Order Code RL30561
CRS Report for Congress
Received through the CRS Web
The U.S. Trade Deficit in 1999:
Recent Trends and Policy Options
Updated January 10, 2001
Craig Elwell
Specialist in Macroeconomics
Government and Finance Division
Congressional Research Service ˜ The Library of Congress
The U.S. Trade Deficit in 1999:
Recent Trends and Policy Options
Summary
The U.S. trade deficit has risen steadily since 1992. It reached $331.4 billion in
1999, an increase of $118.4 billion over the 1998 deficit, and a rise of about $286
billion since 1992. The deficit’s growth in 1999 was proximately the consequence of
a sharp acceleration of import purchases. Exports rebounded from their decline in
1998, but were greatly outpaced by surging imports, leaving the trade deficit at a
record size. The deficit in the investment income component of the current account
continued to rise in 1999, reaching $18.4 billion. This is a telling sign of the
accumulating burden of the United States’ persistent large trade 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 the
higher level of investment possible. For the U.S., 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 2000 and
2001.
The benefit of the trade deficit is that it allows the United States to spend now
beyond current production. 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
substantially raise the risk of economic instability, but they do impose burdens on
trade sensitive sectors of the economy.
Policy action to reduce the trade deficit is problematic. Standard trade policy
tools (
e.g., tariffs, quotas, and subsidies) do not work. Macroeconomic policy tools
can work, but have a limited scope for action in practice. It is most probable,
however, that the trade deficit will correct itself, without crisis, under the pressures
of normal market forces.
Congressional Research Service ˜ The Library of Congress
Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Trade Performance in 1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Goods Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Services Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Investment Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
The Tendency for Large Trade Deficits . . . . . . . . . . . . . . . . . . . . . . . 2
Why the Trade Deficit Widens . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
A Saving-Investment Imbalance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Recent Patterns of U.S. Saving and Investment Behavior . . . . . . . . . . 4
Policy Responses to Trade Deficits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Trade Policy Responses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Macroeconomic Policy Responses . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Sustainability of the Trade Deficit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Borrower’s Constraint . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Lender’s Constraint . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Special Considerations for the United States . . . . . . . . . . . . . . . . . . . . 9
Prospects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Is the Trade Deficit a Problem? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Intertemporal Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Debt Service Burden . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Instability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Sectoral Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
List of Tables
Table 1. U.S. Current Account and Components . . . . . . . . . . . . . . . . . . . . . . . . 3
Table 2. U.S. Saving-Investment Balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Congressional Research Service ˜ The Library of Congress
The U.S. Trade Deficit in 1999:
Recent Trends and Policy Options
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 some sectors of national economies. The importance of trade is
well-recognized by Congress, which in recent years has paid close attention to many
dimensions of the U.S. international trade performance. This report examines the
much-watched 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 1999
The U.S. trade deficit as reflected in the
current account balance1 rose to $331.4
billion in 1999, up nearly $118.4 billion over 1998. As a percentage of GDP the 1999
trade deficit stands at 3.7%, exceeding the previous record of 3.5% set in 1987. The
trade deficit rose more or less steadily from 1992 to 1997, then posted very large
increases over the next two years. The deficit’s increase in 1999 amounts to about
40 percent of the $300 billion total increase since 1992. On its current path the deficit
will likely approach $500 billion in 2000. Table 1 shows the anatomy of recent trade
trends.
Goods Trade.
Goods trade has been the dominant proximate source of change behind the
surging trade deficit, with the 1999 deficit in goods trade rising to $345.5 billion, a
substantial increase of just over $100 billion over the 1998 goods deficit. Since 1995
the goods trade deficit has increased nearly $154 billion. Export sales had fallen in
1998 in response to slack demand in Asia. Goods exports in 1999 increased to
$684.3 billion from $670 billion in 1998, resuming the steady rise that had been
occurring prior to the Asian crisis. Imports of goods had decelerated their rate of
advance in 1998, but sharply re-accelerated in 1999, rising to $1,029.9 billion from
$917.1 billion in 1998.
1 The 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.
Congressional Research Service ˜ The Library of Congress
CRS-2
Services Trade.
In contrast to goods, services trade showed a slowly rising surplus over the early
years of the current economic expansion. That trend ended in 1998, however, with
the services surplus shrinking from $91.9 in 1997 to $79.9 in 1998, but 1999 the
services surplus rose slightly to $80.5 billion. In 1999 exports of services rose to
$271.8 billion from $263.6 billion in 1998. This modest gain reflects how pervasive
economic weakness in most other economies has taken its toll on the travel and
tourism component of U.S. services exports. Imports of services, however, increased
to $191.1 billion from $182.6 billion in 1998.
