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Gary Clyde Hufbauer
Gary Clyde Hufbauer
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As promised during the election campaign, on Jan. 23, President Trump signed the executive order withdrawing the United States from the Trans-Pacific Partnership, a trade deal with 11 other countries. Renegotiation of the North American Free Trade Agreement is Mr. Trump’s next big step on trade policy. In his first week, his administration suggested that Mexican imports would potentially face a 20 percent tax in order to finance a wall on the U.S.-Mexico border.
The president’s actions are rooted in his belief that U.S. free trade agreements have enlarged U.S. trade deficits, causing job losses and wage declines.
A trade deficit happens when a country’s imports of goods and services exceed its exports of goods and services. In other words, when a country buys more from the rest of the world than it sells, the country incurs a trade deficit. In 2016, the U.S. trade deficit was about $500 billion.
The size of the trade deficit is primarily determined by four macroeconomic forces:
Putting these forces together, the United States incurs a trade deficit when it spends more than it earns — bearing in mind that national spending and earnings are influenced by the tempo of economic activity abroad and the foreign exchange value of the dollar. When economic activity abroad is robust, it’s easier for U.S. firms to sell goods and services to foreign buyers, but when the dollar is strong, U.S. firms find it harder to sell abroad and easier to buy foreign goods and services.
Because the United States persistently spends more than it earns and because the dollar is historically strong thanks to its safe-haven virtues, the United States has incurred trade deficits for almost half a century. Since 2000, the annual trade deficit has averaged $535 billion.
To finance the trade deficit, the United States must either borrow from foreign lenders or attract investment from abroad. In 2015, the United States earned $16.9 trillion by producing goods and services for domestic and foreign markets, but spent $17.4 trillion buying goods and services made at home as well as abroad. Thus, the U.S. trade deficit was $500 billion in 2015, and it was financed both by loans from abroad and foreign firms investing in the United States.
READ MORE: Column: Trump’s border tax is not the right fix for U.S.-Mexico trade
How do trade agreements like NAFTA and the Korea-U.S. Free Trade Agreement fit into this story? Fundamentally, they reduce frictions that impede two-way trade, financial flows and investment between the partner countries, but they do not alter the broad macroeconomic forces just listed above. Free trade agreements might alter the size of the U.S. bilateral trade deficit with the partner country, but they make little difference to the overall size of the U.S. trade deficit with the world. If the U.S. trade deficit with Mexico, for example, grows, because NAFTA reduces border frictions between the United States and Mexico, the U.S. trade deficit with the rest of the world will shrink to the same extent.
The table below summarizes U.S. two-way trade and the trade balance (deficit or surplus) with major trading partners in 2015. The United States runs bilateral trade deficits with China, Germany, Japan, Korea and Mexico, but it runs small trade surpluses with Canada and the United Kingdom.
But this table provides a misleading guide for making trade policy, which should ideally seek to expand multilateral trade between all parties, not to redress bilateral imbalances. In previous work, Gary Hufbauer and Zhiyao (Lucy) Lu showed that free trade agreements have little or no impact on the size of the U.S. global trade deficit.
While the trade deficit has become a punching bag in U.S. politics, in the realm of economics, the debate is not one-sided. When a country is growing rapidly or experiencing high inflation, economists generally believe that the benefits from a trade deficit outweigh its costs. But during a recession or when a country suffers deflation, a trade deficit probably does more harm than good.
What are the economic costs of the trade deficit?
READ MORE: Column: The great irony of the Mexico tariff is that Americans would pay for it too
What are the economic benefits of the trade deficit?
Reducing the U.S. trade deficit with the world will require macroeconomic policies that increase the savings of households and business firms, decrease government deficits and make the dollar more competitive in foreign exchange markets. Here are a few policies that would do that:
However, President Trump’s economic agenda centers on tax cuts, infrastructure and defense, implying a larger budget deficit and considerable fiscal stimulus. This may be just what the lackluster U.S. economy needs, but it’s not a prescription for smaller trade deficits.
Moreover, to forestall a spike of inflation, the Federal Reserve might accelerate the rise of interest rates, pushing the dollar higher. A stronger dollar and stronger domestic demand will almost certainly enlarge the trade deficit. Withdrawal from Trans-Pacific Partnership, renegotiation of the North American Free Trade Agreement and launching trade actions against China ensure political headlines, but they will not make much difference to the global U.S. trade deficit. Nor will they bring more jobs and higher wages to U.S. workers.
Gary Clyde Hufbauer has been the Reginald Jones Senior Fellow at the Peterson Institute for International Economics since 1992. Hufbauer has written extensively on international trade, investment, sanctions and tax issues. His coauthored titles include "Bridging the Pacific: Toward Free Trade and Investment between China and the United States," "Economic Normalization with Cuba: A Roadmap for US Policymakers," "Outward Foreign Direct Investment and US Exports, Jobs," and "NAFTA Revisited: Achievements and Challenges."
Euijin Jung is a research analyst at the Peterson Institute for International Economics.
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