoting particular industries, two have some plausible economic merit. One is
support for industries that will have the potential to generate substantial economic
benefits to other sectors, but only a fraction of those benefits can be appropriated by
the firm. If left to the private market this will lead to under-investment in the socially
desirable activity. The second type of special industry that could warrant government
support is a new endeavor that will only exist in a highly concentrated market
structure (i.e., oligopoly) where sizable monopoly profits are likely to be emerge.
Claiming the lion’s share of those profits will depend on which nation gets there first
and which nation can be deterred from trying. Government support can influence
which nation ultimately claims those monopoly profits. In both cases, the role of
19 BLS data as reported in the 2003 Economic Report of the President, p. 376.
20 See Robert Lawrence and Matthew Slaughter, International Trade and the American
Worker: Giant Sucking Sound or Small Hiccup? Brookings Papers on Economic Activity
(Washington: Brookings Institution, 1993).
21 For further discussion, see CRS Report 98-441, Is Globalization the Force Behind Recent
Poor U.S. Wage Performance?: An Analysis, by Craig K. Elwell.

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CRS-13
government support is to overcome a “market failure”and by doing so raise the
economic well-being of the nation.
The generation of new ideas is often the activity of central economic importance
for economic well-being. Because an idea can have limited excludability it can be
difficult for the firm to fully appropriate the economic benefits of the idea it has
created. The new idea may easily spill over to benefit other enterprises without
compensation accruing to its creators. In this environment, without government
support the firm will not have the incentive to invest in the knowledge-creating
process at a level that the whole society would find most economically beneficial.
This is a theoretically valid argument for government support for an industry
that generates significant benefits that are external to the firm. In practice, however,
it is a problematic endeavor.22 To be economically effective such support needs to
be targeted at the knowledge that would not otherwise be produced. This is likely a
difficult task. Even if the right target is identified, it will be virtually impossible to
know what amount of support is called for because these types of activities to not
carry a market price from which to judge relative scarcity. A tariff or other forms of
protection from international competition is likely to be too blunt an instrument to
achieve this goal as it is likely to create other costly distortions. At the international
level knowledge nurtured at considerable expense by one nation may be easily
appropriable by industries in other nations, tending to reduce any national advantage
to accrue from supporting a special firm.
The other theoretically valid argument for government promotion of a particular
industry is based on the possible existence of “strategic industries.” These are
industries in which only a very few firms would be able to operate profitably. In this
oligopolistic market structure, firms will likely have a significant degree of monopoly
power and the potential to earn above normal profits. Capturing those profits would
increase the home nation’s economic well-being. In this environment, nations may
be tempted to compete for those profits. Without government support those profits
will most likely be appropriated by the first few firms to establish themselves in the
industry. Subsequent entry by other firms would be deterred as they can only expect
to incur losses. This outcome can be altered if the government of one country gives
support, with an export subsidy for instance, sufficient to assure that whether firms
from other nations enter or not, its firm will earn a profit. Because any unsubsidized
firm would now earn losses they will be deterred from entry. The subsidized firm is
said to have a strategic advantage over its potential competitors, so this type of action
has been called strategic trade policy. In theory, a well placed subsidy to assure the
timely entry and successful operation of the “strategic industry” can actually raise
economic well-being in the home economy.
Again, while it is conceptually possible for a strategic trade policy to raise
national economic well-being, its practical significance has been widely questioned
by economists. Perhaps the greatest doubt as to the efficacy of strategic trade policy
22 For a discussion of the problematic success of industrial policy in practice in several
industrial countries, see Paul Krugman and Maurice Obstfeld, International Economics:
Theory and Policy (New York: Harper-Collins, 1994), pp. 287-296.

