The United States foreign trade deficit continues to rank near the
top of disturbing economic issues. A number of explanations for the
trade imbalance have been proffered, including unfair trade practices
abroad, the dollar's high international value, financial problems of
some large developing countries, and sluggish growth elsewhere in the
industrial world. Depending on the explanation selected, alternative
remedies have been proposed. Much of the discussion to date, though,
has failed to consider the mix of macroeconomic policiesthat is,
fiscal and monetary policiesin contributing to the recent trade
With a few exceptions, little is understood of the relationship
between federal government budget deficits and trade deficits. Consequently,
solutions to our trade deficit tend to emphasize policy measures
that are either impotent or very costly. Typical recommendations
include protectionist policies to reduce imports without regard
to how our trading partners might respond, or accommodative monetary
policy to reduce the dollar's international value without considering
its domestic value. These recommendations ignore the consequences
of reducing the trade deficit without a corresponding reduction
in the budget deficit.
The unpleasant arithmetic of budget and trade deficits shows that,
with aggregate savings fixed, large budget deficits inevitably will
be accompanied by foreign trade deficits or a slowing in domestic
investment. Further, improvement in the trade balance, if achieved
with out comparable reductions in the budget deficit, may not necessarily
be beneficial. If, for example, improvement comes through import
restrictions, it will simply result in growing weakness in private
investment. And while accommodative monetary policy may drive down
the international value of the dollar, it is not clear that this
development, in and of itself, will lead to a significant improvement
in the trade balance. In fact, if the economy is at full employment
so that aggregate savings are fixed, accommodative monetary policy
could worsen the trade balance.
In this essay we first review economic performance over the past
several years with reference both to the effects of large budget
deficits and to the growing trade problem. The initial question
is whether those concerned that outsized budget deficits would "crowd
out" domestic investment were simply "crying wolf." We find that
they were not, but that their concern was misplaced. Instead of
reducing domestic investment, these deficits appeared to reduce
net exports. We demonstrate this other type of crowding out by introducing
a basic GNP accounting identity. This identity, along with some
standard economic assumptions, has a significant implication for
reducing the trade deficit: reduction in the budget deficit is essential
to satisfactory resolution of the trade gap. We then contrast this
conclusion with two alternative remedies to the trade problem, namely
protectionism and monetary accommodation, and argue that both are
Crowding Out or Crying Wolf?
For the past five years, persistently large federal budget deficits
to many observers have been among the most troubling aspects of
the economy. According to conventional analysis, these massive budget
deficits would result in inordinately high real interest rates as
the government's demand for funds collided with private financing
requirements. In the process, high real interest rates would crowd
out private financing. Following this line of reasoning, residential
construction, business investment in plant and equipment, and perhaps
consumer spending on durable goods would be hard hit by the stance
of fiscal policy, especially if monetary policy was nonaccommodative.
Moreover, it was anticipated that with these large sectors remaining
sluggish, the overall expansion would be subdued.
Although the federal government deficit increased to over $200
billion by 1986, these dire predictions did not come true. Real
interest rates did rise, but consumer spending on durables increased
steadily and substantially through the expansion, and housing activity
was strong. A marked pickup in business plant and equipment spending
occurred as well, at least during the first three years of the expansion.
The economy's overall growth, too, surpassed expectations. It
expanded uninterruptedly from 1983 through 1986 at a 4 percent annual
rate, with growth in the first two years of the expansion averaging
a robust 5.6 percent per annum. Over the whole period, total employment
climbed about 12 million workers. Market interest rates dropped
perceptibly and inflation was subdued, averaging just over 3 percent.
These relatively favorable statistics do not mean that large budget
deficits had no adverse consequences for economic performance, although
identification of the effects of the budget deficits was sufficiently
difficult that those who have expressed concern appear to have been
crying wolf. But a component of economic activity that clearly has
not fared well as the expansion has proceeded is the foreign trade
balance: the difference between U.S. exports and imports. Over the
four-year period ending with 1986, goods and services produced abroad
and imported into the United States rose by an estimated $176 billion.
