Trade, Trade Barriers, and Trade Deficits: Implications for U.S. Economic Welfare

CRS Report for Congress
Trade, Trade Barriers, and Trade Deficits:
Implications for U.S. Economic Welfare
Updated May 22, 2006
Craig K. Elwell
Specialist in Macroeconomics
Government and Finance Division

Congressional Research Service ˜ The Library of Congress

Trade, Trade Barriers, and Trade Deficits:
Implications for U.S. Economic Welfare
This report provides an overview of the economics of international trade that
may be helpful for consideration of many recurring international economic policy
issues. It is intended as a general explanation of mainstream economic principles that
may be considered in gauging the economic significance of trade issues as well as
the trade-offs inherent in many policy choices. A fundamental tenet of economics
is that international trade is a means to a higher standard of living for all trading
nations. The post-war era has seen a rapid expansion of trade and the United States
has been a major participant in this process both as a trading nation and as a leader
in the steady lowering of barriers to trade worldwide. The significant benefit of trade
does not come without disruption and cost, however. Gaining the benefit of trade
and also treating equitably those hurt by trade is often a difficult public policy issue.
There is recurring congressional concern about the effect of trade on U.S.
economic welfare. Current issues include bilateral and multilateral trade
liberalization initiatives, steel dumping, export controls, and the rapidly growing
trade deficit. This report provides a brief overview of the economic arguments for
free trade, common arguments for trade barriers, and the cause and economic
significance of persistent large trade deficits. A central theme is that the economic
benefit of specialization and trade is a fundamental aspect of economic life whether
for the individual, region, or nation. This benefit is mutual, enriching each trader;
moreover, the gain from trade can accrue to a trading partner even if that partner is
less efficient in the production of all tradable goods. Trade can also lead to economic
gains by allowing a fuller use of economies of scale and by inducing productive
innovation. Trade is, however, a disruptive force as well, advancing the economic
position of relatively efficient activities, but diminishing that of relatively less
efficient activities. This process will often place significant economic and social
costs on workers and industries in adversely affected activities.
Arguments for trade barriers come in many forms but none is generally accepted
by economists. Trade barriers are often seen as a redress to the social and economic
costs of trade or as a way of enhancing economic advantage. In most cases, however,
economists argue protection from trade imposes costs on the economy that exceed
the benefits obtained. These costs can arise from inefficient resource allocation,
intractable implementation, and foreign retaliation.
The trade deficit is not a necessary aspect of trade, nor is it caused by foreign
trade barriers. A trade deficit is rooted in macroeconomic behavior at home and
abroad. The deficit is a means for the nation to spend beyond current production,
with a like sized inflow of borrowed foreign capital that funds the added spending.
Spending beyond current production, particularly on investment, can confer
significant benefits. But, borrowing will entail some level of cost as debts are repaid.
This report will be updated infrequently with changes in economic knowledge
and with current trade data.

The Growing Importance of Trade to the U.S. Economy...................1
Why Do Countries Trade?...........................................1
Specialization, Comparative Advantage, and Gains from Trade..........2
Other Sources of Gains from Trade................................4
Measuring the Gains from Trade..................................5
The Economic Effect of Trade Barriers.................................6
Common Arguments for Trade Barriers ............................8
Jobs Are Destroyed by Trade.................................8
Worker Wages Are Hurt by Trade............................10
National Security Is Threatened by Trade......................13
Special Industries with Unique and Substantial Economic
Potential Will Not Mature Without Protection from Trade.....13
Unfair Competition Undermines the Benefits of Trade............15
The Trade Deficit.................................................17
A Saving — Investment Imbalance ..............................18
The Benefits and Costs of Foreign Debt...........................20
Reducing the Trade Deficit.....................................23
Conclusion ......................................................24

Trade, Trade Barriers, and Trade Deficits:
Implications for U.S. Economic Welfare
The Growing Importance of Trade to
the U.S. Economy
The American economy has experienced steady and substantial growth of
international trade since the end of World War II. Total trade (the combined value
of exports and imports) as a share of gross domestic product (GDP) has risen from
around 10% in the 1950s to about 26% in 2005. Even this large increase may
understate the rising impact of trade on the economy because of the large share of
services output, much of which is non-tradable, in U.S. GDP. For example, looking
at merchandise exports as a share of total tradeable output for the United States
shows growth from near 4% in 1950 to more than 40% in 2005. For the United
States, however, international trade is still much less important than in other
industrial economies, where, as in most European countries, trade often exceeds 50%1
of GDP.
The rising integration of the American economy with the world economy has
been facilitated by technical advances that have reduced the natural barriers of time
and space that separate national economies. Integration has also been facilitated by
recurrent multi-national policy actions that have steadily lowered various man-made
barriers to international exchange. The United States has always played a leading
role in pursuing these trade liberalization initiatives. As natural and man-made
barriers have fallen, the considerable economic advantages of trade have induced
large increases in the international exchange of goods, and a mutual gain in the
economic well-being of trading nations.
Why Do Countries Trade?2
Trade occurs because it is mutually enriching, with a positive economic effect
like that caused by technological change, whereby economic efficiency is increased,
allowing greater output and consumption from the same endowment of productive
resources. Think of international trade as a productive process, with U.S. exports as
the inputs and foreign imports as the output. But, most importantly, it is a more
efficient productive process that provides American consumers with goods and
services they want at a lower cost than can domestic producers. The notion “exports

1 See International Monetary Fund, World Economic Outlook, June 2005.
2 For a fuller discussion, see N. Gregory Mankiw, Principles of Economics (New York:
Dryden Press, 1997), pp. 45-57.

are good and imports are bad,” often colors public policy debates about international
trade. As the cited analogy suggests, from a macroeconomic perspective both exports
and imports are “good.” The benefit of free trade is attached to the product received,
not in the product given. The United States want imports, and exports are how they
are paid for. This is an exchange of something of value to acquire something of
greater value. And what is gained from such exchange is increased by anything that
allows the United States to exchange a smaller volume of exports for any given
volume of imports (i.e., by a reduction in the export cost of imports).
Like technological change and other market forces, international trade creates
wealth by inducing a reallocation of the economy’s scarce resources (capital and
labor) into relatively more efficient activities and away from less efficient activities.
In the case of international trade, however, the more efficient activities are located
beyond the nations borders. Such reallocation can be characterized as a process of
“creative destruction” generating a net economic gain to the overall economy, but
also being disruptive and costly to workers in adversely affected industries. These
displaced workers will likely bear significant adjustment costs and many may find
work only at a lower wage. Although economic analysis almost always indicates that
the economy-wide gains from trade exceed the costs, the perennially tough policy
issue is how to secure those gains for the wider community while dealing equitably
with those who are hurt by the process.3
Specialization, Comparative Advantage,
and Gains from Trade
The importance of the gains from trade is clearly evident in individual economic
behavior. Rather than a person building his or her own automobile, providing his or
her own medical services, or producing his or her own food, it far more efficient for
an individual to specialize in the production of some good or service in which he or
she is good at and trade these (indirectly with the use of money) for most other goods
or services that are desired. Such specialization and trade clearly allow each person
to consume far more than would be possible if he or she were completely self-
sufficient. The same is true for a country, albeit to a less extensive degree in most
cases (i.e., U.S. imports of goods and services amount to about 15% of GDP).
Economics also tells us that the gains from specialization and trade are mutual,
occurring even if the trading parties have an absolute advantage or disadvantage in
the efficiency with which they produce all tradable goods. All that is required is a
difference in relative efficiency, that is, a difference among countries in the rate at
which the output of one good must be curtailed to expand production of another
good. (In other words, a difference in opportunity costs exists). If these rates are
different, then each country has a comparative advantage in the production of one
of the goods, creating the potential for gains from trade. In this circumstance, each

3 For further discussion of the nature and significance of integrated global markets, see
Thomas Friedman, The Lexus and the Olive Tree (London: Harper Collins, 2000); Martin
Wolf, Why Globalization Works (New Haven: Yale University Press, 2004); and Gary
Burtless, Robert Z. Lawrence, and Robert Litan (Washington D.C.: The Brookings
Institution, 1998).

