Fiscal Conservatives Should Care About Trade Deficits

Fiscal conservatives have always argued that chronic budget deficits are unsustainable, but when it comes to the trade deficit, many are either silent or downplay its importance. This was especially true during the Tea Party era, when many called out then-unprecedented deficits and bailouts during the Bush and Obama administrations, but rarely called out trade deficits, which were rising just as quickly and persistently.

Still today, the ever-increasing debt clock—now at nearly $35 trillion—is offered as an omen of impending economic disaster. But our net international investment position, which runs parallel to our trade balance and represents the difference between foreign assets we hold versus our assets held abroad, is nearly $20 trillion in the red and largely ignored. As a recent article from CATO put it, “the trade deficit is a (arguably mismeasured) statistic with little relation to a country’s prosperity… the vast majority of trade economists do not see the US trade deficit as a ‘problem’ to be solved.”

The problem is not debt itself: almost all successful ventures start with loans and governments often need to borrow in times of emergency. Ideally, this would look like investment, which entails allocating resources today toward efforts that will yield even greater resources in the future. But sound lending means that loans will be repaid once value is realized. When our debt and trade deficit rise year after year, decade after decade, regardless of war, peace, growth, recession, or a corresponding rise in investment and value creation, that looks less and less likely.

Fiscal conservatives should understand that budget deficits and trade deficits are linked. As L. Randall Wray explains in American Affairs, as a matter of accounting, our trade deficit must be balanced by a combination of public and private deficits. This means that if we were to hypothetically eliminate the budget deficit while holding the trade deficit constant, private sector debt or dissaving would have to rise to make up the difference. Put another way, our government and private sectors cannot both run surpluses unless our economy is running a trade surplus.

The relationship between these three balances is best understood by starting with a closed economy with no international trade. In such a case, when the government runs a budget deficit, spending more than it taxes, the private economy must run an offsetting surplus, creating savings that the government can borrow (e.g. through Treasury bonds). If that economy were then opened to trade, both the government and private sector could become borrowers. In such a case, foreign economies that produce more goods than they consume would use their trade surplus earnings to either purchase assets from our private sector (stocks, bonds, real estate, etc.) or secure commitments for payment in the future from our government (Treasury bonds, etc.). In such a case, the deficit economy consumes its imported goods on credit while slowly selling off its assets. As Warren Buffett once put it, “Our country has been behaving like an extraordinarily rich family that possesses an immense farm. … We have, day by day, been both selling pieces of the farm and increasing the mortgage on what we still own.”

As Wray points out, this scenario is basically what happened in the late 1990s and early 2000s, when our government ran a rare budget surplus and our trade deficit began to surge:

…[there was a] striking anomaly [during] the decade from approximately 1997 to 2007. The first half experienced [a] very unusual government budget surplus while the private sector experienced two unusual camel humps of large deficits over the decade… The first of these humps coincided precisely with the Clinton budget surpluses. But, holding the [trade] deficit constant, a move to a budget surplus had to be matched by a movement to a private sector deficit…In the second of the camel’s humps, the longer-term growth of the [trade] deficit was so large that the smaller turn of the private sector toward deficit implied an offsetting movement of the government’s budget toward only smaller deficits.”

In other words, the surge in the trade deficit after China was granted permanent normal trade relations with the U.S. in 2001 was so large that both the private and public sector ran deficits. Though it is rarely part of the diagnosis of the 2007 financial crisis and Great Recession, excess foreign savings contributed significantly to the asset bubbles that broke our economy.

When foreign countries sell more to the U.S. than they buy, they often use their excess dollars to purchase Treasury bonds (a.k.a. U.S. government debt). Rather than send back U.S.-produced goods in exchange for foreign imports, we send back pieces of paper promising that the nation will produce enough to make payments later. Before the 1970s, foreigners held only 5% of treasury bonds compared to around 40% today.

Some argue that foreign countries “reinvest” their dollars back into the U.S. economy, but over 95% of this “foreign direct investment” goes toward purchasing existing assets, not building new American industrial capacity. This misunderstanding is parallel to the reckless defense of budget deficits on grounds that borrowing to invest is healthy. Yes, if the federal government were borrowing to make far-sighted investments that would pay dividends to future generations (or, for instance, to win a major war), the debt might be sensible. But that is not what is happening. Instead, we are largely borrowing to fuel consumption. Both arguments—one often made by the right and the other by the left—imply investment and value creation where there is principally consumption billed to the next generation.

Others argue that if China can produce and sell goods more cheaply than America, consuming them is to our benefit. But that is only true in the long run if China is exchanging those goods for American goods in which we have a comparative advantage. In reality, much of China’s cost advantage has been due to suppressed consumption and industrial subsidies, which boost the kind of savings and investment in China that fiscal conservatives, at least in theory, should want to see accruing in the American economy instead.

To close the deficit, our government would need to cut spending or increase taxes, either of which would lower private savings. Were our government to close the budget deficit and stop issuing new bonds, without taking any action to rebalance trade, foreign surplus holders would simply buy existing bonds from our private sector and continue purchasing U.S. assets, earning interest and appreciation that would otherwise accrue to American savers. At the same time, our industrial capacity would continue to decline in the face of trade abuses and unfair competition, resulting in slower productivity, less innovation, fewer quality jobs, more destabilizing inequality, and slower growth. All of these factors, in turn, would make eliminating the budget deficit more difficult and more painful.

If one is genuinely concerned about the budget deficit and wants to reduce it in the way least damaging to our economy, one should therefore aim to reduce it while also lowering the trade deficit.

The savings and investments afforded China by our trade deficits are already bearing fruit as China overtakes us in several key industries, including many that America pioneered and previously dominated. This shows the obvious difference between short-term consumption and long-term prosperity that some on the right elide. And if those two measures indicated the same thing, why care about government budget deficits if they increase consumption now?

The obvious answer on the budget front is inflation. On the trade front, our deficits should result in our dollar weakening against the currencies of surplus countries whose economies generate more value instead of more debt. But because the dollar is the world’s reserve currency and because our leaders do little in the face of currency manipulation and wage suppression by surplus countries, our dollar has not adjusted…yet. But it is clearly unsustainable for the United States to account for 78% of the total trade deficit of industrial nations. (China, for reference, represents 45% of the world’s trade surplus.)

Our currency is the world’s reserve because of the stability of our government, consistency of our laws, and the relative strength of our economy. But none of those are guaranteed. Our debt has already been downgraded twice, and our leaders do not seem intent on making any major adjustments in response.

Likewise, while America spent most of the twentieth century as the world’s lead innovator and producer, running trade surpluses until around 1970, we have now fallen far behind. Once a defining feature of our economy, America’s advanced technology manufacturing fell from a trade surplus of $38 billion in 1991 to a trade deficit of $243 billion in 2022. Even as a share of U.S. manufactured exports, high-technology goods fell from a 30% share in 2007 to 18% in 2022.

To lower or eliminate the budget deficit without tanking private savings, America must return to producing at least as much as it consumes. Our persistent and growing trade deficit means that, on net, our nation isn’t doing that. If we are going to work our way out of the red without selling off our country, we need to acknowledge and address both deficits together.