[Editor's Note: This article was first published November 24, 2005.]

The US trade deficit is often viewed with alarm and has attracted considerable attention from both the public at large and policy makers. Much of the uneasiness about the US trade deficit can quite simply be attributed to the term "deficit" itself, which holds with it many underlying negative connotations. However, in answer to these concerns, one may take the perspective, drawing on the theories of Ludwig on Mises and Friedrich August von Hayek from the Austrian School of Economics, that the US trade deficit is merely a reflection of the competitive advantage that the United States has been enjoying over the past decades.

Opting for a relatively free-market system, the United States appears to have succeeded in providing an environment more conducive to investment and growth than other currency regions, most notably Europe and Japan. This is evidenced, for instance, in its higher growth and capital return rates. In the words of Mises, "[…] the tremendous progress of technological methods of production and the resulting increase in wealth and welfare were feasible only through the pursuit of those liberal policies […]" That said, the current deficit in the United States may very well be a result of its adherence to a more efficient economic model than many other currency areas.

"The idea that there is a third system — between socialism and capitalism, as its supporters say — a system as far away from socialism as it is from capitalism but that retains the advantages and avoids the disadvantages of each — is pure nonsense." […] "The idea of government interference as a "solution" to economic problems leads, in every country, to conditions which, at the least, are very unsatisfactory and often quite chaotic. If the government does not stop in time, it will bring on socialism."

Building on what Mises termed the infeasibility of pursuing the idea of a third system, Friedrich August von Hayek in his Fatal Conceit (1988) asserted that such attempts would interrupt the natural operation of a market economy and individual freedom and yield worse results than a spontaneously working economic order. In contrast to the fairly strong degree of government interventions in the market system practiced in many Western industrialized countries — be it via taxation, regulation, redistribution of market generated incomes, etc. — the United States may still be inspiring confidence among investors that liberal economic principles and, as a result, a systematic economic outperformance might be preserved.

The upshot of such an interpretation would be that the United States continues to attract funds from abroad as long as internationally scarce resources are allowed to be used most efficiently. As long as demand for US dollar-denominated assets from abroad exceeds US residents' demand for assets from the rest of the world, we should see the United States continue to accumulate capital surpluses — here regarded as merely the flip side of trade balance deficits; an interpretation which echoes the work of Eugen von Böhm-Bawerk (1914), who wrote that the capital account would reign over the trade balance. To shed some more light on such a conclusion, we must take a closer look at the economic precepts underlying our understanding of the US trade deficit.

A country's transactions with the rest of the world within a given period of time are recorded on its "balance of payments." Goods transactions are shown in the trade balance. A country records a trade deficit (surplus) if the value of its exports to other countries falls short of (exceeds) the value of imports from abroad. However, the trade balance shows only "one side" of total transactions, namely a country's goods transactions. The other side comprises capital flows, which are recorded in the capital account.

The capital account provides a contrast between a country's capital imports and exports. If, for instance, foreigners buy more stocks and bonds in the United States than US citizens purchase abroad, the capital account balance records a surplus. Japan and Germany, for example, are "chronic" capital exporters, meaning that the amount of assets they acquire abroad exceeds foreign demand for Japanese and German assets. As a result, the capital account deficits of these countries corresponds with US trade surpluses.

Importantly, when one has a free floating exchange rate, a deficit (surplus) in the trade balance will by definition be accompanied by a surplus (deficit) in the capital account, and the balance of payments will always be balanced — i.e., the amount of goods and services bought and sold equals the amount of money spent and received from abroad.

How It Worked Under the Gold Standard

To better understand why a trade deficit is widely viewed as "dangerous," it is useful to look briefly at the period when the gold standard prevailed. Under such a monetary regime, countries' trade balances tended to be zero, with temporary trade surpluses or deficits ironed out over time. For example, think of a country accumulating a trade surplus during this period. It would receive gold inflows from importing countries. The increase in the domestic stock of gold, in turn, would make the domestic money supply "looser," thereby stimulating output and employment.

The rise in the domestic money supply would then translate, sooner or later, into higher domestic prices, which caused exported goods to be less price competitive and imported ones more attractive. As a result, a country's exports declined and imports rose. The trade balance "deteriorated," that is to say the surplus declined (and even became negative), as did the stock of domestic gold (i.e., money); the latter declined to the same extent to which the trade surplus declined. So over time, a country's trade balance tended to follow along the line of a "zero mean reverting" process.

Figure 1 illustrates this point. It shows the US current account as a fraction of total output on a historical basis. On average, the ratio was less than 0.5% (close to zero) from 1870 to 1973, after which the gold standard (i.e., the system of fixed exchange rates) finally broke down. Since then, the trade deficit has embarked upon a widening trend. In 2004, the deficit ratio amounted to 5.5%, the highest proportion from 1870 to 2004.

Figure 1

Source: Historical series is from International Historical Statistics, 'The Americas 1750-1993', 4th Edition by B. R. Mitchell; Graph is taken from Pakko, M. R., 'The U.S. Trade Deficit and the "New Economy"'.