country can improve its economic well-being by producing what it does (relatively)
best and trading for the rest. A nation does not compete with its trading partners, it
engages in mutually beneficial exchange with them. Therefore, business metaphors
such as “competitiveness” that are relevant to the individual firm are unlikely to be
useful in understanding the “two-way” nature of trade and significance of the mutual
gains from trade.
This principle of comparative advantage would explain, for example, why the
$200 per hour attorney, despite being able to type very fast and accurately, would still
find it more efficient to employ a secretary for $25 an hour to do that job. The
income gained from using the time he or she would spend typing to practice law
would likely more than compensate for the cost of the secretary. (The opportunity
cost of the attorney typing for one hour exceeds the cost of the using a secretary for
that task.) Similarly, the secretary gains by spending more time typing and less time
attempting to practice law. (The pay from typing exceeds the opportunity cost of not
practicing law.)
Differences in comparative advantage will arise between countries because of
differences in the relative abundance or scarcity of the factors of production.
Comparative advantage will be found in those activities that make intensive use of
the abundant productive resource. For example, compared with many other
countries, the United States, with a relative abundance of high-skilled labor, will find
that specialization in the production of goods that use high-skilled labor intensively
will, with trade, raise national income. In contrast, China, which has a relative
abundance of low-skilled labor and relative scarcity of high-skilled labor, would find
that specialization in the production of goods that use low-skilled workers intensively
would, with trade, raise that country’s real income. (Differences in productive
technology among countries could also create differences in relative efficiency and
form a basis for trade.)
Comparative advantage can emerge in the production of intermediate products
as well as final products. With some increasingly fragmentable production processes,
it may be more efficient to produce a particular component in one country, another
component in a second country, and assemble the final product in a third country.
It is also found that comparative advantage will vary over the life cycle of a product.
At the stage of innovation and product development where high-skilled workers and
specialized capital are required, an economy with an abundant endowment of such
resources like the United States would be the more efficient location for production.
At a later stage in the product’s life, with greatly expanded sales, a settled technology,
the capability for standardized production, and a falling price, production would be
more efficient in an economy with an abundance of low-wage labor such as in China.
It is important to highlight that the gains from trade will most often arise from
there being differences between the trading partners, not just economic differences
but social, political, geographical, or demographic differences can be of significance
as well.4 This explains why many economists do not find useful the sports metaphor

4 The exception would be a difference caused by a man-made barrier to trade, such as a

commonly used in trade policy discussions — the need for a “level playing field”
among trading partners. If each person, region, or country were alike in every way
there would be little to gain from trading. This observation may be particularly
important when considering the merits of U.S. trade with poorer, less economically
advanced countries, who will very often have sharply different economic, cultural,
and other characteristics. Economic theory indicates that using these differences to
generate trade will be an important means by which a rich or poor nation can improve
its economic well-being.
Other Sources of Gains from Trade
Trade is also enriching to the extent it allows countries to take greater advantage
of economies of scale. The longer a production run, the lower unit production costs
may be. Many products require huge initial investments in research and development
as well as large investments in a highly specialized physical plant and equipment.
The ability to reach a larger world market through international trade can greatly
reduce average production costs and the final price consumers must pay for the
In addition, open markets and international trade can increase the flexibility of
an economy. Trade can enhance an economy’s ability to respond quickly and
efficiently to rapidly changing economic conditions in the global market place by
improving access to foreign markets, resources, and technologies.
Further, trade can increase the competitive pressures in the market place,
pushing firms to cut waste, keep prices down, improve quality, and raise productivity.
Such pressure can also be an effective check against the use of monopoly power and
in general a clear benefit to the nation’s consumers.
Finally, trade can accelerate the pace of technical advance and boost the level
of productivity. By raising the expected rate of return to successful innovation and
spreading research and development costs more widely, trade can propel a higher
pace of innovation. With more competitive pressure firms must quickly adopt new
practices, or risk business failure. Greater international trade can also enhance the
exchange of technical knowledge among countries as human and physical capital
may move more freely. Economic theory suggests that these inducements will
increase an economy’s rate of growth, causing, not just a one-time boost to economic
welfare, but a persistent increase in income that gets steadily larger as time passes.5

4 (...continued)
tariff. In this case, removal of the “difference” through elimination of the tariff would
increase the gains from trade and economic well-being.
5 Another possible benefit of more open trade for the United States can arise because its
level of trade barriers is already very low relative to most other trading partners. Therefore,
a removal of those barriers would likely have a stronger positive effect on the demand for
U.S. exports than it will on U.S. demand for imports. This can cause a rise in the relative
price of U.S. exports. A rising export price will increase the import purchasing power of
any given volume of U.S. exports and increases the gains from trade to the United States.

Measuring the Gains from Trade
Through these several forces, economists reason that free international trade
will raise the efficiency of the world economy and improve the living standard of
most trading nations. Moreover, these gains are permanent, accruing to the economy
each year, and making their full significance better measured by a cumulative gain
over the stretch of decades. In the postwar era international trade worldwide has
grown three times as fast as a briskly advancing world output, leaving little doubt that
trade has made an important contribution to the growing prosperity of the United
States and the world economy. Initiatives such as the creation of the European Union,
implementation of Uruguay Round of market openings, and the North American Free
Trade Agreement (NAFTA) all speak to the importance of trade. It is also apparent
that trade has played an important role in the dramatic transformation of the emerging
economies in East Asia.
Many studies have measured the benefits of trade to be sizable, with the overall
gain typically growing with the degree of openness to international trade. For
example, a 1999 study by Frankel and Romer looked at data from 123 countries to
assess the relationship between openness to trade and the growth of real per capita
income. They found that each percentage point increase in openness ( as measured
by the sum of exports and imports as a percentage of GDP) led to a 0.34 % increase
in real per capita income. For the United States between 1960 and 1997, there was
a 12.7% increase in openness to trade and an associated 4.3% increase in real per
capita income, and they expected this gain to increase as the time period is extended
into the future.6 A 2003 study by Catherine Mann looked at the economic
consequences of the globalized production and international trade of information
technology (IT) hardware. It found that increased IT hardware trade between 1995
and 2002 generated a cumulative gain of $230 billion to the U.S. economy.7
The likely sizable benefits derived from trade’s inducement for the
development of new products, provision of an enhanced array of products, and
generation of increased productivity are not easy to measure. Therefore, it is likely
that the full magnitude of the gains from trade are underestimated in most
quantitative studies.8

6 Jeffery Frankel and David Romer, Does Trade Cause Growth?, NBER Working Paper No.

5476, June 1999.

7 Catherine L. Mann, Globalization of IT Services and White Collar Jobs: the Next Wave of
Growth, International Economics Policy Briefs, no. pb03-11 (Washington: IIE, Dec. 2003).
8 For more evidence on the gains from trade, see Edward E. Leamer and James Levinsohm,
“International Trade Theory: The Evidence,” in The Handbook of International Economics,
vol. 3 (Amsterdam: North Holland, 1995), and Douglas A. Irwin, Free Trade Under Fire
(Princeton NJ: Princeton University Press, 2003), pp.29-54.

The Economic Effect of Trade Barriers9
If international trade is economically enriching, imposing barriers to such
exchanges will prevent the nation from fully realizing the economic gains from trade
and must reduce welfare. Protection of import-competing industries with tariffs,
quotas, and non-tariff barriers can lead to an over-allocation of the nation’s scarce
resources in the protected sectors and an under-allocation of resources in the
unprotected tradeable goods industries. In the terms of the analogy of trade as a more
efficient productive process used above, reducing the flow of imports will also reduce
the flow of exports. Less output requires less input. Clearly, the exporting sector
must lose as the protected import-competing activities gain.
But, more importantly, from this perspective the overall economy that consumed
the imported goods must also lose because the more efficient production process —
international trade — cannot be used to the optimal degree, and, thereby, will have
generally increased the price and reduced the array of goods available to the
consumer. Therefore, the ultimate economic cost of the trade barrier is not a transfer
of well-being between sectors, but a permanent net loss to the whole economy arising
from the barriers distortion toward the less efficient the use of the economy’s scarce
The United States and other nations have made great progress in the post-war
era in reducing trade barriers. The average tariff among industrial nations has been10
reduced from near 50% after WW II to near 5% today. Barriers in many developing
economies have also fallen but are still generally higher than those of the industrial
economies. These remaining impediments to trade, nevertheless, have significant
economic costs. A 1994 estimate of the economic cost of existing U.S. barriers in 21
highly protected sectors was $70 billion per year, with economic cost per protected
job ranging from $100,000 to more than $1 million and averaging about $170,000.11

