Question

4. Comment briefly on the following: If we have an overall trade deficit in any year, we lose, and we should do our utmost to have surpluses overall annually.

Answer 1

Introduction

In the past few years, the U.S. trade deficit has soared to unprecedented heights, surpassing the levels reached in the late 1980s. In 1998, the merchandise deficit reached $246.9 billion, the goods and services deficit was $164.3 billion, and the current account deficit hit $220.6 billion, all of which were all-time records. Moreover, these deficits have been running at even higher rates in preliminary data for the first several months of 1999. With the trade deficit rising to these historically high levels, there has been growing public concern over its causes and consequences, as well as about the scope for policies that could potentially reduce it. In keeping with the theme of this first panel of the Trade Deficit Review Commission’s hearings, I will restrict my remarks in this statement primarily to the causes of the growing trade deficit. Needless to say, however, one’s analysis of the causes inevitably colors one’s view of appropriate policy responses, and therefore I will briefly outline the policy implications of my causal analysis at the end. In analyzing the causes of the rising U.S. trade deficit, it is important to distinguish longterm and short-term factors. The United States has had a long-term tendency toward greater trade deficits since the 1960s, as illustrated in Figure 1.1 The trade balance for the first half of 1999 reached an all-time low of !3.5% of GDP, surpassing the previous peak deficit of !3.4% in 1987. Figure 1 also shows that the trade balance has fluctuated widely around its generally downward trend. These fluctuations reflect a variety of short-term factors, including oil price shocks in the 1970s (which raised the price of imported petroleum) as well as changes in the exchange value of the dollar and business cycles at home and abroad. And, underlying the exchange rates and business cycles are the macroeconomic and monetary policies of the United States and its trading partners. In what follows, I will address the causes of the long-term trend deterioration in the U.S. trade balance first and then discuss the causes of the short-term fluctuations, including the recent surge in the late 1990s. In between these two parts, I will comment on the famous macroeconomic identity that links the trade balance to the gap between a nation’s saving and investment. I will also briefly comment on the sustainability of the U.S. trade deficit in regard to the worsening U.S. net international debt and the policy perspective implied by my analysis. Long-Term Causes The falling long-term trend in the U.S. trade balance over the four decades shown in Figure 1 is not a mere coincidence. It reflects deep, underlying asymmetries in U.S. trade relations with our major trading partners, which have caused our purchases of imports to grow faster than other countries’ purchases of our exports on average for 40 years, in spite of all the ups and downs of exchange rates, oil prices, and macroeconomic policies that have caused temporary fluctuations of the trade balance around this trend. The bottom line is that the U.S.market has consistently and effectively been much more open to imports than foreign markets, in spite of many rounds of trade negotiations and mutual reductions in legal trade barriers—and in spite of the fact that, on paper, the reductions in foreign trade barriers often appear to be greater than the reductions in U.S. trade barriers. Economic research has long recognized the existence of this unfavorable difference between the responsiveness of U.S. demand for imports and foreign demand for U.S. exports. In technical terms, economists have found that the “income elasticity of U.S. import demand” is significantly higher than the “income elasticity of U.S. export demand,” which means that for an equal (say, 1%) rise in national income, the U.S. increases its purchases of imports proportionately more than other countries increase their purchases of U.S. exports (holding relative prices of U.S. and foreign goods constant). This result was first obtained by Hendrik Houthakker and Stephen Magee in a famous 1969 article and has been corroborated by numerous researchers many times since.2 This discrepancy between our demand for imports and foreign demand for our exports implies that we will face a continuously declining trend in our trade balance, unless one of two types of adjustment takes place.3 First, there could be a price adjustment, if we make our goods relatively cheaper compared with foreign products. This would require that we continuously depreciate the dollar in real (inflation-adjusted) terms, thus reducing our purchasing power over foreign goods and services, but making our goods more price-competitive in order to offset the otherwise faster growth of our imports compared with our exports. Second, there could be an income adjustment, if we constrain our economy to grow more slowly than our trading partners’ economies. Slower growth at home would reduce the rate at which our imports increase, and thus keep them from rising faster than our exports, even if relative prices stay constant. The fact that the United States faces this unfavorable trade-off between depreciating its currency, slowing its growth, and accepting rising trade deficits is a sign of declining competitiveness of the U.S. economy vis-à-vis its major trading partners. In years when these adjustments have occurred—such as the late 1980s for dollar depreciation and the early 1990s when we were in a recession—the trade deficit has indeed fallen. However, neither of these types of adjustment is desirable, which is why it essential to find long-term policy solutions that can enable us to escape the dilemma of having to either depreciate

The Macroeconomic Identity and the Disappearing “Twin Deficits” Some economists have argued that trade barriers and competitiveness problems cannot possibly account for trade deficits, because the trade balance has to be equal to the gap between a nation’s saving and investment: (1) Exports ! Imports = National Saving ! Domestic Investment which is implied by the logic of the national income accounts. In this view, trade deficits are always blamed on a shortfall of national saving relative to domestic investment. National saving in turn consists of three parts:

= Government Saving (budget surplus [+] or deficit [!]) + + Corporate Saving (retained corporate earnings) Personal Saving (household and unincorporated business savings) This has led to certain claims about the causes of the trade deficit, such as the myth of the “twin deficits” (budget and trade) that was promulgated in the 1980s, and the current fixation of some commentators on the low personal saving rate (both of which arguments tend to forget that corporate savings account for the lion’s share of national saving, and have been quite robust).