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CRS-14
is that the information required for the government to successfully execute the policy
most likely exceeds what would be readily available. Economic theory indicates that
the conditions needed for the execution of a successful strategic trade policy are
many and a favorable outcome will be extremely sensitive to small deviations from
any of those necessary conditions. This means that pursuing such a policy with
substantially incomplete information could easily result in subsidies supporting more
inefficiency than efficiency, and leading to more loss than profit. Further, if large
subsidies are to be handed out without all necessary information available, policy
makers can anticipate some politicalization of the process and the rising probability
that more subsidies will be given than can be analytically justified. Success is likely
to be even less tractable if trading partners can be expected to retaliate against a
policy that will clearly make them worse off. Finally, economic studies have
suggested that even if the policy is well implemented, the realized gains could be
very small. For all these reasons, it is unlikely in practice that trade protection to
support strategic industries would raise economic welfare.
Unfair Competition Undermines the Benefits of Trade. Can trade be
beneficial if all parties don’t abide by the same rules and regulations? Economic
theory says it can. If another country chooses to give a subsidy to an exporting
industry, buying those now-cheaper exports will hurt domestic industries that
compete with those foreign goods, but it will benefit the domestic consumers who
purchase them. Economists assert that the gain to consumers will typically exceed
the loss to producers and workers. Therefore, from the standpoint of overall
economic welfare, here defined as increased national income, an efficient economic
response may be to accept the gain in real income offered by the subsidized foreign
goods and facilitate the adjustment of the adversely affected home workers to more
efficient endeavors.

Similarly, many economists see a possible economic advantage of buying
foreign goods produced under different labor and environmental standards. They
view differences in such standards as a basis for creating comparative advantage and
realizing mutual gains from trade. In addition to the economic benefit to the U.S.
economy, for many poor nations the ability to use such advantages to produce a
tradeable good today may offer the best vehicle to increased productivity and a
steadily rising living standard in the future. Despite the economic gain to the United
States, trade on this basis can undermine long held domestic norms of “fair” market
conduct. It is at the core of many domestic disputes regarding trade and trade
barriers as many see trade as eroding labor and environment standards. If deviation
from these norms is unacceptable in domestic transactions, it may be hard to justify
them in international exchanges.
Yet it is also probably unrealistic to expect our trading partners to be just like
us in these practices. Poor countries with much lower levels of productivity simply
cannot afford the American level of wages and labor standards.23 Rich or poor, other
countries often have different social and economic priorities and may choose to live
with very different environmental standards. One thing that is clear from the
23 See Stephen Golup, Does Trade with Low-Wage Countries Hurt American Workers
(Federal Reserve Bank of Philadelphia, 1998).

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CRS-15
economic history of the now-rich industrial nations: With rising income there also
came rising labor and environmental standards. It can be plausibly assumed that
many now poor countries will follow a similar path, and that trade can be an
important means for achieving higher income.
Another common activity widely seen as an unfair trade practice is foreign
dumping of exports.24 Dumping can hurt particular workers and firms and is not
acceptable under U.S. law. But, to believe that total economic welfare is reduced by
dumping one has to accept the premise that there can be a price that is too low. Price
cutting is a basic element of competition, widely practiced in the domestic economy,
that leads to greater efficiency and economic gain to consumers. Actions to prevent
dumping curtail the benefit of such competition in international commerce. An
exception would be instances of dumping that are “predatory” and part of a plan to
establish monopoly power. Such predatory practices would ultimately reduce
economic welfare and preventing them is in a nation’s economic interest. Because
predatory pricing is rare, economists place little merit in most claims of dumping.
Nevertheless, the number of antidumping actions has risen precipitously in the last
15 years. Once the protectionist tool of choice of a few rich nations, antidumping
actions are now being emulated by many other nations.
The discussion so far shows that mainstream economics gives little reason to
expect that deviations from free trade improve a nations economic well-being, yet
trade barriers persist. This most likely occurs because barriers have very focused
benefits accruing to well defined groups with a concentrated political voice, while the
barriers costs are often widely dispersed over the population among people with less
natural cohesion and a more diluted political voice. Economic analysis demonstrates
that the protected groups gain, however, is most often at the greater expense of the
wider community.25 The tough policy question is finding an acceptable reconciliation
of the conflicting goals of improved economic efficiency that comes with open trade
and social equity that is often compromised by more open trade, without necessarily
relying on trade barriers.
In the post-WW II era, most large market economies have prospered, but they
have also maintained a “social bargain,” whereby society is asked to embrace the
wealth-building power of the open market economy in return for an acceptable
degree of cushioning from the periodic social disruption and cost that also comes
with that process. In effect workers in these economies have been given an amount
of social insurance to ameliorate the risk to job and income inherent in the operation
of markets. Extending this idea, the case can plausibly be made that with more open
trade that risk increases and a commensurate enhancement of that social insurance
is called for.
Thus to secure the economic benefits of reduced trade barriers and more open
trade, societies may, in the interest in economic equity and social cohesion, extend
24 For a fuller discussion, see CRS Report RL31468, Dumping of Exports and Antidumping
Duties: Implications for the U.S. Economy, by Craig K. Elwell.
25 See Gary Clyde Hufbauer and Kimberly Ann Eliott, Measuring the Costs of Protection
in the United States (Washington: Institute for International Economics, 1994).

