FEDERAL RESERVE BANK OF SAN FRANCISCO

E D U C AT I O N

DR. ECON

Is the U.S. trade de　⸀cit a problem? What is the link

between the trade de　⸀cit and exchange rates?
June 2007

I am so glad you asked this important question. The size of the U.S. trade
de　⸀cit, and its implications for this country’s future, has been a hotly
debated topic among academics and policymakers for quite some time. To
take a stab at helping you think about this complicated issue, let me begin
with some de　⸀nitions.

What is a trade de　⸀cit?

Before we talk about trade de　⸀cits, we need to start with the things that
make up the trade balance. The trade balance is the difference between
exports (domestically produced goods and services sold to other countries)
and imports (goods and services purchased from other countries).
Exporting goods and services produces income for a country; therefore,
exports add to the trade balance, which in turn contributes to total Gross
Domestic Product (GDP). Alternatively, when a country imports goods and
services, it sends some of its income abroad to pay for them; thus imports
detract from the trade balance and from GDP. When a country exports more
than it imports (i.e., the difference between exports and imports is positive),
the country is said to have a trade surplus. When the opposite is true, the
country is said to have a trade de　⸀cit. When a country exports exactly as
much as it imports, the country is said the have balanced trade.

The current account is another term that is commonly referred to when the
trade balance is discussed. The current account is the sum of the trade
balance and net unilateral transfers of income. The current account balance
is the difference between the nation’s income and expenditures, and any
additional debt the country takes on to cover the difference (in cases when
income exceeds expenditures, as it does in the U.S.) As you can see in
Valderrama (2007), the trade balance is a major component of the current
account balance. Thus, it is common to see the terms “current account
balance” and “trade balance” used interchangeably, although the two are not
exactly synonyms.  

The current account also re㠀⸀ects a comparison of national saving and

national investment. By the national income accounting identity the current
account balance is equal to the difference between national saving and
national investment. Therefore, when a country has a trade surplus (a
positive trade balance), national saving must, by de　⸀nition, exceed domestic
investment. That is, a country with a current account surplus is also a net
lender (this country uses savings that is not invested domestically to make
loans to foreigners). When a country has a current account de　⸀cit, national
saving must, by de　⸀nition, be below investment. In this case, the country is a
net borrower (as national saving is not suf　⸀cient to 　⸀nance all of domestic
investment, and so the extra investment must be 　⸀nanced by borrowing
from abroad).

The current account is only one part of a broader accounting concept called
the balance of payments that tracks international transactions of goods,
services, and 　⸀nances. Put differently, the balance of payments records the
composition of the current account balance and of the transactions that
　⸀nance it. There are three main components of the balance of payments:
the current account, the 　⸀nancial account, and the capital account.

As you already know, transactions that arise from the exporting or importing
of goods and services enter directly into the current account. As you
probably also know, countries do not engage in trade of goods and services
exclusively: they also engage in trade of 　⸀nancial assets. Transactions that
arise from the trade in 　⸀nancial assets are recorded in the 　⸀nancial account.
For instance, when a U.S. citizen purchases a plant in another country, the
transaction enters the U.S. balance of payments as a debit in the 　⸀nancial
account (you can think of this as the U.S. “importing” an asset, the plant).
When a foreigner purchases a U.S. asset, the transaction enters the U.S.
balance of payments as a credit in the 　⸀nancial account.

Lastly, the balance of payments records certain other activities resulting in

transfers of wealth between countries. Those are recorded in the capital
account. For the most part, these transactions result in trade in
nonproduced, non　⸀nancial, and possibly intangible assets (such as
copyrights and trademarks). Such asset movements do not amount to much
for the United States.

Note that every international transaction is recorded as both a debit and a

credit somewhere in the balance of payments, re㠀⸀ecting that every
acquisition of a good, service, or asset must be paid for with a
corresponding transaction. The result of this accounting identity is the
fundamental balance of payments identity, which says that the sum of the
current account, 　⸀nancial account, and capital account must be zero by
de　⸀nition.

Lastly, my answer will touch a bit on exchange rates. The nominal exchange
rate is the rate at which a person can trade the currency of one country for
the currency of another. The real exchange rate is the rate at which a person
can trade the goods and services of one country for the goods and services
of another. Nominal exchange rates generally are what you would see in the
media, whereas real exchange rates are a more theoretical concept that
economists use when analyzing the “real” effects of exchange rate
㠀⸀uctuations on the economy.

What does the U.S. trade balance look like?