9 Man-made trade barriers come in several forms. Two common manifestations are tariffs
and quotas. Tariffs are a tax on imported goods. Quotas are a limit on the quantity of a good
that can be imported. A variant of the quota is the voluntary export restraint (VER), where
the exporting country imposes the restriction. Other barriers against imports (often called
non-tariff barriers) include local content requirements, national procurement policies, and
unduly protracted health, safety, and customs procedures. The magnitude of the negative
effect on economic welfare will likely vary with the type of barrier used. In general, for a
given level of protection quota-like restrictions carry a greater potential for reducing welfare
than do tariffs. Tariffs, quotas, and non-tariff barriers lead too few of the economy’s
resources being used to produce tradeable goods. An export subsidy can also be used to
give an advantage to a domestic producer over a foreign producer. Export subsidies tend to
have a particularly strong negative effect because in addition to distorting resource
allocation, they reduce the economy’s terms of trade. In contrast to tariffs, export subsidies
lead to an over allocation of the economy’s resources to the production of tradeable goods.
For a fuller discussion of the nature and implications of different forms of trade barriers, see
W. M. Corden, The Theory of Protection (Oxford: Clarendon Press, 1971).
10 OECD, Indicators of Tariff and Non-tariff Barriers, Paris, various issues.
11 See Gary Clyde Hufbauer and Kimberly Ann Eliott, Measuring the Costs of Protection

In all 21 cases, the cost of protection was far higher than the workers average annual
earnings and far higher than any likely worker adjustment program would cost.
A 2004 study of eight industrial nations, including the United States, provides
estimates of the extent of integration among these economies and the welfare gains
from further integration.12 On the question of extent of integration, it was found that
despite considerable lowering of trade barriers over the post-world war II sizable
barriers still existed (in 1999), with average product prices differing by a third.
On the welfare gains from further integration, it was found that removal of the
remaining trade barriers among these eight countries would lead to an increase in
global GDP of more than $500 billion (in 1997 dollars) or 2.1% of global GDP. The
gain to the U.S. alone was estimated to be about $77 billion (in 1997 dollars) or
about 1% of GDP. Highlighting the greater gain associated with a multi-lateral
lowering of trade barriers, this study also estimated the gains to each of the eight
countries if each removed their trade barriers unilaterally. In this circumstance, the
GDP increase for the United States is pared to $30 billion or 0.4% of GDP.
In general, the welfare gains to the United States are smaller then those of the
other eight countries. This is thought to occur for three reasons: one, U.S. trade
barriers were already lower than those in the other countries; two, trade represents a
comparatively smaller share of economic activity in the U.S. economy; and three,
there are increases in import prices because of the huge size of the U.S. market,
causing some deterioration of the terms of trade and an associated decrement to
economic welfare.
The issue, however, is not just whether to continue removing barriers but
whether to resist the erection of new barriers. The world economy saw the most rapid
removal of trade barriers and greatest increase in economic integration in the years
between 1870 and 1913. During most of the first half of the 20th century, trade
barriers grew sharply, reversing the substantial trade liberalization achieved in the
previous century. During World War I, world trade had been tightly controlled.
Nations grew more insular in the 1920s and sentiment for trade protectionism grew
in Europe and the United States, causing a creeping up of tariff rates over the period.
The onset of the Great Depression accelerated this pattern. In the United States, the
Smoot-Hawley Tariff of 1930 raised tariffs on manufactured goods to a lofty 48%.
Swift retaliation by Europe and Britain followed. In the aftermath, it is estimated that
between 1929 and 1932 the value of world trade fell by 70%. An outcome that
doubtless only exacerbated the ongoing collapse of economic activity across the
world economy. Therefore, much of the effort towards free trade in the post-World

11 (...continued)
in the United States (Washington: Institute for International Economics, 1994).
12 Scott Bradford and Robert Z. Lawrence, Has Globalization Gone Far Enough? The Cost
of Fragmented Markets (Washington: Institute for International Economics, 2004).

War II era has involved reversing and guarding against the re-erection of those
protectionist structures.13
Common Arguments for Trade Barriers
Demands for the preservation or augmentation of trade barriers continues to be
part of the public debate over trade policy. Five of the more common arguments for
trade barriers are evaluated below for their likely economic effects.
Jobs Are Destroyed by Trade. It is asserted that trade has created jobs for
foreign workers at the expense of American workers. It is more accurate to say that
trade both creates and destroys jobs in the economy just as other market forces do.
Economy-wide, trade creates jobs in industries that have comparative advantage and
destroys jobs in industries that have a comparative disadvantage. In the process, the
economy’s composition of employment changes, but according to economic theory
there is no net loss of jobs due to trade. Over the course of the last economic
expansion, from 1992 to 2000, U.S. imports increased nearly 240%. Over that same
period, total employment grew by 22 million jobs and the unemployment rate fell
from 7.5% to 4.0% (the lowest unemployment rate in more than 30 years.)14 Foreign
outsourcing by American firms, which has been the object of much recent attention,
is a form of importing and also creates and destroys jobs, leaving the overall level of15
employment unchanged.
There are two complementary reasons for increased international trade not
leading to any net job loss. First, the Federal Reserve, using monetary policy, can set
the overall level of spending in the economy to a level consistent with full
employment.16 Although deviations from full employment can occur, a well-run

13 See Kevin H. O’Rourke and Jeffery G. Williamson, “Trade, Growth and Distribution
Since 1500,” National Bureau of Economic Research, Working Paper 8955, May 2002.
14 These data can be found in the most recent annual report of the Presidents Council of
Economic Advisers. Since the end of the recession in late 2001, the labor market has
responded slowly, with the unemployment rate continuing to rise even as economic growth
strengthened. Relatively weak aggregate spending, caused by a number of recent economic
shocks, is the most likely cause of poor employment growth. For a fuller discussion, see
CRS Report RL32047, The “Jobless Recovery” From the 2001 Recession: A Comparison
to Earlier Recoveries and Possible Explanations, by Mark Labonte and Linda Levine.
15 See CRS Report RL32484, Foreign Outsourcing: Economic Implications and Policy
Responses, by Craig K. Elwell and CRS Report RL32350, Deindustrialzation of the U.S.
Economy: The Roles of Trade, Productivity, and Recession, by Craig K.Elwell.
16 Economies always have some amount of unemployment. Each economy will tend to have
a natural rate of unemployment around which the actual unemployment rate fluctuates. This
natural rate will also represent the rate at which the economy is effectively at full
employment because a lower rate of unemployment would not be sustainable due to the
inducement of a higher rate of inflation. The natural rate is not zero because at any point in
time there will be some people who are changing jobs and other people who normal market
forces have temporarily displaced. The more fluid the economy’s labor markets the lower
its natural rate of unemployment is likely to be. For most of the last 30 years, the U.S.

monetary policy will minimize the incidence and duration of such episodes and help
keep the total level of employment high in most years with or without outsourcing,
trade deficits, or trade in general. To give some perspective on the relation between
“job loss”and total employment, as well as the potential significance of foreign
outsourcing in this dynamic process, consider that in any quarter of 2000, at the peak
of the last economic expansion, with total employment at about 111 million, gross
job losses tallied between 8.5 and 9.0 million. Nevertheless, the economy at that
time was operating at the lowest rate of unemployment in 40 years. Over the whole
course of that expansion, gross job loss actually rose as the unemployment rate
steadily fell. But with adequate economy-wide spending, it was possible to create job
gains that more than offset job losses. In the far weaker labor market of 2003, gross
job losses per quarter measured 7.2 to 7.8 million. Gross job gains in 2003 were at
about the same as losses, leaving total employment steady. In each quarter of 2004
and 2005, however, gross job gains exceeded gross job losses by between 200,000
to 900,000 jobs, causing the U.S. unemployment rate to fall from 6% to 5%. This
occurred despite the U.S. economy’s total level of trade (exports plus imports)
growing from $2.6 trillion to $3.3 trillion over the same period. In either time period,
gross job losses occurred on a scale far greater than that attributed to foreign
outsourcing alone.17
Second, against the economic backdrop of adequate aggregate spending, any
increase in the purchase of imports will tend to generate an equal increase in the sale
of the country’s exports of goods or assets. This outcome follows from the
fundamental economic requirement that imports must be paid for and exports are the
only means for making that payment. The export sold does not have to be a currently
produced good or service, it can also be the sale of an asset such as a deposits in a
bank account, shares of stock, bonds, or real property, but in the end when tallied
across transactions in goods and assets, a nation’s trade is always in balance in the
sense that any imbalance in goods trade must be offset by a compensating imbalance
in asset trade. Both types of export sales will have a positive effect on domestic
output and employment, countering across the whole economy the negative effect of
increased imports. In short, the U.S. deficit in trade is offset by the surplus in capital
There is no denying that with international trade there will be short-run hardship
for some, but economists maintain the whole economy’s living standard is raised by
such exchange. They view these adverse effects as qualitatively the same as those
induced by purely domestic disruptions such as shifting consumer demand or
technological change. In that context, economists argue that easing adjustment of
those harmed is economically more fruitful than protection given the net economic
benefit of trade to the total economy.

