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Do Deficits Matter?

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This is an excerpt from our most recent Economic Outlook report. To access the full PDF, please click here

July marked the biggest increase in the U.S. trade deficit in 3 years. This occurred as the domestic economy continues to grow stronger, while demand abroad has weakened, due to slightly slower growth in Europe and Asia. Consult the percent change version of the Trade Balance, Goods and Services, Balance of Payments Basis in the graph below.

Coming out of the 2008-9 recession, the U.S. trade deficit displayed (in absolute terms) an upward cyclical build to a 2012 peak. That increasing trade deficit trend appeared to have reversed, up to 2014, as global growth ramped. Confirm this in the Trade Balance $M graph below. Since early 2016, it has been increasing again. The U.S. trade deficit reached $50.08 billion in July 2018.

The Trump administration has made narrowing the overall U.S. trade deficit and implementing specific National Security industry protections as one of the key deliverable items in its policy playbook, and has announced and implemented tariffs on a number of products such as steel and aluminum.

The most recent increase in the U.S. trade deficit is most likely driven by a reversal of the process we witnessed in the second quarter, where U.S. exporters preempted tariffs, which provided a massive tailwind to the U.S. economy. That is, retaliatory tariffs (e.g. China’s tariff on soybeans) showed up in the statistics.

Second, a continuing strengthening of the U.S. dollar against other currencies contributed to this trend, making imports to the U.S. cheaper while making domestic products more expensive abroad. Finally, the U.S. federal budget deficit continues to escalate while the economy is at full employment, forcing this open economy to cover its rising internal demand by increasing production from abroad.

The question on investor’s minds is about the degree this increase in the U.S. trade deficit is meaningful, and how is it going to impact financial markets in future? The chart below shows the U.S. Current Account Balance in National Currency terms, going back to the 1960s.

As you can see in the Current Account Balance graph above, the United States has been building up a larger current account deficit at least since the early 1990s. The U.S. was able to maintain this trade deficit for such a long time by being a reputable net borrower of choice over this time period. That is, it saved less than it borrowed. And the world took on the U.S. debt happily.

What has caused the expansion in the sister U.S. trade deficit? A number of different culprits have been proposed over the years, such as the U.S. federal budget deficit, as it increases domestic demand. Huge federal budget deficits do claim a rising share of national savings, thereby creating a rising need for foreign capital inflows. This is known as the “twin deficits” hypothesis among economists. Or look to the global savings glut, which led to a massive influx of capital into the U.S., which supported low interest rates over the years. That just names two of the most prominent macroeconomic culprits.

To what degree is the U.S. trade deficit a problem?

There is no simple answer to this. The consequences of a trade deficit depend on a number of variables, one of the most important ones being the level of long-term interest rates that accompany the stock of debt. That is, running a huge trade deficit will not be detrimental, as long as the U.S. is able to maintain access to cheap and liquid credit, and U.S. Treasuries remain the safe haven for the world. This however bears the risk of financial bubbles building somewhere in the system, as large numbers of assets receive much higher demand, which can cause inflated asset prices to spike to excesses.

By itself, however, the trade deficit does not necessarily impose a large threat to the growth and health of the U.S. economy. A large trade deficit can be caused by a strengthening domestic economy that increases demand for foreign products, as consumers spend more on products from abroad.

Meanwhile, a strengthening domestic economy is typically also accompanied by an increase in internal interest rates, as we are currently experiencing. This also contributes to large capital inflows and thereby adds to the trade deficit.

This explains why there is very little correlation between trade deficits and unemployment too. That is, increasing trade deficits do not necessarily lead to job losses in certain import-sensitive sectors, as trade-related job losses oftentimes get compensated with jobs created in other sectors, from the growing internal demand.

Thus, trade policies that allow similar access to the respective markets of trade partners are in all parties’ interest and should be a motivation, in and of itself. So the overall trade deficit expansion --by itself-- does not provide ample evidence to be an immediate concern.

SECTION 3: CONCLUSIONS

The revised Q2 +4.2% U.S. GDP growth rate is not the growth news with the most merit. Look at the quarterly U.S. GDP growth path, in the chart we provided earlier, going back to early 2016. Since 2016, consistent U.S. real growth across each quarter is what is notable.

In 2018, stock markets, consumer confidence, wages and core consumer price inflation are inching inexorably higher too. 4 Fed rate hikes in 2018 correspond to this data.

July marked the biggest increase in the trade deficit in three years. Don’t think this isn’t another part of (1) and (2). It is. Strong domestic growth will increase imports, raise interest rates, and strengthen the U.S. dollar. Those are the open economy components to a thriving internal economy.

However, the rising U.S. Federal budget deficit AND the rising U.S. trade deficit should NOT be as easily shrugged off. That builds pressure in asset markets, somewhere, somehow. And it leaves the next generations with restricted budget choices.




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