Our Friend, the Trade Deficit

It helps to keep the economy from overheating and inflation down.

By Robert G. Murphy

Friday, May 21, 1999; Page A31

The U.S. trade deficit ballooned to a record level last year, reaching $233 billion on a current-account basis. Although the deficit was smaller relative to the economy than the previous high reached in 1987, projections for this year show it widening to more than $300 billion and place the gap at an all-time high as a share of the economy's output. The burgeoning deficit is likely to fuel protectionist sentiment already simmering in the steel industry and farm sector. And presidential hopeful Pat Buchanan has pledged to make the trade deficit a central issue in next year's campaign.

But the deficit is not caused by, and should not be attributed to, unfair practices of our trading partners. While ensuring fair play in international markets must always be an important aim of U.S. trade policies, the overall deficit says nothing at all about the success or failure of those policies. Instead, the expanding deficit is largely a symptom of faster economic growth at home compared with growth abroad, which has spurred a greater rise in imports to the United States than exports from the United States. This widening shortfall between receipts for exports and payments for imports requires Americans to borrow more from abroad. Whether this rise in foreign borrowing is good or bad depends on whether it helps finance an increase in domestic investment or merely substitutes for a decline in national saving.

As in the 1980s, foreign borrowing has risen during recent years in line with an expanding trade deficit. But this time around, the rise in foreign borrowing has been associated with an investment boom that has outpaced a solid gain in national saving -- unlike the 1980s, when the rise in foreign borrowing largely offset a sharp drop in national saving. Accordingly, the mushrooming trade deficit along with the concomitant increase in foreign borrowing are helping support a rising rate of investment that already may be paying dividends through the recent step-up in U.S. productivity.

Investment has surged by about three percentage points as a share of gross domestic product since the current expansion began in 1991, while the share of national saving has risen roughly 1.5 percentage points. The larger increase in investment compared with saving has been made possible by a jump in net foreign borrowing and the trade gap from roughly zero in 1991 to about 2.5 percent of gross domestic product in 1998. By comparison, the share of investment rose by just under one percentage point, and the share of national saving fell by two percentage points between 1982 (when the 1980s' expansion started) and the peak trade-deficit year of 1987. This drop in saving was offset by a rise in net foreign borrowing and the trade deficit from about zero in 1982 to more than 3 percent of gross domestic product in 1987.

The gain in national saving during the 1990s may seem surprising given recent attention-grabbing headlines about the personal saving rate falling below zero. But although private saving has dropped sharply, government saving has risen by more, pushing up national saving. The rise in government saving reflects an enormous swing in the federal budget from a deficit of $290 billion in fiscal year 1992 to a surplus of $69 billion last year.

By contrast, during the early 1980s a decline in private saving was accompanied by an exploding federal budget deficit and a substantial drop in national saving. A common refrain of those days highlighted the evils of "twin deficits," whereby foreign borrowing was seen as financing fiscal profligacy. But because today's widening deficit has supported a surge in investment financed by foreign borrowing, this "solo" deficit will pay off over time in productivity gains and a rising standard of living.

Besides financing investments for the future, the trade deficit also provides economic benefits today. First, the deficit helps keep the economy from overheating as strong growth in business and consumer spending is met with imports. This safety valve has allowed the economic expansion to continue into its ninth year without hitting the capacity limits and bottlenecks so often seen at mature stages of an expansion.

Second, the rising trade deficit had been accompanied by a decline in prices of imported goods -- until recently, especially oil and related products -- keeping a lid on inflation despite tight labor markets. The rate of unemployment has been at or below 4.5 percent for the past year, and below 5 percent for well over two years, with absolutely no sign of price pressure.

Finally, increased foreign competition associated with the widening trade gap has spurred recent gains in productivity as U.S. firms are forced to improve their efficiency. Indeed, the strongest gains in productivity during the past few years have been in the manufacturing sector, precisely where foreign competition has been keenest. Perhaps the best example is the significant gain in productivity over the past decade in U.S. auto manufacturing, which is universally viewed as a response to intense competition from abroad. And while such gains may sometimes result in lost jobs, the appropriate policy response is not to pull up the drawbridge and refuse to compete but to provide adjustment and training assistance to workers.

Over the next year, international trade critics likely will point to record-breaking U.S. deficits as a symptom of failed trade policies and unfair competition from abroad. But the trade deficit tells us nothing about whether competition is fair or unfair in any particular market -- only economic analysis on a case-by-case basis can uncover violations of trade rules. The deficit, however, does reflect a shortfall of national saving relative to domestic investment. And on this score, the deficit's recent rise has been associated with a surge in investment that should enhance future economic performance.

The writer is a professor of economics at Boston College. He served in the first Clinton administration as a senior economist at the Council of Economic Advisers.

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