16 (...continued)
economy’s natural rate was judged to be in the 5.5% to 6.0% range. Since the mid-1990s,
the natural rate has likely fallen to the 4.5% to 5.0% range. Most often an appropriate level
of aggregate spending is that consistent with employment at the natural rate.
17 U.S. Department of Labor, Bureau of Labor Statistics, Business Employment Dynamics,
various issues.

Worker Wages Are Hurt by Trade. Many people believe that imports from
countries with low wages has put downward pressure on the wages of Americans.
There is no doubt that international trade can have strong effects, good and bad, on
the wages of American workers. The plight of the worker adversely affected by
imports comes quickly to mind. But it is also true that workers in export industries
benefit from trade. Moreover, all workers are consumers and benefit from the
expanded market choices and lower prices that trade brings. Yet concurrent with the
large expansion of trade over the past 25 years, real wages (i.e., inflation adjusted
wages) of American workers grew more slowly than in the earlier post-war period,
and the inequality of wages between the skilled and less skilled worker rose sharply.
Was trade the force behind this deteriorating wage performance?
The effect of trade on wages in the U.S. economy has been the focus of
numerous studies over the past 10 years, and the conclusions that may be drawn from
these efforts are as follows:
!As regards the slow growth of the average real wage from the mid-
1970s to the late 1990s, increased trade is not seen as being the
cause of that sluggish performance, rather the identified reason was
slow productivity growth. Labor’s share of the economic pie was not18
getting smaller; the economic pie just was not growing as fast.
When productivity accelerated in the late-1990s average real wages
also increased at a faster pace. That the level of wages is most often
reflective of the level of worker productivity also explains why
higher wage American workers are not necessarily at a disadvantage
to lower wage foreign workers. The critical comparison is of unit
labor costs, not of the level of wages. The high productivity that is
the basis of a high wage means that unit labor costs can be lower in
the high-wage economy than in the low-wage economy because
productivity in low-wage economies is commensurately low as well.
!As regards trade and increased wage inequality, the research
indicates that trade was a contributing factor, but a minor one,
accounting for perhaps 10% to 20% of the observed increase in wage
inequality. It would seem then that from the standpoint of the
economy as a whole, trade with low-wage economies has not
triggered a “race to the bottom.”
A likely important reason for the small effect of trade on wages for the U.S.
economy was that trade with low-wage countries was still relatively small, amounting
to less than 2% of GDP in 2000. In fact, among U.S. trade partners the average wage
level in manufacturing relative to the U.S. manufacturing wage level grew from 60%19
in 1975 to 76% of the U.S. level in 2000. This has occurred because many trading

18 This conclusion is also confirmed by the absence of any deterioration in labor’s share of
national income, which has remained at about 70% throughout the post-World War II era.
19 U.S. Department of Labor, Bureau of Labor Statistics, “A Perspective on U.S. and Foreign
Compensation Costs in Manufacturing,” Monthly Labor Review, vol. 125, no. 6 (June 2002),

partners who were once low-wage economies have, with open trade and steady
economic growth, become high-wage economies. As the once poor have moved up
the income ladder, they have also withdrawn from the production of goods that use
low-skill and low-wage labor intensively and these products are then imported from
the newer emerging economies. China has picked up this task, as other East Asian
economies have withdrawn, and, in turn, as these economies did when Japan shifted
away from this type of production. So U.S. trade with low-wage economies is not
rising to a significant degree; rather, it is shifting location.
Economies of scale are also a factor that likely helps hold up industrial wages
in the face of low-wage foreign competition. Scale effects are thought to be a
significant force in many industries and, when present, would tend to increase worker
productivity and decrease unit labor costs. It is also possible that the increase of
competition itself spurs companies to higher levels of efficiency that also lowers unit
labor costs and helps preserve a higher wage level.
Another reason for the small impact of trade on wages in the United States is
that as the once low-wage economies have absorbed current technology, raised the
capital intensity of their production, and transformed to high-wage economies; two
events occur: one, they produce less of the goods typically produced by low-wage
workers; and two, they increase their demand for the products produced by low-wage
workers. The two effects exert upward pressure on the wages of these workers,
including any producing similar labor-intense products in the United States. This
outcome is consistent with the evidence that for the United States the relative price
of unskilled, labor-intensive, import competing goods rose in the 1980s and 1990s.
Based on this evidence, it can be argued that trade with low-wage economies is likely
to have improved wages in the United States, at least in the sense that they are higher
than they otherwise would be.20
It is also apparently true that import penetration by labor-intense products has
not changed greatly, but the location of that production has. Reviewing the period
1994 through 2003, the Council of Economic Advisors concludes that for United
States the increase in share of total U.S. imports accounted for by imports of goods
from China has been largely offset by a decrease in the share of goods imports from
other Pacific Rim countries. Therefore, many of the export jobs in non-China Asia
are migrating to China, so the distributional effects of this change fell on workers in
China and the Pacific Rim economies rather than workers in the United States.21

19 (...continued)
pp. 36-49.
20 Jagdish Bhagwati and Vivek Dehejia, “Freer Trade and Wages — Is Marx Striking
Again,” in Jagdish Bhagwati and Marvin Kosters, eds., Trade and Wages:Leveling Wages
Down? (Washington: AEI Press, 1995), pp. 36-75.
21 This also suggests any restriction placed on China’s imports to the United States would
not increase domestic output, rather it would increase the output of the Pacific Rim
economies whose exports to the United States would increase as they become a replacement
for restricted Chinese goods. For a discussion of this and other aspects of trade with China,
see The Economic Report of the President (Washington: GPO, 2004), pp. 65-68 and CRS

Of course, it cannot be ruled out that if trade with relatively low-wage
economies does grow in importance, the negative effects on U.S. worker wages of
such trade would grow in significance. Yet, there is probably an upper bound to this
effect, for it is possible that in the future with only relatively moderate differences
between home and foreign production costs, complete specialization would occur.
That is, the United States would no longer produce much of what is imported from
low-wage foreign economies. Since the United States would then no longer have
industries that use low-wage labor intensively, there would be no downward pressure
on domestic wages caused by such trade. To the extent that this pattern of trade
allows for a fuller realization of economies of scale and lowers product prices,
domestic workers’ real wages could be increased. The change in the location of U.S.
imports from low-wage economies noted above suggests that a sizable amount of
such specialization may have already occurred.
It is also known that industries that export pay wages that are, on average, higher
wages than industries that compete with imports. Therefore, as a rising level of trade
and outsourcing creates jobs in exporting industries, and destroys jobs in import-
competing industries there is a tendency for the average industrial wage to rise. It is
also useful to keep in mind that the U.S. economy is still largely domestic in
orientation, with perhaps as much as two-thirds of the labor force working and
having wages determined in activities largely unaffected by trade.
Economic analyses indicates that it is very unlikely that growing international
trade has had much to do with the slowdown in real wage growth and unlikely that
trade has caused more than a minor share of rising wage inequality. In the United
States, the slower productivity growth evident from the mid-1970s to the mid-1990s
is seen as the principal cause of slow real wage growth in this period. The experience
during the 1992-2000 period shows that despite a rapidly rising level of imports real
hourly earnings in the U.S. manufacturing sector (the sector most strongly effected
by trade but one with relatively high productivity growth in this period) rose 26%.22
For trade to have reduced the relative wages of lower skilled workers there would
need to be an associated fall in the market price of those import-competing goods that
are produced using lower-skilled workers intensively. This has not occurred.23
A more likely reason for increased wage inequality is the presence of a bias in
recent technological change toward greater use of higher skilled workers economy-
wide, tending to pull up their wages relative to those of the less skilled. Other factors

