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Nothing to Brag About

U.S. Trade Deficit Remains High Priority Despite Recent Improvements

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At first glance, the recent improvement in the aggregate U.S. trade deficit seems like a single bright spot amid the recent onslaught of bad news about the U.S. economy.The trade deficit first began to fall at the end of December 2006, when the quarterly aggregate deficit dropped by over 11 percent in a single quarter. The aggregate U.S. trade deficit showed an improvement from 2006 to 2007 for the first time since 2001; it dropped from $765 billion in 2006 to $708.5 billion in 2007. It also decreased, relative to the size of the economy, from 5.8 percent of gross domestic product to 5.1 percent during the same period.

But a closer look reveals that the new trade numbers may not be so encouraging. The total U.S. trade deficit is still large and, despite a recent improvement, remains worse than at any point prior to 2004.The long-term trends that pushed the trade deficits to record highs in the first place still persist, and much of the improvement in recent quarters reflects slower import growth in the face of a weakening economy.

The aggregate U.S. trade deficit has worsened significantly over the past seven years. The deficit as a share of GDP climbed over 6.0 percent in December 2005 for the first time on record and settled at 5.1 percent for December 2007. This is a significant increase since March 2001, when the deficit accounted for 3.9 percent of GDP. It is also a larger deficit level than any point prior to March 2004.

Why Are Deficit Levels Still High?

A diverse set of factors initially pushed the U.S. trade deficit to record highs since the beginning of the current business cycle in March 2001 and have kept it continuously high ever since, including deteriorating trade with China, a worsening balance in the trade of high-technology products, and an ever-increasing dependence on foreign petroleum imports.

The trade balance with our top trading partners—especially China—remains high. Trade balances with several smaller trade partners may have improved over the past year, but China’s contribution to the deficit has not slackened. If the deficit in trade with China had stayed at March 2001 levels, our aggregate deficit today would be 24.3 to 28.5 percent smaller (Table 1).1

China is the largest contributor to our deficit, but it is certainly not the only contributor. Deficits for all of our top five trading partners are large and, with the exception of Canada, have deteriorated significantly since March 2001. The aggregate deficit would have been between 5.7 and 8.9 percent lower if we had maintained our March 2001 balance of trade with the EU, for example (Table 1).

More surprising may be Mexico’s increasingly large contribution to the aggregate trade deficit. Mexico’s negative effect on the deficit since March 2001 climbed from between 3.3 and 4.3 percent in 2006 to between 7.1 and 8.5 percent in 2007. From 2006 to 2007, trade with Mexico saw the highest percentage increase—15.7 percent—out of any of our top trading partners.

Our competitive edge in high-technology products continues to slip away quickly. The deficit in high-technology goods continued down a long path of deterioration over the past year, indicating our country’s increasing inability to compete in a global innovation economy. In 2001, we still maintained our competitive edge in such products, running a surplus of $4.5 billion for the year. Yet by 2006, this figure had deteriorated to a $44.4 billion deficit.

Most recently, the United States posted a record-high $53.5 billion deficit in high-tech products for 2007. Even as nominal U.S. import growth slowed to just over 6 percent from 2006 to 2007—down from over 17 percent during the previous year—our deficit in high-tech imports jumped by $15.4 billion, a deterioration of over 40 percent. If the balance in high-tech products had remained the same as it was in March 2001, we would have seen an 11.5 to 12.5 percent reduction in the aggregate trade deficit today (Table 1).

Dependence on petroleum imports continues and is worsening. Our continued dependence on foreign imports of petroleum products remains one of the largest contributors to our aggregate trade deficit. In 2001, petroleum imports totaled $93 billion for the year. By the end of 2007, the total deficit in petroleum products had climbed to a record-breaking figure of $296.8 billion, including a $34.8 billion deficit in December 2007 alone. The overall U.S. trade deficit grew by 95.3 percent overall from 2001 to 2007, while the deficit in petroleum products grew at a much faster rate of 219.1 percent over the same time period, presenting even more cause for concern (Figure 2).

U.S. petroleum imports totaled 2.6 percent of our country’s GDP in the fourth quarter of 2007. Had the quarterly deficit remained at March 2001 levels in absolute terms, the aggregate fourth quarter U.S. trade deficit for 2007 would have been 36.3 percent lower. Had the same remained true as a share of GDP, we would have seen a 30.2 percent reduction in the current fourth quarter deficit. This trend has continued even as the total trade deficit actually shrank by 7.4 percent since December 2006. Over the same time period, the deficit in petroleum products increased by 102.3 percent.

Why Have Deficit Levels Improved Recently?

