Question

What have been the major causes of the large U.S. trade deficits in recent years? What are the major benefits and costs associated with trade deficits? Explain: "A trade deficit means that a nation is receiving more goods and services from abroad than it is sending abroad." How can that situation be considered "unfavorable"?

Short answer

The major causes of trade deficits are the rapid expansion of the U.S. economy, trade imbalance with China, declining saving rate of Americans, and high-risk coverage for U.S. assets to foreigners.

The major benefit of the trade deficit is the improvement in the living standard of Americans, and the significant cost involved is the reduced future consumption in the U.S. economy.

A surge in import of goods and services by Americans and a declining saving rate make the trade deficit unfavorable for the U.S. economy.

Step-by-step solution

Step 1:Causes of the trade deficit in the U.S.

The large U.S. trade deficits have several causes explained as below:

• The rapid expansion of the U.S. economy between 2002 and 2007 enabled Americans to greatly increase imports from trading partners like Japan and European nations. In contrast, others suffered a recession, causing slow income growth over the same period.

• The large trade deficit of U.S. trade is also due to trade imbalance with China. In 2017 the United States imported $336 billion more of goods and services from China than it exported to China and continued in a recession year, 2009. In addition to this, China's government fixed the yuan's exchange rate to a basket of currencies, including the U.S. dollar.

Therefore, China's large trade surpluses with the United States have not caused the yuan to appreciate much against the U.S. dollar. The yuan's appreciation would have made Chinese goods more expensive and thus reduced U.S. imports from China.

• A declining U.S. saving rate (= saving/total income), which started before the recession of 2007–2009, also accounts for the large U.S. trade deficits.

The U.S. saving rate declined substantially, while its investment rate (= investment/total income) increased. This created a void between U.S. investment and U.S. savings. Foreign purchases of U.S. real and financial assets filled this gap, creating a large surplus on the U.S. capital and financial account, resulting in a current account deficit.

• Foreigners' belief for U.S. assets to be relatively high risk-adjusted rates of return resulted in purchasing those assets, thereby providing foreign currency to Americans. Again the capital account surpluses resulted in high U.S. trade deficits to balance the BOP statement.

Cost-benefit analysis of trade deficit

BENEFIT:

American consumers benefit from a trade deficit in the sense that the United States receives more goods and services as imports from abroad than send out as exports, thus allowing the United States to consume outside its production possibilities curve. It augments the domestic standard of living.

COST:

The gain in present consumption comes at the expense of reduced future consumption. When the current account deficit declines, American consumption will be less than before and maybe even less than the production possibility curve.A trade deficit is financed by borrowing from the rest of the world, selling off assets, and reducing official reserves.

The rise in capital and financial account surpluses includes debt issued by Americans. Therefore, when U.S. exports are insufficient to finance U.S. imports, the United States increases its debt to people abroad and the value of foreign claims against assets in the United States.

Financing of the U.S. trade deficit creates a larger foreign accumulation of claims against U.S. financial and real assets than the U.S. claim against foreign assets.If the United States wants to regain ownership of these domestic assets in the future, it will have to export more than its imports. At that time, domestic consumption will be lower because the United States will need to send more of its output abroad than it receives as imports.

Therefore, the higher current consumption with current account deficit means permanent debt, permanent foreign ownership, or large sacrifices of future consumption.

Unfavorable for U.S. economy

As discussed in previous steps, trade deficits are unfavorable for the U.S. economy because the import of goods and services rises and exports fall. The gain in present consumption is beneficial in the current time but adversely affects future consumption and thus America’s welfare.

Also, trade deficits negatively affect the saving rate, making it unfavorable for the people of the United States.