21 (...continued)
Report RL32165, China’s Exchange Rate Peg : Economic Issues and Options for U.S. Trade
Policy, by Wayne M. Morrison and Marc Labonte.
22 BLS data as reported in the 2003 Economic Report of the President, p. 376.
23 See Robert Lawrence and Matthew Slaughter, International Trade and the American
Worker: Giant Sucking Sound or Small Hiccup? Brookings Papers on Economic Activity
(Washington: Brookings Institution, 1993).

that are thought to have made minor contributions to wage inequality are
immigration, deunionization, and a falling real minimum wage.24
National Security Is Threatened by Trade. Some industries, or at least
components of some industries, are vital to national security and possibly may need
to be insulated from the vicissitudes of international market forces. This
determination needs to be made on a case-by-case basis since the claim is made by
some who do not meet national security criteria. Such criteria may also vary from
case to case. It is also true that national security could be compromised by the export
of certain dual-use products that, while commercial in nature, could also be used to
produce products that might confer a military advantage to U.S. adversaries.
Controlling such exports is clearly justified from a national security standpoint; but,
it does come at the cost of lost export sales and an economic loss to the nation.
Minimizing the economic welfare loss from such export controls hinges on a well-
focused identification and regular re-evaluation of the sub-set of goods with
significant national security potential that should be subject to control.25
Special Industries with Unique and Substantial Economic Potential
Will Not Mature Without Protection from Trade. In theory, there can be
“special” industries, which, if given government nurturing, including protection from
international trade, will grow to generate large economic returns in the future. But
without this public support these special industries will not emerge or will occur at
too small a scale. While there are many variants of the argument for government
promoting particular industries, two have some plausible economic merit. One is
support for industries that will have the potential to generate substantial economic
benefits to other sectors, but only a fraction of those benefits can be appropriated by
the firm. If left to the private market this will lead to under-investment in the socially
desirable activity. The second type of special industry that could warrant government
support is a new endeavor that will only exist in a highly concentrated market
structure (i.e., oligopoly) where sizable monopoly profits are likely to be emerge.
Claiming the lion’s share of those profits will depend on which nation gets there first
and which nation can be deterred from trying. Government support can influence
which nation ultimately claims those monopoly profits. In both cases, the role of
government support is to overcome a “market failure”and by doing so raise the
economic well-being of the nation.
The generation of new ideas is often the activity of central economic importance
for economic well-being. Because an idea can have limited excludability it can be
difficult for the firm to fully appropriate the economic benefits of the idea it has
created. The new idea may easily spill over to benefit other enterprises without
compensation accruing to its creators. In this environment, without government

24 For further discussion, see CRS Report 98-441, Is Globalization the Force Behind Recent
Poor U.S. Wage Performance?: An Analysis, by Craig K. Elwell.
25 It is beyond the scope of this report, but it is worth noting that there is a sizable body
international relations literature on the question of whether economic integration reduces
the likelihood of war. See for example: Richard Rosecrance, The Rise of the Trading State:
Commerce and Conquest in the Modern World (New York: basic Books, 1986).

support the firm will not have the incentive to invest in the knowledge-creating
process at a level that the whole society would find most economically beneficial.
This is a theoretically valid argument for government support for an industry
that generates significant benefits that are external to the firm. In practice, however,
it is a problematic endeavor.26 To be economically effective such support needs to
be targeted at the knowledge that would not otherwise be produced. This is likely a
difficult task. Even if the right target is identified, it will be virtually impossible to
know what amount of support is called for because these types of activities to not
carry a market price from which to judge relative scarcity. A tariff or other forms of
protection from international competition is likely to be too blunt an instrument to
achieve this goal as it is likely to create other costly distortions. At the international
level knowledge nurtured at considerable expense by one nation may be easily
appropriable by industries in other nations, tending to reduce any national advantage
to accrue from supporting a special firm.
The other theoretically valid argument for government promotion of a particular
industry is based on the possible existence of “strategic industries.” These are
industries in which only a very few firms would be able to operate profitably. In this
oligopolistic market structure, firms will likely have a significant degree of monopoly
power and the potential to earn above normal profits. Capturing those profits would
increase the home nation’s economic well-being. In this environment, nations may
be tempted to compete for those profits. Without government support those profits
will most likely be appropriated by the first few firms to establish themselves in the
industry. Subsequent entry by other firms would be deterred as they can only expect
to incur losses. This outcome can be altered if the government of one country gives
support, with an export subsidy for instance, sufficient to assure that whether firms
from other nations enter or not, its firm will earn a profit. Because any unsubsidized
firm would now earn losses they will be deterred from entry. The subsidized firm is
said to have a strategic advantage over its potential competitors, so this type of action
has been called strategic trade policy. In theory, a well placed subsidy to assure the
timely entry and successful operation of the “strategic industry” can actually raise
economic well-being in the home economy.
Again, although it is conceptually possible for a strategic trade policy to raise
national economic well-being, its practical significance has been widely questioned
by economists. Perhaps the greatest doubt as to the efficacy of strategic trade policy
is that the information required for the government to successfully execute the policy
most likely exceeds what would be readily available. Economic theory indicates that
the conditions needed for the execution of a successful strategic trade policy are
many and a favorable outcome will be extremely sensitive to small deviations from
any of those necessary conditions. This means that pursuing such a policy with
substantially incomplete information could easily result in subsidies supporting more
inefficiency than efficiency, and leading to more loss than profit. Further, if large
subsidies are to be handed out without all necessary information available, policy

26 For a discussion of the problematic success of industrial policy in practice in several
industrial countries, see Paul Krugman and Maurice Obstfeld, International Economics:
Theory and Policy (New York: Harper-Collins, 1994), pp. 287-296.

makers can anticipate some politicalization of the process and the rising probability
that more subsidies will be given than can be analytically justified. Success is likely
to be even less tractable if trading partners can be expected to retaliate against a
policy that will clearly make them worse off. Finally, economic studies have
suggested that even if the policy is well implemented, the realized gains could be
very small. For all these reasons, it is unlikely in practice that trade protection to
support strategic industries would raise economic welfare.
Unfair Competition Undermines the Benefits of Trade. Can trade be
beneficial if all parties do not abide by the same rules and regulations? Economic
theory says it can. If another country chooses to give a subsidy to an exporting
industry, buying those now-cheaper exports will hurt domestic industries that
compete with those foreign goods, but it will benefit the domestic consumers who
purchase them. Economists assert that the gain to consumers will typically exceed
the loss to producers and workers. Therefore, from the standpoint of overall
economic welfare, here defined as increased national income, an efficient economic
response may be to accept the gain in real income offered by the subsidized foreign
goods and facilitate the adjustment of the adversely affected home workers to more
efficient endeavors.
Similarly, many economists see a possible economic advantage of buying
foreign goods produced under different labor and environmental standards. They
view differences in such standards as a basis for creating comparative advantage and
realizing mutual gains from trade. In addition to the economic benefit to the U.S.
economy, for many poor nations the ability to use such advantages to produce a
tradeable good today may offer the best vehicle to increased productivity and a
steadily rising living standard in the future. Despite the economic gain to the United
States, trade on this basis can undermine long held domestic norms of “fair” market
conduct. It is at the core of many domestic disputes regarding trade and trade barriers
as many see trade as eroding labor and environment standards. If deviation from
these norms is unacceptable in domestic transactions, it may be hard to justify them
in international exchanges.
Yet it is also probably unrealistic to expect U.S. trading partners to be just like
the United States in these practices. Poor countries with much lower levels of
productivity simply cannot afford the American level of wages and labor standards.27
Rich or poor, other countries often have different social and economic priorities and
may choose to live with very different environmental standards. One thing that is
clear from the economic history of the now-rich industrial nations: With rising
income there also came rising labor and environmental standards. It can be plausibly
assumed that many now poor countries will follow a similar path, and that trade can
be an important means for achieving higher income.

27 See Stephen Golup, Does Trade with Low-Wage Countries Hurt American Workers
(Federal Reserve Bank of Philadelphia, 1998).