The aggregate U.S. trade deficit has improved over the past five quarters.The total trade deficit saw a drop of $56.5 billion from 2006 to 2007, based on year-end calculations. The last time the U.S. trade deficit recorded a drop of this magnitude was between 1990 and 1991, when the total deficit was significantly smaller, improving from $80.9 billion in 1990 to $31.1 billion in 1991.

The recent deficit improvement mirrors similar conditions in 1990, when weakening of the U.S. dollar and strengthening of the economies of foreign countries significantly increased demand for U.S. goods and services. Today we face a similar situation; the dollar has fallen against a variety of foreign currencies, and continued global growth has strengthened world appetite for American exports.

The good news is that drivers of the aggregate U.S. deficit improvement since the fourth quarter of 2006 are diverse, occurring against a wide array of countries and in a broad range of products. This indicates that the improvements in the U.S. trade balance are not solely the result of weaker economic growth.

Global demand for U.S. services has increased. We have seen a $10.6 billion increase in the surplus in U.S. services trade over the past five quarters—an improvement of 54 percent since the fourth quarter of 2006. U.S. services, which include education, travel, and financial services, were a major contributor to the overall positive change in the U.S. trade balance, accounting for more than half of the total $56.5 billion improvement from 2006 to 2007. Had the quarterly U.S. services balance remained the same as the balance in March 2001 in absolute terms, the aggregate trade deficit for the fourth quarter of 2007 would have been 6.8 percent greater than it was (Table 1).

Deficits with key trading partners have improved. The U.S. deficit with some key trading partners saw an improvement since the fourth quarter of 2006. Our balance with Canada shrank the most—$3.4 billion, a 19 percent change. Our quarterly trade balance with the EU improved by $937 million, or 3 percent. And U.S. trade with Japan also saw a small improvement of $19 million over the same period.

The U.S. goods deficit has shrunk. The past five quarters saw an improvement of $10.8 billion in the U.S. goods deficit, largely because exports grew faster than imports. Exports jumped by 16.9 percent, improving by $44.0 billion, while imports continued to grow, but at a slower rate, climbing by $33.2 billion at 6.9 percent from the fourth quarter of 2006 to the fourth quarter of 2007.

Much of the improvement in the trade deficit is the result of slower imports, which resulted in part from a slowing U.S. economy. If U.S. imports had remained at the same level as in March 2001, our total trade deficit for last quarter would have been smaller by between 54.5 and 139.1 percent. In other words, we could have had a trade surplus.

A look at the past five quarters reveals that improvements in the import balance drove some of the overall improvement of the aggregate deficit, as import growth began to slow in the face of a weakening economy. Real import growth tied a record high 4.1 percent in the final quarter of 2005, but backed off significantly in 2006 and 2007 (Figure 3). Over the past five quarters, real quarterly import growth has been minimal or negative, falling between -0.6 percent and 1.0 percent.

Conclusion

Several long-term, deep-seated factors have kept the trade deficit high and negated some of the recent improvements in the aggregate U.S. trade deficit over the past five quarters: deteriorating trade with China and other large trading partners, a worsening balance in trade in high-technology products, and an ever-increasing dependence on foreign petroleum imports.

While data indicate that the rising tide of the aggregate U.S. trade deficit has slackened over the past five quarters, the negative trade balance still remains extremely high. What’s more, the current improvement has been driven by a weakening U.S. economy that has been increasingly unable to buy foreign imports, which makes it unlikely that the improvements will be enough to allow the trade deficit to shrink on a sustained basis.

As the pace of the U.S. economy slows and the pace of growth in other countries’ economies also weakens, it should be clear that we cannot simply rely on our weakening currency to boost our imports and solve our deficit dilemma. Trends in the U.S. trade deficit point to several long-term problems and require an immediate and multi-dimensional policy response.

We can begin by taking a policy approach to our large and worsening deficit in high-technology products by working to develop a strong innovation agenda that would encourage the investment in education and technology necessary to help the United States regain its competitive edge in the global high-tech market. Also important would be a commitment to reducing our dependence on foreign petroleum products through a more comprehensive U.S. energy policy dedicated to improving energy efficiency and increasing energy conservation. Meanwhile, the United States can work with its international trade partners to encourage them to revalue their currency and ease downward pressure on the dollar. These measures would be a good first step in the direction of creating a more sustainable trade balance for the United States through increased competitiveness and less foreign oil dependence.

Endnotes

1. There are several possible counterfactual scenarios. Two are considered here. First, the nominal trade balance in specific areas would have held constant, and second, the trade balance in specific trade areas relative to the gross domestic product would have held constant. The difference between the two scenarios can be summarized as follows. Holding a trade balance constant relative to GDP increases the impact on the trade deficit if the starting point is a trade surplus and reduces the impact on the trade deficit if the starting point is a trade deficit, compared to holding the trade balance constant in nominal terms.

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