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. The deficit in this category rose substantially in 1999, up to $18.4 billion
from $6.2 billion in 1998. Receipts from foreign investments rose to $276.0 billion
from $256.5 billion in 1998, reversing two years of near stagnation caused by
generally weak economic performance abroad. On the other hand, payments to
foreign investors continued its brisk advance, rising to $294.6 billion from $264.6
billion in 1998.
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 has been in
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 is a measure of the growing economic cost of America’s persistent,
large trade deficits.
The Tendency for Large Trade Deficits.
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 play
a 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 widening trade deficits in all but recession
conditions. The next section will examine in more depth the fundamental
determinates of the trade balance.
Congressional Research Service ˜ The Library of Congress
CRS-3
Table 1. U.S. Current Account and Components
(BOP basis, billions of dollars, annual rate)
1993
1994
1995
1996
1997
1998
1999
Current account
-85.2
-121.7
-113.6
-129.3
-143.5
-220.5
-331.4
balance
Goods balance
-132.6
-166.2
-173.7
-191.3
-196.7
-246.9
-345.5
Exports
456.8
502.4
575.9
612.1
679.7
670.2
684.3
Imports
589.4
668.6
749.6
803.3
876.4
917.2
1029.9
Services balance
62.7
67.8
76.2
86.9
91.9
82.7
80.5
Exports
184.9
199.6
217.6
239.7
258.2
263.6
271.8
Imports
122.3
131.9
141.4
150.8
166.9
181.0
191.3
Investment income
23.2
16.0
19.4
17.2
3.2
-7.0
-18.4
Transfers (net)
-38.5
-39.1
-35.4
-42.2
-41.9
-44.0
-46.5
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
Why the Trade Deficit Widens
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 United States 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. 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.
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 asset
market transactions that are the key to understanding aggregate trade imbalances.
Congressional Research Service ˜ The Library of Congress
CRS-4
It is an economic truism 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 it. However, neither
the level of saving available nor the level of investment undertaken is necessarily
limited by sources or uses in the
domestic economy.2 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.
A nation with a “surplus” of domestic savings over domestic investment
opportunities will likely see some portion of domestic saving flow outward to finance
more profitable investment opportunities abroad. This net outflow of purchasing
power, which generally can only be used to purchase goods (or assets) denominated
in this country’s currency, will 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, can attract an inflow of foreign saving to help support domestic
investment. Such a nation becomes a net importer of foreign saving, using the
borrowed purchasing power to acquire foreign goods and services, and leading to a
like sized net inflow of goods and services — a trade deficit. The United States has
been consistently in this category for the last 18 years.3
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.
2 Saving in a macroeconomic framework is the portion of current income that is left after
households, businesses, and government pay for their current spending. 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.
3 For a fuller discussion of this analytical framework see: Mankiw, N. Gregory.
Principles
of Economics. Fort Worth, Texas. The Dryden Press, 1997, pp 659; and also, The
Congressional Budget Office.
Causes and Consequences of the Trade Deficit: An Overview.
CBO Memorandum, March 2000.
Congressional Research Service ˜ The Library of Congress
CRS-5
After recovery from the 1991 recession, the U.S. saving-investment imbalance
began to increase steadily, but the form of the imbalance had changed. The rates of
saving and investment both rose, but the investment rate climbed faster. The
turnaround in the overall saving rate has been 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 has increased the public saving rate from -2.5% (i.e, dis-
saving) in 1992 to 3.9% in 1999. Dampening the rise of the overall saving rate,
however, has been the continued decline in the household saving rate, falling from
about 6.5% in 1992 to 1.8% in 1999. The rise of the overall saving rate in the 1990s
has not, however, brought that rate to the level that prevailed in the 1950s, 1960s, or
1970s. Further, the rate has fallen well short of the 1990s’ briskly ascending rate of
domestic investment. The predictable consequence of a widening savings-investment
imbalance has been a rising inflow of foreign savings to close that gap, and in turn, an
ever larger trade deficit. In 1999 the investment- saving gap widened to a record size
and so did the trade deficit.
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).4
The reasons for the investment boom in the 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, 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
4 See: U.S. Library of Congress. Congressional Research Service.
The Collapse of Household
Saving: Why Has it Happened and What Are its Implications? By Brian Cashell and Gail
Makinen. Report No. RS20224. March 3, 2000
Congressional Research Service ˜ The Library of Congress
CRS-6
recently in Asia, has made the United States a singularly attractive destination for
foreign investment.
This overall scenario leaves one with two strong impressions. One, U.S. trade
deficits appear to be largely rooted in macroeconomic forces in the domestic
economy. And two, these forces may not be easily manipulated by policy.