Another common activity widely seen as an unfair trade practice is foreign
dumping of exports.28 Dumping can hurt particular workers and firms and is not
acceptable under U.S. law. But, to believe that total economic welfare is reduced by
dumping, the premise that there can be a price that is too low has to be accepted.
Price cutting is a basic element of competition, widely practiced in the domestic
economy, that leads to greater efficiency and economic gain to consumers. Actions
to prevent dumping curtail the benefit of such competition in international commerce.
An exception would be instances of dumping that are “predatory” and part of a plan
to establish monopoly power. Such predatory practices would ultimately reduce
economic welfare and preventing them is in a nation’s economic interest. Because
predatory pricing is rare, economists place little merit in most claims of dumping.
Nevertheless, the number of antidumping actions has risen precipitously in the past
15 years. Once the protectionist tool of choice of a few rich nations, antidumping
actions are now being emulated by many other nations.
The discussion so far shows that mainstream economics gives little reason to
expect that deviations from free trade improve a nations economic well-being, yet
trade barriers persist. This most likely occurs because barriers have very focused
benefits accruing to well-defined groups with a concentrated political voice, while
the barriers costs are often widely dispersed over the population among people with
less natural cohesion and a more diluted political voice. Economic analysis
demonstrates that the protected groups gain, however, is most often at the greater
expense of the wider community.29 The tough policy question is finding an
acceptable reconciliation of the conflicting goals of improved economic efficiency
that comes with open trade and social equity that is often compromised by more open
trade, without necessarily relying on trade barriers.
In the post-WW II era, most large market economies have prospered, but they
have also maintained a “social bargain,” whereby society is asked to embrace the
wealth-building power of the open market economy in return for an acceptable
degree of cushioning from the periodic social disruption and cost that also comes
with that process. In effect workers in these economies have been given an amount
of social insurance to ameliorate the risk to job and income inherent in the operation
of markets. Extending this idea, the case can plausibly be made that with more open
trade that risk increases and a commensurate enhancement of that social insurance
is called for.
Thus to secure the economic benefits of reduced trade barriers and more open
trade, societies may, in the interest in economic equity and social cohesion, extend
and improve that social insurance. This would point toward government policies to
better provide for temporary support of income, to better provide for worker
retraining, and to better provide for geographic mobility.30

28 For a fuller discussion, see CRS Report RL31468, Dumping of Exports and Antidumping
Duties: Implications for the U.S. Economy, by Craig K. Elwell.
29 See Gary Clyde Hufbauer and Kimberly Ann Eliott, Measuring the Costs of Protection
in the United States (Washington: Institute for International Economics, 1994).
30 For a discussion of striking a balance between fairness and free trade, see Dani Rodrik,.

The persistence of trade barriers is also a consequence of the slow, incremental
process that the world’s economies have used to reduce those barriers. Although a
unilateral reduction or removal of a nation’s trade barriers would most often improve
its economic well-being, it is rarely used.31 The steady reductions of tariffs and other
trade barriers by the world’s economies over the past 60 years was largely achieved
by successive rounds of multilateral reductions. Since WW II, there have been eight
major multilateral trade agreements, the most recent being the Uruguay Round,
which was completed in 1994.32 This is a slow process with each round taking many
years to negotiate and implement a partial reduction of existing barriers. Yet it is a
process that confers significant advantages, not likely to occur with unilateral action.
First, the economic gains are likely to be considerably larger if all economies reduces
their barriers, because gains arise from the freer flow of both imports and exports.
Second, multilateral action gets exporters on board with consumers to broaden
political support for the market opening process. And third, the multilateral process
develops an institutional framework for dispute settlement that better insures that
once reduced barriers stay down, and institutional momentum that keeps the trade
liberalization process moving forward through successive rounds.
The Trade Deficit33
The U.S. trade deficit has risen, more or less steadily since 1992.34 It reached
$805 billion in 2005, more than doubling in size since 2001, and with a cumulative35
increase of more than $700 billion since 1995. As a share of GDP the trade deficit
over the past decade has risen from less than 2% of GDP to reach a record 6.4% in

2005. In the 1990s, the trade deficit grew despite good export sales in those years.

The 2001 recession reduced the trade deficit, but with economic recovery it has
grown larger and economic projections point to the trade deficit continuing to grow

30 (...continued)
Has Globalization Gone too Far? (Washington: Institute For International Economics,


31 There are plausible scenarios where nations, if left only with the use of unilateral action,
might see their best option to choose protection, while in a multilateral framework they
would see that a better result comes from choosing mutual barrier reduction. Thus the use
of the multilateral option would reduce the risk of trade wars. This is an example of a
situation called the “prisoner’s dilemma,” where individual action always leads to an
outcome inferior to the outcome from collective.
32 Preliminary negotiations called the Doha Development Agenda have occurred to set the
stage for the initiation of a ninth round of multilateral negotiations to achieve further
reductions of trade barriers worldwide.
33 For a fuller discussion, see CRS Report RL31032, The U.S. Trade Deficit: Causes,
Consequences, and Cures, by Craig K. Elwell.
34 The trade deficit measure used here is the “current account balance.” This is the nation’s
most comprehensive measure of international transactions in goods, services, and investment
35 For details of U.S. trade performance in 2004, see U.S. Department of Commerce, Bureau
of Economic Analysis, “News Release: U.S. International Transactions,” Mar. 16, 2005.

this year to more than $800 billion, assuming the economic expansion maintains
But, it is not necessary that an economic expansion generate a large trade
deficit. A rising current account deficit (or a falling surplus) over the course of a
brisk economic expansion is not a remarkable event for the U.S. economy. In the
1960s, brisk economic growth steadily eroded a small current account surplus. In the
1970s, modest deficits occurred with each economic expansion. However, in the
1980s and 1990s, the size of the trade deficits increased greatly. Cyclical factors
certainly at times played some role in this phenomenon, particularly in recent years
with the U.S. growing rapidly relative to most major trading partners. Trend forces
are also at work, however, inclining the U.S. economy toward generating large trade
deficits in all but recession conditions.
The trade deficit widens as the economy expands, not because of trade barriers
abroad, not because of foreign dumping of imports, and not because of any inherent
inferiority of U.S. goods on the world market, but primarily because of underlying
macroeconomic conditions at home and abroad. In effect, the U.S. economy spends
more than it produces, and this excess of demand is met by a net inflow of foreign
goods and services leading to the U.S. trade deficit.36 Of course, the U.S. trade
deficit is only possible if there are foreign economies that produce more than is
absorbed by their current spending and are able export the surplus. Trade deficits and
trade surpluses are jointly determined. International capital flows will allow a
mutually favorable reconciliation of these domestic spending-production imbalances.
These imbalances will be sensitive to the short-run effects of the business cycle (at
home and abroad) as well as long-term effects of trends in spending and production.
But, these imbalances will not be efficiently changed by trade policies that try to
directly alter the levels of exports or imports such as tariffs, subsidies, or quotas.
A Saving — Investment Imbalance
National spending-production imbalances are most usefully analyzed from the
standpoint of national saving and investment behavior. Saving is just the flip side of
the same phenomenon (an excess of spending essentially translates into a deficiency
of savings) but has the advantage of more clearly rooting the phenomenon in the
international asset market transactions, which is the key to understanding the
mechanism that generates aggregate trade imbalances.
It is an economic identity that the amount of investment undertaken by an
economy will be equal to the amount of saving — that is, the portion of current
income not used for consumption — that is available to finance investment. But for
a nation this identity can be satisfied through the use of both domestic and foreign

36 It is useful to remember that “income”/ “spending” are the flip side of “production”/
“output.” Any given value of production generates an equal value of income. Thus the
income the economy earns can support spending sufficient to purchase the economy’s
current output. With international trade, however, it is possible for there to be a divergence
of spending and production through the borrowing and lending of current income and output
between nations.