Figure 1 shows the U.S. trade balance. In the 　⸀gure, gray bars denote
1
recession periods. The thick red line shows the real trade balance, while the
2
thin blue line shows the nominal trade balance. As you can see, the United
States has been running a trade de　⸀cit at least since the early 1990s. In
2007, the U.S. ran a trade de　⸀cit of $708.5 billion (nominal).

Figure 1. U.S. Real and Nominal Trade Balance

How is it possible for a country to purchase more goods and services from
the rest of the world than it sells to the rest of the world? The answer lies in
the 　⸀nancial account of the balance of payments. Countries can trade
assets in addition to trading goods and services, and such transactions are
tracked in the 　⸀nancial account. Given Figure 1, it must be the case that the
U.S. has sold more assets to foreigners than it has purchased from them. In
other words, the U.S. has had to borrow from abroad since the early 1990s
in order to 　⸀nance this trade de　⸀cit. The money it receives for the sale of
those assets has 　⸀nanced its trade de　⸀cit. Indeed, net 　⸀nancial in㠀⸀ows (net
acquisitions by foreign residents of assets in the United States less net
acquisitions by U.S. residents of assets abroad) were $657.4 billion in
3
2007.

Rather than looking just at the size of the U.S. trade balance shown in Figure
1, for context it may be more useful to look at its share of the country’s total
income. Figure 2 below shows trade balance as a percent of Gross
Domestic Product (GDP) for the U.S. In 2004:Q4, the trade balance was
close to -5.9 percent of GDP—the lowest point shown in Figure 2. However,
this trend has reversed a bit, as the trade balance as a percent of GDP fell in
magnitude to -4.24 percent in 2008:Q1.

Figure 2. U.S. Trade Balance as a Percentage of GDP

 
Recall that by the national income identity, a country running a current
account de　⸀cit must, by de　⸀nition, also have national saving that is below
domestic investment. This is demonstrated in Figure 3, which shows both
U.S. national saving (thin blue line) and U.S. domestic investment (thick red
line) as percent of U.S. GDP. You can see that U.S. domestic investment has
4
remained above the country’s saving for several years.

Figure 3. U.S. Saving and Investment as a Share of GDP

What has caused the U.S. trade de　⸀cit?

Over the years, many explanations of the persistent U.S. trade de　⸀cit have
been proposed. Let me give you a brief review of some of the points that
have been raised.

By the national income identity discussed above, a trade de　⸀cit is caused by

a change in national saving or investment or both. U.S. national saving
began declining in the 1950s, and this decline further accelerated in the
1980s. Both federal government and personal saving declined during the
period (CBO 2000 , p. 9). The growing U.S. budget de　⸀cit has been blamed
for the widening trade de　⸀cit because of the so-called “twin de　⸀cit”
hypothesis (which states that budget de　⸀cits cause trade de　⸀cits). However,
as then–Fed Governor Ben Bernanke discussed in a 2005 speech , to
understand the U.S. current account de　⸀cit, one must look beyond the U.S.
5
borders. He suggested that “over the past decade a combination of diverse
forces has created a signi　⸀cant increase in the global supply of saving—a
global saving glut—which helps to explain both the increase in the U.S.
current account de　⸀cit and the relatively low level of long-term real interest
rates in the world today” (Bernanke 2005 ).

The increase in labor productivity that the U.S. has experienced since
roughly 1996 might also be part of the explanation behind the widening of
the U.S. trade balance. An increase in productivity can both increase the
investment rate and lower the saving rate. This, in turn, would lead to a wider
current account de　⸀cit (for more on the link between productivity and the
current account, see Valderrama 2007).

Is the U.S. trade de　⸀cit a problem?

There is no quick answer to the very important question you posed (nor is
there likely one correct answer). Many academics and policymakers have
expressed concern about the widening U.S. trade de　⸀cit. However, there is a
lot of disagreement about the severity of the problem and the potential
consequences:

The current pattern of international capital 㠀⸀ows—should it persist—could

prove counterproductive.
Ben Bernanke (2005)

We can run huge de　⸀cits for the time being, because foreigners— in particular,
foreign governments— are willing to lend us huge sums. But one of these
days the easy credit will come to an end, and the United States will have to
start paying its way in the world economy.
Paul Krugman (2005)

My view is that the trade de　⸀cit is not a problem in itself but is a symptom of
a problem. The problem is low national saving. Given that national saving is
low, I am not eager for the trade de　⸀cit to disappear, because that would
mean that domestic investment would need to fall to the low level of national
saving. But I do think it would be good if the trade de　⸀cit were to disappear
accompanied by an increase in national saving.
N. Gregory Mankiw (2006)

Should there be a correction to the U.S. current account, it is an abrupt

(rather than gradual) correction that many fear. Experiences of the Mexican
crises of 1981 and 1994 and the East Asian crisis of 1997 come to mind,
when consumption, investment, and output in these nations contracted
quickly, asset prices deteriorated, wealth declined dramatically, and their
banking systems faced many dif　⸀culties. However, it is important to keep in
mind that the evidence from developing countries may not be directly
applicable to the U.S., a developed nation with an advanced economy.
Existing evidence from developed countries suggests that the current
account adjustments in industrialized countries have much milder
consequences (Croke, Kamin, and Leduc 2005 ).