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CRS-16
and improve that social insurance. This would point toward government policies to
better provide for temporary support of income, to better provide for worker
retraining, and to better provide for geographic mobility.26
The persistence of trade barriers is also a consequence of the slow, incremental
process which the world’s economies have used to reduce those barriers. While a
unilateral reduction or removal of a nation’s trade barriers would most often improve
its economic well-being, it is rarely used.27 The steady reductions of tariffs and other
trade barriers by the world’s economies over the last 60 years was largely achieved
by successive rounds of multilateral reductions. Since WW II there have been eight
major multilateral trade agreements, the most recent being the Uruguay Round which
was completed in 1994.28 This is a slow process with each round taking many years
to negotiate and implement a partial reduction of existing barriers. Yet it is a process
that confers significant advantages, not likely to occur with unilateral action. First,
the economic gains are likely to be considerably larger if all economies reduces their
barriers, because gains arise from the freer flow of both imports and exports. Second,
multilateral action gets exporters on board with consumers to broaden political
support for the market opening process. And third, the multilateral process develops
an institutional framework for dispute settlement that better insures that once reduced
barriers stay down, and institutional momentum that keeps the trade liberalization
process moving forward through successive rounds.
The Trade Deficit29
The U.S. trade deficit has risen, more or less steadily since 1992.30 It reached
$665 billion in 2004, more than doubling in size since 1999, and with a cumulative
increase of more than $600 billion since 1992.31 As a share of GDP the trade deficit
26 For a discussion of striking a balance between fairness and free trade, see Dani Rodrik,.
Has Globalization Gone too Far? (Washington: Institute For International Economics,
1997).
27 There are plausible scenarios where nations, if left only with the use of unilateral action,
might see their best option to choose protection, while in a multilateral framework they
would see that a better result comes from choosing mutual barrier reduction. Thus the use
of the multilateral option would reduce the risk of trade wars. This is an example of a
situation called the “prisoner’s dilemma,” where individual action always leads to an
outcome inferior to the outcome from collective.
28 Preliminary negotiations called the Doha Development Agenda have occurred to set the
stage for the initiation of a ninth round of multilateral negotiations to achieve further
reductions of trade barriers worldwide.
29 For a fuller discussion, see CRS Report RL31032, The U.S. Trade Deficit: Causes,
Consequences, and Cures, by Craig K. Elwell.
30 The trade deficit measure used here is the “current account balance.” This is the nation’s
most comprehensive measure of international transactions in goods, services, and investment
income.
31 For details of U.S. trade performance in 2004, see U.S. Department of Commerce, Bureau
(continued...)

