PPI: Putting the U.S. Trade Deficit in Perspective by Jenny Bates

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PPI | Fact Sheet | February 1, 2000
Putting the U.S. Trade Deficit in Perspective
By Jenny Bates

The Current Situation

The protests that surrounded the World Trade Organization (WTO) meeting in Seattle have focused public attention on international trade and, more specifically, on its costs and benefits to the United States. Many of those who demonstrated in Seattle complained that the world does not trade "fairly" and that the United States is not competing on a "level playing field." These critics often cite the growing U.S. trade deficit as evidence of both the unbalanced nature of global trade and the "costs" of globalization.

The United States has been importing more than it exports for more than two decades. Indeed, the U.S. trade deficit has been on an upward trend since 1991 and in the first three quarters of 1999, the deficit for trade in goods and services was $193 billion or 2.1 percent of GDP. But to extrapolate severe impacts on the U.S. economy from this fact involves a fundamental misunderstanding of both the trade deficit data and its economic meaning. Furthermore, a protectionist trade policy aimed at reducing the trade deficit would be misguided. Microeconomic policy tools such as tariffs are ineffective in reducing macroeconomic trade deficits. Countering such misguided protectionist arguments thus requires a solid understanding of the facts about the U.S. trade deficit and its impact on the U.S. economy.

Lessons for Policymakers

The U.S. economy benefits from the opportunity to trade. Trade increases competition, improves the allocation of resources, provides consumers with a wider range of products at lower prices, and promotes innovation--all of which aid economic growth.

In and of itself, a trade deficit (or surplus) says very little about the health of the economy. The trade deficit simply shows that the U.S. economy is consuming more than it is producing and is funding the process with foreign capital. While the United States will have to pay these loans back in future, policy should not be aimed primarily at reducing the trade deficit.

Employing microeconomic policy tools such as tariff barriers or quotas will not reduce the trade deficit. Indeed, restricting trade can be counterproductive--by provoking retaliation in trading partners, reducing competitive pressures, and slowing economic growth.

Bilateral deficits are different. U.S. trade balances with individual countries are not a problem from the macroeconomic perspective--every country runs deficits with some nations and surpluses with others. Bilateral deficits, however, may give some indication as to the nature of the trading relationship between the United States and specific countries--or in specific sectors (such as inequalities in market access).

Some Important Definitions--There is No Such Thing as the Trade Deficit

The term "trade deficit" is often misused. It is used interchangeably for three different statistical measures but is rarely defined. Thus, with the trade deficit more than any other trade statistic, it is important to be precise as to the actual figure being cited.

The Merchandise Trade Deficit: This is the narrowest concept and refers only to trade in goods. In 1998, goods accounted for 72 percent of U.S. exports and 84 percent of U.S. imports. Thus, while goods are the largest component of U.S. trade, looking only atthe narrow "merchandise trade balance" does not tell the full story. Despite this limitation, most news stories still focus on this incomplete definition of trade.

The Deficit in Goods and Services: This is the best measure of what most people understand to be the trade deficit. This measure includes trade in both goods and services. It includes significant U.S. economic services such as international tourism, transportation, financial services, and telecommunications--all of which are excluded from the merchandise trade deficit.

The Current Account Deficit: This is the broadest concept and goes beyond trade as most people understand it. The current account includes trade in goods and services, investment income, and unilateral transfers (e.g. unilateral U.S. aid payments to developing countries).²

These distinctions matter because the United States is becoming a service- based economy. While the United States is a net importer of goods, it is a net exporter of services--in 1998, the United States ran a surplus of $83 billion on trade in services. Therefore, the overall deficit (goods and services) is less than the merchandise trade deficit.

The Deficit in Perspective

Despite the continuing process of globalization, the U.S. economy remains relatively less dependent on trade than other smaller economies. Exports account for 13 percent of U.S. gross domestic product (GDP) compared to more than 20 percent in Canada, Mexico, and most Western European countries. Similarly, while the United States has the world's largest gross current account deficit, its current account deficit is only 2.5 percent of GDP. This compares with a surplus of 3.2 percent of GDP for Japan, and deficits of 0.2 percent, 1.8 percent, 4.8 percent, and 6.1 percent of GDP in Germany, Canada, Australia, and New Zealand, respectively (1998 figures).

