The U.S. Trade Deficit: How Much Does It Matter?

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Let me begin by thanking Chairwoman Ros-Lehtinen and members of the subcommittee for inviting me to testify on the growing U.

No aspect of American trade is talked about more and understood less than the trade deficit. It has been cited as conclusive proof of us trade account deficit trade barriers abroad and a lack of competitiveness among U.

It has been blamed for destroying jobs and dragging down economic growth. None of these charges are true. The most important us trade account deficit truth to grasp about the U. And those flows are determined by how much the people of a nation save and invest - two variables that are only marginally affected by trade policy. By definition, the balance of payments always equals zero - that is, us trade account deficit a country buys or gives away in the global market must equal what it sells or receives - because of the exchange nature of trade.

People, whether trading across a street or across an ocean, will generally not give up something without receiving something of comparable value in return. The double-entry nature of international bookkeeping means that, for a nation as a us trade account deficit, the value of what it gives to the rest of the world will be matched by the value of what it receives. Us trade account deficit balance of payments accounts capture two sides of an equation: The current account side of the ledger covers the flow of goods, services, investment income, and uncompensated transfers such as foreign aid and remittances across borders by private citizens.

Within the current account, the trade us trade account deficit includes goods and services only, and the merchandise trade balance reflects goods only. On the other side, the capital account includes the buying and selling of investment assets such as real estate, stocks, bonds, and government securities. The necessary balance between the current account and the capital account implies a direct connection between the trade balance on the one hand and the savings and investment balance on the other.

That relationship is captured in the simple formula:. Thus, a nation that saves more than it invests, such as Japan, will export its excess savings in the form of net foreign investment. In us trade account deficit words, it must run a capital account deficit. The money sent abroad as investment will return to the country as payments for its exports, which will be in us trade account deficit of what the country imports, creating a corresponding trade surplus.

A nation that invests more than it saves - the United States, for example - must import capital from abroad. In other words, it must run a capital account surplus. The transmission belt that links the capital and current accounts is the exchange rate. As more net investment flows into the United States, demand rises for the dollars needed to buy U. As the dollar grows stronger relative to other currencies, U.

Falling exports and rising imports adjust the trade balance until it matches the net inflow of capital. In effect, foreign investors will outbid foreign consumers for limited U. Of course, most day-to-day currency transactions are not directly related to trade, but demand for U. Germany in the early s offers a case study of how this mechanism works.

What caused the switch was the huge increase in domestic investment needed to rebuild formerly communist eastern Germany. An increase in domestic investment repatriated a huge amount of German savings that had been flowing abroad, thus reducing the amount of German marks in the foreign currency markets and raising their value relative to other currencies.

The causal link between investment flows, exchange rates, and the balance of trade explains why protectionism cannot cure a trade deficit. If Congress were to implement that awful idea, American imports would probably decline as intended. But fewer imports would mean fewer dollars flowing into the international currency markets, raising us trade account deficit value of the dollar relative to other currencies.

The us trade account deficit dollar would make U. Exports would fall and imports would rise until the trade balance matched the savings and investment balance. Without a change in aggregate levels of savings and investment, the trade deficit would remain largely unaffected.

All the new tariff barriers would accomplish would be to reduce the volume of both imports and exports, leaving Americans poorer by depriving them of additional gains from the specialization that accompanies expanding international trade. Government export subsidies would be equally ineffective in reducing the trade deficit. Partly in response to the Asian financial crisis, President Clinton proposed in his federal budget an increase in subsidies to U.

By allowing certain exporters to lower their prices on sales abroad, the subsidies would stimulate foreign demand, but the greater demand for dollars needed to buy U. The stronger dollar, in turn, would raise the effective price of U. Total exports, and hence the trade deficit, would remain unchanged. Subsidies only divert exports from less favored to more favored sectors. For example, a higher tariff would presumably raise government revenue through additional customs duties, thus reducing the budget deficit or increasing the surplus and reducing the need to borrow from abroad - resulting in a smaller trade deficit.

But a tariff can also stimulate investment in the protected industry, increasing demand for foreign capital and leading to a larger trade deficit. After surveying the various theories, Labor Department economist Robert C. Another temptation is to intervene by intentionally devaluing the national currency in the foreign exchange market. A falling currency can stimulate exports and dampen demand for imports, thus reducing a trade deficit.

