America's Record Trade Deficit: A Symbol of Strength

The U.S. Commerce Department announced today that America's trade deficit in 2005 was the biggest in the history of the world. The difference between what Americans imported and exported last year should reach about $725.8 billion -- more than $550 billion larger than the previous record deficit set in 1999 and double the 1998 deficit.

Many headlines and quotes from trade skeptics will sound a familiar refrain: "Worst Year Ever for American Trade." "Trade Deficit Costs Jobs." "Trade Gap Undermines Dollar, Threatens Expansion." Should Americans worry about the trade deficit? Or is it a sign of our nation's strong economy? A $2-million federal commission on the trade deficit issued a final report in November that answered yes to both questions.

Economic theory and experience show that trade deficits are driven by levels of national saving and investment in the U.S. economy, not by allegedly unfair trade barriers abroad or by declining industrial competitiveness at home. America's record trade deficit is a symbol of economic strength, reflecting a strong net inflow of foreign investment drawn to America's dynamic economy.

Growing trade deficits signal improving economic conditions, while shrinking deficits often occur in times of economic trouble. During the last 25 years, the U.S. economy has on average grown about a percentage point faster, 3.5 percent vs. 2.6 percent, in years when the trade deficit expanded compared with years when it shrank. The unemployment rate on average fell 0.4 percentage points during years of rising deficits and rose 0.4 points when the deficit shrank. Manufacturing output rose much faster during years of rising trade deficits than during years of shrinking deficits.

America's largest trade deficits in recent decades occurred during economic expansions, its smallest deficits during recessions. It's no coincidence that as the economy shows signs of slowing down, the monthly trade deficit numbers have also begun to shrink with the economy's growth rate. (Those critics who demand that something be done to "fix" the trade deficit should be concerned that they might get what they ask for.)

Critics of trade liberalization often point to the trade deficit as proof that trade destroys jobs. If exports create jobs, they argue, then surely imports mean less domestic production and fewer jobs. In fact, imports and domestic production rise and fall together. Since 1987, manufacturing output in the United States has risen the fastest during years when the volume of imported goods has also risen the fastest. The two years of slowest import growth, 1990 and 1991, were the only two years in which manufacturing output actually fell. The same economic expansion that spurs manufacturing growth also attracts more imports and enlarges the trade deficit.

Another unfounded worry about the trade deficit is that it will saddle future generations with an unsustainable "foreign debt." It is true that foreign investors own about $1.5 trillion more in U.S.-based assets than Americans own in foreign assets abroad. But about half of foreign-owned assets in the United States are not debt but equity--direct investment in factories and real estate and portfolio investment in corporate stock. And the $1.5 trillion in net foreign investment in the United States is only about 16 percent of Gross Domestic Product, and 4 percent of the net wealth of all U.S. households and non-profit organizations. Net payments to finance our foreign "debt" were less than $20 billion in 1999, about one-fifth of one percent of GDP.

Yet another worry is that chronic trade deficits will spook foreign investors and undermine the foreign-exchange value of the U.S. dollar -- sending stock and bond markets and the real economy into a tailspin. The problem with that scenario is that it ignores the fact that trade deficits are linked to a strong, not a weak, dollar. The trade deficit increases the supply of dollars in the global economy, as foreign producers accept more dollars in payment for imports. But in times of economic expansion, the demand for those dollars by foreign investors seeking to buy U.S. assets is even greater. As long as foreign demand for U.S. assets remains strong, the dollar will remain high, and so will the trade deficit.

The best policy is to ignore the trade deficit, however large it may now seem, and concentrate on maintaining a strong and open domestic economy that welcomes foreign investment. As long as investors world-wide see the United States as a safe and profitable haven for their savings, the trade deficit will persist, and Americans will be better off because of it.