Large Trade Deficits Don”t Matter

The United States is running the largest trade deficit in its history – almost $340 billion for 1999 – and many policy-makers are concerned about the long-run implications of such a vast imbalance. But mainstream economic theory suggests that large trade imbalances may not really be a problem and that the ones we observe today, albeit larger than ever, are a reasonable and normal response to current economic conditions. In a study published in the latest issue of the Economic Journal, Professors Paul Bergin and Steven Sheffrin uncover significant evidence in support of this view.

Over the last 20 years, the researchers note, theoretical analysis of trade and current account balances has assumed that imbalances result from optimal behaviour. The idea behind this is to think of the economy as being like individual consumers, who earn income and use it to purchase consumption goods in a way to maximise their welfare. For example, suppose a country is in a recession, with output temporarily low. Rational consumers probably would not cut consumption dramatically along with the fall in their income. Rather, they would be happier if they cut consumption only a small amount, borrowed from the rest of the world to import extra consumption goods, and then repaid the loan gradually over time. The resulting trade deficits can be rationalised as the optimal response to economic conditions.

But other conditions can also generate trade deficits. For example, a change in the exchange rate or interest rate may induce countries to run a trade deficit by making it cheaper to borrow now. Theoretical work has extended this explanation in many directions but to date, empirical testing has lagged far behind.

Bergin and Sheffrin”s study develops a means to test fluctuations in the interest rate and exchange rate as additional causes of the trade balance. Analysing data from the last 40 years on the current account, output, interest rate and exchange rate – and focusing on three small open economics: Canada, Australia and the UK – the study confirms that the theory successfully explains current account fluctuations. Fluctuations in the exchange rate are especially important as an explanation, but fluctuations in output and interest rates also play a role.

”Interest Rates, Exchange Rates, and Present Value Models of the Current Account” by Paul Bergin and Steven Sheffrin is published in the April 2000 issue of the Economic Journal. Bergin and Sheffrin are Professors of Economics at the University of California, Davis.

001-530-752-8398 | prbergin@ucdavis.edu