Is Our Trade Deficit a Problem? [Archive.org URL]

What is a trade deficit?

A trade deficit happens when a country’s imports of goods and services exceed its exports of goods and services. In other words, when a country buys more from the rest of the world than it sells, the country incurs a trade deficit. […] The size of the trade deficit is primarily determined by four macroeconomic forces:

1. The difference between U.S. household and business savings on the one hand and spending by U.S. residential construction and business investment on the other hand;
2. The combined deficit of federal, state and local governments;
3. The level of economic activity in the rest of the world, particularly in countries that are close trading partners of the United States;
4. The trade-weighted exchange rate of the U.S. dollar.

Because the United States persistently spends more than it earns and because the dollar is historically strong thanks to its safe-haven virtues, the United States has incurred trade deficits for almost half a century. Since 2000, the annual trade deficit has averaged $535 billion.

To finance the trade deficit, the United States must either borrow from foreign lenders or attract investment from abroad. In 2015, the United States earned $16.9 trillion by producing goods and services for domestic and foreign markets, but spent $17.4 trillion buying goods and services made at home as well as abroad. Thus, the U.S. trade deficit was $500 billion in 2015, and it was financed both by loans from abroad and foreign firms investing in the United States.

How do trade agreements like NAFTA and the Korea-U.S. Free Trade Agreement fit into this story? Fundamentally, they reduce frictions that impede two-way trade, financial flows and investment between the partner countries, but they do not alter the broad macroeconomic forces just listed above. Free trade agreements might alter the size of the U.S. bilateral trade deficit with the partner country, but they make little difference to the overall size of the U.S. trade deficit with the world.

Is a trade deficit good or bad?

While the trade deficit has become a punching bag in U.S. politics, in the realm of economics, the debate is not one-sided. When a country is growing rapidly or experiencing high inflation, economists generally believe that the benefits from a trade deficit outweigh its costs. But during a recession or when a country suffers deflation, a trade deficit probably does more harm than good.

What are the economic costs of the trade deficit?

1. Since the trade deficit is concentrated in manufactured goods, a larger deficit translates into fewer manufacturing jobs. […] Those who view manufacturing as superior to the service industry accordingly criticize the trade deficit.
2. The longer large trade deficits persist, the greater the extent of foreign claims on the United States, either in the form of loans that must be refinanced or repaid or assets owned by foreigners (firms, buildings or land). […] If net foreign claims (now $7.3 trillion) become a very high fraction of U.S. GDP (currently about 40 percent), the burden of paying interest and dividends could become a significant drain on the U.S. economy.

What are the economic benefits of the trade deficit?

1. The trade deficit provides real resources for investment in U.S. productive assets, because it is financed by foreign direct investment, loans and bonds. Research shows that foreign firms operating in the United States pay above average wages, invest more in research and development and generate spillover effects that enhance the productivity of U.S. companies.
2. A trade deficit dampens inflationary pressures when the economy approaches full employment (less than 5 percent unemployment). Larger imports can supply goods and services to the domestic market that cool down prices.
3. Finally, a U.S. trade deficit furnishes economic stimulus to the world economy, a feature that can be helpful when world growth is lethargic — the situation today.

President Trump’s economic agenda centers on tax cuts, infrastructure and defense, implying a larger budget deficit and considerable fiscal stimulus. This may be just what the lackluster U.S. economy needs, but it’s not a prescription for smaller trade deficits.

Moreover, to forestall a spike of inflation, the Federal Reserve might accelerate the rise of interest rates, pushing the dollar higher. A stronger dollar and stronger domestic demand will almost certainly enlarge the trade deficit. Withdrawal from Trans-Pacific Partnership, renegotiation of the North American Free Trade Agreement and launching trade actions against China ensure political headlines, but they will not make much difference to the global U.S. trade deficit. Nor will they bring more jobs and higher wages to U.S. workers.