Is The Trade Gap A Ticking Bomb?

It could lead to a run on the dollar

Ask economists to identify the most positive element of U.S. public policy in recent years, and a vast majority will cite cutting the federal government's deficit. Yet as Wall Street economic consultant Peter L. Bernstein points out, in a key respect, deficit reduction has failed to deliver what the experts promised: America's chronic trade gap shows no signs of receding.

The notion that the U.S. budget and trade gaps are linked, notes Bernstein, first surfaced in the 1980s, when both deficits exploded. The chain of causation supposedly began with the need to finance the huge budgetary shortfall that emerged in the wake of Reagan-era tax cuts and defense spending. This led to a sharp rise in U.S. interest rates that attracted foreign investors and caused the dollar to take off. And that unleashed a flood of newly cheap imports and lagging U.S. exports.

In basic economic terms, however, the scenario was more simple: The ballooning federal deficit had cut national saving far below the nation's investment needs. As a result, the U.S. had to import capital from overseas, which inevitably resulted in a trade deficit.

By this logic, says Bernstein, the solution to the trade shortfall seemed clear. If the two deficits are truly twins, as many experts insisted, then the U.S. could solve its trade woes by eliminating the federal government's drain on national saving. As it happens, however, while the budget gap has virtually disappeared, the trade gap hasn't budged--and is clearly headed much higher.

Why did the experts' predictions miss so badly? The long answer is that trade flows are influenced by many more variables than the federal budget--by monetary policy and relative interest rates, by the business cycle, by shifting conditions and economic policies abroad.

The short answer, says Bernstein, is that the experts forgot that government savings and private savings often move in opposite directions. Thus, while the public sector's savings performance has improved mightily in recent years, America's household savings rate has plummeted to its lowest level in 39 years--leaving the U.S. still highly dependent on foreign capital.

The upshot is that the dollar has risen by 12% over the past year, and the merchandise trade gap could rise as much as $40 billion in 1998, by some estimates. With the economy currently in overdrive, that doesn't seem to be much of a problem today. Indeed, it should temper U.S. growth and keep inflation at bay over the near term while bolstering our ailing Asian trading partners.

Over the longer run, however, warns Bernstein, the persistence of large trade deficits could cause foreign investors to shift out of dollar assets--perhaps precipitously. "The dollar," he says, "is becoming increasingly over-owned, vulnerable, and exposed. It is an accident waiting to happen."

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