CAUSES OF THE TRADE DEFICIT
John H. Makin
Testimony to the Trade Deficit Review
August 19, 1999
First, I would like to thank the members of the Trade Deficit
Review Commission for allowing me to present my views. I hope the
material presented here will be helpful to the Commission during
Definitions: Trade and Current Account
Let me offer some basic definitions. The trade balance, as
usually measured for the United States, is the difference between
the dollar value of goods and services sold abroad and the dollar
value of goods and services purchased abroad. The major
categories of the trade balance are the balance on merchandise
trade (or net goods sales to foreigners) and services trade (or
net services sales to foreigners). The other major category of
U.S. external accounts is net income on foreign investments, when
added to the trade balance, gives the more comprehensive current
The United States usually runs a deficit on merchandise trade
and a surplus on services trade. In 1998 for example, the
merchandise or goods trade balance, was a deficit of $246.9
billion. The services balance was a surplus of $82.6 billion.
Together, these put the trade balance deficit at $164.3 billion
or about 1.9 percent of GDP. Since U.S. liabilities to foreigners
exceed U.S. claims on foreigners by about $1 trillion, net income
from foreign investments was a negative $56.3 billion in 1998.
Combining that with the trade deficit of $164.3 billion gives a
current account balance in deficit at $220.6 billion or 2.6
percent of GDP.
It is not too misleading to use the trade balance and current
account balance interchangeably, remembering that the only
difference between the two is the fairly stable number between 50
and 60 billion dollars of net income or outflow on the United
States' net foreign asset position. With the U.S. net foreign
asset position at about negative $1 trillion and annual income
(GDP) at $8.5 trillion, U.S. global indebtedness is not too
alarming, and is something like a young professional household
with $85,000 in annual income carrying $10,000 in net debt. It is
hardly surprising that foreign claims on the U.S. have grown more
rapidly than U.S. claims on foreigners during a decade when the
U.S. has experienced a remarkably vigorous, investment-led,
non-inflationary expansion. This had led foreigners to be anxious
to invest more in the U.S. than the U.S. invests abroad. More
specifically, with the U.S. stock market rising rapidly, foreign
investors want to participate just as much as American investors.
When they do so, net foreign claims on the U.S. rise more rapidly
than U.S. claims on foreigner's rise. In sum, the rise in U.S.
liabilities to foreigners is more a sign of U.S. strength as an
attractive destination for global investors than it is a sign of
Conceptual Definition and the Trade/Current Account
A useful way to view the trade/current account balance of the
U.S. when considering policy or other practical implications is
to express it in terms of some basic accounting identities. The
U.S. current account balance is, by definition, the sum of
private net saving and public net saving. More concretely, if
private savings equals private investment and all government
budgets are in balance, the current account balance will be zero.
Alternatively, if U.S. investment exceeds U.S. saving while
government accounts are in balance, the U.S. will have a current
account deficit that measures the net capital inflows required to
finance the excess of domestic investment over domestic
This last condition reflects another identity that the U.S.
current account balance is equal to net capital flows in or out
of the country. When the U.S. account is in deficit, it simply
measures U.S. spending in excess of income that must be financed
by capital inflows, alternatively net borrowing, from abroad.
Causes of the U.S. Trade Deficit
In view of these definitions, what then are the causes of the
U.S. trade deficit? Fundamentally, the U.S. current account
deficit measures an excess of U.S. spending over U.S. income.
Proximately, if U.S. income grows rapidly relative to income
growth abroad, then U.S. imports will grow more rapidly than U.S.
exports, which, after all, are just the mirror image of imports
by foreigners. So one of the causes of a trade deficit could be
an extraordinarily rapid period of U.S. growth. Indeed, the last
time the U.S. had a current account surplus was during the brief
1990/91 recession. Since 1991, the U.S. current account deficit
has risen steadily as a result of rapid U.S. growth and
simultaneously, the eagerness of foreign investors to push funds
into the U.S. which, in turn, implies that U.S. spending
rises even more since it is financed on easier terms than would
be available if the U.S. economy were not able to absorb foreign
To put all this another way, if the U.S. were to have another
recession and/or if the U.S. stock market were to collapse, the
U.S. current account deficit would likely fall rapidly and might
even move into surplus. The reasons would be several. First,
slower U.S. growth would mean that the U.S. demand for imports,
both for consumption and as inputs in U.S. production, would
drop. Simultaneously, if growth abroad were sustained, U.S.
exports might hold steady or even rise.
A U.S. recession or a U.S. stock market collapse would reduce
the U.S. current account deficit in another way. A weaker U.S.
economy and/or stock market would make it less attractive for
foreigners to invest in the U.S. and so the terms on which
Americans could borrow from global capital markets would become
worse. Interest rates would rise; U.S. spending growth would
fall, including a fall in investment, which woud mean that
private U.S. dis-saving would fall, thereby reducing the current
account deficit, other things being equal.
In A U.S. recession, government surpluses would fall or
deficits rise, thereby increasing the current account deficit.
However, since private sector spending usually falls by more than
government sector spending increases, the U.S. current account
deficit usually falls in a U.S. recession -- especially one that
is accompanied by a weak equity market.