Trade deficit statistics are often inaccurate. The U.S. Census Bureau recently estimated that $62 billion of U.S. goods exports go unreported each year--this amounts to almost one-third of the current U.S. merchandise trade deficit. ³ Similarly, new areas such as trade over the Internet and high value, high-tech products transported by air often go un- or under- reported. While the government is working to improve these figures, more accurate data will not be available for several years. ⁴

What Does a Trade Deficit Mean?

In and of itself, a trade deficit says very little about the economy. It is, at best, one of a number of indicators of the overall (or "macroeconomic") health of the U.S. economy. Indeed, deficits have been associated with booms and slumps, with periods of free trade, and those of greater protectionism.

Yet one fact remains true--a nation's trade or current account balance reflects the difference between national saving and investment. When the United States runs a trade deficit, it is, as a nation, consuming more than it is producing and is thus borrowing savings from the rest of the world. Conversely, when the United States has a surplus, it is a net lender to the rest of the world.

Whether a country is able to borrow from, or lend to, the rest of the world is not determined solely by domestic policies. Inflows of foreign capital will depend partially on investors' perceptions of the riskiness of a country and its currency. The United States has advantages in attracting foreign capital due to the size and strength of its economy and the role of the dollar as the world's main trading (or reserve) currency. Thus, the United States is in a better position to finance a trade deficit (through international borrowing) than small, open economies with weak or less-traded currencies.

Do Trade Deficits Matter?

Whether the U.S. trade deficit (net borrowing) matters depends, as it would for any individual, on what the United States does with its loan. If the net inflow of capital is used to finance productive investment, the U.S. economy will benefit from greater productivity, output, and income in the future. More importantly, the United States will then be able to use some of the extra output to pay back its debt. Conversely, if the borrowing is used to finance consumption or government budget deficits (as was true in the 1980s), the deficit is more likely to have a negative impact on the economy (through reduced aggregate consumption).

What About China?

The merchandise trade deficit with China increased from $13 billion to $57 billion between 1991 and 1998. While imports of goods from China have more than tripled during that period (from $19 billion to $71 billion), U.S. exports of goods to China have only doubled ($14 million). It is important to note that these figures include only trade in goods. This is significant because the United States is a net exporter of services and thus the overall trade deficit with China (including exports of services from the United States) is likely to be lower. Moreover, the bilateral deficit partly reflects the fact that China has become an increasingly competitive exporter while retaining a relatively closed domestic market. Indeed, China currently imposes regulations on many foreign investors requiring that they re-export a certain percentage of their total production from China.

Many critics of the bilateral trade deficit with China fear that Chinese products will flood the U.S. market. However, it is important to note that trade with China only amounts to 2 percent of total U.S. trade. Half of all U.S. trade is with three partners-- Canada, the European Union, and Mexico. Moreover, increased Chinese imports tend to displace imports from other countries, mostly Southeast Asian countries. One recent study showed that two-thirds of China's exports to the U.S. displace third country exports rather than American products. ⁵ Finally, and perhaps most importantly, cheaper, more competitive Chinese imports amount to a price cut for U.S. consumers. According to a 1994 World Bank study, importing from China compared to importing similar products from any other country saves the American public $14 billion per year.⁶

The deal reached between China and the United States last November regarding China's accession to the WTO includes a wide range of market-opening concessions from China, while the United States will make no changes to its trade barriers. Thus, a wide range of U.S. producers, from sectors as diverse as agriculture to financial services, will have increased access to Chinese markets. It is difficult to quantify the precise effect of such changes, but one official study estimated that U.S. exports to China will increase by 10 percent while U.S. imports from China will rise 6.9 percent.7 Perhaps the most important aspect of Chinese accession to the WTO is that it will bring China into the rules-based international trading system and advance the process of economic change and reform in China, encouraging the transition to a market-based economy.

Notes

1. Annual trade figures are the best indicators of an economy's overall performance, as monthly or quarterly data are subject to seasonal variations and are often revised later in the year.

2. Investment income includes payments to American holders of foreign financial assets, such as stocks, bonds, bank deposits, etc.

3. U.S. Census Bureau, Understatement of Export Merchandise Trade Data, (Washington, DC: July 1998).

4. The current data on services is so out of date that the Census Bureau is in the process of reforming the standard industry classification system to include nine new service sectors and 250 new service industries.

5. Rosen, Daniel H., China and the World Trade Organization: An Economic Balance Sheet, Institute for International Economics, (Washington, DC: June 1999).

6. Ibid.

7. U.S. International Trade Commision, Assesment of the Economic Effects on the United States of China's Accession to the WTO, (Washington, DC: August 1999).

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