Balancing the Federal Budget and U.S. International Trade Deficits

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The administration and the Congress have agreed to enact legislation that would eliminate the federal budget deficit by year 2002. Underlying that agreement is the broadly shared view among economists and policymakers that eliminating the federal deficit would yield wide-ranging economic benefits to the U.S. economy, including lower interest rates and higher real economic growth.

One of the important presumed benefits of eliminating the federal deficit is the possible favorable effect on the U.S. international trade position. Indeed, the popular mainstream view implies that balancing the federal budget would eliminate much of the U.S. trade (current account) deficit, provided that the economy's overall saving increases dollar-for-dollar in response to changes in the budget.

The mainstream view holds that the primary fundamental cause of the persistent U.S. trade deficit is that national saving - the sum of private saving and public sector deficits or dissaving - dropped sharply in the early and mid-1980s and has remained low thereafter (see, for example, Krugman, 1994). Part of the fall in national saving was attributable to the decline in private (household) saving, while the remainder reflected higher federal deficits. Thus, with unchanged private saving, the implication is that eliminating the federal deficit will raise national saving proportionately and should be more or less fully reflected in a lower current account deficit, ceteris paribus. Judging from recent levels of the two deficits, this is tantamount to eliminating the current account deficit (Table 1).

I think this is an overly optimistic view. As important as balancing the federal budget is for a variety of reasons, its benefits for the trade deficit are likely to be quite modest, even granting the strong, unrealistic assumption of dollar-for-dollar increases in national saving. It will almost certainly not come even close to eliminating the trade deficit. This paper makes a case for this less optimistic view.


The U.S. trade deficit can be reduced through one or more of the following channels: (1) a reduction in the level of U. S. domestic demand, a fraction of which would be presumably translated into lower demand for imports; (2) a switch of U.S. demand for imports (goods produced abroad) to U.S. produced goods; (3) a switch of foreign demand from foreign goods to U. S. goods; and (4) an increase in domestic demand abroad, a fraction of which would be presumably translated into higher demand for U.S. exports (U.S. produced goods).

Table 1

Federal Budget and International Trade Deficits

                   1993    1994    1995    1996     1997      2002

Federal Budget

Billions of $      255     203     164     107      169(b)    189(b)
Percent of GDP     3.9     3.0     2.3     1.4      2.1

Current Account

Billions of $      100     148     148     150(d)   150(d)
Percent of GDP     1.5     2.1     2.0     2.0      1.9

a Fiscal year

b Congressional Budget Office baseline, or current policy-based
estimates (CBO), 1996).

c Calendar year

d International Monetary Fund projections (IMF, 1996).

Eliminating the federal deficit has no consequences for domestic demand in foreign countries, but it can affect the other three channels. The most obvious and definitive effect of eliminating the federal deficit will be to reduce the level of U.S. aggregate demand significantly, although the extent of decline is far from clear. The actual reduction in demand will no doubt be smaller than would be implied by the size of the deficit, because part of the demand decline will be offset by changes in private saving and spending behavior resulting from lower actual or prospective deficits. …