America's Maligned and Misunderstood TRADE DEFICIT.

• Author: Griswold, Daniel T.

"It is imports, not exports, that allow Americans to enjoy a higher standard of living. Exports without imports are like a job without a paycheck."

One of the most politically volatile consequences of the financial and economic turmoil in the Pacific Rim will be a rising U.S. trade deficit in 1998. Plunging growth rates in the region will mean less demand for U.S. exports, while falling foreign currency values will make Asia's exports to the U.S. more affordable, spurring demand by American consumers. The result, widely predicted by economists, will be a mercantilist's nightmare--a growing gap between the value of the imported goods and services and the value of what America exports. If the past is any guide, the growing trade gap will fuel anguish in the news media and protectionist sentiments in Congress.

On March 23, 1998, the Senate voted to spend $2,000,000 to fund an Emergency Trade Deficit Review Commission. The 12-member commission would be given 18 months to study the causes of the U.S. merchandise and current account deficits and recommend policy changes, with special focus on the bilateral deficits with China and Japan.

No aspect of international trade is talked about more and understood less than America's perennial trade deficit. Critics of free trade, and most of the public for that matter, believe the trade deficit is prima facie evidence that American companies are failing to compete in global markets or that U.S. exporters face "unfair" trade barriers abroad, or both. The obvious implication is that, if other nations were to open their markets as wide as the U.S. supposedly has opened its, or if American companies became more competitive against foreign rivals, the U.S. could export more relative to imports, thus reducing the trade deficit.

The popular thinking on trade deficits is simple, appealing--and wrong! Trade deficits are not determined by the microeconomics of trade policy or industrial competitiveness. They reflect underlying macroeconomic factors, specifically investment flows and, ultimately, the national rates of savings and investment that determine those flows. The recent experience of the U.S. and its trading partners confirms this conclusion.

Understanding the trade deficit has profound implications for the national debate about trade. The U.S. trade deficit can not be reduced by restricting imports to the American market or persuading or bullying other governments to lower barriers to their markets. The trade deficit can not be reduced through government-directed industrial policy, managed trade, or export subsidies aimed at boosting national "competitiveness" (however one defines the concept). Moreover, contrary to the headlines, trade deficits are not necessarily bad news for the U.S. economy. They even may be good news.

Americans have run an annual trade deficit in goods and services with the rest of the world in every year since 1976. That unbroken string of deficits has colored much of the trade debate in the U.S. during the last two decades.

Beginning in the early 1980s, annual American trade deficits reached unprecedented levels. After decades of postwar surpluses, the trade deficit topped $100,000,000,000 in 1984 and peaked at a record $153,000,000,000 in Fiscal Year 1987. The trade deficit shrank to a low of $31,000,000,000 in 1991, but has grown again to more than $100,000,000,000 a year since 1994, reaching $113,700,000,000 in 1997. (The $198,700,000,000 deficit in goods partially was offset by an $85,000,000,000 surplus in services.)

Throughout the 1980s and 1990s, trade deficits have spawned worry about "unfair" foreign trade barriers, lost jobs, and America's ability to compete in the global marketplace. In the debate in the fall of 1997 over renewal of fast-track trade authority, opponents of the measure cited the continuing over-all American trade deficit as evidence that trade harms the U.S. economy, and destroys jobs. To discredit the North American Free Trade Agreement, and by association all free-trade agreements, opponents of fast-track authority hammered away at the bilateral trade deficits the U.S. runs with both of its NAFTA partners, Mexico and Canada.

The deficit with Mexico drew the most fire because America's bilateral balance with Mexico had been in surplus before 1995. In September, 1997, Steve Beckman, an economist for the United Auto Workers labor union, testified before the Subcommittee on Trade of the House Ways and Means Committee that bilateral trade deficits with Canada and Mexico had created a "trade debacle" costing the U.S. economy more the 400,000 jobs.

Bilateral trade deficits continue to complicate America's commercial relations with a number of major trading partners, chief among them Japan and China. In 1997, the U.S. recorded a $55,700,000,000 bilateral trade deficit with Japan and a $49,700,000,000 deficit with China, by far the nation's two largest bilateral imbalances. The deficit with China appears even more threatening to some trade critics because it has grown so rapidly in recent years, more than quadrupling from $11,500,000,000 in 1990. The bilateral deficit with China has been used to argue against renewal of China's Most Favored Nation status and against admitting it to the World Trade Organization. America's bilateral trade deficit with Japan probably has been the single biggest source of trade friction between the two countries.

The most important economic truth to grasp about the trade deficit is that it has virtually nothing to do with trade policy. A nation's trade deficit is determined by the flow of investment funds into or out of the country. Those flows are determined by how much the people of a nation save and invest--two variables that are only marginally affected by trade policy.

An understanding of the trade deficit begins with the balance of payments, the broadest accounting of a nation's international transactions. By definition, the balance of payments always equals zero--that is, what a country buys or gives away in the global market must equal what it sells or receives--because of...