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Friday, July 23, 2010

The U.S. Trade Deficit: Causes, Consequences, and Policy Options

Craig K. Elwell
Specialist in Macroeconomic Policy

The current account balance is the nation's most comprehensive measure of international transactions. It has three component balances: the goods and services balance, the investment income balance, and net unilateral transfers. These are all transactions thought to be closely related to current production, consumption, and income. For the United States, the size of the current account deficit is largely the refection of a similarly sized goods and services deficit (i.e., trade deficit).

The U.S. current account (trade) deficit grew steadily from 1992 through 2006. In 2007, however, the trade imbalance decreased to $726.6 billion from $803.5 billion in 2006. In 2008 and 2009, the trade deficit continued to decrease, reaching $706.1 billion and $419.9 billion, respectively. These decreases reflected strong export sales and a steady weakening of import purchases. A sizable depreciation of the dollar from 2002 through 2007 made U.S. exports more attractive to foreign buyers and imports less attractive to American buyers. In addition, since 2006, economic growth in the United States slowed relative to that of its major trading partners. As a percentage of GDP, the trade deficit in 2009 decreased to 2.9%, down from a record 6.1% in 2006.

The size of the U.S. trade deficit is ultimately rooted in macroeconomic conditions at home and abroad. U.S. saving falls short of what is sought to finance U.S. investment. Many foreign economies are in the opposite circumstances, with domestic saving exceeding domestic opportunities for investment. This difference of wants will tend to be reconciled by international capital flows. The shortfall in domestic saving relative to investment tends to draw an inflow of relatively abundant foreign savings (capital), seeking to maximize returns and, in turn, the saving inflow makes a higher level of investment possible. For the United States, a net capital (savings) inflow also leads to a like-sized net inflow of foreign goods—a trade deficit. In 2007 and 2008, both saving and investment fell, but in a weakening economy investment fell more, causing the trade deficit to narrow.

The benefit of the trade deficit is that it allows the United States to spend now beyond current income. Since the 1980s, that added spending was largely for investment in real estate, durable goods, and capital equipment. In recent years, the added spending was for consumption. The cost of the trade deficit is a deterioration of the U.S. investment-income balance, as the payment on what the United States has borrowed from foreigners grows with rising indebtedness. Borrowing from abroad allows the United States to live better today, but the payback may cause some decrement to the rate of advance of U.S. living standards in the future. U.S. trade deficits do not now substantially raise the risk of economic instability, but trade deficits can impose adjustment burdens on some trade-sensitive sectors of the economy.

Policy action to reduce the overall trade deficit is problematic. Standard trade policy tools (e.g., tariffs, quotas, and subsidies) do not work. Macroeconomic policy tools can work, but recent and prospective government budget deficits will reduce domestic saving and most likely tend to increase the trade deficit. Most economists believe that, in time, the trade deficit will correct itself, without crisis, under the pressures of normal market forces. But the risk of a more disruptive adjustment cannot be completely discounted.

Date of Report: July 12, 2010
Number of Pages: 27
Order Number: RL31032
Price: $29.95

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