I have placed very little emphasis on the level of the
exchange rate as a determinant of the trade balance. This is
because there is no unique relationship between the level of the
exchange rate and the level of trade balance. For example, during
the last decade while the U.S. current account deficit has risen,
the trade-weighted dollar has held steady or strengthened. Most
of the strengthening of the trade-weighted dollar has come during
the period of the most rapid increase in the U.S. current account
deficit. The reason for this is related to capital flows. When
the U.S. economy is expanding rapidly and the stock market is
booming, foreigners are anxious to invest more in the U.S. As
they purchase dollars in order to purchase U.S. investments, the
dollar rises. However, the rapid inflow of capital from abroad
permits more rapid spending growth and more rapid spending growth
increases the U.S. current account deficit by virtue of more
purchases of foreign goods and services. In fact, as we have
already noted, the U.S. current account balance is a measure of
U.S net national saving or dis-saving. However, if that increase
in U.S. dis-saving is because U.S. investment is rising more
rapidly then U.S. savings, it may well be a sign of conditions
that represent a relatively strong U.S. economy and, therefore,
are consistent with a rising dollar.
There are conditions under which a rising current account
deficit is associated with a falling dollar. If U.S. monetary
policy is too easy and spending grows too rapidly, especially
spending purely for consumption purposes that does not add to
U.S. productive capacity, then U.S. consumers are essentially
borrowing heavily from foreigners in order to finance spending in
excess of income. That type of a U.S. spending boom is one that
foreigners are more reluctant to finace and so as they purchase
fewer U.S. assets it is necessary for U.S. interest rates to rise
in order to fund a U.S. external deficit. Under those conditions
a rising U.S. external deficit is accompanied by a falling dollar
which itself is a signal of a need for less spending by U.S.
consumers and businesses and/or higher interest rates to continue
to finance the level of spending in excess of income.
There always arise the question of whether policy makers ought
to "do" something about the U.S. trade balance. The intuition of
most policy makers is that a rising trade deficit or current
account deficit is bad while surpluses are good. This intuition
is a poor guide to policy. First, it ignores the distinction
between rising current accounts deficit that are associated with
a stronger currency and rising investment opportunities in the
United States such as occurred during most of the 1990s and
rising trade deficits accompanied by a weaker currency such as
occurred during the inflationary 1970s. Second, market forces
operating on their own produce self-correcting forces that
operate on the U.S. trade balance. If, for example, a trade or
current account deficit rises more rapidly than foreigners are
willing to finance with net investments in the United States,
then U.S. interests rates will rise, income growth will fall, and
U.S. spending growth will fall back toward domestic income
growth, thereby reducing the U.S. trade and current account
This process may actually be under way now in the middle of
1999 with the U.S. current account deficit approaching $25
billion per month. U.S. interest rates are rising while the
dollar has begun to weaken since mid-july. These events suggest
that foreigners are not willing to finance U.S. spending in
excess of income (the U.S. current account deficit) at current
levels without being compensated by higher interest rates.
Therefore, U.S. interest rates are rising and eventually U.S.
spending growth will fall and the current account deficit will
begin to come down.
Alternatively, if the U.S. stock market remains strong and
resilent in the face of higher interest rates, and foreigners
decide they want to buy more U.S. stocks then foreign capital
inflows to the United States will continue to rise and the
current account will rise as the dollar strengthens.
Broadly speaking, the United States is unique among industrial
countries since it tends to run a current account deficit that
has been associated, at least over the last 15 years, with
rapidly rising investment opportunities in the United States. In
short, investment opportunities in the United States have risen
more rapidly than have the domestic savings available to finance
those investment opportunities. Rapid growth of foreign
investment into the U.S. real and financial assets has, in a
sense, made it easier for U.S. spending growth to exceed income
growth. An interesting corollary to this current account deficits
being financed by foreign savings, would do if the U.S. dollar
suddenly depreciated by 25 percent. This, of course, would make
U.S. goods more competitive in global markets while reducing U.S.
purchasing power in global markets. In effect, a rapid dollar
depreciation would have the U.S. exporting deflation much as
Asian and emerging market economies exported deflation in
1997/98. The weaker dollar would shift demand onto U.S. products
and away from products produced in Asia and Europe. U.S.
consumers woud spend less of a weaker U.S. dollar.
Simultaneously, if U.S. asset markets fall, the negative effect
on U.S. spending would accentuate the transmission of
deflationary pressure from the United States to the rest of the
world. Policy makers outside the U.S. would have to ease monetary
policy (or less optimally, ease fiscal policy) in an attempt to
offset the deflationary pressure (stronger currency) attendant
upon a weaker U.S. currency.
Summary and Policy Implications
The causes of the U.S. trade deficit are simply U.S. spending
in excess of U.S. income. However, when that spending is
investment spending that increases U.S. productive capacity and,
in many cases, U.S. competitiveness a rising trade deficit is not
a bad thing -- it is simply an indication of how much net
investment foreigners want to provide to the United States under
existing conditions. The process is self limiting in the sense
that if foriegn lending to the United States begins to finance
consumption instead of investment, the implied pressure in the
United States will create a weaker dollar which, in turn, will
begin to cause U.S. interest rates to rise and U.S. investment to
fall relative to U.S. savings.
The byproducts of a reduction in the U.S. trade balance in
1999 and beyond, after a decade of investment-led growth financed
to some extent by foreign investors, may not be attractive. It is
probably better to let adjustments in interest rates, exchange
rates, and incomes produce a sustainable trade or current account
balance for the U.S. rather than to intervene directly by
imposing restrictions on flows of goods and capital. The free
flow of international goods and capital is very much in the
interest of the United States which has become a competitive
producer of goods and services in a global market and as
effective competitor for global capital by virtue of rapidly
rising investment opportunities in the United States. Unilateral
action by the United States to impede the global flow of goods,
services or capital will lead to similar measures by foreigners,
especially by other countries less able to compete in modern
global markets than the United States. The result would be a
shrinkage of world trade in which every country would be a loser.
But the U.S., as a low cost producer of many goods and services
would serve to lose more than would less efficient producers.