Spring 2006

The U.S. Trade Deficit: Cause to Worry?

By Jimmy Squibb'07

Although most readers of this article are probably better economists than I, a quick macro lesson should help to get everyone on the same page. The trade balance--the value of total exports minus imports, called a deficit because it now is negative--comprises most of the “current account” (government transfers to foreign entities make up the other important component). Any imbalance in the current account must be made up for in the capital account or in some sort of “official” holdings of dollars. That is, the dollars that Americans exchange for foreign currencies to purchase foreign goods and services must go somewhere. If not held by a foreign government as reserves, these dollars go into dollar-denominated assets, including American stocks, bonds, etc.[1] In effect, Americans’ ability to import more than they export depends on the degree to which foreigners are willing to hold assets denominated in dollars.

In a world of “floating”, or market-determined, exchange rates, the purchasing power of those dollars in a foreign investor’s home country carries no guarantee. So, the more fearful foreign investors are of the dollar’s future value, the more dollars they require to give up a given amount of their own currency, leading to changes in exchange rates (the story is a little different with fixed exchange rates). As the exchange rate of the dollar adjusts for increasing foreign reluctance to hold, Americans need more and more dollars over time to purchase the same foreign good or service.

This adjustment can affect everyone, not just Americans who like Belgian chocolates or Italian Ferraris. As much of American economic output depends on foreign inputs, increases in the prices of those inputs could reverberate throughout the American economy. Firms’ adjustments for higher input prices could result in higher prices of outputs, otherwise known as inflation. With individuals, firms, and even the government demanding more dollars, interest rates could increase. Higher interest rates translate directly to more expensive credit, thus more difficult to buy houses, cars, get college loans…

Even though the U.S. has been running a current account deficit hovering around $60 billion, or a little over 6% of gross domestic product (GDP), not everyone believes the American economy stands on the precipice of a crisis (The Economist, Apr. and May 2005). The degree of increases in interest rates or the price level depends on the degree and abruptness of a loss of foreign confidence in the dollar. Stuart Brown and David Levy, proponents of the view that America need not fear, point out that unlike other countries that have experienced crises due to high levels of foreign debt,[2] America’s sovereign debt is denominated in its own currency, protecting it from the consequences of sovereign default. They suggest that America still displays strong growth and gives foreign investors little reason to doubt that growth, resulting from America’s technological and innovative dominance, will come to an abrupt end. That is, with advances in technology and productivity, American firms will continue to be profitable and attract foreign investment. Furthermore, according to Brown and Levy, Asian sustenance of the U.S. current account deficit is a matter of export-promoting policy exercised through artificially devalued currency, a policy unlikely to end anytime soon. Exchanges rates will indeed adjust, but slowly, resulting in a “soft landing” for the American economy in the form of repatriating investments and higher global demand for American exports (2005).

The American economy is rather open, and thus at risk. Whether the current account deficit indicates deeper, more systemic problems in the American and global economies remains a question.

1 These dollar-denominated assets could and often are issued by foreign institutions. It really does not do justice to this essay not to include the Net International Investment Position (NIIP), which more clearly shows foreigners’ holdings of American assets versus Americans’ holdings of foreign assets. The deficit here is approximately 25% of GDP (Brown and Levy, 2005).

2 American debt to foreigners is a dollar-denominated asset as described above. A discussion of relative savings rates is also pertinent to this essay, but beyond its scope.

Bibliography

Levey, David H. and Stuart S. Brown. (2005). “The Overstretch Myth.” Foreign Affairs, (84)2, pp. 2-7. Retrieved March 23, 2006, from EBSCOhost database.

(2005). “Surprise Shrinkage.” The Economist. <http://www.economist.com/PrinterFriendly.cfm?story_id=3968488>. Accessed March 23, 2006.

(2005). “Wise Men at Ease.” The Economist. <http://www.economist.com/PrinterFriendly.cfm?story_id=3915038>. Accessed March 23, 2006.

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