FEDERALRESERVEBANKOFSANFRANCISCO

E D U C AT I O N

DR. ECON

Is the U.S. trade decit a problem? What is the link

between the trade decit and exchange rates?
June 2007

I am so glad you asked this important question. The size of the U.S. trade
decit, and its implications for this countrys 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 denitions.
What is a trade decit?
Before we talk about trade decits, 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 decit. 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 nations 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 reects 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 denition, 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 decit, national
saving must, by denition, be below investment. In this case, the country is a
net borrower (as national saving is not sufcient to nance all of domestic
investment, and so the extra investment must be nanced 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 nances. Put differently, the balance of payments records the

composition of the current account balance and of the transactions that

nance it. There are three main components of the balance of payments:
the current account, the nancial 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 nancial assets. Transactions that
arise from the trade in nancial assets are recorded in the nancial 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 nancial
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 nancial 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, nonnancial, 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, reecting 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, nancial account, and capital account must be zero by
denition.
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
uctuations on the economy.
What does the U.S. trade balance look like?
Figure 1 shows the U.S. trade balance. In the gure, gray bars denote
1
recession periods. The thick red line shows the real trade balance, while the
2

thin blue line shows the nominal trade balance. As you can see, the United
States has been running a trade decit at least since the early 1990s. In
2007, the U.S. ran a trade decit 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 nancial account of the balance of payments. Countries can trade
assets in addition to trading goods and services, and such transactions are

tracked in the nancial 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 nance this trade decit. The money it receives for the sale of
those assets has nanced its trade decit. Indeed, net nancial inows (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
3
2007.
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 countrys 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 GDPthe 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 decit must, by denition, 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
4
remained above the countrys saving for several years.
Figure 3. U.S. Saving and Investment as a Share of GDP

What has caused the U.S. trade decit?

Over the years, many explanations of the persistent U.S. trade decit 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 decit 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 decit has been blamed

for the widening trade decit because of the so-called twin decit
hypothesis (which states that budget decits cause trade decits). However,
as thenFed Governor Ben Bernanke discussed in a 2005 speech , to
understand the U.S. current account decit, one must look beyond the U.S.
5
borders. He suggested that over the past decade a combination of diverse
forces has created a signicant increase in the global supply of savinga
global saving glutwhich helps to explain both the increase in the U.S.
current account decit 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 decit (for more on the link between productivity and the
current account, see Valderrama 2007).
Is the U.S. trade decit 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 decit. However, there is a
lot of disagreement about the severity of the problem and the potential
consequences:
The current pattern of international capital owsshould it persistcould
prove counterproductive.
Ben Bernanke (2005)
We can run huge decits 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 decit 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 decit 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 decit 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 difculties. 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 decit 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:
/publications/fedinprint/

National Bureau of Economic Research (take a look at the working

papers):
http://www.nber.org/
Peterson Institute for International Economics (take a look at the
publications):
http://petersoninstitute.org/
The link between trade decits and exchange rates
Finally, let me address the last part of your question regarding the link
between trade decits and exchange rates.
First, exchange rates determine the relative prices of domestic goods and
foreign goods, thus, they can inuence 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 Obsteld (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 decits might exert pressure on the exchange rate. To be specic,
current account decits might weaken the currency. To read more about
that, please take a look at my October 1999 and June 2001 responses.
Endnotes
1. Recession periods are as dened by the National Bureau of Economic Research or NBER
information, please visit the NBER web site

. For more

2. Real variables are adjusted for ination. Nominal variables are not.

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.

5. Note that here I switched from discussing the trade balance to discussing the current account balance.
However, as mentioned, they are closely related concepts.

References
Bernanke, Ben S. 2005. The Global Saving Glut and the U.S. Current
Account Decit.
Remarks by Governor Ben S. Bernanke At the Sandridge
Lecture, Virginia Association of Economics, Richmond, Virginia.

CBO. 2000. Causes and Consequences of the Trade Decit: an

Overview.

Congressional Budget Ofce.

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.
2005.

New York Times Nov. 25,

Krugman, Paul and Maurice Obstfeld. 2006. International Economics: Theory

and Policy. 7th ed. Addison-Wesley.
Mankiw, N. Gregory. 2006. Is the U.S. Trade Decit 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 Decit.FRBSF Economic Letter, 2006-08.