I am so glad you asked this important question. The size of the U.S. trade deficit, 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 definitions.
What is a trade deficit?
Before we talk about trade deficits, 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 deficit. 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 reflects 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 definition, 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 deficit, national saving must, by definition, be below investment. In this case, the country is a net borrower (as national saving is not sufficient to finance all of domestic investment, and so the extra investment must be financed 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 finances. Put differently, the balance of payments records the composition of the current account balance and of the transactions that finance it. There are three main components of the balance of payments: the current account, the financial 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 financial assets. Transactions that arise from the trade in financial assets are recorded in the financial 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 financial 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 financial 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, nonfinancial, 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, reflecting 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, financial account, and capital account must be zero by definition.
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 fluctuations on the economy.
What does the U.S. trade balance look like?
Figure 1 shows the U.S. trade balance. In the figure, gray bars denote recession periods.1 The thick red line shows the real trade balance, while the thin blue line shows the nominal trade balance.2 As you can see, the United States has been running a trade deficit at least since the early 1990s. In 2007, the U.S. ran a trade deficit 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 financial account of the balance of payments. Countries can trade assets in addition to trading goods and services, and such transactions are tracked in the financial 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 finance this trade deficit. The money it receives for the sale of those assets has financed its trade deficit. Indeed, net financial inflows (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 2007.3
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 deficit must, by definition, 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 remained above the country's saving for several years.4
Figure 3. U.S. Saving and Investment as a Share of GDP
What has caused the U.S. trade deficit?
Over the years, many explanations of the persistent U.S. trade deficit 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 deficit 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 deficit has been blamed for the widening trade deficit because of the so-called "twin deficit" hypothesis (which states that budget deficits cause trade deficits). However, as then–Fed Governor Ben Bernanke discussed in a 2005 speech, to understand the U.S. current account deficit, one must look beyond the U.S. borders.5 He suggested that "over the past decade a combination of diverse forces has created a significant increase in the global supply of saving—a global saving glut—which helps to explain both the increase in the U.S. current account deficit 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 deficit (for more on the link between productivity and the current account, see Valderrama 2007).
Is the U.S. trade deficit 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 deficit. However, there is a lot of disagreement about the severity of the problem and the potential consequences:
The current pattern of international capital flows—should it persist—could prove counterproductive.
Ben Bernanke (2005)
We can run huge deficits 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 deficit 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 deficit 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 deficit 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 difficulties. 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 deficit 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:
- National Bureau of Economic Research (take a look at the working papers):
- Peterson Institute for International Economics (take a look at the publications):
The link between trade deficits and exchange rates
Finally, let me address the last part of your question regarding the link between trade deficits and exchange rates.
First, exchange rates determine the relative prices of domestic goods and foreign goods, thus, they can influence 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 Obstfield (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 deficits might exert pressure on the exchange rate. To be specific, current account deficits might weaken the currency. To read more about that, please take a look at my October 1999 and June 2001 responses.
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.
Bernanke, Ben S. 2005. "The Global Saving Glut and the U.S. Current Account Deficit." Remarks by Governor Ben S. Bernanke At the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia.
CBO. 2000. "Causes and Consequences of the Trade Deficit: an Overview." Congressional Budget Office.
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 Deficit 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 Deficit."FRBSF Economic Letter, 2006-08.