However, a cheaper currency also means that asset values in that country drop in foreign currency terms, attracting foreign investment flows that increase the capital account and the corresponding current account deficit. And eventually the weaker currency feeds back into the domestic economy in the form of higher overall prices, that is, inflation. One way to reduce the trade deficit would be for Americans to save more.

A larger pool of national savings would reduce demand for foreign capital; with less foreign capital flowing into the country, the gap between what we buy from abroad and what we sell would shrink.

A related way to cut the trade deficit is for the government to borrow less. The inflow of foreign capital prompted by the budget deficit allowed Americans to buy even more goods and services than they sold in the international marketplace. Another, less appealing way to reduce the trade deficit is to reduce investment. That occurs more or less naturally during times of recession, when business confidence falls and companies cut back on expansion plans.

As Americans consume and invest less, demand for imports and foreign capital falls along with the trade deficit. That explains why the smallest U. In fact, the U. That is exactly what happened to Us trade account deficit in Perhaps NAFTA critics who believe our bilateral trade deficit with Mexico is such a terrible development would have preferred that the U.

Of course, Us trade account deficit workers would have suffered, but it would have done wonders for our bilateral trade balance.

An understanding of us trade account deficit all-important role of investment flows should liberate trade policy from its obsessive focus on the current account balance. The trade deficit is not a function of trade policy, and therefore trade policy cannot be a tool for reducing the trade deficit. Misunderstanding of the U. The following are among the most common and harmful myths surrounding the trade deficit. Countries with which the United States runs large deficits are not characteristically more protectionist toward U.

Canada and Mexico, two countries that are very open to U. Americans face a common external tariff when exporting to members of the European Union, yet some EU members the Netherlands and Belgium are among the top surplus trade partners, and others Germany and Us trade account deficit are among the top deficit partners. Trade policy cannot explain those differences. Blaming bilateral deficits exclusively us trade account deficit differences in trade policy once again misses the reality of investment flows.

In Japan, high domestic savings rates provide a pool of capital that far exceeds domestic investment opportunities. That allowed a tsunami of Japanese savings to flow across the Pacific to the United States, where it could draw a more favorable rate of return. Despite the common perception, Japan was actually more open to U.

The same cannot be said for our bilateral deficit with China. Despite substantial progress in the last 10 years, its barriers to imports remain relatively high. Those barriers partly explain the bilateral surplus China runs with the United States, but the primary explanation is us trade account deficit benign: We like to consume the products China sells. China similarly runs bilateral surpluses with Japan and Europe for this reason.

A rising dollar caused by increased demand for U. If the United States were to impose higher tariffs aimed at imports from China say, by revoking its Normal Trade Relations statusthat too might reduce the bilateral deficit, but not the overall U. Higher tariffs against Chinese imports would merely shift some of the bilateral trade deficit to other countries while raising us trade account deficit for American consumers.

Since the Cuomo Commission report, the United States has enjoyed seven consecutive years of healthy, noninflationary growth along with historically large and rising trade deficits. Meanwhile, Japan and Germany, the two export-driven juggernauts that were supposed to eclipse the United States as economic powers in the s, have struggled with us trade account deficit growth and rising unemployment. Industrial production in the United States has climbed steadily in the past two decades during a time of historically large U.

Between andwhen the U. The same story has repeated itself in the s. Between and the annual U. Meanwhile, since total industrial production in the United States has surged by 24 percent and manufacturing production by 27 percent. In Japan during the same period, industrial production has grown by only 8 percent, and in Germany growth has been less than 1 percent. America runs substantial bilateral trade deficits with both countries.

Between andU. By any definition, the ability of American industry to compete in the world has not suffered because of a rising trade deficit. The experience us trade account deficit the s and s points in quite the opposite direction. A study by the Institute for Policy Studies in January predicts that the larger trade deficit caused by the East Asian financial meltdown will cost the U.

Columnist Patrick Us trade account deficit, when running unsuccessfully for the Republican presidential nomination inoffered his own, back-of-the-envelope estimate of jobs lost because of the trade gap: The total number of jobs in the United States is largely determined by fundamental macroeconomic factors such as labor-supply growth and monetary policy. Trade with other nations does not reduce the number of jobs, but it does quicken the pace at which production shifts us trade account deficit one sector to another.

Trade, like new technology, lowers demand us trade account deficit some jobs while raising demand for us trade account deficit.

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