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Yi Wen is an economist and assistant vice president in the Research division at the Federal Reserve Bank of St. Louis. He joined the St. Louis Fed in 2005 after teaching at Cornell University for six years as an assistant professor. His research field is in macroeconomics with a focus primarily on the business cycle. His hobbies include walking, swimming and playing badminton. To read more on his work, see http://research.stlouisfed.org/econ/wen/

Why does the U.S. have such a large trade deficit with China?

Prices of consumer goods in the United States have been remarkably low and stable for decades. One of the most important reasons for this, besides sound monetary policies conducted by the Fed, is international trade with developing countries, such as China.

Each year, China sells goods to us at very low prices. For example, Chinese workers need to use 16 million T-shirts to exchange for one Boeing 737-800 airplane from us (at about $5 per T-shirt). More than that, they even lend goods to us by keeping our paper money for a long time.

The result is a huge trade deficit with China: For every dollar Americans spend on Chinese goods, Chinese spend 30 or fewer cents on American goods. China currently holds a total of $3 trillion in foreign reserves, mostly in U.S. dollars or U.S. government bonds. This means that U.S. consumers have been enjoying huge quantities of low-cost goods by borrowing cheaply from China at negative real interest rates.

The question is why Chinese people are willing to lend goods to us when they are still struggling with very low per capita income and consumption levels. One answer from economic theory is that they have a strong need to save for a rainy day. At their current stage of economic development, Chinese workers do not have a well-developed financial market and social safety net, both of which would reduce their need to save and would allow them to borrow when needed. Hence, even though their general economy is growing very fast, the rising uncertainty for each individual in both spending needs (such as the rising costs in health care, education and housing) and income prospects (such as unemployment risk) induces them to save excessively to provide the self-insurance that is not available to them from the market. Therefore, for every dollar a Chinese worker makes in trading with the U.S., he or she feels the need to save at least a quarter. The remaining part of the dollar is not even spent entirely on U.S. goods because Chinese workers (firms) also need dollars to buy raw materials from other countries to produce consumption goods, as China is a resource-poor country. This implies that the total imports of China from us will be substantially less than its total exports to us, leading to the U.S.-China trade imbalance.