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What causes trade deficits? Whether bilateral, aggregate, short-term or long, understanding their causes is essential – whether they are harmful or not, whether they are the product of bad domestic policies or unfair foreign trade practices, or whether they are just a feature of a global economy much like temperature is a feature of the climate.
Not unreasonably, President Trump posed this question in the form of Executive Order 13786 and tasked his Commerce Secretary and the United States Trade Representatives’ Office to find some answers, to be summarized in an “Omnibus Report on Significant Trade Deficits.” Naturally enough, this exercise raises concerns given the president’s sometimes worrisome language on trade. However, as the United States has run a large trade deficit almost non-stop for decades, the president is asking a sensible question: What really does cause America’s trade deficits?
Traditional economic theory provides elegant and intuitive explanations for the gains from trade, why countries which embrace the challenge of international competition flourish and prosper, and why those which shrink from the challenge consistently falter. Beyond comparative advantage, however, in practice trade theory provides little help in answering the basic question President Trump asks, leaving a fertile field for speculation and possibly the planting of harmful policy tares amongst the wheat.
To be sure, America’s trading partners don’t always play by the rules, and when they don’t, the federal government should vigorously respond through the existing legal channels provided in U.S. law and through existing international bodies set up for the purpose. But the history of the U.S. trade deficit as described in the chart below supports the suspicion that our persistent U.S. trade deficit is almost surely not the result of any one or even some collection of countries’ discrete misbehaviors. Whether the accused is Germany, Mexico, Japan, or China, their particular roles in mathematically contributing to the U.S. trade deficit is confined to only a relative few years when compared to the duration of the deficit.
The chart depicts the growth of nominal GDP and the trade deficit plus a suggested trend line for the trade deficit, demonstrating a fairly close parallel between U.S. economic growth from 1980 to the present and the rise in the U.S. trade deficit. As the U.S economy grew over this period, imports grew faster than exports. This is hardly surprising, but trade theory suggests other prices and practices should have adjusted so periods of surplus would tend to balance periods of deficit, which obviously didn’t happen. The chart highlights as well that something unusual occurred between the latter half of the Clinton Administration and the Great Recession to disrupt the usual relationship between the trade deficit and the economy, but then the recent trend re-appeared.
If not unfair trade practices, then what may answer the President’s apt question? An essential element may be found in Daniel Griswold “Plumbing America’s Balance of Trade”:
“America’s commerce with the rest of the world must be and always is balanced when taking into account investment flows as well as the exchange of goods and services… [O]ne key insight for public policy is that the total outflow of dollars each year from the United States to the rest of the world is matched by an equal inflow of dollars from the rest of the world to the United States.”
Griswold’s statement affirms that when we say the “balance of payments,” we mean it. The balance of payments balances, just as an ongoing business’ “balance sheet” must balance showing equal parts assets and liabilities.
As Timothy Taylor points out, anyone who has taken a college international trade course will find Griswold’s assertion about as remarkable as observing that water is wet. Yet this fundamental concept appears to be at the heart of the question President Trump implicitly poses while remaining unfamiliar to a vast army of commenters opining on the persistent U.S. trade deficit.
An interesting implication of Griswold’s statement and the expression “balance of payments” is that if the trade deficit is a “problem” beckoning of federal policy remedy, then so too must be large and persistent net capital inflows. As the two – net trade inflows and net capital inflows – must be equal, if one is a problem, then the other must equally be a problem in some sense, while policies intended to address one must also address the other.
Generally, U.S. policy seeks to make the United States a place where foreigners want to invest, to encourage foreigners to invest their saving into U.S. opportunities. Prices, interest rates, and exchange rate adjust to ensure economies have access to foreign saving to augment domestic saving when appropriate to meet the needs of businesses and households as well as the combined financing needs of federal, state, and local governments. Fortunately, other nations run trade surpluses as their domestic saving exceeds domestic financing needs and thus, again, prices adjust so the supply of saving meets demand.
To be sure, trade deficits and their matching inflows of foreign capital are not always benign. History provides many examples typically involving countries with fixed or managed exchange rate regimes where large trade deficits created real problems. What distinguishes a healthy trade deficit and an unsustainable deficit? As so often happens, the telltale sign is the price.
Consider a somewhat different scenario. How does one conclude a business has taken on too much debt? By the income statement? By the balance sheet? By the CEO’s worrylines? These all provide clues, but to an outside observer, the most important clue is found in the price the market is charging the company to borrow. The same holds for countries and their trade deficits.
When the borrowing rates foreign lenders charge are low, it’s a market-based signal that current trends are probably not a concern from a macroeconomic perspective. It’s not that the market is always right, but it is right more often than any other signal.
When rates start to rise, it’s a sign that foreign lenders are beginning to worry, and the trade deficit – and quite likely the central government budget deficit – may be too large. When borrowing rates rise to high levels, or when a country is cut off entirely from international capital markets as happens from time to time, it means the trade deficit is a huge problem and a correction is imminent one way or another. The U.S. today borrows at amazingly low prices.
Given the requirement that the balance of payments must balance, and given the remarkably low interest rates that have prevailed in the United States for over a decade, the evidence suggests the ongoing trade deficit is more or less the normal result of ongoing macroeconomic trends given current policies. This conclusion does not mean trade deficits of such magnitudes are ideal, only that they appear to be sustainable, and in some sense, normal. Likewise, concluding current trade deficit levels are sustainable does not mean policy is incapable of reducing them, but doing so materially will require policy changes affecting both the trade and capital flows sides of the balance of payments.
Regulatory relief, pro-growth tax reform, and sound infrastructure investment are obvious avenues for improving the competitiveness of U.S. businesses and workers, while spending reductions to reduce the budget deficit and thereby reduce the need to import savings from abroad would likely facilitate a parallel and healthy reduction in net capital imports. Smart policies can make a difference in reducing the trade deficit and net capital inflows assuming policymakers decide this is a goal worth pursuing. Fortunately, the benefits of these policies ring out even for countries running trade surpluses. Sound economic policy is good policy under any circumstances.