During this same period, exports gained only $45 billion, so the
trade balance deteriorated by $131 billion.
Within this deterioration in the trade balance, two sectors in
particular stand out. While the U.S. agricultural trade balance
is still in surplus, it has diminished significantly in recent years,
falling from over $18 billion in 1983 to just over $2 billion in
1986. Thus, agriculture has contributed about $16 billion to a worsened
trade situation over the past four years (see chart 1).
Serious deterioration occurred as well in manufacturing, especially
in low-technology. (Low-tech manufacturing includes non- electrical
machinery, some fabricated metal products, household appliances,
autos, ships, and railroad equipment. High-tech includes production
of electronic components, computers, aircraft, and defense equipment.)
Not unexpectedly, low-tech is an area where the United States has
run a trade deficit for years. The deficit recently has widened
materially. In high-tech manufacturing a trade surplus persists,
although it has narrowed perceptibly over the past few years.
The decline in manufacturing trade is reflected in both employment
and output statistics. Employment in manufacturing declined by more
than 300,000 workers between the middle of 1984 and the end of 1986,
and expansion in industrial production in the United States slowed
to an annual average rate of 1.5 percent in 1985 and 1986, down
dramatically from the pace of the first two years of the expansion.
Enormous trade deficits have accompanied the large federal budget
deficits (see chart 2). This fact does not necessarily mean that
budget deficits are responsible for the trade problem. Indeed, several
other determining factors are commonly cited for the pronounced
deterioration in our trade balance in the 1980s. One such factor
is the marked appreciation of the dollar relative to many other
currencies, as it made U.S. goods relatively expensive domestically
and around the world. Another factor is robust growth in our domestic
demand compared with sluggish expansion abroad particularly
in much of Western Europe and Japanas our domestic market
pulled in products from around the world. Finally, a third frequently
cited factor is curtailed demand by those developing countries with
international debt problems, particularly those that formerly represented
large markets for us.
Although a useful description of some of what has happened in
the world economy in the 1980s, these explanations of our trade
problem relying as they do on either the relative value of
the dollar, slow growth elsewhere in the industrialized world, or
special financial problems of some developing countriesdo
not get at root causes. For it is the mix of fiscal and monetary
policies pursued by countries around the world that ultimately affects
interest rates, exchange rates, and domestic growth; these variables
are not independent of policy fundamentals. That is, it is fiscal
policygovernment spending and tax policiesand monetary
policy that are relatively exogenous to the economic process and
that determine, at least in part, economic performance.
In the United States, a highly expansionary fiscal policy was
enacted with the tax reduction legislation of 1981. This policy
succeeded in stimulating domestic demand and contributed, not unexpectedly,
to high real interest rates as large budget deficits became commonplace.
The stance of fiscal policy was particularly telling since over
much of the period domestic monetary policy was oriented toward
In contrast, other major industrial countries adopted fiscal policies
that were less stimulative so that, given our relatively nonaccommodative
monetary policy, our real interest rates were high relative to those
prevailing abroad. And through this channel, the policy stance contributed
to the sharp appreciation of the dollar. Moreover, the adoption
by some developing countries of austerity measures to improve their
trade balances and enhance their abilities to service their foreign
debts resulted in little or no growth in demand for goods produced
in the industrialized countries. In this regard, it is revealing
that the deterioration in the U.S. trade balance occurred across
a broad spectrum of trading partners (see chart 3). Since the early
1980s, the U.S. trade gap with virtually all major areas of the
world has widened; perhaps particularly striking is the swing from
surplus to deficit in trade with both Europe and Latin America,
in part a consequence of the problems that have beset the global
economy in recent years.
What we have described to this point is a set of economic policies
which contributed to the marked worsening in U.S. trade performance
over the 1982-86 period. Apparently those concerned about the adverse
repercussions of large federal budget deficits were not just crying
wolf. Serious sectoral problems did in fact materialize, although
they were foreign-trade-sensitive, rather than interest-rate-sensitive.
This may have been because the income effect associated with stimulative
fiscal policy offset the domestic effects of high real interest
rates on the interest-rate-sensitive sectors. At the same time,
the income effect and the high dollar reinforced each other with
regard to our imports, while the high dollar lowered world demand
for our exports.
