The U.S. Trade Deficit: Trends, Theory, Policy, and Sustainability

This report briefly surveys recent trends in the U.S. trade deficit and the economic theory and policies surrounding it. After dropping to $74 billion in 1991, the U.S. merchandise trade deficit increased by $49 billion in 1998 to a record high of $248 billion. Even though the reasons for the rising deficit seem apparent, it raises questions about the theoretical analysis that underlies U.S. policies to deal with it and its sustainability and effect on the U.S. economy. The Federal Trade Deficit Review Commission was organized on June 10, 1999, and is responsible for developing trade policy recommendations by examining the economic, trade, tax, and investment policies and laws, and other incentives and restrictions that are relevant to addressing the causes and consequences of the U.S. merchandise and current account deficits. Economic theory is evolving with respect to the international trade side of the U.S. economy and the relevant policy implications. The standard macroeconomic approach to explaining the trade deficit is encountering some obstacles. First, the savings and investment equality is an ex post identity, a framework for analysis, and not a behavioral equation. Second, the linkage between macroeconomic conditions and a nation's exchange rate has not been established; exchange rate changes do not translate completely into price changes for imports and exports, and exchange rates tend to overshoot the equilibrium rates. This brings other inefficiencies into an economy. Government policy may also affect exchange rates. Recent weakness in the Japanese yen, for example, has been exacerbated by Japanese government policy. The United States does not seem to have a transparent method of determining if and when it should intervene in currency markets. A third issue is that a focus on the savings-investment relationship in the economy can lead to dubious policy prescriptions -- such as the assertion in the 1980s that eliminating the federal budget deficit would do the same for the trade deficit. A fourth problem is that a static macroeconomic approach does not account for why the United States may be borrowing from abroad and how those funds are being used. There may be an optimal level for a nation's current account deficit, and borrowing may be justified if it is used to increase productivity. Recent U.S. trade data indicate that a rising share of U.S. imports has been for capital goods that should raise U.S. productivity and economic growth. The policy implications with respect to trade still center on the belief that free trade is optimal, but extensions of the theory now allow for a strategic trade policy aimed at assisting certain industries. The conventional economic conclusion that all intervention into trade flows has no effect on the trade deficit, however, is yet to be demonstrated empirically. In terms of sustainability, if the recent large capital inflows reaching nearly $200 billion per year continue into the next century, a U.S. foreign debt would develop equivalent to a quarter of GDP and foreigners may end up owning more than half the U.S. federal debt. If the capital inflows do not continue, the U.S. trade and current account deficits of today will be unsustainable.