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CRS-17
over the last decade has risen from less than 2% of GDP to reach a record 5.7% in
2004. In the 1990s, the trade deficit grew despite good export sales in those years.
The 2001 recession reduced the trade deficit, but with economic recovery it has
grown larger and economic projections point to the trade deficit continuing to grow
this year to over $800 billion, assuming the economic expansion maintains
momentum. But, it is not necessary that an economic expansion generate a large trade
deficit.
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,
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 U.S.
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 trade deficit widens as the economy expands, not because of trade barriers
abroad, not because of foreign dumping of imports, and not because of any inherent
inferiority of 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.32 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
31 (...continued)
of Economic Analysis, “News Release: U.S. International Transactions,” Mar. 16, 2005.
32 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.

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CRS-18
international asset market transactions, which is the key to understanding the
mechanism that generates aggregate trade imbalances.

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.33 In a relatively open world economy with reasonably fluid and
well functioning international capital markets, capital flows from lender to borrower
are the means by which the saving of one country can finance the investment of
another. 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. If
international capital flows did not occur domestic investment could be no larger or
smaller than domestic saving.
Differences in the level of interest rates between economies are what induces
saving (capital) flows between countries as international 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 U.S. 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
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. (In recent years, a large share of this inflow of capital has been the
result of official purchases of dollar assets by foreign governments which are most
33 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-19
often not prompted by relative rate of return. Therefore, these purchases can run
counter to the direction of capital flows induced by private investors. This contra-
movement of capital will most often modulate the impact of private capital flows, but
not likely to offset or reverse the impact of those flows.)
The purchase of a foreign asset will require the use the appropriate foreign
currency. Therefore, asset market transactions will also change the demand for and
supply of national currencies needed to purchase foreign assets, causing changes in
currency exchange rates, which, in turn, induce an equivalent sized net flow of goods
(i.e., trade deficits and trade surpluses) between economies. The exchange rate acts
as the equilibrating mechanism, stimulating imports and dampening exports so as
to generate a net inflow (outflow) of goods that is in line with the net inflow
(outflow) of capital. A net inflow of capital bids up the exchange rate and the
exchange rate will increase by enough induce an equivalent net inflow of goods —
a trade deficit. A net outflow of capital bids down the exchange rate and the
exchange rate will decrease by enough to induce an equivalent net outflow of goods
— a trade surplus.
The United States has in recent years had a rising shortfall of domestic saving
relative to domestic investment and has received a growing net inflow of foreign
capital to bridge this gap. This rising inflow of capital caused a steady appreciation
of the dollar until early 2002. The dollars rise, in turn, lead to a steady rise of the
trade deficit. The recent depreciation of the dollar suggests that the size of the net
inflow of capital to the United States may be ebbing and, with some time lag, this
will lead a slowing of the rate of increase in the trade deficit and untimely induce a
shrinking of that imbalance. The ebbing of foreign capital inflows by private
investors is most likely due to some reduced attractiveness of the American economy
as a destination for investment in the wake of recession, slow economic recovery,
low interest rates, corporate malfeasance, and war. Of more enduring significance
for the path of the dollar and the trade deficit is the now large share of dollar assets
in the investment portfolios of foreign investors causing those investors to prudently
seek to increase the diversity of their portfolios by moving away form dollar assets.
While further depreciation of the dollar is expected in the near-term, the intensity and
duration of this trend is problematic. One must also weigh the prospect of
accelerating economic growth in the United States, weak growth abroad, continuing
large official purchases of dollar assets, and the interest raising effect large federal
budget deficits will tend to raise the relative rate of return on dollar assets, boost their
attractiveness to foreign investors, and exert upward pressure on the dollar and tend
to widen the trade deficit.
What is certain, however, is that 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 of commensurate size.
The Benefits and Costs of Foreign Debt
A trade deficit is not necessarily undesirable. Increasing current spending
beyond current means need not be imprudent behavior. Borrowing is widely and
usefully done by individuals and businesses and so too by countries. Trade deficits
in the 1990s were a means to help finance an elevated level of domestic investment

