CIAO DATE: 05/02

Georgetown Journal of International Affairs

Volume 1, Number 1, Winter/Spring 2000

 

Stop Worrying about the U.S. Trade Deficit
by Daniel T. Griswold

 

The United States is enjoying its longest peacetime economic expansion in history, and the boom shows few signs of relenting. Rising productivity continues to fuel strong GDP growth, while inflation and unemployment remain near thirty–year lows. The stock market has emerged unscathed from recent bouts of volatility and resumed its record–shattering ascent. More than eight years into this expansion, the U.S. economy still seems to be firing on all cylinders. Yet, in the public mind at least, there is an ominous cloud on the horizon that seems to threaten this newfound prosperity: America’s yawning trade deficit.

The trade deficit, a widely reported but poorly understood figure, has become a symbol of lingering angst over America’s uneasy marriage to the global economy. To labor union leaders and their anti–trade allies on the left, the trade deficit means lost jobs and “de–industrialization.” The anti–deficit invective from isolationist factions on the right has been equally potent. Reform Party Presidential candidate Patrick Buchanan calls the trade deficit a “cancer” that threatens to devour the American dream. Even a few pro–trade economists and policy wonks have begun to question whether the current trade deficit is indeed “sustainable.”1 Such is the furor surrounding this statistic that in 1998 Congress felt compelled to spend $2 million dollars to create a Trade Deficit Review Commission. The Commission’s task is to examine the causes and consequences of the trade deficit and to recommend what, if anything, the U.S. government should do about it.

The short answer is: nothing. The trade deficit poses no threat to America’s economic prosperity. In this article, I explain why the United States has run such large trade deficits over the past two decades, what those deficits tell us about the relative strength of the U.S. economy, and how the trade deficit is relevant to America’s place in the global economy.

Follow the Dollars. It is an indisputable fact that America’s balance of trade has turned sharply negative, both in absolute and relative terms. In 1998, the deficit on the current account–the broadest measure of current international transactions–reached a record $220 billion, and this figure will almost certainly top $300 billion in 1999. Relative to gross domestic product, America’s current account deficit in 1999 could surpass the 1987 record of 3.6 percent.

The merchandise trade deficit by itself amounted to $247 billion in 1998 and is on pace to reach $330 billion for 1999. When combined with services, where the United States typically runs a surplus, the trade deficit was on track in 1999 to exceed $260 billion–yet another absolute record.2 While the size of the trade deficit is unusual, its existence is not: Americans have run trade deficits with the rest of the world for the last twenty–three years. Why all this “red ink” in trade?

As counterintuitive as it may seem, America’s trade deficit is not a result of unfair trade barriers abroad or declining industrial competitiveness at home, but of a net inflow of capital. The trade balance is the mirror image of the capital account: We run a trade deficit year after year because, year after year, more capital flows into the United States than flows out.

The cause of the trade deficit is easier to understand if we borrow the axiom of investigative journalists and “follow the money.” U.S. dollars tend to flow in a circular fashion. Dollars that leave the country to buy imports or to be invested overseas soon make their way back to the United States to buy the goods and services we export, or to invest in our domestic assets. In practice, for every one hundred U.S. dollars that flow into the international exchange markets, more than ninety–eight flow back to the United States. (The rest stay abroad where they are often used in place of local currency.) When we send $15,000 overseas to pay for an imported Japanese car, almost all of those dollars return to the United States to purchase such items as wheat, computer software, a Disney World vacation, or stock in a NASDAQ–listed company.

In the aggregate, then, when Americans spend $300 billion more on imports in a year than foreigners spend on our exports, nearly all those excess dollars flowing overseas return to the United States. But rather than using them to buy American goods and services, foreigners spend them to acquire American assets–real estate, stocks, corporate bonds, bank deposits, and Treasury bills. In other words, they invest in America. Thus America’s trade deficit is inextricably linked to domestic savings and investment. When a country’s level of savings exceeds domestic investment (as in Japan), its excess capital will flow overseas, resulting in a current account surplus. When a country’s level of savings falls short of domestic investment (as in the United States), capital will tend to flow in from overseas to fill the gap, resulting in a current account deficit.

A Sign of Economic Strength. One consequence of this linkage is that America’s trade deficit tends to rise in line with domestic investment, which in turn rises along with the overall economy. As a result, trade deficits are strongly pro–cyclical. When the U.S. economy is expanding, as it has through most of the 1990s, the trade deficit grows. When the economy slips into recession, the trade deficit shrinks dramatically (as it did during the 1990–1991 downturn).

