South-Western College Publishing - Economics  
Long-run Effects of the Trade Deficit
Subject Trade Deficit
Topic International Finance
Key Words

Imports, Exports, Foreign Investment, and Foreign Trade

News Story

Spurred by a weak dollar and increased foreign demand for American products, especially autos and auto parts, the trade deficit was reduced in February by $1.4 billion, according to a recent government report. This is good news for the American economy, which has relied too heavily on consumer spending for its recovery from recession.

The long-run nature of the recovery is highlighted by Nariman Behravesh, chief economist for Global Insights, "We need exports as another leg of the stool; it shows there is diversity in our recovery. We're in a very deep hole, and it's going to take a while for us to make a dent."

Still, the trade deficit, at $42.1 billion, remains near the record high set in January of 2004 and a more serious threat to the U. S. economy will come if foreign investors turn away from U. S. debt instruments. The U. S. has been borrowing at a record pace from foreign investors and banks to finance the trade deficit.

"We don't know how long foreigners will be willing to hold our debt, both our massive rising federal debt, and massive foreign debt, and that is very troublesome," said Barry Bluestone, economist at Northeastern University in Boston. Just as the national debt must be financed, so too must the trade deficit. Normally a trade deficit is financed by a capital account surplus - that is, an inflow of investment and financial capital (loans) from abroad. Countries where imports exceed exports must make up the difference by selling assets to or gaining loans from foreigners.

With interest rates low, as they are now, the cost of financing is not as great. However, recent mutterings by the Federal Reserve suggests that higher interest rates will come; it is just a matter of time. Should these rates increase, the threat becomes more serious as it will be more costly to finance both the trade deficit and the national debt. Although a trade deficit is a blessing to American consumers, allowing them to consume more than they could domestically produce, the long-term impacts are worrisome and largely unknown.


(Updated June, 2004)

Questions
1.

How does a weak dollar help reduce the trade deficit?

2. Why is the deficit a blessing for American consumers?
3. Use the Internet to find the record high trade deficit for January.
4. Identify the three categories of the "Current Account".
Source Elizabeth Becker, "Trade Deficit Falls $1.4 Billion in Month", New York Times Online, April 15, 2004.

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