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The US Trade Deficit: Why Is It Important?

The US Trade Deficit: Why Is It Important?

For a long time now, economists have argued whether a trade deficit is harmful for the domestic economy. While there are theories that propose that a deficit is detrimental to a nation’s economy, proponents of the free markets suggest that these negative effects get balanced out over time.

A trade deficit arises when a country’s annual imports exceed its total exports. The United States is one country that has been running up a huge trade deficit for years. Since the 1980s, the US has seen a steady widening of its trade deficit, averaging $535 billion since 2000, substantially higher than the deficit of previous decades.

In 2018, the nation’s net exports stood at $2.5 trillion, while net imports totalled $3.121 trillion, leading to a deficit of $621 billion, almost 3% of its total GDP. This huge trade deficit remains unchanged in 2019.

President Trump has made reducing this deficit a priority. But, even launching a trade war against the nation he blames for the deficit isn’t helping matters much. So, what are the causes of this deficit? And how important is it for the US and the rest of the world?

Reasons for the US Trade Deficit

Many theories have been proposed over the years, to account for this deficit. Here’s a look at some prominent ones.

1.      Collapse of the Bretton Woods System

Bretton Woods established the US Dollar as the world’s reserve currency and fixed the value of the greenback to gold (at a price of $35/ounce). In the 1960s, the US aggregate demand increased and the countries that had trade surpluses with the US went on to exchange their Dollars for gold, reducing the nation’s gold reserves. This led to the collapse of the Bretton Woods agreement in 1971.

After the end of Dollar convertibility to the gold system, the US Dollar became a global currency, and Dollar-denominated securities became much coveted. This rising demand for the American currency made the value of Dollar as good as gold. So now, the US could purchase goods from the market simply by increasing its money supply and issuing debt. This led to a persistent growth in its trade deficits. Foreign holdings of US debt were as low as 3% in 1970, which increased to 34% by 2015.

2.      Widening National Saving-Investment Gap

National saving in the US has been declining since the 1950s, which further accelerated from the 80s onwards. Insufficient national savings to finance national investment causes imbalance in the trade balance. This cumulative saving-investment gap has grown to $11 trillion in recent years, and a significant portion of this figure is accounted for by foreign holdings of US government bonds and currency.

The fact that the US Dollar is the world’s reserve currency and its government issued securities are in such high demand remains among the biggest causes of the rising trade deficit.

3.      Decline in Manufacturing Activity – Shift in Comparative Advantage

Persistent trade deficits can lead to a decrease in manufacturing employment. Rapid technological advances and improved labour productivity (rising wages) are also likely culprits. Labour-intensive mass production technologies were profitable in America until the 1960s, after which technological advancements and labour productivity took on a whole new life.

Capital intensive production technologies were adopted by firms to reduce labour costs. Those who could not do this, chose to move their operations to developing countries, like India and China, where labour is cheaper. With an increase in labour costs and capital becoming cheaper, the US domestic economy saw de-industrialisation, along with an expanding services sector and social welfare programs. Since the 1960s, the US has started to transition to something like a welfare state, while its manufacturing activities have shifted overseas.

Manufacturing jobs steadily declined by about 20% from 2000 to 2007, much before the recession. China has been blamed for the declining manufacturing jobs in the US and the rising trade deficit. But, how much is China really to blame?

The US-China Trade Deficit

Thanks to the shifting of competitive advantage, China became a major manufacturing hub. After joining the WTO in 2001, the Asian nation’s share of the total US deficit rapidly increased from 15% in 1991 to 45% in 2016.

A highly consumer-based economy in the 21st century, the US is a net importer from China, especially for major market sectors like consumer electronics, apparel, industrial supplies, raw materials and furniture. In 2018 alone, America imported $539.5 billion worth of goods from China, while exporting only $120.3 billion in goods.

The United States’ largest bilateral trade imbalance is with China, fixing which has been the agenda behind the ongoing trade war. But President Trump’s protectionist tariffs on Chinese goods and retaliatory tariffs imposed by Beijing have not had any significant impact on reducing this gap.

Many detractors have also pointed out that the US President is unnecessarily focusing on goods trade, whereas the services sector actually accounts for the larger share of the economy. Along with China, Japan and Europe accounted for more than three quarters of the $742.78 billion US trade deficit from January to October 2018.

Is the US Trade Deficit Good or Bad?

Continuing trade deficit for a long time can hurt the US economy, by reducing its competitiveness. An economy that is financed with debt runs huge credit and default risks. Large inflows of foreign capital, which come with rising trade deficit, can lead to financial bubbles. This might have been one of the reasons for the US housing crisis of 2006. A large deficit has the potential to slow economic growth, by reducing demand within the domestic economy.

But some economists say that this trade deficit is necessary for the US to maintain the Dollar’s reserve currency status. The US will continue to create and add more debt, as long as there is a strong demand for the Dollar worldwide. There are significant economic advantages when your domestic currency is the global currency.

Increased demand for dollar-denominated assets keeps interest rates low. Foreign investors buy short-term US Treasury yields, while Americans invest in long-term high-yielding assets. The returns on such investments are usually much higher for the US, as compared to returns on debt.

The current trade deficit is doing more harm than good, as is the trade war, which is hurting the country’s international supply chains. The US merchandise trade deficit stood at $900 billion in July 2019. Short-term interest rates are rising over long-term rates, leading to an inverted yield curve (or a likely inversion) during much of 2019.

Manufacturing activity is contracting, while the production-line capex is stagnant. Recessionary elements appear to be gradually returning, which is not a good sign for the global economy.

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