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surplus.

To answer this question, let’s explore the connection between the budget deficit and the trade deficit in more detail. To do so, we need one simple piece of arithmetic.

Begin with the familiar equilibrium condition for GDP in an open economy:

Y 5 C 1 I 1 G 1 (X 2 IM)

Because GDP can either be spent, saved, or taxed away,3

Y 5 C 1 S 1 T

Equating these two expressions for Y gives

C 1 I 1 G 1 (X 2 IM) 5 C 1 S 1 T

Finally, subtracting C from both sides and bringing the I and G terms over to the righthand side leads to an accounting relationship between the trade deficit and the budget deficit:

X 2 IM 5 (S 2 I) 2 (G 2 T)

Notice that this equation is a matter of accounting, not economics. It must hold in all countries at all times, and it has nothing to do with any particular economic theory. In words, it says that a trade deficit—a negative value of (X 2 IM)—can arise from one of two sources: a government budget deficit (G larger than T) or an excess of investment over saving (I larger than S).

Now let’s apply this accounting relationship to actual U.S. events in the 1990s. As we know, the government deficit, G 2 T, fell precipitously. Other things equal, that should

3 If you do not see why, recall that GDP equals disposable income (DI) plus taxes (T), Y 5 DI 1 T, and that disposable income can either be consumed or saved, DI 5 C 1 S. These two definitions together imply that Y 5 C 1 S 1 T.

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have reduced the trade deficit. But other things were not equal. The equation reminds us that the balance between saving and investment matters, too. As shares of GDP, business investment boomed while household saving declined from 1992 to 1998. So S 2 I moved sharply in the negative direction. And that change, as our equation shows, should raise the trade deficit (reduce net exports).

In brief, taken by itself, deficit reduction would have increased net exports. But in reality, sharp changes in private economic behavior—specifically, less saving and more investment—overwhelmed the government’s actions and made net exports fall instead. The link from the budget deficit to the trade deficit can be a loose one.

SHOULD WE WORRY ABOUT THE TRADE DEFICIT?

The preceding explanation suggests that the large U.S. trade deficits over the past decade are a symptom of a deeper trouble: The nation as a whole—including both the government and the private sector—has been consuming more than it has been producing for years. The United States has therefore been forced to borrow the difference from foreigners. The trade deficit is just the mirror image of the required capital inflows.

Those who worry about trade deficits point out that these capital inflows create debts on which interest and principal payments must be made in the future. In this view, we Americans have been mortgaging our futures to finance higher consumer spending.

But another, quite different, interpretation of the trade deficit is possible. Suppose foreign investors come to see the United States as an especially attractive place to invest their funds. Then capital will flow here, not because Americans need to borrow it, but because foreigners are eager to lend it. The desire of foreigners to acquire American assets should push the value of the dollar up, which should in turn push America’s net exports down. In that case, the trade deficit would still be the mirror image of the capital inflows. But it would signify America’s economic strength, not its weakness.

Each view has elements of truth, but the second raises a critical question: How long can it go on? As long as the United States continues to run large trade deficits, foreigners will have to continue to accumulate large amounts of U.S. assets—one way or another. As we noted in the previous chapter, starting in 2002 private investors abroad began concluding that they had acquired about all the American assets they wanted. That would have marked the day of reckoning for the United States but for one important fact: The governments of Japan and China decided to buy hundreds of billions of dollars (selling equivalent amounts of their own currencies) rather than let the yen and the yuan appreciate. These large government capital inflows allowed the U.S. to continue to run mammoth trade deficits for a few more years. Then in 2007, with the U.S. economy looking weaker than in the past, foreigners decided to buy fewer U.S. assets, and the dollar declined again.

ON CURING THE TRADE DEFICIT

How can we ameliorate our foreign trade problem and reduce our addiction to foreign borrowing? There are four basic ways.

Change the Mix of Fiscal and Monetary Policy

The fundamental equation

X 2 IM 5 (S 2 I) 2 (G 2 T)

suggests that a decrease in the budget deficit (that is, shrinking G 2 T) would be one good way to reduce the trade deficit. According to the analysis in this chapter, a reduction in G or an increase in T would lead to lower real interest rates in the United States, a depreciating dollar, and, eventually, a smaller trade deficit.

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When the government curtails its spending or raises taxes, aggregate demand falls. If we do not want the shrinking budget deficit to slow economic growth, we must therefore compensate for it by providing monetary stimulus. Like contractionary fiscal policy, expansionary monetary policy lowers interest rates, depreciates the dollar, and should therefore help reduce the trade deficit. So the policy recommendation actually amounts to tightening fiscal policy and loosening monetary policy.

As we have just noted, the U.S. government—after years of vacillation—changed the policy mix decisively in this direction in the 1990s. But our trade deficit rose anyway because private investment spending soared while private saving stagnated. Then, starting in 2001, the federal budget turned rapidly from a substantial surplus to a record-high deficit, which pushed the trade deficit up further. What else might work?

More Rapid Economic Growth Abroad

One factor behind the growing U.S. trade deficit is that the economies of many foreign nations—the customers for our exports—grew more slowly than the U.S. economy for years. If foreign economies would grow faster, the U.S. government frequently argued, they would buy more American goods, thereby raising U.S. exports and reducing our trade deficit. So we have regularly urged our major trading partners to stimulate their economies and to open their markets more to American goods—but with only modest success. When the U.S. economy slowed down in 2000–2001, our trade deficit did recede a bit—albeit temporarily. And the same thing happened again in 2007–2008. But no one thought slower U.S. growth was a very good remedy.