America’s large trade deficit is not a sign of economic weakness but of relative strength. In today’s international marketplace, it is American consumers who are flush with cash to buy ever–greater amounts of imports. And it is the U.S. economy that is producing the investment opportunities that attract savings from around the world. In contrast, Japan has been plagued for most of the decade by slow growth (if not outright recession), falling demand, rising unemployment, and a bust in asset values. Meanwhile, the major economies of the European Union have struggled with sluggish growth and chronic high unemployment. In fact, advanced nations that ran trade deficits in the 1990s (the United States and Great Britain) grew faster and created more jobs than those that ran trade surpluses (Germany, Italy, and Japan). The result of economic troubles abroad has been a flight of capital to the United States and the stagnation of U.S. export growth–essential ingredients in the rising U.S. trade deficit.

In the Economic Report of the President 1999, the Council of Economic Advisers (CEA) concluded, “Arguments about the adverse consequences of trade deficits are largely misplaced: the rising U.S. trade deficit is primarily a reflection of strong U.S. investment, employment, and output growth, not a symptom of economic weakness.”3 Any objective look at the U.S. economy will confirm the CEA’s conclusion. By almost every measure, the U.S. economy has performed spectacularly well in the 1990s even as our trade deficit with the rest of the world has continued to climb. Since 1992, the trade deficit has increased more than sixfold. During this same period, real GDP has grown by a cumulative 25 percent, the economy has added a net fifteen million new jobs, real private fixed nonresidential investment has increased 81 percent, and real wages have at last begun rising for workers all along the income scale.

Even manufacturing, long the symbol of international economic might, has enjoyed resurgence in the benign shadow of the U.S. trade deficit. Since 1992, total industrial production in the United States has risen 34 percent, and manufacturing output by 39 percent. Production of durable goods, including motor vehicles, heavy machinery, and appliances, is up a robust 65 percent. By comparison, industrial production has grown only 3 percent in Germany since 1992 and has actually fallen slightly in Japan. So much for the de–industrialization of America.

America as a “Debtor Nation.” Anxiety about the trade deficit seems to have shifted subtly from the present to the future. Sure, the U.S. economy is humming now, skeptics acknowledge. But how long can these large and chronic trade deficits continue? Those fearful of the trade deficit warn that if Congress and the Clinton administration fail to take steps to curb the deficit, our children will be left with a mountain of foreign debt to pay. Creditor nations will gain intolerable leverage over the United States, exposing the U.S. government to threats from foreign finance ministers and central bankers. Eventually foreign investors will lose confidence, withdraw their money, and the U.S. economy and dollar will both come crashing down. Let’s examine each of these fears in turn.

The most common worry relates to the accumulation of net foreign ownership of U.S. assets. In the late 1980s, America switched from being a net creditor to a net debtor nation, at which point the value of foreign–owned assets in the United States surpassed the value of American–owned assets abroad. By the end of 1998, the gap between the current market value of foreign–owned assets in the United States and that of American–owned assets abroad had reached $1.5 trillion.

This may seem a huge debt for a nation to carry, but it is much less worrisome when put in perspective. Although nominally large, America’s negative net investment position at the end of 1998 represented only 4.2 percent of its total financial wealth. It is also misleading to describe a negative investment position as “debt” in the usual sense of the term. Of the $7.5 trillion in foreign–owned assets in the United States in 1998, $2.2 trillion represented direct investment in U.S. businesses and real estate, and another $1.1 trillion was in the form of portfolio investment in corporate stocks.4 None of this equity investment represents debt in the sense of an obligation to repay a fixed amount over a certain time period.

A related worry about the net accumulation of foreign assets in the United States is the ability to make future payments to the owners of those assets. Like the federal government’s accumulated fiscal debt, this issue arouses intergenerational concerns that we might be burdening our children with future obligations in order to support current consumption. But by any measure, America’s net payments on investment are modest and should be manageable for the foreseeable future. In 1998, Americans paid out $270.5 billion to foreign investors and received $258.3 billion from U.S. investments abroad, for a net payments deficit of $12.2 billion.

Once again, what may seem to be a large amount in nominal terms proves to be modest when compared to America’s $8.5 trillion GDP in 1998. As a share of what we produce, the net investment payments flowing out of the United States in 1998 amounted to less than one–fifth of one percent of GDP. The equivalent net “debt service” payment for a family earning $85,000 a year would be $122, an amount easily sustainable. Even if the trends of the last ten years continue, Americans should have no trouble financing the accumulation of net foreign investment in the United States for the next decade or longer. If payments on foreign–owned assets in the United States and receipts on American–owned assets abroad were to continue to grow at the same rate as during the last decade, America’s net payments deficit would reach $103.1 billion by 2009. But if we assume a 5 percent annual growth of nominal GDP during that same period, net payments would still amount to only 0.7 percent of GDP.

