The Trade Gap: How Long Can It Go On?

Some economists see it as sustainable, but most believe the U.S. spree must soon end

The rapid growth of the U.S. trade deficit has sparked vociferous debate -- and fresh research -- among international economists. The majority of the profession argues that the trade deficit is unsustainable in the long run because it's piling big foreign debts on the next generation -- and unsustainable in the short term because it threatens to trigger a financial or political crisis.

On the other hand, it's also possible to believe that the U.S. could run a trade deficit indefinitely without creating big problems. Some economists even argue that U.S. trade deficits, by lubricating global growth, actually have the support of important global players. Here's a quick guide to the issues:

How big is the trade deficit?

Huge. On Nov. 10, the Commerce Dept. reported the September deficit in goods-and-services trade was nearly $52 billion, the third-biggest ever after June and August. The deficit in the current account -- which covers trade in goods and services as well as investment income and unilateral transfers -- zoomed to a record 5.7% of gross domestic product in the second quarter. That towers above a previous high of 3.5% in 1986, when the yawning trade deficit stirred calls for protection against Japanese and European imports.

How is the deficit being financed?

The U.S. is borrowing from abroad and attracting foreign investments into assets such as stocks, corporate bonds, and Treasury securities. But much of the rising flow of money from overseas is coming from foreign central banks, especially Japan's and China's. They favor a strong dollar to keep Americans buying exports. Asian central banks added $160 billion of U.S. securities in the first half of 2004. If they change policies, it would be far harder for the U.S. to finance its deficit.

What are the arguments that the U.S. can keep running big trade deficits?

One idea is that the U.S. can easily afford to keep paying for imports with American assets like stocks and bonds because U.S. wealth is growing faster than it's being sold off. From 2000 to the second quarter of 2004, according to Federal Reserve data, the net worth of the U.S. household sector grew by $3.9 trillion. Household net worth still rose even assuming that Americans are responsible for the soaring debt of the federal government. From 2000 to the second quarter of 2004, the gross federal debt went up by roughly $1.6 trillion. Taking this debt into account means that Americans are $2.4 trillion richer than in 2000 despite the big trade deficits.

Isn't the deficit unsustainable because the U.S. has to pay lots of interest on its foreign debt?

You would think so. But the U.S. still receives slightly more income on its investments abroad than foreigners do on their larger investments in the U.S. In the second quarter the investment income surplus was $4 billion, better than one might expect.

Still, doesn't everyone agree that the trade deficit should shrink?

No -- some argue that U.S. deficits serve vital interests. American factory workers suffer, but consumers and the government get to spend more than they earn. And nations such as Japan and China benefit from having the U.S. run trade deficits because they rely on exports to the U.S. for growth. Economist Michael P. Dooley of the University of California at Santa Cruz argues that China's biggest problem is the number of unemployed Chinese who need to be given paying work. The best way for China to deal with that problem is by keeping its trade surplus with the U.S. large.

Foreign nations with high savings rates also get a chance to invest surplus capital in the U.S., which is still perceived as having a bright future because of high productivity growth and an unrivaled system for efficiently allocating capital. Federal Reserve Chairman Alan Greenspan argues that the pool of international capital available for investment in promising places like the U.S. is deeper than ever.

Isn't it risky for foreigners to invest so much in the U.S.?

Actually, it can be just the opposite. China, for example, is faster-growing but riskier than the U.S. because of the weak Chinese financial system and the possibility of political turmoil. So finance theory says that the Chinese have a strong interest in diversifying out of their home country into safer, more liquid investments such as U.S. Treasuries.

Why do most economists worry about the trade deficit?

Because, they argue, Americans are living beyond their means. They say a trade deficit and inflow of foreign capital can be healthy if the U.S. is investing in projects that generate future wealth. But in recent years, investment has been weak. Imported capital has primarily allowed U.S. consumers to go on a spending binge. In the third quarter, personal saving was just 0.4% of after-tax income, the lowest ratio since at least World War II. As for the rise in Americans' wealth, some say it's largely the result of a bubble in the housing market.

Are there signs that the financial markets are getting worried?

Yes. The clearest indication is downward pressure on the dollar, which in recent days has dropped to a new low against the euro. Against a Federal Reserve trade-weighted index of the currencies of major trading partners, adjusted for inflation, it has fallen 24% from its most recent peak three years ago.

If the dollar keeps falling, will this solve the trade deficit problem?

In the ideal scenario, the weaker dollar would raise the price of imports and make American exports more competitive, especially if China lets its currency rise against the dollar. Over time, Americans would curb consumption and increase savings and investment. Other countries would gradually wean themselves off reliance on exports to the U.S. That's pretty much what happened when the dollar fell 40% against major currencies between early 1985 and late 1990. The current account went from a deficit equaling 3.5% of GDP in 1986 to a small surplus in the first two quarters of 1991.

But the transition might not be gradual?

Right. Some analysts worry that the imbalances are so great that any small event could trigger an avalanche. If there's a panicky run on the dollar, the Federal Reserve might have to jack up interest rates to attract foreign capital. And import prices would leap, threatening stagflation. A slowdown in demand from the U.S. would chill the world economy. While the dollar's 1980s fall was mostly uneventful, some historians say dollar jitters contributed to the stock market crash of Oct. 19, 1987 -- the biggest one-day percentage decline ever.

What would reduce the probability of a deficit-induced crisis?

A key element, many economists say, is for Americans to spend less and save more. That would include reducing the government budget deficit. Also, economists Maurice Obstfeld of the University of California at Berkeley and Kenneth S. Rogoff of Harvard University say the U.S. must increase the productivity of its traded-goods sector even more in order to export more and compete with imports.

What's the bottom line for the deficit?

It's hard to say because this experiment has never been conducted before. What happens when the world's sole superpower becomes history's biggest debtor? No one's really sure.

By Peter Coy in New York

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