Are Trade Deficits Good for the U.S. Economy?

by Daniel T. Griswold Daniel Griswold is director of the Center for Trade Policy Studies at the Cato Institute in Washington. February 15, 2005 The news that the U.S. trade deficit reached a record level of $618 billion in 2004 is sure to reignite heated debate in Washington. Politicians will clamor for measures to reduce the trade deficit on grounds that it hurts the U.S. economy, manufacturing and employment. But in looking at the evidence, Dan Griswold of the Cato Institute comes up with some very surprising findings. It may be counterintuitive for many people, but by the most basic measure of economic performance -- the change in real GDP -- the evidence points to what seems like a perplexing finding.

Is "deterioration" good?

Years in which the U.S. current account deficit -- which largely consists of the trade deficit -- is rising show stronger growth than years in which the current account deficit is shrinking.

Let's first look at those years where the current account deficit shrank, which -- according to conventional wisdom -- should be a good thing. But the data says otherwise: In those years since 1980 when the current account deficit declined as a share of GDP, the economy grew by an annual average of only 1.9%.

In contrast, during those years in which the current account deficit grew moderately, real GDP grew at an annual average of 3.0%.

Four of the five best years for U.S. GDP growth since 1980 have occurred in the same years when the U.S. current account deficit was growing most rapidly.

More astonishingly yet, in those years when the U.S. trade deficit "deteriorated" most rapidly, to borrow another popular characterization, real GDP grew by a robust annual average of 4.4%. In other words, growth in those years was more than twice as strong as in years when the deficit was "improving."

Manufacturing...

As a matter of fact, four of the five best years for U.S. GDP growth since 1980 have occurred in the same years when the U.S. current account deficit increased most rapidly.

The same pattern emerges in the U.S. manufacturing sector. It has become the conventional wisdom that a trade deficit hurts manufacturing activity in the United States, because imports presumably displace domestic production.

...and jobs

But the plain evidence of the past quarter century contradicts that general presumption. U.S. manufacturing output actually declined slightly on average in those years in which the U.S. current account deficit shrank.

In contrast, manufacturing output grew by 4.1% in years when the current account deficit grew moderately -- and by a brisk 5.3% when the deficit grew rapidly.

In fact, five of the six years that saw a decline in U.S. manufacturing output occurred in years in which the current account deficit was declining.

In seven of the eight years in which the U.S. current account deficit "improved," the U.S. unemployment rate went up.

The pattern also applies in the politically sensitive area of employment. Again, the conventional wisdom holds that a trade deficit "destroys jobs" -- by supposedly shipping them overseas.

Changes in the unemployment rate

But once again the evidence suggests something quite different. In years with an "improving" U.S. current account deficit, the U.S. unemployment rate on average jumped by 0.8 percentage points.

In years when the deficit moderately "worsened," the unemployment rate fell by an average of 0.2 percentage points. And in years when the deficit grew most rapidly, the U.S. unemployment rate fell by an even larger average of 0.7 percentage points.

What happened in '04?

Indeed, in seven of the eight years in which the U.S. current account deficit "improved," the U.S. unemployment rate went up. And in 13 of the 16 years in which the current account deficit "worsened," the unemployment rate went down.

In 2004, a rising U.S. current account deficit may have been bad news to headline writers -- but it appears to have accompanied good news for the U.S. economy.

The year 2004 appears to fit the pattern comfortably. Through the first three quarters of the year -- January through September 2004 -- the U.S. current account deficit averaged 5.5% of GDP, a 0.6 percentage point increase compared to 2003.

That would place 2004 somewhere between a moderate and rapid growth of the current account deficit. Befitting the pattern, economic performance in 2004 was also moderate to robust.

In 2004, a rising U.S. current account deficit may have been bad news to headline writers — but it appears to have accompanied good news for the U.S. economy.

Real GDP grew an average annual rate of 4.4% in 2004, while manufacturing output grew 4.9% during the year -- and the unemployment rate dropped by 0.3 percentage points during the full year.

A good year after all?

Still, we need to be careful about which conclusions to draw from these findings. For example, the evidence does not suggest that expanding U.S. trade deficits cause the superior economic performance.

Cause and effect

More plausibly, causation runs in the other direction. An expanding U.S. economy fuels demand by American consumers and producers to buy more imports as well as domestically produced goods and services.

Rising U.S. domestic output, in turn, attracts the foreign investment that finances an expanding U.S. current account deficit.

In contrast, slowing U.S. domestic demand not only depresses U.S. output and employment growth -- but also lessens demand for imports and the inflow of foreign investment.

Politicians would only hurt economic growth in the mistaken belief that protectionism would cut the trade deficit — and spur the economy.

In addition to the uncertain causality, the evidence also does not address the question of how persistent and rising current account deficits may affect the U.S. economy in the long run.

But is it sustainable?

The "sustainability" of the U.S. current account deficit has been much debated among the experts. But whatever negative impact the deficit may have in the long run, there is no evidence that it poses a drag on the U.S. economy in the short run.

Why does all this matter? The answer is simple. Misperceptions about the U.S. trade deficit and the economy can tempt U.S. policymakers to "do something" about the deficit to show that they are concerned.

More harm than good

But chances are that overeager politicians would only hurt economic growth.

The most obvious example of such a scenario would be if the U.S. Congress were to raise barriers to imports in the mistaken belief that protectionism would cut the trade deficit and spur the economy.

Whatever negative impact the deficit may have in the long run, there is no evidence that the U.S. trade deficit poses a drag on the U.S. economy in the short run.

But even if higher trade barriers could somehow trim the U.S. trade deficit, there is simply no evidence that such a policy goal would deliver faster growth in GDP, manufacturing and employment.

This article appeared on the Globalist on February 15, 2005.