Macroeconomic Forces Underlying Trade Deficits

March 31, 2016 10:30 AM

In an earlier post, we addressed one of the contentions of opponents of US free trade agreements (FTAs) that FTAs enlarge US merchandise trade deficits. We showed evidence that indicates the opposite: FTAs have no lasting impact on the size of national trade deficits or surpluses. FTA opponents seldom acknowledge a fundamental relation in international economics—that macroeconomic forces largely determine a country’s global trade deficit or surplus. The key forces are domestic levels both of private savings and investment and of government deficits. Added together, these levels give net national savings (or, when negative, net national borrowing), which determine the size of the national trade surplus or deficit.

What this means is that the United States is bound to run an overall trade deficit with the rest of the world when combined US savings of the household, business, and government sectors are negative, as they have been for some years. To finance the trade deficit, the United States is obliged to borrow or attract investment from the rest of the world, making a global US trade deficit inevitable. At best, trade agreements exert a second-order impact, possibly changing the pattern of bilateral surpluses and deficits but only marginally influencing the size of the global trade deficit which is determined by underlying forces.

So how do these underlying forces work? Though a household budget analogy might seem simplistic, it’s not far off the mark. When a household earns $100,000 and spends $105,000 on goods and services, that household has a deficit of $5,000. The deficit must be financed by a mortgage loan, credit card debt, or a generous relative. Likewise, when a nation earns $16.9 trillion and spends $17.4 trillion on goods and services (approximately the US case in 2015), the national trade deficit will be $500 billion. That deficit must be financed by loans or investment from abroad.

The figure portrays this fundamental story in bar graphs. The annual US trade deficit closely matches, year by year, the combined deficiency in US net national savings (in other words, net national borrowing). The combined deficiency is the sum of household financial savings (or deficits), government deficits, and business financial savings (the difference between company profits and company investments). Adding these three components gives net national borrowing—in other words, negative net national savings. When net national borrowing goes up, so does the trade deficit—because the borrowed money is spent on foreign goods and services (or, to put the relationship another way, because the United States spends more than it earns, it must borrow or attract investment from abroad).

US trade deficit in goods and services and net national savings, 2000-15

US trade deficit in goods and services and net national savings, 2000-15

Note: Negative savings values indicate net borrowing. The trade balance reflects the current account balance, excluding investment income.
SourceFederal Reserve Bank of St. Louis.

If the United States wants to reduce its trade deficit many policies can help. As Bergsten and Gagnon (2012) have urged, the United States might seek a realignment of exchange rates—in plain English, a cheaper dollar relative to the euro, the yuan, and the yen. The US Export-Import Bank might increase its loans to foreign buyers of US goods. Greater US access to foreign markets through new trade agreements can also boost exports. These and similar policies would help by making US exports of goods and services cheaper to foreign buyers.

But if the United States is producing near full employment, larger exports will overheat the economy, leading to higher domestic prices. The trade deficit will then reassert itself through greater imports or fewer exports, unless something is done to cool the economy by correcting the imbalance between national savings on the one hand and national investment and government deficits on the other.1 What’s required, as a companion to export promotion measures, are policies that reduce net national borrowing. Household and business financial savings must rise or government deficits must fall. Policies that achieve these outcomes are often unpopular.

One policy that makes no sense, and will do little or nothing to reduce the trade deficit, is to block new FTAs—such as the Trans-Pacific Partnership (TPP)—because in nearly every US FTA (including the TPP), foreign partners have cut or will cut their barriers to a much greater extent than the United States has.

This text is adapted from Hufbauer, Cimino, and Moran, NAFTA at 20: Misleading Charges and Positive AchievementsPolicy Brief 14-13, May 2014, Peterson Institute for International Economics.


1.  In conditions of widespread unemployment and spare capacity, the trade deficit can be narrowed with little or no pressure on the domestic price level. Bergsten and Gagnon (2012) used the Federal Reserve macro model to argue that dollar depreciation in the slack economy then prevailing could raise GDP by 1.5 percent and narrow the current account deficit by about 1 percent of GDP.  In 2016, as contrasted to 2012, the US economy has much less slack, a critical distinction emphasized by Robert Lawrence.

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