saving, or domestic and foreign investment. Therefore, a saving-investment
imbalance is a relationship between domestic saving and investment and one that can
only occur if foreign saving or investment are available to satisfy the overall saving
investment identity.37 In a relatively open world economy with reasonably fluid and
well functioning international capital markets, capital flows from lender to borrower
are the means by which the saving of one country can finance the investment of
another. With a willing lender and a willing borrower, flows of capital from one
nation to another can achieve overall saving-investment balance for both nations. If
international capital flows did not occur domestic investment could be no larger or
smaller than domestic saving.
Differences in the level of interest rates between economies are what induces
saving (capital) flows between countries as international investors seek out higher
rates of return. A nation with a “surplus” of domestic saving over domestic
investment opportunities will tend to have relatively low domestic interest rates
because the domestic supply of loanable funds (i.e., saving) exceeds the domestic
demand for loanable funds (i.e., investment) pushing down interest rates (i.e., the
price of loanable funds). As a result, this economy will also likely see some portion
of domestic saving flow outward, attracted by more profitable investment
opportunities abroad. This net outflow of purchasing power, which generally can
only be used to purchase goods (or assets) denominated in the country’s currency,
will, through changes in exchange rates, induce a like-sized net outflow of real goods
and services — a trade surplus. Japan is an example of a nation that in recent
decades has produced large net outflows of saving to the U.S. and other nations.
Conversely, another nation that finds its domestic saving falling short of desired
domestic investment will tend to have relatively high domestic interest rates because
the domestic demand for loanable funds exceeds the domestic supply of loanable
funds. As a result this economy will likely attract an inflow of foreign saving,
attracted by the higher rate of return. and that inflow will help support domestic
investment. Such a nation becomes a net importer of foreign saving (income), able
to use the borrowed purchasing power to acquire foreign output, and leading to a like
sized net inflow of foreign output — a trade deficit. That deficit augments the output
available to the domestic economy, allowing the nation to invest beyond the level of
domestic savings. (In recent years, a large share of this inflow of capital has been the
result of official purchases of dollar assets by foreign governments that are most
often not prompted by relative rate of return. Therefore, these purchases can run
counter to the direction of capital flows induced by private investors. This contra-
movement of capital will most often modulate the impact of private capital flows, but
not likely to offset or reverse the impact of those flows.)
The purchase of a foreign asset will require the use the appropriate foreign
currency. Therefore, asset market transactions will also change the demand for and

37 Saving in a macroeconomic framework is the portion of current income that is left after
households, businesses, and government pay for their current consumption. A household
that diverts some amount of current income to a bank, mutual fund, or government bond is
saving. Similarly the tax revenue that the government has left after paying for its spending
is (public) saving.

supply of national currencies needed to purchase foreign assets, causing changes in
currency exchange rates, which, in turn, induce an equivalent sized net flow of goods
(i.e., trade deficits and trade surpluses) between economies. The exchange rate acts
as the equilibrating mechanism, stimulating imports and dampening exports so as
to generate a net inflow (outflow) of goods that is in line with the net inflow
(outflow) of capital. A net inflow of capital bids up the exchange rate and the
exchange rate will increase by enough induce an equivalent net inflow of goods —
a trade deficit. A net outflow of capital bids down the exchange rate and the
exchange rate will decrease by enough to induce an equivalent net outflow of goods
— a trade surplus.
The United States has in recent years had a rising shortfall of domestic saving
relative to domestic investment and has received a growing net inflow of foreign
capital to bridge this gap. In 2000, at the peak of the previous economic expansion,
the U.S. gross saving rate (total savings as a percent of GDP) was 18%, the gross
investment rate was 22%, with the difference being made up by an inflow of foreign
saving (or lending) equal to 4%. Since then, the U.S. saving rate has fallen reaching

13.5% of GDP in 2005. Because of the 2001 recession and its after effects, the U.S.

gross investment rate fell, but since 2003 it has risen to 19.7% in 2005. Again, the
saving investment gap was bridged by an inflow of foreign saving equal to 6.4% of
This rising inflow of foreign capital caused a steady appreciation of the dollar
through early 2002. The dollars rise, in turn, lead to a steady rise of the trade deficit.
The recent depreciation of the dollar suggests that the size of the net inflow of capital
to the United States may be ebbing and, with some time lag, this will lead a slowing
of the rate of increase in the trade deficit and untimely induce a shrinking of that
imbalance. The ebbing of foreign capital inflows by private investors is most likely
due to some reduced attractiveness of the American economy as a destination for
investment in the wake of recession, slow economic recovery, low interest rates,
corporate malfeasance, and war. Of more enduring significance for the path of the
dollar and the trade deficit is the now large share of dollar assets in the investment
portfolios of foreign investors causing those investors to prudently seek to increase
the diversity of their portfolios by moving away form dollar assets. While further
depreciation of the dollar is expected in the near-term, the intensity and duration of
this trend is problematic. Also weigh the prospect of accelerating economic growth
in the United States, weak growth abroad, continuing large official purchases of
dollar assets, and the interest raising effect large federal budget deficits will tend to
raise the relative rate of return on dollar assets, boost their attractiveness to foreign
investors, and exert upward pressure on the dollar and tend to widen the trade deficit.
What is certain, however, is that so long as domestic saving in the United States
falls short of domestic investment and an inflow of foreign saving is available to fill
all or part of the gap, the United States will run a trade deficit of commensurate size.
The Benefits and Costs of Foreign Debt
A trade deficit is not necessarily undesirable. Increasing current spending
beyond current means need not be imprudent behavior. Borrowing is widely and
usefully done by individuals and businesses and so too by countries. Trade deficits

in the 1990s were a means to help finance an elevated level of domestic investment
and may be so again if the current economic expansion gains momentum. Investment
augments the nation’s future productive possibilities and is a boon to economic
growth and long-term economic welfare.
Of course borrowing carries a cost as the lender at least demands that interest
be paid on the borrowings. This “debt service cost” is a burden the borrower must
carry tomorrow for living beyond his or her means today. A person’s judgement
about the desirability or undesirability of the trade deficit may hinge on the benefits
gained from that added spending relative to the debt service burden that is also
incurred. That decision may depend on how the foreign borrowing is used. If used
to finance investment (that raises productive capacity), the economy’s future output
may increase by an amount sufficient to meet debt service costs and also add to the
output available for domestic uses. If used to finance public or private consumption,
there will be no enhancement of productive capacity, and meeting future debt service
costs must come at the expense of future living standards.38
Through the end of 2004, the United States net accumulation of foreign
obligations (i.e. the value of U.S. assets abroad minus the value of foreign assets in
the United States) is about $2.5 trillion. This net indebtedness will continue to grow
so long as there is a net inflow of foreign funds caused by the shortfall of domestic
saving relative to domestic investment.39 The current debt service burden of
Americas stock of foreign debt can be roughly judged from changes in the net
investment income component of the current account balance, which tallies income
earned from U.S. foreign investments in foreign assets against U.S. payments to
foreigners for their investments in U.S. assets. In 2005, the surplus in the U.S.
investment income account declined to $1.5 billion , from $30.4 billion in 2004. The
investment income balance is a tally of what U.S. foreign investments earn against
what foreign investments in the U.S. earn. This erosion was generally consistent with
the rapid growth of foreign assets in the United States relative to the stock of U.S.
assets in the rest of the world. Since 1998, the surplus in investment income has
exhibited a general rising trend, despite the continued growth of U.S. net

38 Whether used for investment or consumption, such borrowing and lending between
nations is intertemporal trade. These are exchanges of current goods for claims on future
goods and can also be seen as a type of gain from trade. If there are differences in the
valuation of current versus future consumption between countries then gains from trade are
possible. The borrower gains by being able to consume now beyond what his or her current
income allows. The lender gains by being able to consume more in some future period.
International capital flows are thus facilitating a more efficient use of global saving and a
more optimal pattern of spending over time. Some see the current pattern of intertemporal
trade as troublesome because it is a flow of capital (saving) from poor developing economies
to a much richer U.S. economy. The opportunities for investment would be expect to be
higher in the capital poor developing economies and the need for saving higher in the United
Sates with its rapidly aging labor force and, therefore for capital to flow form the U.S. to the
developing economies. For further discussion of this a typical pattern of international
borrowing and lending, see Ben S. Bernanke, Speech “The Global Saving Glut and the U.S.
Current Account Deficit,” Board of Governors, The Federal Reserve, Mar. 10, 2005.
39 U.S. Department of Commerce, Bureau of Economic Analysis, Survey of Current
Business, July 2004.