Meanwhile, the additional domestic investment made possible by the net inflow of foreign capital will help make America a more productive country. Current and future workers will be more productive because of the larger capital stock, thus expanding the economy and easing the relative burden of servicing our net foreign investment position. A second, persistent worry is that growing foreign ownership of U.S. assets will leave America vulnerable to foreign manipulation. The fear is that America’s principal creditors–Japan in particular– could wield influence over U.S. government decisions by threatening to cut off the supply of capital inflows, or by threatening to withdraw capital already invested.

Foreign investors in theory could attempt to exert political pressure on the United States by threatening to stop investing here, but such an act would have negative consequences for the creditor as well as the debtor. Americans would lose, of course, because a withdrawal of capital would drive up domestic interest rates while the falling dollar would stoke inflationary pressures. But America’s creditors would also suffer if the U.S. economy were to tip into a recession. Falling demand in the United States would quickly translate into falling exports to the U.S. market, while a depreciating dollar and slumping economy would lower the value of foreign–owned assets remaining in the United States.

This far–fetched scenario also assumes that foreign investors would act in concert. In reality, such an orchestrated withdrawal of credit is unlikely. Private investors in industrialized countries do not usually act at the behest of their governments. Even in Japan, a government decision to dump dollars or withdraw funds from U.S. markets would not mean that private companies and individuals in Japan would necessarily do likewise. If the real U.S. economy remains fundamentally sound, other global investors would likely see the temporary decline in the dollar and U.S. asset prices as an opportunity to buy. Foreign governments attempting to exert leverage over the United States would in the end inflict only temporary damage on the U.S. economy at the cost of their own long–term interest.

When an economy is as large and as important to the global economy as that of the United States, its chief creditors have a stake in keeping its economy on track. They have a strong incentive to act prudently with their investments so as not to undermine their own position. If any country wields the leverage, it is the world’s chief debtor, the United States.5

A third looming concern about the trade deficit is that it will eventually undermine the confidence of foreign investors. According to this scenario, foreign investors will wake up one morning and realize that the U.S. trade deficit is really big. They will then rush to withdraw their investment funds, leading to a plunging dollar, rising inflation, higher interest rates, and a hard landing–even recession–for the U.S. economy.

Such a chain of events is unlikely to occur. Most international investors are savvy enough to understand that America’s trade deficit is a reflection of underlying strength, not weakness, for all the reasons outlined above. Even if a rising trade deficit were to become a concern of investors, it would not prompt a mass exodus of capital. The U.S. economy, the largest and most sophisticated in the world, is fundamentally sound. Its financial markets are highly liquid and remarkably transparent. Returns on U.S. assets remain high relative to risk. Investors are unlikely to abandon this attractive market simply because the current account deficit is rising.

As for exchange rates, the trade deficit is not the cause of a weak dollar but rather the result of a strong dollar. Since 1980, the trade deficit as a percent of GDP has closely tracked the real value of the dollar on the foreign exchange market. When the dollar rises, so does the trade deficit, and vice versa. Despite its recent fall against the yen, the real value of the U.S. dollar has been trending upward in the 1990s along with the size of the trade deficit.

Stop Worrying. The only real sense in which the trade deficit is a threat to the U.S. economy is its potential effect on public policy. Persistent worries about the trade deficit could prompt policy makers to implement a “cure” for the trade deficit that itself could impose serious damage on the economy.

One such response would be to raise trade barriers on the mistaken assumption that fewer imports would mean a smaller trade deficit. An across–the–board 20 percent tariff, for example, would drastically cut the amount of imports entering the United States. But it would also reduce the amount of U.S. dollars flowing into the international exchange markets as Americans reduce spending on imports, thus causing the dollar to appreciate. The stronger dollar would partially offset the impact of the tariff by reducing the price of imports for American consumers while at the same time curbing American exports by making them relatively more expensive for foreign buyers. The end result would be the imposition of huge dislocations and inefficiencies in the U.S. economy without altering the size of the trade deficit.

The best policy response would be to ignore the U.S. trade deficit and concentrate on maintaining a strong and open domestic economy that welcomes foreign investment. As long as investors around the world see the United States as a safe and profitable haven for their savings, the trade deficit will persist, and Americans will be that much better off.