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and may be so again if the current economic expansion gains momentum. Investment
augments the nation’s future productive possibilities and is a boon to economic
growth and long-term economic welfare.
Of course borrowing carries a cost as the lender at least demands that interest
be paid on the borrowings. This “debt service cost” is a burden the borrower must
carry tomorrow for living beyond his means today. One’s judgement about the
desirability or undesirability of the trade deficit may hinge on the benefits gained
from that added spending relative to the debt service burden that is also incurred.
That decision may depend on how the foreign borrowing is used. If used to finance
investment (that raises productive capacity), the economy’s future output may
increase by an amount sufficient to meet debt service costs and also add to the output
available for domestic uses. If used to finance public or private consumption, there
will be no enhancement of productive capacity, and meeting future debt service costs
must come at the expense of future living standards.34
Through the end of 2004, the United States net accumulation of foreign
obligations is about $2.8 trillion and growing.35 The current debt service burden of
Americas stock of foreign debt can be roughly judged from changes in the net
investment income component of the current account balance, which tallies income
earned from U.S. foreign investments in foreign assets against U.S. payments to
foreigners for their investments in U.S. assets. From a surplus of near $33 billion in
1981, U.S. net foreign investment income has fallen steadily to a deficit in 2000 of
$14 billion. Since 2000, the investment income balance has bounced back and forth
from a surplus of about $11 billion in 2001, to a deficit of about $4 billion in 2002,
and back to a surplus of about $24 billion in 2004. This back and forth pattern is the
result of changes in asset valuations caused by the short-run effects of the business
cycle here and abroad as well as exchange rate changes. In the long-run it seems
likely that the United States’ large stock of foreign indebtedness will come to
dominate movement of the investment income balance and lead to steadily larger
deficits in this balance. The investment income deficits of the recent past have been
very moderate in size; however, this payment could easily grow to $100 billion or
34 Whether used for investment or consumption, such borrowing and lending between
nations is intertemporal trade. These are exchanges of current goods for claims on future
goods and can also be seen as a type of gain from trade. If there are differences in the
valuation of current versus future consumption between countries then gains from trade are
possible. The borrower gains by being able to consume now beyond what his current
income allows. The lender gains by being able to consume more in some future period.
International capital flows are thus facilitating a more efficient use of global saving and a
more optimal pattern of spending over time. Some see the current pattern of intertemporal
trade as troublesome because it is a flow of capital (saving) from poor developing economies
to a much richer U.S. economy. One would expect the opportunities for investment to be
higher in the capital poor developing economies and the need for saving higher in the United
Sates with its rapidly aging labor force and, therefore for capital to flow form the U.S. to the
developing economies. For further discussion of this a typical pattern of international
borrowing and lending, see Ben S. Bernanke, Speech “The Global Saving Glut and the U.S.
Current Account Deficit,” Board of Governors, The Federal Reserve, Mar. 10, 2005.
35 U.S. Department of Commerce, Bureau of Economic Analysis, Survey of Current
Business, July 2004.