indebtedness to the rest of the world. This surplus reached $46.3 billion in 2003 and
fell to $30.4 billion in 2004. The persistence of the U.S. investment income surplus
most likely reflects the interplay of several forces. First, U.S. investments abroad on
average earn a higher return then do foreign investments in the United States. This
differential is thought to result from a higher incidence of mature, high yielding,
assets in the U.S. investment portfolio, greater risk exposure, and the special status
of the dollar as the worlds reserve currency of choice. Second, the sharp fall of
interest rates has translated into a fall in the rate of return as a large portions of U.S.
debt is repeatedly rolled-over. Third, in the period 2002 to 2004, a falling dollar,
particularly against the Euro, leads to a rise in the foreign currency value of U.S.
foreign assets and the associated earnings.
In the long run, it seems likely that the United States’ large stock of foreign
indebtedness will come to dominate movement of the investment income balance and
lead to steadily larger deficits in this balance. The investment income deficits of the
recent past have been very moderate in size; however, this payment could easily grow
to $100 billion or more in the near future. This is far from insolvency, but a net
outflow of resources to foreigners of that size would be a significant decrement to the
annual rate of advance of the nation’s living standard and a decrement that can get
larger. Some observers maintain that it is a burden that needs to be curtailed.
Dependence on foreign capital often raises concerns about economic and
financial instability that could be associated with these often volatile asset flows. A
sharp retreat from dollar assets by foreign investors could send such a sizable shock
to the United States and other industrial economies that might induce recession here
and abroad. There are good reasons to doubt that a sharp, damaging turnaround in
foreign capital flows is likely.40
However, recent experience with the panic of foreign investors, such as the
Asian financial crisis of the late 1990s has shown that such behavior most often
results from the growing likelihood that in the face of weak economic growth and
dwindling foreign exchange reserves, creditors would not be repaid, that debt service
payments were doubtful. This occurred when country’s that had borrowed substantial
amounts abroad that was denominated in foreign currencies found the rising value
of those currencies relative to the home currency made it doubtful that they could
continue to pay debt service. These are not risk factors that have much relevance to
the circumstances of the United States, which has strong growth and does not fix its
exchange rate, and is able to borrow abroad in its own currency. In addition, a large
proportion of foreign investments made in the United States have been long-term in
nature and not particularly prone to quick changes in commitment.
It is very likely that many foreign investors generally see the U.S. economy as
a bastion of long-run economic strength and will continue to invest for long-term
gain. Further, since the dollar is the worlds reserve currency of choice, the ongoing
demand for liquidity and a store of value that the dollar serves undergirds the desire

40 On the subject of sustainability of the trade deficit see CRS Report RL33186, Is the U.S.
Current Account Sustainable, by Marc Labonte.

to hold dollar assets, particularly short-term assets such as treasury bills that function
essentially as an international currency.
Another possible cost of large persistent trade deficits is that they are very likely
to lead to more calls for costly protection from foreign competition. Economic
analysis indicates that since such measures have no effect on the macroeconomic
factors that cause a trade deficit, they will not reduce it.
Reducing the Trade Deficit
The mechanics of the saving-investment relationship in an internationally open
economy such as the United States suggests that there are essentially three ways the
trade gap can be reduced: one, the rate of domestic investment falls; two, the level
of domestic saving rises; or three, some combination of one and two occurs.
Macroeconomic policy, the use of monetary and fiscal policy tools, can in theory
effect changes in these variables. Monetary policy, by raising domestic interest rates
and braking economic activity, can lower the rate of domestic investment and likely
narrow the trade deficit. It is also possible that the adjustment to a smaller current
account deficit would be initiated by a reduction in preference of dollar assets by
foreign investors. A diminished inflow of foreign capital, absent any increase in
domestic saving, would tend to increase domestic interest rates and force so as to
force a reduction of domestic investment consistent with the smaller inflow of
foreign capital and overall saving-investment balance. (At the extreme, a recession
would likely dramatically reduce the trade deficit as it did in 2001.) Because of its
negative effects on economic growth, decreasing the rate of domestic investment is
not generally considered the most desirable economic course to follow, however.
The second course to a smaller trade deficit, raising the domestic saving rate,
while having considerable economic merit, is a very problematic goal for
macroeconomic policy. As explained above, fiscal decisions on taxing and spending
influence the deficit or surplus position of the federal budget and the rate of public
saving. As seen in the late 1990s, a rise in the U.S. overall saving rate as a
consequence of a rising public saving rate stemmed from the sharp swing of the
federal budget from a deficit to a surplus of in 2000. But budget deficits have
returned and the government saving rate has fallen accordingly. Given the political
nature of budget deliberations, it seems very problematic whether the federal budget
can be an exploitable policy tool for reducing the trade deficit.
Can macroeconomic policy lift the low private saving rate? Proposals have
been made to use the tax code to raise incentives for saving by households. Careful
analysis reveals that such proposals most often have uncertain effects on the saving-
investment balance, as they tend to raise both saving and investment or merely shift
saving from source to another with no net gain.41 Other proposals, such as individual
retirement accounts, may just redistribute saving, raising the household rate (a little),
but lowering the public rate by an offsetting amount.

41 See CRS Report RL30873, Saving in the United States: How Has It Changed and Why
Is It Important?, by Brian Cashell and Gail Makinen.

Economic policy abroadcan also work to reduce the U.S. trade deficit. Polices
to increase the pace of economic growth abroad, as well as policies to help shift the
locus of economic growth from net exports toward domestic demand. And also tend
to reduce the outflow of saving from these economies into the U.S. economy. If such
policies are concurrent with U.S. policies to raise domestic saving, a smaller trade
deficit can occur without a reduction in domestic investment in the United States.
Otherwise a smaller inflow of foreign capital will induce a reduction in the trade
deficit by forcing a reduction of domestic investment.
Regardless of the posture of economic policy here and abroad, foreign investors
can step back from the purchase of dollar assets in response to greater rates of return
outside of the United States, or in an attempt to increase the diversification of their
portfolios, now overly stocked with dollar assets. Such a move would decrease
capital inflows to the U.S. market, and reduce saving available to the United States.
The trade deficit, with a time lag, would tend to fall. But lacking an increase in the
rate of domestic saving, interest rates would rise, and the rate of domestic investment
would also fall.
The depreciation of the dollar exchange rate from 2002 to 2004 was ,in part, the
consequence of foreign investors reducing there purchases of dollar assets. This
pattern was reversed in 2005, however, with a renewal of strong demand for dollar
assets resulting from the interaction of rising short-term interest rates in the United
States and a large volume of petroleum export earning looking for a safe and liquid
resting place. It seems probable that the behavior of foreign capital inflows to the
United States will hinge on a balancing of the attractiveness of dollar assets against
the risk to foreign investors of holding to large a share of dollar assets in their
portfolios. The outcome of this calculation is subject to a large degree of uncertainty,
but it does seem clear that the pressure for diversification away from dollar assets is
rising rapidly.
For economists, the case for free trade is strong and compelling. A reduction
of impediments to the flow of goods among nations will raise each trading nation’s
economic welfare. This conclusion has been repeatedly validated by studies of trade
liberalization policies such as the Uruguay Round Agreement and North American42
Free Trade Agreement.
However, public debate over such initiatives makes very clear that many
Americans do not share economists’ optimism about the virtues of free trade. Some
of this antipathy might arise from economic concerns that U.S. workers and
industries hurt by trade do not receive equitable compensation and other adjustment
assistance. Allaying this concern, some economists argue, is best achieved by efforts
to augment and refine the various government programs that help to support and
retrain workers displaced and hurt by market forces.

42 For example, see Nora Lustig, Barry Bosworth, and Robert Lawrence, Assessing the
Impact of North American Free Trade (Washington: Brookings Institution, 1992).

Others may simply doubt that trade is beneficial. If unconvinced by the various
technical studies, they might consider that the United States itself gives clear
evidence of the virtue of free trade. This country comprises 50 separate political
entities that under the Constitution are required to allow unfettered trade among
themselves. Specialization has occurred, interstate trade has grown, and national
economic welfare has benefitted.43 Certainly U.S. economic welfare would be
reduced if barriers to interstate trade were erected. Economists view the benefits of
interstate trade as of the same nature as the benefit of international trade. In policy
deliberations, of course, national economic welfare will be considered in conjunction
with political, social, and national defense issues that will also influence trade policy

43 The 50 states, of course, have the same labor and environmental standards.