Each issue of The Regional Economist, published by the Federal Reserve Bank of St. Louis, features the section “Ask an Economist,” in which one of the bank’s economists answers a question. The answer below was provided by Senior Economist YiLi Chien.
The answer to this question depends on several factors. Under certain favorable conditions, it is possible that the trade deficit is not a major concern.
The fact that the U.S. has a trade deficit means that the U.S. consumes more than it produces net of investment. This deficit must be financed either by reducing U.S. external assets or by increasing U.S. external liabilities. On balance, it seems possible that a persistent trade deficit would deplete U.S. overseas assets and perhaps, in the longer run, lead to insolvency.
However, this may not be the case because assets pay dividends and are associated with capital gains. Although the current difference between U.S. external assets and liabilities is negative, the U.S. is able to generate a net inflow because of the return difference between U.S. external assets and external liabilities. Economists Pierre-Olivier Gourinchas and Hélène Rey have documented that the U.S. earns a higher rate of return on its overseas assets than it pays on its liabilities to foreigners. The return difference is actually quite large: The U.S. external assets pay on average 3.3-percent-higher annual returns than do external liabilities. This return differential stems from a difference in the composition of U.S. external assets and liabilities. Assets with a higher return and risk, like foreign direct investment and private equity, have a larger portfolio share in the U.S. external assets. The large return differential implies that the U.S. can have net inflows in spite of being a debtor country.
In sum, as long as the net investment income from the U.S. external account is sufficiently large, the trade deficit can be paid for and is not a major concern.
Gourinchas, Pierre-Olivier; Rey, Hélène. "From World Banker to World Venture Capitalist: U.S. External Adjustment and the Exorbitant Privilege," in G7 Current Account Imbalances: Sustainability and Adjustment, NBER Chapters, pp. 11-66. National Bureau of Economic Research, 2007.