Unpleasant Deficit Arithmetic
The relationship between the federal budget deficit, the trade deficit,
and conventional crowding out of domestic investment by government spending
can be effectively illustrated with the following accounting identity,
which is derived from the condition in economics that output must equal
Government Deficit = Savings Surplus + Trade Deficits
or, for analytical purposes,
(G-T) = (S-I) +
where G is government spending, T is taxes, S is savings, I is investment,
M is imports, and X is exports. While these variables can be defined
in several ways, for this discussion we let G and T refer only to the
federal government (G is inclusive of interest on the debt), so that
S is gross private savings including that of state and local governments.
(See table for recent U.S. history of this identity.)
The identity says that a given budget deficit (the difference
between federal expenditures and tax receipts) must be equal to
the sum of the savings surplus (the difference between domestic
savings and investment) and the trade deficit (the difference between
imports and exports). Or equivalently it says that the federal government
has two sources of credit: a government deficit can be funded by
domestic savings or by foreign lenders. (The trade deficit, M -
X, represents the net amount of funds we must borrow from abroad.)
The identity also implies that given fiscal policy, a narrowing
of the savings surplus (e.g., because investment increases) must
be accompanied by deterioration in trade. While some might object
to focusing on a given fiscal policy because a budget deficit could
result from changes in other components of the identity, it is this
deficit, and this deficit alone, that is largely under the control
The implications of this simple expression are striking when coupled
with assumptions about the economy. The conventional view of crowding
out, for example, assumes that the trade balance is both relatively
small and slow to change; hence, it largely ignores the trade deficit
and focuses on the relation between the government deficit and the
savings surplus. Given this assumption, an increase in the budget
deficit must be matched by an increase in the savings surplus. Further,
assuming that the economy is operating at full employment so that
real income and savings are fixed (and assuming savings are not
responsive to changes in interest rates), a budget deficit increase
will result in higher real interest rates and depress private investment.
While the conventional crowding out story is indeed plausible,
it is not what happened as the current economic expansion progressed.
Instead, much of the adjustment to large budget deficits came in
the widening of the trade deficit. High real interest rates drove
up the value of the dollar internationally and through this channel
contributed to the deterioration in trade. At the same time, domestic
investment was apparently little inhibited by high real rates, especially
in the early years of the expansion (see chart 4).
The identity helps to demonstrate the relationship between the
federal budget and trade deficits. Assuming that the economy is
at full employment so that aggregate savings (S) in our economy
are fixed, an increase in the budget deficit must either depress
domestic investment (I) or result in deterioration in the trade
deficit (M - X). This aspect of the unpleasant arithmetic of budget
and trade deficits is often over-looked. It has very significant
implications for policies aimed only at improving our trade position.
The identity tells us that if the trade gap narrows while the budget
deficit does not, or if it diminishes more than the budget deficit,
then the savings surplus must increase. If aggregate savings are
fixed, however, investment must fall in these circumstances. Thus,
improvement in our trade position would not lead to strengthening
in private sector economic activity, as it would be offset by attendant
weakening in investment.
This description of the implications of the identity does not
explain how the adjustment might actually occur. There are any number
of scenarios that might play out, but prices, interest rates and
exchange rates in particular, are likely to be central to all of
them. For illustrative purposes, consider the combination of a fall
in the dollar, a reduction in the trade deficit, and no progress
on the budget deficit. In that circumstance, we know that the savings
surplus must widen and, on our assumption of being at full employment,
the adjustment will not come through increased savings. Hence, investment
must fall, in response perhaps to higher interest rate. In the context
of this example, a rise in interest rates would not be at all surprising
if funds from abroad had to be attracted or retained in the face
of a dollar falling, in part as a consequence of growing reluctance
of foreign investors to acquire dollar-denominated assets.
The identity depicted above thus demonstrates that improvement
in our trade position is not sufficient, in and of itself; to assure
a healthier private economy. Weakened domestic investment spending
could counterbalance diminution of the trade gap.
