Center for American Progress

Underlying Causes of Trade Deficit Cast Doubt on Future Improvements

The U.S. economy is vulnerable on many fronts. One of them is the continuous increase of an already high trade deficit. In the second quarter of 2004, the trade deficit relative to GDP surpassed the 5 percent mark for the first time. Many economists already considered trade deficits above 4 percent of GDP dangerously high. The fear is that continued growth in this external imbalance of the U.S. economy will ultimately spook overseas investors, especially central banks in Asia, and thus make it harder for the U.S. to attract foreign capital to finance its trade imbalance without raising interest rates and slowing economic growth. The growth of the U.S. trade deficit is especially worrisome in light of recent figures that show that hopes of a self-correction through faster export growth in areas where the United States used to have a competitive advantage were misplaced.

However, before we get to that, let's keep in mind that the United States has already amassed a sizeable external debt that needs to be serviced and that becomes more costly when interest rates rise. The Bureau of Economic Analysis at the Department of Commerce reported last week that in the second quarter of 2004, interest rates rose and U.S. borrowers had to pay even more to their overseas lenders than they had in the previous quarters. In the second quarter of 2004, U.S. borrowers paid $24.9 billion more in interest on liquid debt than they earned abroad, compared to $21.1 billion in the first quarter, a deterioration of 18 percent over the span of three months. The federal government alone had to make $1.6 billion in additional interest payments from the first quarter to the second quarter.

In response to the rising net interest payments, one may feel obliged to point out that the United States still earns more money on its direct investment overseas than foreigners earn on their holdings in the United States. This is true. In the second quarter, U.S. residents earned $29 billion more than they had to pay to foreigners. However, this is a decline of $5.8 billion from the first quarter of 2004, or an almost 20 percent drop.

Trade with Europe should have seen a boost given the sharp decline in the dollar against the euro starting in early 2002. Compared to its high point at the end of January 2002, the dollar was down by 42 percent at the end of August 2004. This should have made U.S. exports cheaper in Europe and European imports more expensive in the United States, leading to more U.S. sales in Europe and fewer European sales here. The trade deficit with Europe should have shrunk. However, from 2002 to 2003, the U.S. trade deficit with Europe grew by 13 percent, and the trade deficit for the first seven months of 2004 was 12 percent higher than the trade deficit for the same period in 2003, according to the most recent figures from the Census Bureau. Thus, the decline of the dollar against the euro was offset by slow growth in Europe. Many Europeans simply do not have enough money to buy U.S. products, regardless of their price.

In the service arena, the United States still enjoys an edge over its competitors. However, that edge may be dwindling, too. In 2003, the trade surplus in services was $51 billion, the lowest level since 1991, without even taking inflation and economic growth into consideration. Although the service surplus for the first seven months of 2004 was slightly larger than for the same period in 2003, it remained well below the levels of 2002, according to the latest figures from the Census Bureau.

Lastly, the U.S. continues to lose ground in what was supposed to be another area of competitive advantage, advanced technology products. These products include biotechnology products, information technology, and aerospace products, among others. Since 2002, the United States has actually imported more advanced technology products than it has exported. In fact, the last month during which the United States had an admittedly small surplus in this area was June 2002. The trade deficit in advanced technology products in the first seven months of 2004 was 25 percent larger than the trade deficit during the same period of 2003, continuing the erosion of the U.S. advantage in this area.

Going from record trade deficit to record trade deficit is not sustainable for the U.S. economy. In the past, a number of factors gave rise to the hope that the United States could improve its competitiveness in important areas—trade with Europe, services, and advanced technology products—to reduce the size of its trade deficit. This has turned out to be a false hope, at least so far. In fact, the U.S. trade deficit with Europe is widening again, the U.S. surplus in services is shrinking, and the United States is experiencing a continuous and widening deficit in trade in advanced technology products. To avoid a painful adjustment through slower economic growth at home, U.S. policymakers need to pursue an international pro-growth development agenda sooner rather than later.

Christian Weller is senior economist at the Center for American Progress.

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Christian E. Weller

Senior Fellow