The Causes and Consequences of the U.S. Trade Deficit

By Daniel Griswold
June 11, 1998
Committee on Finance
United States Senate

Mr. Chairman and members of the Senate Finance Committee: Thank you for allowing me to testify on the causes and consequences of the U.S. trade deficit.

The economic turmoil in East Asia has thrust America’s trade deficit back into the news. Perhaps no aspect of American trade is talked about more and understood less than the trade deficit. It has been cited as conclusive proof of unfair trade barriers abroad or a lack of competitiveness among U.S. industries at home. It has been blamed for destroying jobs and dragging down economic growth. I welcome the opportunity to present a more charitable view of this much abused trade number.

The U.S. trade deficit is the result of a net inflow of capital to the United States from the rest of the world. Because of our stable and relatively free domestic market, we remain the world’s most popular destination for foreign investment. We have become a net importer of capital because Americans do not save enough to finance all the available investment opportunities in our economy. This inflow of capital from abroad allows us to pay for imports over and above what we export.

In other words, the trade deficit is simply a mirror reflection of the larger macroeconomic reality that investment in the United States exceeds domestic savings. If we want to change the U.S. trade deficit we must change the rate at which Americans save and invest.

In a study published by the Cato Institute in April, I address four enduring myths about the U.S. trade deficit. Two of them relate to causes, two to consequences.

The first myth is that the overall U.S. trade deficit is caused by unfair trade barriers abroad. Foreign barriers are certainly a problem, just as our own barriers to imports remain a problem. But trade restrictions do not determine the overall U.S. trade deficit, nor do they fully account for the differences in bilateral trade balances. For example, the United States runs a large trade surplus with Brazil, a country with relatively high trade barriers, while we run deficits with Mexico and Canada, two countries virtually open to U.S. exports.

The second myth is that trade deficits are caused by a lack of U.S. industrial competitiveness. This myth has been refuted by the stellar performance of the American economy, which today is the envy of the world. Since 1992, the U.S. trade deficit has tripled. During that same time, U.S. industrial production has surged 24 percent and manufacturing output 27 percent. The American people sell more goods and services in the global marketplace than people of any other country.

A third myth is that trade deficits destroy jobs. Again, the performance of the U.S. economy in the last decade should lay that myth to rest. While the trade deficit has expanded, so have American payrolls. Indeed, there is a strong correlation between rising trade deficits and falling rates of unemployment. The reason is simple: The same expanding economy that stimulates demand for labor also raises demand for imported goods and capital.

The final myth is that trade deficits are a drag on the U.S. economy. With the slowdown in East Asia, this seems a reasonable claim. But the drag is not the trade deficit itself, but falling demand for our exports in the Far East. A trade deficit that reflects both rising exports and even more rapidly rising imports can be a sign of health. That has been the case in the United States for most of past two decades. Since 1980, the U.S economy has grown an average of 3.1 percent in years in which the current account deficit has expanded from the previous year, and an average of only 2.0 percent in years in which the deficit has shrunk. If trade deficits are bad for growth, why does the U.S. economy grow more than 50 percent faster when the trade deficit expands?

Frankly, we would have more reason to worry if the U.S. were running a trade surplus. In Mexico in 1995 and more recently in South Korea and other East Asian countries, trade balances flipped overnight from deficit to surplus because of plunging domestic demand and the flight of foreign capital. In Japan today, a soaring trade surplus has been accompanied by record high unemployment. It’s no coincidence that America’s smallest trade deficit in recent years occurred in 1991 - in the trough of our last recession.

What does all this mean for policy? First, there is no emergency. The trade deficit is not a sign of economic distress, but of rising domestic demand and investment. Second, the trade deficit is largely immune to changes in trade policy. Imposing new trade barriers will only make Americans worse off while leaving the trade deficit virtually unchanged.

In conclusion, I would urge Congress to ignore the trade deficit and focus instead on reducing and eliminating barriers to trade, wherever they exist.

Thank you for letting me speak and I would be glad to answer any questions.