John H. Makin
American Enterprise Institute

Testimony to the Trade Deficit Review Commission
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 its deliberations.

Definitions: Trade and Current Account Balances

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 account balance.

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 U.S. weakness.

Conceptual Definition and the Trade/Current Account Balance

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 saving.

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 capital inflows.

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 deficit.

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.