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more in the near future. This is far from insolvency, but a net outflow of resources
to foreigners of that size would be a significant decrement to the annual rate of
advance of the nation’s living standard and a decrement that can get larger. Some
observers maintain that it is a burden that needs to be curtailed.
Dependence on foreign capital often raises concerns about economic and
financial instability that could be associated with these often volatile asset flows. A
sharp retreat from dollar assets by foreign investors could send such a sizable shock
to the United States and other industrial economies that might induce recession here
and abroad. There are good reasons to doubt that a sharp, damaging turnaround in
foreign capital flows is likely. Recent experience with the panic of foreign investors,
such as the Asian financial crisis of the late 1990s has shown that such behavior most
often results from the growing likelihood that in the face of weak economic growth
and dwindling foreign exchange reserves, creditors would not be repaid, that debt
service payments were doubtful. This occurred when country’s that had borrowed
substantial amounts abroad that was denominated in foreign currencies found the
rising value of those currencies relative to the home currency made it doubtful that
they could continue to pay debt service. These are not risk factors that have much
relevance to the circumstances of the United States, which has strong growth and
does not fix its exchange rate, and is able to borrow abroad in its own currency. In
addition, a large proportion of foreign 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.
Further, since the dollar is the worlds reserve currency of choice, the ongoing
demand for liquidity and a store of value that the dollar serves undergirds the desire
to hold dollar assets, particularly short-term assets such as treasury bills that function
essentially as an international currency.
Another possible cost of large persistent trade deficits is that they are very likely
to lead to more calls for costly protection from foreign competition. Economic
analysis indicates that since such measures have no effect on the macroeconomic
factors that cause a trade deficit, they will not reduce it.
Reducing the Trade Deficit
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
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

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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 very
problematic whether the federal budget can be an exploitable policy tool for reducing
the trade deficit.
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.36 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.
Economic policy abroad can also work to reduce the U.S. trade deficit. Polices
to increase the pace of economic growth abroad, primarily through a stimulus to
domestic demand instead of exports, will tend to reduce the outflow of saving from
these economies to the U.S. economy. If such policies are concurrent with U.S.
policies to raise domestic saving, a smaller trade deficit can occur without a reduction
in domestic investment in the United States. Otherwise a smaller inflow of foreign
capital will induce a reduction in the trade deficit by forcing a reduction of domestic
investment.
Regardless of the posture of economic policy here and abroad, foreign investors
can step back from the purchase of dollar assets in response to greater rates of return
outside of the United States, or in an attempt to increase the diversification of their
portfolios, now overly stocked with dollar assets. Such a move would decrease
capital inflows to the U.S. market, and reduce saving available to the United States.
The trade deficit, with a time lag, would tend to fall. But lacking an increase in the
rate of domestic saving, interest rates would rise, and the rate of domestic investment
would also fall.
The depreciation of the dollar exchange rate since 2002 probably does mean that
there has been some movement away from dollar assets by foreign investors. As was
suggested above, it is difficult to predict if this will be a strong enduring trend.
Nevertheless, the dollar depreciation that has occurred so far can be expected to at
least slow the rate of increase of the trade deficit.
36 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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Conclusion
For economists the case for free trade is strong and compelling. A reduction of
impediments to the flow of goods among nations will raise each trading nation’s
economic welfare. This conclusion has been repeatedly validated by studies of trade
liberalization policies such as the Uruguay Round Agreement and North American
Free Trade Agreement.37
However, public debate over such initiatives makes very clear that many
Americans do not share economists’ optimism about the virtues of free trade. Some
of this antipathy might arise from economic concerns that U.S. workers and
industries hurt by trade do not receive equitable compensation and other adjustment
assistance. Allaying this concern, some economists argue, is best achieved by efforts
to augment and refine the various government programs that help to support and
retrain workers displaced and hurt by market forces.
Others may simply doubt that trade is beneficial. If unconvinced by the various
technical studies, they might consider that the United States itself gives clear
evidence of the virtue of free trade. This country comprises 50 separate political
entities that under the Constitution are required to allow unfettered trade among
themselves. Specialization has occurred, interstate trade has grown, and national
economic welfare has benefitted.38 Certainly U.S. economic welfare would be
reduced if barriers to interstate trade were erected. Economists view the benefits of
interstate trade as of the same nature as the benefit of international trade. In policy
deliberations, of course, national economic welfare will be considered in conjunction
with political, social, and national defense issues that will also influence trade policy
37 For example, see Nora Lustig, Barry Bosworth, and Robert Lawrence, Assessing the
Impact of North American Free Trade (Washington: Brookings Institution, 1992).
38 The 50 states, of course, have the same labor and environmental standards.

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