Under the gold standard, any build-up of export surpluses — and the accompanying "boom" for the domestic economy — was seen as something that needed to be reversed, a process accompanied by unwanted swings in growth and employment. This explains to some extent why to this day a country's trade imbalance continues to be seen as calamitous. However, such concerns are no longer justified in the post-gold standard era. The "gold automatism" for balancing countries' trade ended with the transition to paper money at the beginning of the 1970s when we began to see the implementation of flexible exchange rates.

But With Free Floating Exchange Rates...

With free floating exchange rates and virtually free capital movements, the build-up of persistent trade deficits and surpluses — which are usually referred to as "imbalances" — has become a characteristic of the world trading system. The latest rush towards an ever-more globalized economy seems to have added greatly to the dispersion of international investment and savings, and thus the build-up of trade surpluses and deficits among countries.

Today, countries' trade (e.g., capital) account balances reflect the increasing internationalization of investment and savings. A country with a trade surplus simply saves by investing more in foreign rather than in domestic assets: it sells more goods and services abroad than it imports from the rest of the world, and uses the proceeds for investing abroad (in bonds, stocks and real investment in such areas as machinery). Likewise, a country showing a trade deficit receives more money from abroad than it is itself saving abroad.

Figure 2

Thomson Financials; own calculations. — A rise (decline) in the real effective US dollar exchange rate signals an appreciation (depreciation) of the dollar against its trading partner currencies.

It is often said that a rising trade deficit will lead to a depreciation of the US dollar. However, data paint a very different picture. Figure 2 shows the real effective external value of the US dollar and the US trade deficit as a percentage of GDP from the middle of the 1970s to Q1 05. It shows that a rising (shrinking) trade deficit has been, on average, accompanied by an appreciation (depreciation) of the real value of the trade-weighted greenback.

How can such a finding be interpreted? A growing (shrinking) trade deficit would imply a growing (shrinking) capital account surplus, which should imply rising (declining) demand for US balances relative to foreign currencies. This, in turn, would suggest that a rising trade balance should be, on average, accompanied by an appreciating external value of the US dollar, a result supported by the figure above. This is not to say, of course, that there is a clear-cut "causality" between the exchange rate and the trade deficit. It might well be that both variables are driven by other determinants.

Since the second half of 2002, however, the widening of the trade balance has been accompanied by a depreciation of the real trade-weighted US dollar exchange rate. Is the latest exchange rate move a precursor to a forthcoming reversal of the US trade deficit? Not necessarily. It might simply be attributable to the latest swelling of US government deficits. Investors could interpret rising deficit spending as a result of growing societal aversion to a continued reliance on pure market forces and an increasing desire to take recourse through state intervention, which in turn runs the risk of denting investor confidence that a market-oriented system will be preserved.

This leads us to the crucial question: How long can, and will, the US trade deficit actually persist? The widely held notion that a reduction of the US trade balance is inevitable rests on the tenets of the traditional growth theory. This theory suggests that divergences between currency areas' growth and capital return rates might prove to be temporary in nature, as they tend to converge sooner or later. If such a convergence were to hold true, then indeed the US trade deficit would have to shrink at some point.

However, the new growth theory suggests that this very adjustment process might not necessarily unfold. This theory propounds that institutions — bearing in mind their cultural and traditional variances, as well as deliberately chosen economic systems — could prevent at least a "full" convergence of those factors that are held responsible for determining a country's growth path. According to new growth theorists, it is not inconceivable that trade "imbalances" could become entrenched in certain countries.

Foreign Investment Pours In, Increasing the Trade Deficit

As suggested earlier, the continued appeal of investing in the United States relative to other currency areas might be a key factor in the continuance of the US trade deficit. As long as the United States is perceived by investors as providing the market place with institutions that are conducive to free market economies and which generate favorable growth and capital return rates (compared to Europe and Japan for example), the United States will maintain its position as a favored investment region. As a result, the United States is likely to remain in a position to accumulate capital account surpluses, with the external value of the greenback remaining under appreciating pressure.

Of course, under such a scenario, any initiative to increase economic growth in trading partner countries would work towards eliminating currently existing trade deficits and surpluses. As the current US account deficit directly correlates to capital imports, a reduction in the "growth gap" between the United States and the rest of the developed countries would presumably lower capital inflows into the United States, thereby contributing to a lower US trade balance and, correspondingly, lower capital account deficits in the trading partner countries.

In summary, under the prevailing flexible exchange rate regime, the US trade deficit should not be viewed as a worrisome economic "imbalance" that will inevitably have to be corrected. So far, the US trade deficit seems to be a reflection of the US economy's strength vis-à-vis its trading partners. And it might well be that the US trade deficit will continue to widen in the coming years — which would be the case if the United States' trading partners prove to be unsuccessful in making their economies more conducive to investment and growth compared with the status quo.

So the essential issue about the future of the US trade deficit is whether and how the current relative growth performance constellation in the world trading system will be changing in the coming years. As long as the United States keeps its preference for a free market regime, it might well retain, or even increase, its competitive advantage in allocating scare resources more efficiently than currency areas where relatively wide-spread government interventions have become a characteristic of societal organization. In today's world of flexible exchange rates, the United States' competitive edge is reflected by a capital surplus, i.e., a trade deficit.