Table 2. U.S. Saving-Investment Balance
(percent of GDP)
Ann.
Ann.
Avg.
Avg.
1975
1983
to
to
1982
1990
1993
1994
1995
1996
1997
1998
1999
Saving
19.7
17.1
14.5
15.5
16.0
16.6
17.4
17.3
18.6
Investment
20.3
19.5
16.5
17.5
17.2
17.7
18.6
21.2
21.8
*Net
lending(+) or
borrowing(-)
-0.6
-2.4
-2.0
-2.0
-1.2
-1.1
-1.2
-2.9
-3.2
* Net lending, in concept, should equal the current account balance. Statistical
discrepancies prevent a precise matching, however.
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
Policy Responses to Trade Deficits
So long as domestic saving in the U.S. 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 significant efficiency effects on the domestic
economy, would not
over time change the domestic investment-saving imbalance and
therefore, would not change the size of the trade deficit.5 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
5 Similarly, the removal of U.S. trade barriers, while conferring significant efficiency gains,
would not change the domestic investment-saving imbalance and, therefore, would not widen
the trade deficit.
Congressional Research Service ˜ The Library of Congress
CRS-7
altering one side of the trade equation will lead to induced 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 U.S. will also reduce the demand for foreign exchange needed by
the U.S. 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 economic well-being, but the
trade deficit is unchanged. Alternatively, getting our trading partners to remove trade
barriers will stimulate export sales, but will also 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 is still unchanged. Finally, an export
subsidy will also stimulate export sales but an exchange rate induced rise of import
sales will also leave the trade balance unchanged. (In the case of the subsidy, 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 open economy
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 savings 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.) 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. We have seen in recent years a rise in the U.S. overall saving rate as a
consequence of a rising public saving rate stemming from the sharp swing of the
federal budget from deficit to surplus. This contribution from public saving has
probably gone about as far as it is going to go and, therefore, does not offer much
promise for boosting the overall saving rate much further. 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 most often reveals that such
proposals have uncertain effects on the private saving rate as they tend to raise both
saving and investment.6 Other proposals, such as individual retirement accounts, may
6See U.S. Library of Congress. Congressional Research Service.
Saving in the United States:
(continued...)
Congressional Research Service ˜ The Library of Congress
CRS-8
just redistribute saving, raising the household rate (a little), but lowering the public
rate an offsetting amount.
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 $450 to $500 billion range.7
Nevertheless, a rapidly increasing trade deficit is not likely to be a phenomenon that
is 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 trade deficit.
Borrower’s Constraint.
The central issue for a borrower country like the U.S. 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 U.S. 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 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 1999 this
ratio has risen from 7.3% to 18.1%, a substantial gain, but still well short of the debt
burden of many households, and apparently not high enough to sate the appetite for
foreign capital. Evidence from other industrial countries does not clearly point to a
value at which 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 U.S. has risen from 0.8% in 1992 to 3.7% in 1999.
Evidence from industrial economies indicates that, on average, when the CA/GDP
ratio exceeds 4.2% the current account begins to narrow.8 This suggests that the U.S.
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
6(...continued)
Why Is It Important and How Has It Changed? By Brian Cashell and Gail Makinen.
Report
No. 98-580.
7 See forecasts by: DRI/McGraw-Hill.
The U.S. Economy. April, 2000.
8 See: Mann, Catherine L.
Is the Trade Deficit Sustainable. Washington D.C., Institute for
International Economics, 1999, pp 156.
Congressional Research Service ˜ The Library of Congress
CRS-9
of the American economy that would allow it to prudently push borrowing beyond
this benchmark ratio.
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. 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 U.S. 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.
Special Considerations for the United States.
There are factors unique to the U.S. that may reduce the constraints on
international lending or borrowing. First, over 90% of the U.S. international
borrowing is denominated in dollars. 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 is largely not an issue for the United States.
Second, about 75% of U.S. foreign investment is in more stable long-term
investments. Such investments tend to have a more enduring flow that is less prone
to reversals in confidence. Third, about 50% of the investment in the U.S. 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 U.S. in a special position as a borrower.
Prospects.
