America’s trade balance “plumbing” explained in new Mercatus research paper
The Trump administration has targeted the U.S. trade deficit as a major problem for U.S. trade policy. To help the public and policy makers understand just what the trade deficit means, and what it doesn’t mean, the Mercatus Center today published my new study on the subject, “Plumbing America’s Balance of Trade.”
In the study, I provide a comprehensive analysis of all the ways Americans engage in commerce with the rest of the world, and the inflow and outflow flow of trillions of dollars each year to finance those transactions. The study explains how underlying levels of savings and investment determine the size and direction of America’s trade balance, why bilateral deficits with trading partners do not indicate a failure of US trade policy, and why efforts to employ trade policy to fix the overall trade deficit or bilateral deficits would be futile and self-damaging.
Here is an excerpt from the paper explaining why the Trump administration’s determination to reduce our bilateral trade deficits with China, Mexico, Germany, and other major trading partners is based on faulty assumptions:
If the US government were to attempt to shrink or eliminate its bilateral deficit with a particular country in order to reduce the overall trade deficit but do so without changing the underlying balance of savings and investment, the effort would be doomed to fail. America can badger another country into buying more US exports, or it can block their imports with tariffs. Either action may shrink the bilateral deficit, but without a change in the underlying macroeconomic factors that determine the overall balance, it would simply reallocate the balance among America’s other trading partners.
Today, critics of the trade deficit often focus on US trade with China because of the large bilateral trade deficit. (In the 1980s the focus was on America’s bilateral trade deficit with Japan.) These trade critics see reducing the deficit with China and other major deficit partners as the key to reducing the overall deficit. But absent a change in the domestic savings and investment levels in the United States, a change in the China bilateral deficit would be unlikely to impact the overall US trade balance.
Consider the recent example of America’s trade in petroleum. From 2011 to 2015, the United States experienced a dramatic change in its demand for petroleum imports. The change was caused by America’s increased competitiveness in petroleum production, allowing a kind of import substitution that caused a sharp drop in Americans’ demand for imported petroleum products.
To better illustrate the point, assume the US petroleum trade is conducted with one country, called Petrostan. Petrostan buys all US petroleum exports and supplies all US petroleum imports. In 2011, the United States exported $113 billion to Petrostan while importing a whopping $439 billion, for a bilateral trade deficit of $326 billion (roughly the same magnitude as the United States’ bilateral deficit with China in 2011).
Through an aggressive effort to produce more petroleum in America, our country was able to dramatically reduce its imports from Petrostan, resulting in a much reduced bilateral trade deficit of $85 billion in 2015. The impact on America’s overall current account deficit was zero. In fact, the current account deficit grew slightly in the same period, from $460 billion to $463 billion. (See figure 2.) The $241 billion reduction in the bilateral deficit with Petrostan was more than offset by the $244 billion increase in the current account deficit with the rest of the non-Petrostan world. The dollars that were flowing out to buy barrels of oil continued to flow out, but they were used to buy other goods or services or to pay interest on Treasury bills.
Without a change in the underlying levels of savings and investment in America, any change in the bilateral trade balance with one country will be offset by changes in other bilateral balances. That means that even if the US government could force a reduction in the bilateral trade deficit with China through a combination of export promotion and import restraints, any reduction in the deficit would be apportioned to the United States’ other bilateral trading partners, leaving the overall balance unchanged.
Among the other key points made in the study:
America’s net positive inflow of capital year after year indicates the continuing attractiveness of the United States as a destination for foreign investment;
Imports benefit US consumers as well as producers; and
Direct foreign investment abroad by US companies is not primarily a platform for importing goods and services back to the United States but for expanding sales to foreign customers.
