The U.S. Trade Deficit

The twin oil price shocks of 1973-1974 and 1979-1980 vividly exposed the interdependence of the United States and the world economy. Exports as a share of total U.S. production had increased dramatically since World War II, and more U.S. workers were exposed to the vagaries of the international marketplace.

The global recession that followed the second oil price shock caused international trade to stagnate; global trade actually fell in 1982 and 1983. The United States and many other nations struggled to overcome inflation and recession, and to achieve economic recovery and growth.

At the same time shifts in international competitiveness were beginning to be felt. By the late 1970s, many countries, particularly newly industrializing countries, had begun to demonstrate increased ability to compete on a global basis. South Korea, Hong Kong, Mexico and Brazil are just a few of the countries that had become efficient international producers of such products as steel, textiles, footwear, auto parts and many consumer products. These new conditions altered the global trade environment and the dominant position of the United States within that milieu.

As other countries became more successful, U.S. support for liberal trade began to erode. U.S. workers in export industries worried that other countries were unfairly winning markets in third countries through foreign industrial targeting -- the direct support that foreign governments give to select industries, such as steel -- and through trade policies that explicitly promote exports over imports.

During this period, many U.S.-based multinational firms began moving production facilities overseas. Technological advances made such moves more practicable, and a change in locale was often made to allow a firm to take advantage of lower wages, fewer regulatory hurdles or other conditions that would reduce production costs. Many goods that the United States had previously exported began to be produced overseas.

Yet the event that had the most adverse affect on the U.S. trade balance -- the ratio of imports to exports -- was the unexpected jump in the foreign exchange value of the dollar. Between 1980 and 1985, the dollar's value rose some 40 percent in relation to the currencies of major U.S. trading partners. It was as if a tax had been placed on U.S. exports, while a subsidy had been given to foreign imports.

In 1972 foreign imports exceeded U.S. exports by $5.7 thousand-million. By 1985 the value of imports over exports had ballooned to well over $100 thousand-million, and the merchandise trade deficit hit a high of $152 thousand-million in 1987. However, as the effects of the depreciated dollar began to be felt, the trade deficit started downward; by 1990, it had dwindled to $101 thousand-million. But why did the dollar appreciate? The answer can be found in U.S. recovery from the global recession of 1981-1982 and in huge U.S. federal budget deficits, which acted together to create a need for foreign capital. U.S. recovery from the recession began in the end of 1982, earlier than it did in other countries. With recovery came an increase in U.S. demand for goods including imports. U.S. imports jumped 24 percent from 1983 to 1984. Foreign demand for U.S. goods did not grow at the same rate since recovery had not yet begun in other countries.

At the same time U.S. recovery brought an increase in demand for funds for domestic investment. Yet U.S. savings were not large enough to meet expanding demand for investment at a time of record federal budget deficits. The combination of large budget deficits and a tight monetary policy, which was being maintained to inhibit inflation, kept U.S. interest rates high relative to rates in other industrialized countries. High interest rates induced foreigners to invest in the United States. Thus, foreign demand for dollars bid up the dollar's value.

In the short term, the strong dollar provided significant benefits to the U.S. economy. By making imports cheaper, it inhibited inflation, while making it possible for the United States to finance both an enormous budget deficit and increases in private investment. But, by increasing the relative price of U.S. exports, the strong dollar engendered the huge U.S. trade deficit.

Dollar appreciation was not the only cause of the U.S. trade deficit, but most policymakers and economists attribute about 50 percent of the deficit to the dollar's rise. Decisionmakers came to agree that the trade deficit would only fall significantly if the federal deficit and, thus, the need for international borrowing, were reduced.

Congress responded to this situation in 1985 by enacting the Gramm-Rudman-Hollings deficit reduction legislation, which was designed to force annual deficit cuts through mandatory spending reductions. (This law was tempered by a Supreme Court review of its constitutionality, and its original deadlines had to be scrapped as a result of a ballooning deficit in the 1990s.)

The executive branch also took action to promote orderly reduction in the dollar's value. In 1985, the U.S. secretary of the treasury met with the finance ministers of France, Germany, Japan, and the United Kingdom to discuss actions each could take to promote the orderly depreciation of the dollar against the currencies of major trading partners. With central bank intervention in foreign exchange markets, the dollar gradually fell, losing almost half its value between September 1985 and January 1988. By 1988, the dollar depreciation had contributed to a falling U.S. trade deficit.