A mid-1999 study by Katherine Mann of the Institute for International
Economics evaluates the several factors governing the behavior of lenders and
borrowers and estimates that the U.S. trade deficit is not on a sustainable course.9
Mann judges that the most probable path is one of expansion for two to three more
years very likely reaching $500 billion. By 2001 or 2002, however, the trade deficit
will likely begin to shrink. This turnaround, in her estimation, will be forced by the
tightening of the borrower’s constraint as United States citizens retreat from further
large increases in debt service expense. The lender’s constraint is judged to be
9 Mann, Katherine, L. op cit, p. 149.
Congressional Research Service ˜ The Library of Congress
CRS-10
significantly less binding with foreign creditors likely willing to lend at high volume
for a longer period of time. This projection is contingent on some moderate slowing
of the pace of U.S. economic growth and a significant acceleration of growth in the
rest of the world over the next few years. Absent an unexpected rise in domestic
saving, a shrinking trade deficit must also mean a shrinking of the rate of investment
in the United States.
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
deficits do not cause slower economic growth or lead to any economy-wide loss of
jobs. As seen in the 1980s and as is very evident in the 1990s, for the United States
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 sectors 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.
Congressional Research Service ˜ The Library of Congress
CRS-11
As already noted, since the early 1980's the U.S. 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 U.S. in 1998, for example, the trade deficit represented about 3.5%
of GDP and about 15% of domestic investment spending. The trend, nevertheless, has
clearly been toward larger external imbalances (surpluses and deficits).
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 from 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 $1,082 billion in 1999, or a cumulative
swing of nearly $1.5 trillion over this period.
The current 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 and/or
receipts on past investment and debt. If positive, the United States earned more than
it paid; if negative, the U.S. paid more than it earned. Movement in this measure is
reflective of changes in the stock of net indebtedness. We see in Table 1 that
international investment income in 1999 was a deficit of $18.5 billion, up from a
deficit of $6.2 billion in 1998. If the trade deficit remains on its current upward
trajectory, it is quite credible to imagine U.S. international debt payments reaching the
$40 to $50 billion range before the net borrowing stops growing.
A $40 to $50 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. By the year
2001, the United States will likely have a GDP valued at over $10 trillion dollars. For
an economy of this size, a $50 billion foreign debt service burden amounts to only
0.5% of GDP. Clearly, insolvency is not lurking just over the horizon. 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 can be expected to average
about 2.5% per annum. Thus a yearly debt service burden of about 0.5% of GDP
would mean that the rate of growth of domestic spending is reduced to 2.0%. That
is a sizable erosion of the rate of expansion of the U.S. living standard. At a 2.5%
annual growth rate national income doubles about every 29 years, whereas at a 2.0%
annual rate, doubling occurs every 36 years. Put another way, growing at 2.5% for
Congressional Research Service ˜ The Library of Congress
CRS-12
29 years, GDP per capita would equal about $60,000, whereas growing at 2.0% for
that same period would bring per capita GDP to only $53,000 or about 13% 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 recent years from using foreign
borrowing to support, more or less exclusively, added domestic consumption to using
those borrowings to also increasingly support rising domestic investment. (Keep in
mind, 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.)
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 U.S.,
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 circumstances
of the United States.
In addition, a large proportion of investments made in the U.S. 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 be muted by the
Congressional Research Service ˜ The Library of Congress
CRS-13
large size of the overall U.S. capital market relative to the scale of the foreign capital
flows. In 1999, the current account deficit of $331.4 billion was equal to about 15%
of the $2,222.8 billion raised in U.S. capital markets that same year.
Sectoral Effects.
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
small reduction in
the size of the domestic manufacturing sector.10 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. Domestic spending is
predominantly spending on services, while trade is rich in manufactures and a poor
vehicle for acquiring 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.11
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 the crises affected countries. Adjustment to such trade effects can be
economically painful for workers in these harmed sectors. In most circumstances it
is 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 which
provide some amount of
trade adjustment assistance, but there are important
questions about the adequacy of these programs.
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
10Rowthorn, Robert and Ramana Ramaswamy. Deindustrialization: Causes and Implications.
Staff Studies for the World Economic Outlook, IMF, 1997.
11This 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.
Congressional Research Service ˜ The Library of Congress
CRS-14
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 most 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 without harming domestic investment remains unclear.
Generating a sustained increase in the 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.
There is also the very likely prospect that the trade deficit may 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. The combination of a moderate slowing of
the pace of economic growth in the U.S.( reducing domestic investment relative to
domestic saving at home) and a significant acceleration of the rate of growth abroad
( raising domestic investment relative to domestic saving abroad) would likely initiate
such a process. A change in relative growth rates away from the current extreme
differential would most likely alter rates of return between the U.S. and the rest of
the world, redirect a larger share of international investment flows towards
destinations other than the U.S., and shrink the U.S. trade deficit. A smaller trade
deficit will, lacking an increase in the rate of domestic saving, likely lead to a
reduction in the rate of domestic investment.
Congressional Research Service ˜ The Library of Congress