Promise of the Plaza
As we have seen, the stance of fiscal policy is at the heart of
our trade imbalance and the associated sectoral problems. Correction
of the trade problem thus requires addressing macroeconomic policies
appropriately. We believe that the so-called Plaza Agreement (fall
1985) was such an attempt.
In the abstract, international coordination of macroeconomic policies
should be beneficial. As a consequence of highly integrated global
financial and product markets, one country's policy choice affects
the economic performance of many others. One country's borrowing
may affect world interest rate levels, and its demand may influence
world prices. As a result of this interdependence, economic performance
and welfare can be improved if coordinated policies are implemented
rather than if alternatively, each country determines policy on
the assumption that policies of other countries are fixed. There
is value to international policy cooperation irrespective of the
state of trade flows or, for that matter, of the business cycle.
September 1985 marked the beginning of an overt effort to coordinate
policies among several major industrial countries, with the objective
of achieving a more balanced pattern of world growth and trade.
The effort was the Plaza Agreement among the G-5 countries, which
called for economic policy coordination, particularly among West
Germany, Japan, and the United States. As part of the Plaza strategy,
it was envisioned that fiscal policies that is, government
spending and tax policieswould be modified here and abroad
in order to adjust aggregate demand and realign exchange rates.
Coordinated intervention in the foreign exchange markets by major
central banks was a second aspect of the strategy.
As events unfolded, it appeared that some of the objectives of
the Plaza Agreement were achieved. To be sure, the decline of the
dollar began in March 1985, prior to the agreement. However, there
was coordinated intervention in the foreign exchange markets by
major central banks in the wake of the Plaza Agreement which was
accompanied, for a time, by sympathetic reductions in interest rates.
The dollar declined appreciably.
Despite this apparent success, there should be serious misgivings
about the way in which the Plaza Agreement has been implemented.
As a key part of that agreement, it was intended that U.S. fiscal
policy would be altered to reduce, in a meaningful and sustained
way, the federal budget deficit. Although there has been some movement
to a lower deficit, the burden of adjustment to achieve Plaza Agreement
objectives so far has fallen to monetary policy.
Consequently, U.S. monetary policy was decidedly more accommodative
in much of 1985 and 1986 than it had been earlier in the economic
expansion. Growth in M1, the narrow monetary aggregate, was exceedingly
rapid in those years, and bank reserves increased substantially
(see chart 5). This accommodative policy contributed to the decline
in the dollar but simultaneously served to bolster demand for goods
and services in this country. Thus the decline in the dollar has
not as yet generated any demonstrable improvement in the trade balance,
and it is possible that it never will.
Again, the GNP accounting identity can help to elucidate the consequences
of various policy choices. A less stimulative fiscal policy will
be accompanied by improvement in the trade balance and/or in domestic
investment, as a decline in real interest rates aids these sectors.
However, stimulative monetary policy, under the assumption of full
employment, should reduce the nominal value of the dollar but will
also contribute to inflation, at least over time, leading to little
if any improvement in the terms of trade and in the trade balance.
Indeed, if the drop in interest rates leads to a substantial increase
in investment, the identity implies that the terms of trade must
worsen so as to increase the trade deficit.
Of course, the economy over the last two years was not at full
employment. Consequently, the stimulative monetary policy may have
had some positive effects on the trade balance. In the first instance,
such a policy lowers real interest rates and the foreign exchange
value of the dollar. Lower interest rates in turn stimulate domestic
investment so that aggregate income is higher than it otherwise
would be. The income effect by itself worsens the trade deficit
as the rise in income induces consumers to buy more imports. However,
this effect can be more than offset by the terms of trade if the
dollar falls without a corresponding rise in domestic prices. Moreover,
as income increases, the budget deficit should narrow as tax revenues
climb. In short, in these circumstances accommodative monetary policy
can ameliorate the trade and budget deficits, at least to a degree.
However, as we have seen, the ability of expansionary monetary
policy to accomplish these objectives is significantly circumscribed
as the economy approaches full employment. The practical experience
of the past two years, as the dollar has declined with accommodative
monetary policy, suggests that the effects of such a policy may
be small indeed.
