February 10, 2005 (Trade Byte)

Trade Byte

Trade Deficit Hits 3rd Consecutive Record

February 10, 2005
By Dean Baker 
The trade deficit, measured as a share of GDP, soared to yet another record in 2004, reaching 5.3 percent of GDP, or $617.7 billion. This is the third consecutive record deficit, and the 4th record in the last five years. Before the recent run-up in deficits, which began in 1998, the prior peak was just 3.1 percent of GDP in 1987.

The 2004 deficit was $121.2 billion higher than in 2003. It was driven by an extraordinary rise in imports, which grew by 16.3 percent in 2004, after growing by 8.5 percent in 2003. This growth rate is striking, given the decline in the dollar over the last two years. Exports grew at a healthy 12.3 percent rate, after growing by just 4.6 percent in 2003 and falling 2.7 percent in 2002.

At present, the trade deficit is still increasing, the deficit for the last quarter of 2004 was running at a $687.3 billion annual rate, or 5.7 percent of GDP. Unless the dollar tumbles sharply, or the economy slumps into a recession, the deficit is likely to set yet another record in 2005.

Imports grew sharply in almost every category. Higher oil prices were an important factor, with the deficit in petroleum products rising by $43.6 billion, but this still accounted for just over one-third of the increase in the deficit. Imports rose sharply in nearly every category. Imports of capital goods, automotive parts, and consumer goods rose by 16.2 percent, 8.6 percent, and 11.8 percent, respectively.

The deficits also increased with most countries. The deficit with North America increased $18.5 billion, mostly due to a $14.1 billion increase in the deficit with Canada. The deficit with China jumped by $37.9 billion to $162.0 billion, by far the largest deficit with any single country. The deficit with Japan rose $9.2 billion to $75.2 billion. Even the deficit with Western Europe rose, increasing $13.8 billion to $114.1 billion. This shows the problems that the U.S. economy is having competing, even with the competitive advantage it has gained following the sharp drop in the dollar against the euro.

The current deficit levels cannot be sustained for long. The net foreign indebtedness of the United States is currently in excess of $3 trillion. If the trade deficit were to remain constant as a share of GDP at its current level, the net foreign indebtedness of the United States would exceed the total value of the stock market in approximately a decade. It is not plausible that foreign investors would be willing to assume such a large stake in U.S. assets.

The trade deficit will have to decline sharply in the near future, which will happen when the dollar falls. This is the only plausible mechanism for adjusting the trade deficit - a lower dollar makes U.S. exports cheaper and imports more expensive.

There has been considerable confusion about the relationship between the budget deficit and the trade deficit. In standard theory, a lower budget deficit can reduce a trade deficit by lowering interest rates - which in turn leads to a lower dollar. In other words, a lower budget deficit lowers the trade deficit because it lowers the dollar; there is no other mechanism. (The alternative view implies that people decide between imported and domestically produced goods at the store based on the size of the U.S. budget deficit.)

There is an important relationship in the other direction between the trade deficit and the budget deficit which has been largely overlooked - a large trade deficit will lead to higher future budget deficits. The trade deficits are being financed by foreign investors who buy U.S. stock, bonds, and other financial assets. When the assets are foreign-owned, the income they generate will largely escape U.S. taxation, thereby lowering future revenue. The Congressional Budget Office may have under-estimated the ten year deficit by close to $600 billion because it has ignored the growth in foreign owned assets in its projections (see "The Current Account Deficit and the Budget Deficit: Is $600 Billion Missing?").

Dean Baker is Co-Director of the Center for Economic and Policy Research in Washington, D.C.

CEPR’s Trade Byte is published every year upon release of the Commerce Department's report on U.S. international trade.