We Know What Causes Trade Deficits
On March 31, President Donald Trump ordered a study of the causes of the US trade deficit that will focus on trade barriers and unfair trade practices in foreign countries. Economists, however, broadly agree that trade barriers do not cause trade deficits. A country can have a trade deficit only if it is borrowing on net from the rest of the world. Trade barriers have only minor effects on borrowing and lending decisions. They can reduce imports in affected industries, but they cause the exchange rate to appreciate to bring about offsetting changes in other imports and exports.
Massive purchases of US and other bonds by some foreign governments—a form of lending also known as currency manipulation—were the largest factor behind the record global trade imbalances leading up to the Great Recession, with fiscal deficits in some countries also playing an important role. At present, currency manipulation is only a minor factor, and imbalances are down from their peaks. The threat of future currency manipulation, however, may well be providing an implicit “dollar put” that has the effect of encouraging excessive private lending that supports the trade deficit.1 A US fiscal expansion, which some expect, is not appropriate at this point and would widen the trade deficit.
It is important to stipulate that trade is not a zero-sum game in which imports are losses and exports are wins. Trade in both directions carries abundant advantages, which a forthcoming Policy Brief by Gary Hufbauer and Zhiyao (Lucy) Lu estimates to be worth around $2 trillion in additional income for the US economy (an earlier 2003 analysis estimated the amount at $1 trillion). Reducing the trade deficit by reducing overall trade would throw the baby out with the bathwater. Moreover, moderate temporary trade deficits are not necessarily a bad thing, as explained by Gary Hufbauer. Right now, however, the US trade deficit already exceeds a sustainable level and is poised to widen further in coming years. Action to narrow the deficit would be beneficial if it can be taken without harmful side effects. The key point is that action on the financial side will be more effective and less distortionary than action on the trade policy side, such as tariffs, duties, and quotas.
A series of research studies identifies the fundamental factors behind trade imbalances (Chinn and Prasad 2003; Gruber and Kamin 2008; Chinn, Eichengreen, and Ito 2011; Gagnon 2012; IMF 2012; Gagnon 2013; Bayoumi, Gagnon, and Saborowski 2015; and Gagnon et al. 2017).2 The most important factors include fiscal policy, intervention in currency markets, trend economic growth rates, per capita income levels, and prospective population aging. Barriers on financial flows have an important interaction with these factors; when financial markets are open, these factors generally have a larger effect on trade imbalances. Many studies focused on long-term factors, but business cycles may also be an important temporary factor. None of the studies found any role for trade barriers.
Figures 1 and 2 show little apparent correlation between average tariff rates or overall trade barriers and trade balances. If anything, higher tariffs are associated with lower trade balances (larger deficits). Including tariffs in regression analysis that controls for other factors yields an effect that is close to zero. Data for overall trade barriers are not available for a long enough time span to include in the regression analysis.
Figure 1 Tariffs and trade balances, 2000–2014
Figure 2 Overall barriers and trade balances, 2000–2014
Note: Tariffs are the simple average across categories, but similar results are obtained using tariffs weighted by trade in each category. Overall trade barriers are estimated costs of total trade obtained within a gravity model of bilateral trade patterns. Sources: World Bank World Development Indicators and Trade Costs datasets, International Monetary Fund World Economic Outlook database, and author’s calculations.
These results do not mean that tariffs and other trade barriers have no effects. Suppose the United States were to impose prohibitive tariffs or an absolute ban on steel imports. Total iron and steel imports in 2016 were $34 billion. These imports would drop to zero. The ban would protect US steelmakers from foreign competition. But a small appreciation of the dollar (just over 1 percent) would be sufficient to increase imports in other categories and reduce exports in all categories by the same amount on net.3 There would be no effect on the overall trade deficit. There would be a reduction in total trade (exports plus imports), and thus we would lose roughly a proportionate amount of the very large net benefits of trade.
Why would the dollar appreciate? The answer is that a steel tariff, in isolation, does not change household saving behavior or overall business investment (though it may shift across sectors as production rises in the steel industry and falls in other industries).4 The factors identified as influencing trade imbalances in the studies cited above share the feature that they operate through saving and investment. A trade deficit is an excess of investment over saving, whereas a trade surplus is an excess of saving over investment. The most important government policies influencing trade imbalances are fiscal balances and currency intervention. A higher fiscal balance increases national saving directly. Currency intervention consists of government borrowing at home to invest abroad with no net change in public saving or investment. The domestic borrowing raises interest rates, increasing private saving and reducing private investment at home, with opposite effects in the rest of the world. Figures 3 and 4 show that these policies do have important effects on trade balances. Note that an increase in the trade balance caused by either of these policies operates roughly equally through higher exports and lower imports with little effect on total trade and thus little effect on the net benefits of trade.
In a forthcoming book, Currency Conflict and Trade Policy: A New Strategy for the United States, Fred Bergsten and I show that at the peak of the global imbalances in 2007, essentially all of China’s trade surplus could be explained by China’s currency manipulation. At the same time, about 35 percent of the US trade deficit was explained by foreign currency intervention and another 25 percent by the US fiscal deficit. Going forward, the most productive policies for keeping the US trade deficit on a sustainable path are to prevent another outbreak of currency manipulation among US trading partners and to gradually reduce the US fiscal deficit.
Figure 3 Fiscal policy and trade balances, 2000–2014
Figure 4 Currency policy and trade balances, 2000–2014
Sources: International Monetary Fund World Economic Outlook database, Bergsten and Gagnon (2017), and author’s calculations.
The data underlying this analysis are available here [zip].
1. The implicit put option is that any future downward pressure on the dollar would spark currency intervention by foreign central banks that would allow investors to unload their dollars without taking a large loss.
2. The studies generally focused on the current account balance, which is the broadest measure of trade.
4. If the tariff were viewed by investors as a harbinger of a damaging trade war or generally bad economic policies, it might reduce inward investment in the United States, causing the dollar to fall and the trade deficit to narrow.