What's Behind the U.S. Trade Deficit?

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Running a trade deficit is not new for the U.S. It’s been mostly running trade deficits since the 1970s. However, this trade imbalance has recently become hotly scrutinized. Much of the concern stems from a fear that trade deficits lead to declines in manufacturing sector employment.

In a recent Regional Economist article, Assistant Vice President and Economist Yi Wen and Research Associate Brian Reinbold explored why the U.S. runs a trade deficit, why manufacturing employment is declining and how these two are related. They also looked at the trade relationship with China, which is the largest supplier of goods to the U.S.—and by extension, its biggest creditor.

The long-running U.S. trade deficits and the emergence of China as a major creditor nation are largely the result of two economic forces, they wrote:

1. The rise of the U.S. currency and U.S. government debts to become the world currency and a global form of liquidity and store of value following the collapse of the Bretton Woods system
2. The comparative advantage shift in goods production, which caused labor-intensive manufacturing to move from the U.S. to nations with cheaper labor

After World War II, a new international monetary system, referred to as Bretton Woods, established the U.S. dollar as an international reserve currency. The dollar would be backed by gold, and any country could exchange dollars for gold. “This new system facilitated and stabilized global trade, especially trade among the industrialized nations,” Wen and Reinbold wrote.

However, after years of U.S. aggregate-demand growth, countries running trade surpluses with the U.S. sought to exchange their dollars for gold, rapidly shrinking U.S. gold reserves, the authors noted. The Bretton Woods system effectively ended in 1971 when the U.S. ended dollar convertibility to gold.

Subsequently, because of the historical strength of the U.S. dollar, it became the global currency, and U.S. government securities became the most-demanded foreign reserve in the world, the authors pointed out.

When the U.S. can purchase goods from the world market simply by issuing debt, it is likely to run persistent trade deficits, they said. Indeed, since the mid-1970s, the U.S. has seen persistent and growing trade deficits.

“[T]he current international monetary system—based on the U.S. dollar as the dominant world reserve currency and U.S. government securities as the most-sought-after store of value—is the root cause of persistent trade deficits in the U.S.,” Wen and Reinbold wrote.

The next question the authors addressed is: Do trade deficits lead to a decline in employment in the manufacturing sector? Not necessarily, they explained. The more likely causes are rapid technology growth and improved labor productivity, similar to what happened in the U.S. agricultural sector.

Manufacturing employment in the U.S. started to decline in the 1960s as labor productivity rose. The authors pointed to research by Timothy Kehoe, Kim Ruhl and Joseph Steinberg Kehoe, Timothy J.; Ruhl, Kim J.; Steinberg, Joseph B. “Global Imbalances and Structural Change in the United States.” Journal of Political Economy, April 2018, Vol. 126, No. 2, pp. 761-96. that showed that about 85 percent of the drop in employment in the goods manufacturing sector from 1992 to 2012 was due to the rising labor productivity. Only 15 percent was due to rising U.S. trade deficits.

“When workers get pushed out of agriculture and goods-producing sectors, they enter the service sector,” Wen and Reinbold wrote. “This phenomenon of structural change (caused by technology growth) is observed across all successfully industrialized nations.”

Manufacturing employment in the U.S. declined nearly 20 percent from 2000 to 2007, even before the Great Recession, the authors pointed out. They added that this sharp decline correlated with a worsening U.S. trade balance and a growing trade deficit with China.

However, the global comparative advantage in manufacturing has been shifting away from the U.S. since World War II, they noted. Following the war, it shifted to recovering countries such as Germany and Japan. It gradually shifted to the so-called Asian Tigers in the 1970s and 1980s, and then to China.

But while the total U.S. goods trade deficit with Asia has been increasing, its share of the U.S. deficit has been declining, the authors noted. In 1991, the East Asian and Pacific region (which includes China) accounted for more than 80 percent of the total U.S. goods trade deficit. That now stands at around 65 percent, despite China’s rise as the largest supplier of goods to the U.S.

“In other words, the rise of China since the late 1980s—especially after joining the WTO [World Trade Organization] in 2001—has not increased the total share of Asia’s contribution to the U.S. trade imbalance; China simply substituted out other Asian economies by taking their positions,” Wen and Reinbold wrote.

So, even though China’s share in total U.S. trade deficits increased from around 15 percent in 1991 to 45 percent around 2016, it has not increased the total share of Asia’s trade position with the U.S., they pointed out.

The rise of the U.S. dollar as an international reserve currency and a shift in comparative advantage in manufacturing are key economic changes driving the large U.S. trade deficit.

“Given this perspective, a trade war with China may not necessarily solve the U.S. trade imbalance problem,” the authors said. They identified three likely outcomes from an extended trade conflict with China, none of which are likely to increase U.S. exports and reduce its trade deficits:

1. Chinese imports becoming more expensive
2. U.S. trade deficits shifting to other countries with similar comparative advantages in producing labor-intensive goods
3. U.S. exports to China becoming more expensive as a result of China’s retaliation

¹ Kehoe, Timothy J.; Ruhl, Kim J.; Steinberg, Joseph B. “Global Imbalances and Structural Change in the United States.” Journal of Political Economy, April 2018, Vol. 126, No. 2, pp. 761-96.

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