America’s merchandise trade
deficit could hit $250 billion in 1998, propelled to a record high
by financial turmoil and plunging growth rates in the Far East. If
the past is any guide, the widening trade gap will be reported
almost universally as grim news. Critics of free trade will wave the
deficit numbers as a rallying call to get tough with "unfair"
But are trade deficits
necessarily bad for the U.S. economy?
The answer is no. Trade
deficits are not a sign of unfair trade practices or a lack of
American "competitiveness." Trade deficits are caused by factors in
the macroeconomy that are not directly related to trade. To
understand why, journalists should borrow a technique from
investigative reporting and "follow the money."
When Americans buy imports,
foreigners must do something with the dollars they earn. They can
either use the dollars to buy American exports or to invest in
American assets, such as Treasury bills, stocks, real estate, and
If the amount of investment
capital entering the U.S. exceeds the amount flowing out, the extra
dollars entering the country can then be used by Americans to buy
imports over and above the amount we could buy merely from what we
earn by selling exports. So a current account deficit is simply the
mirror image of a capital account surplus.
In the global economy, some
countries, such as the United States, are net importers of capital
and thus run a trade deficit. Others, such as Japan, are net capital
exporters because domestic savings exceed domestic investment. The
excess savings these capital exporters send abroad returns to their
home market to purchase exports, creating a trade surplus.
One reason for a trade
deficit can be that the deficit country is growing faster than its
trading partners. Faster growth attracts investment dollars, which,
along with rising incomes, allow the deficit country to buy more
imports on the global market.
countries, demand for imports falls and capital flows outward to
greener pastures. This largely explains our rising trade deficit
with Asian Pacific nations, including Japan.
It also explains why trade
deficits have tended to expand in times of relative prosperity, and
to contract in times of recession. It is no coincidence that the
smallest American merchandise trade deficit since 1982, $74 billion
in 1991, occurred during the period’s only recession.
Germany switched from a
current account surplus of $50 billion in 1990 to a deficit of $20
billion in 1991. This had nothing to do with a change in trade
policy or a sudden loss of competitiveness. In 1991, Germans began
to invest heavily in the former East Germany rather than spend their
savings abroad, leaving foreigners with fewer deutsche marks with
which to buy German exports.
Conversely, Mexico flipped
from a trade deficit in 1994 to a surplus in 1995 as domestic
investment fell in the wake of the peso crisis. Again, the reversal
had nothing to do with trade policy or competitiveness, and
everything to do with investment flows.
If a trade deficit is
determined solely by rates of savings and investment, then the U.S.
trade deficit will be impervious to a get-tough trade policy.
Slapping higher tariffs on imports will only deprive foreigners of
the dollars they would have earned by selling in the U.S. market.
This in turn will reduce
the supply of dollars on the international currency market, raise
the value of the dollar relative to other currencies, and make
dollar-priced U.S. exports more expensive for foreign buyers, thus
reducing demand for our exports. Eventually, the volume of exports
will fall along with imports and the trade deficit will remain
Nations do not trade with
each other; people do. America’s trade deficit with the rest of the
world is only the sum of the individual choices made by American
citizens. Those choices, to buy an import or to sell an export, only
take place if both parties to the transaction believe it will make
them better off. In this way, the "balance of trade" is always
The only reason the U.S.
trade deficit is bad news is that so many people believe it is bad
Daniel T. Griswold is
director of trade and immigration studies at the Cato Institute in