The literature on the causes and consequences of the U.S. trade de　⸀cit is
voluminous, and I cannot possibly do it justice in this short column. In
addition to taking a look at a textbook on macroeconomics or international
economics, here are some suggestions for sources of information about the
topic:

Fed In Print – A comprehensive index to Federal Reserve economic

research:
/publications/fedinprint/
 National Bureau of Economic Research (take a look at the working
papers):
http://www.nber.org/

Peterson Institute for International Economics (take a look at the

publications):
http://petersoninstitute.org/

The link between trade de　⸀cits and exchange rates

Finally, let me address the last part of your question regarding the link
between trade de　⸀cits and exchange rates.

First, exchange rates determine the relative prices of domestic goods and
foreign goods, thus, they can in㠀⸀uence the amount of trade that occurs
between two countries— therefore, exchange rates affect the current
account balance. Economic theory talks about the link between the real
exchange rate and the current account (this discussion is borrowed from
Krugman and Obst　⸀eld (2006). Suppose the domestic currency depreciates
in real terms. Then foreign goods and services become relatively more
expensive than domestic goods and services. Foreign consumers are likely
to increase their demand for domestic products. This should increase
exports, which improves the current account balance. Domestic consumers,
in turn, are likely to respond by purchasing fewer foreign products. This,
however, does not necessarily mean that imports shrink (and the current
account improves). When speaking about imports, we need to measure the
value of imports measured in terms of domestic output. A depreciation of
domestic currency increases the value of each unit of imports in terms of
domestic output units. Thus, on the one hand, domestic consumers
purchase fewer units of foreign goods (the volume effect). On the other
hand, each unit of foreign goods is worth more in terms of domestic output
units (the value effect). Whether imports increase or decrease (and whether
current account improves or worsens) depends on whether the volume
effect or the value effect dominates.

We just discussed the effect of exchange rate changes on the current

account. However, the causality might go the other way as well: current
account de　⸀cits might exert pressure on the exchange rate. To be speci　⸀c,
current account de　⸀cits might weaken the currency. To read more about
that, please take a look at my October 1999 and June 2001 responses.

Endnotes

1. Recession periods are as de　⸀ned by the National Bureau of Economic Research or NBER . For more

information, please visit the NBER web site .

2. Real variables are adjusted for in㠀⸀ation. Nominal variables are not.

3. Detailed data on U.S. International Transactions is publicly available on the Bureau of Economic Analysis

(BEA) web site. The data used in this response can be found at

http://www.bea.gov/newsreleases/international/transactions/transnewsrelease.htm .

4. A natural question that might arise is who holds U.S. debt. I addressed this question in my July 2005

answer.

5. Note that here I switched from discussing the trade balance to discussing the current account balance.

However, as mentioned, they are closely related concepts.

References

Bernanke, Ben S. 2005. “The Global Saving Glut and the U.S. Current
Account De　⸀cit.” Remarks by Governor Ben S. Bernanke At the Sandridge
Lecture, Virginia Association of Economics, Richmond, Virginia.
CBO. 2000. “Causes and Consequences of the Trade De　⸀cit: an
Overview.” Congressional Budget Of　⸀ce.

Croke, Hilary, Steven B. Kamin, and Sylvain Leduc. 2005. “Financial Market
Developments and Economic Activity during Current Account Adjustments
in Industrial Countries.” Board of Governors, International Finance
Discussion Paper 2005-827.

Krugman, Paul. 2005. “Bad for the Country.” New York Times Nov. 25,
2005.

Krugman, Paul and Maurice Obstfeld. 2006. International Economics: Theory

and Policy. 7th ed. Addison-Wesley.

Mankiw, N. Gregory. 2006. “Is the U.S. Trade De　⸀cit a Problem?”

Mankiw, N. Gregory. 2004. Principles of Macroeconomics, 3d ed. Worth

Publishers.

Valderrama, Diego. 2007. “The U.S. Productivity Acceleration and the

Current Account De　⸀cit.”FRBSF Economic Letter, 2006-08.