Raise Domestic Saving or Reduce Domestic Investment

Our fundamental equation calls attention to two other routes to a smaller trade deficit: more saving or less investment.

The U.S. personal saving rate (saving as a share of disposable income) has hit postwar lows in recent years. The approximately 1⁄2 percent saving rates recorded in both 2005 and 2006 were the lowest since the Great Depression of the 1930s! If Americans would simply save more, we would need to borrow less from abroad. This solution, too, would lead to a cheaper dollar and a smaller trade deficit.

The trouble is that no one has yet found a reliable way to induce Americans to save more. The government has implemented a variety of tax incentives for saving, and more are suggested every year. But little evidence suggests that any of them has worked. Instead, large increases in stock market wealth in the second half of the 1990s, and then in housing wealth in the early 2000s, convinced Americans that it was prudent to save even less than they used to.

If the other cures for our trade deficit fail to work, the deficit may cure itself in a particularly unpleasant way: by reducing U.S. domestic investment. The 2001 recession accomplished this to some extent, reducing the share of investment in real GDP from 17.7 percent in 2000 to 15.1 percent in 2003. (It also curbed our appetite for imports.) And with fear of recession rampant in 2008, those effects were expected again. But these side-effects of recession are only temporary, and the longer-run problem mentioned above remains: If our trade deficit persists, we will have to borrow more and more from foreigners who, at some point, will start demanding higher interest rates. At best, higher interest rates will lead to lower investment in the United States. At worst, interest rates will skyrocket, and we will experience a severe recession.

Protectionism

We have saved the worst remedy for last. One seemingly obvious way to cure our trade deficit is to limit imports by imposing stiff tariffs, quotas, and other protectionist devices. We discussed protectionism, and the reasons why almost all economists oppose it, in Chapter 17. Despite the economic arguments against it, protectionism has an undeniable political allure. It seems, superficially, to “save American jobs,” and it conveniently shifts the blame for our trade problems onto foreigners.

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thereby reduce the supply of dollars on the world market—which will push the value of the dollar up. A rising dollar, of course, would hurt U.S. exports and encourage more imports. The fundamental equation

X 2 IM 5 (S 2 I) 2 (G 2 T)

reminds us that protectionism can raise X 2 IM only if it raises the budget surplus, raises saving, or reduces investment.4

CONCLUSION: NO NATION IS AN ISLAND

When the poet John Donne wrote that “no man is an island,” he was not referring to economic globalization. But in the modern world, no nation is isolated from economic developments elsewhere on the globe. Instead, we live in a world economy in which the fates of nations are intertwined. The major trading countries are linked by exports and imports, by capital flows, and by exchange rates. What happens to national income, prices, and interest rates in one country affects other nations. No events make this point clearer than the international financial crises that erupt from time to time.

As we noted in Chapter 18, one root cause of almost all of the crises of the 1990s was countries’ decisions to fix their exchange rates to the U.S. dollar. Unfortunately for nations such as Thailand, Indonesia, and South Korea, the dollar rose spectacularly from 1995 to 1997. With their exchange rates tied to the dollar, the Thai baht, the Indonesian rupiah, and the Korean won automatically appreciated relative to most other currencies—making their exports more costly. Soon these one-time export powerhouses found themselves in an unaccustomed position: running large trade deficits.

Then the crisis hit, and all four of these countries watched their currencies tumble in value. The sharp depreciations restored their international competitiveness, but they also impoverished many of their citizens. Naturally, the shrinking Asian economies curbed their appetites for American goods, so our exports to the region fell—which contributed to further deterioration in the U.S. trade deficit.

Thus, a primarily American development (the rise of the dollar) harmed the Asian economies, and then a primarily Asian development (deep recessions in the Asian Tigers) hurt the U.S. economy. Similarly, the subprime mortgage crisis of 2007–2008, an American phenomenon, threatened economic growth around the world. The nations of the world are indeed linked economically.

4 Here tariffs, which raise revenue for the government, have a clear advantage over quotas, which do not.

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Recall the question with which we began this chapter: Should the United States let the dollar fall or try to stop it? Remember that a falling dollar boosts exports and growth in the United States but reduces exports and growth in, say, Europe and Japan. With economic growth in both Japan and Europe already slow, it was easy to understand why foreign leaders wanted the U.S. government to stop, or at least slow down, the dollar’s rapid descent in 2007 and 2008.

But it was also easy to understand why the United States was not eager to do so, especially with elections on the horizon, because a falling dollar could reasonably be expected to help the United States grow faster—even if that meant that Europe and Japan would grow slower. And indeed, foreign demand for U.S. goods helped support the weakening U.S. economy in 2007 and 2008.

Unfortunately, there is no way to avoid this conflict of interests. A cheaper dollar means a dearer euro and a dearer yen. For better or for worse, we all live in one world.

| SUMMARY |

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392 PART 4 The United States in the World Economy

| KEY TERMS |

| TEST YOURSELF |

| DISCUSSION QUESTIONS |

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APPENDIX: ANSWERS TO ODD-NUMBERED TEST YOURSELF QUESTIONS

Answers to odd-numbered Discussion Questions are available on the text support site at academic.cengage.com/economics/baumol.

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Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.