Protect Us From Protectionism
According to our identity and in light of current economic experience,
it is unlikely that we will make progress on reducing the trade
deficit without also reducing the federal deficit. Even if we can
fix the trade deficit some other way, however, the cure could be
worse than the disease. The best example of such a cure is so-called
"trade legislation" the euphemism for protectionist policies.
Protectionist policies could readily have adverse effects on our
domestic economy. To the extent that they succeed in restricting
the volume of imports, they will raise prices of imported goods,
and thus the American consumer will pay for the policies. There
is evidence to suggest, moreover, that low-income consumers bear
a disproportionate share of these costs. According to a recent staff
study by the Federal Reserve Bank of New York, the cost to U.S.
consumers of trade protection on clothing, sugar, and automobiles
is not only high but also regressive, in that the cost of protection
is many times larger for low-income consumers than it is for those
with high incomes.
Further, if competition is restrained by protectionism, there
may be room for domestic producers to raise prices and, if this
process gains momentum, it could foster rapid inflation. As the
GNP identity discussed earlier makes clear, if the economy is at
full employment, protectionist measures that successfully reduce
the trade deficit must either depress domestic investment or reduce
the government deficit. The latter reaction would result as protectionism
adds to inflation and tax revenues climb with nominal income. This
effect is likely to be small, however. The burden instead will more
likely fall on investment as the private and public sectors will
have to compete for more limited capital funds.
Protectionist policies, too, could make it difficult for domestic
industries to compete effectively here and abroad, if import prices
were to rise beyond levels faced by foreign firms. For example,
if foreign steel were barred from the United States or if its price
rose significantly, U.S. manufacturers that use steel as an input
would face higher costs than their foreign competitors. We should
not expect these manufacturers to do well if we handicap them in
this way. We may also wonder if our trade balance would in fact
improve if our manufacturers were thus shackled.
Retaliation is another likely outcome of protectionist measures.
We are well aware of the trade barriers that exist in many foreign
countries today, yet there is no evidence that these unfair trade
practices abroad have contributed in a major and systematic way
to our trade imbalance. If we began to raise our trade barriers,
foreign governments would probably not stand by and watch. They
are likely to retaliate by imposing tariffs or volume restrictions
on U.S. goods. So the outcome of protectionism for the U.S. economy
as a whole would be deleterious, although specific protected industries
Even this list of protectionism's repercussions does not do justice
to its flaws as public policy. Consider a world economy where trade
legislation and subsequent retaliation have become pervasive. Under
these circumstances, a logical outcome would be a significant contraction
in trade worldwide. Such a contraction would be expensive, in the
sense that employment and production would necessarily be curtailed
around the world. This is, of course, the conventional description
of a worldwide recession, and it would be accompanied by higher
prices for many products than otherwise would be the case.
The performance of the U.S. economy over the past several years,
characterized by growing federal budget deficits, together with
deterioration in the trade balance, can be better understood with
the analytical structures of deficit arithmetic. This arithmetic
shows that budget deficits can indeed crowd out private sector activity,
but perhaps in ways that were more subtle than initially anticipated.
The GNP accounting identity also makes clear that in the absence
of increases in the volume of domestic savings, the only effective
way to alter the arithmetic favorably is to reduce the government's
deficit. If such a policy is not implemented, improvement in the
trade balance will result in weakening in investment spending.
To be sure, reduction of the budget deficit is neither a riskless
nor a new policy prescription. Nonetheless, it remains a sound one.
At this stage, such action would strengthen the private sector of
the economy and would spur improvement in the trade situation. Improving
the trade balance, in and of itself, though, should not be a policy
goal. Protectionist policies aimed at this objective will surely
miss the mark. Progress on the trade issue is also questionable
if we rely solely on accommodative monetary policy. The unpleasant
arithmetic of budget and trade deficits in fact suggests that such
a policy could actually exacerbate the trade problem. At the same
time, it could trigger a reacceleration of inflation.
In summary, if we cannot correct our fiscal imbalance, it may
not be wise to try to redress our trade imbalance.