The US Economy is experiencing a huge trade deficit over last few decades. Explain the causes and consequences of this trade deficit on the US economy. Under what circumstances the trade deficit is really bad and under what circumstances the trade deficit

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Trade Deficits: Causes and

Consequences David M. Gould

Senior Economist and Policy Advisor Federal Reserve Bank of Dallas

Roy J. Ruffin Research Associate

Federal Reserve Bank of Dallas and

M. D. Anderson Professor of Economics University of Houston

For the most part, trade deficits or surpluses are merely a reflection

of a country’s international

borrowing or lending profile

over time. …Neither one, by itself,

is a better indicator of long-run

economic growth than the other.

On September 19, 1996, the Washington Post, Wall Street Journal, and New York Times reported trade figures released by the U.S. De- partment of Commerce showing that the monthly U.S. trade deficit increased by $3.5 billion in July 1996. Almost unanimously, analysts quoted in the articles stated that the recent trade figures showed weakness in the U.S. economy. The news was not earth shattering, nor was the interpretation of the increasing trade deficit con- troversial. The conventional wisdom is that the trade balance reflects a country’s competitive strength —the lower the trade deficit, the greater a country’s competitive strength and the higher its economic growth.

But the conventional wisdom on trade bal- ances stands in stark contrast to that of the economics profession in general. Standard eco- nomic thought typically regards trade deficits as the inevitable consequence of a country’s pref- erences regarding saving and the productivity of its new capital investments. Trade deficits are not necessarily seen as a cause for concern, nor are they seen as good predictors of a country’s future economic growth. For example, large trade deficits may signal higher rates of economic growth as countries import capital to expand productive capacity. However, they also may reflect a low level of savings and make countries more vulnerable to external economic shocks, such as dramatic reversals of capital inflows. Is the conventional wisdom wrong, or has the economics profession just failed to keep its theories well-grounded in fact?

Certainly, anyone can create a theory about trade deficits and speculate about how they may, or may not, be related to a nation’s eco- nomic performance. The paramount question is not whether one can create a theory, but whether it is logically consistent and stands up to em- pirical observation.

The purpose of this article is to answer the question of whether trade deficits, bilateral as well as overall, are related to a country’s eco- nomic performance. We begin by discussing the origin of popular views on trade deficits and compare these views with current economic thought on trade balances. Next, we discuss the relationship between international capital flows and trade balances and relate them to economic growth. We then empirically examine the rela- tionship between trade deficits and long-run economic growth.

The evolution of ideas about trade balances The mercantilists. Much of the current

popular thinking on trade balances can trace its

FEDERAL RESERVE BANK OF DALLAS 11 ECONOMIC REVIEW FOURTH QUARTER 1996

intellectual roots to a group of writers in the seventeenth and eighteenth centuries called the mercantilists. The mercantilists advanced the view that a country’s gain from international commerce depends on having a “favorable” trade balance (favorable balance meaning that exports are greater than imports). The mercan- tilists were businessmen, and they looked at a country’s trade balance as analogous to a firm’s profit and loss statement. The greater are re- ceipts over outlays (exports over imports), the more profitable (competitive) is the business (country). Thus, they argued that a country could benefit from protectionist policies that encour- aged exports and discouraged imports. Because most international transactions during the seventeenth and eighteenth centuries were paid for with gold and silver, mercantilists were ad- vocating a trade surplus so that the country would accumulate the precious metals and, according to their arguments, become rich.1

In 1752, David Hume exposed a logical inconsistency in the mercantilism doctrine through his explanation of the “specie-flow mechanism.”2 The specie-flow mechanism refers to the natural movement of money and goods under a gold standard or, indeed, any fixed exchange rate system in which the domestic money supply is inextricably linked to a reserve asset. The reserve asset need not be gold.3

Hume argued that an accumulation of gold from persistent trade surpluses increases the overall supply of circulating money within the country, and this would cause inflation. The increase in overall inflation also would be seen in an increase in input prices and wages. Hence, the country with the trade surplus soon would find its competitive price advantage disappear- ing as prices rose but the exchange rate re- mained constant. Automatically, through the specie-flow mechanism, the country with a trade surplus would find that its surplus shrank as its prices rose relative to other countries’ prices. Any attempt to restore the trade surplus by raising tariffs or imposing other protectionist policies would simply result in another round of cost inflation, leading ultimately to a balance between exports and imports once again.

Several of the mercantilists —such as Gerard de Malynes (1601) and Sir Thomas Mun (1664) — understood the problems of maintaining a per- petual trade surplus as domestic prices rose but discounted this problem as a very long-run phenomenon and emphasized the benefits of accumulating gold as a means of exchange in a hostile and uncertain world.4

A few decades after Hume’s original writ-

ings, economists such as Adam Smith and David Ricardo added further arguments against the mercantilistic advocacy of trade surpluses. They argued that what really matters to a country is its terms of trade —that is, the price it pays for its imports relative to the price it receives for its exports. Smith and Ricardo stood the advo- cacy of trade surpluses on its head when they showed that a country is better off the more imports it receives for a given number of exports and not vice versa. They argued that the mer- cantilistic analogy between a country’s exports and a firm’s sales was faulty.

Adam Smith in 1776 argued that money to an economy is different from money to an indi- vidual or firm. A business firm’s objective is to maximize the difference between its imports of money and its exports of money. Money “imports” are the sale of goods and money “exports” are the purchases of labor and other inputs to production. However, for the economy as a whole, wealth consists of goods and ser- vices, not gold. Money, or gold, is useful as a medium of exchange, but it cannot be worn or eaten by a country. More money, in the medium and long run, just results in a higher level of prices. In the short run, however, Adam Smith also recognized that under the gold standard, a country’s supply of gold would enable it to purchase the goods of other countries.

To some extent, therefore, the argument between the most able mercantilists and the classical economists was partly a question of emphasis —the mercantilists were concentrating on the fact that in the short run, the accumula- tion of money is wealth, while the classical economists were concentrating on the fact that in the long run, it is only the quantity of goods and services available that is wealth. However, the classical economists primarily were respond- ing to the naive writings of most mercantilists, who confused the flow of money with the flow of goods in the short and long run.

National income accounting. Perhaps the great emphasis placed on national income accounting today is an important reason the naive form of mercantilism lives on in the hearts of many individuals. According to basic national income accounting, gross domestic product (GDP ) is consumption (C ) plus invest- ment (I ) plus government spending (G ) plus exports (X ) minus imports (M ) —that is,

GDP = C + I + G + X – M.

This makes it appear that exports increase gross domestic product while imports reduce gross

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domestic product. This is erroneous because the definition of gross domestic product is just a tautology, and no conclusion about causality is possible. For example, it is equally true that the volume of goods and services available to an economy (C + I + G ) consists of domestic output (GDP ) plus imports minus exports —that is,

C + I + G = GDP + M – X.

Looked at in this way, a trade deficit appears to be “favorable” because we ultimately are interested in domestic spending. But this, too, is definitional. The question of whether defi- cits improve or hurt the economy cannot be resolved by such tautological manipulations. Theory and empirical evidence are required to evaluate whether deficits are favorable or unfavorable.

Employment and trade balances. The na- tional income accounting view often leads many to associate trade deficits with reductions in employment. For example, some have argued that for every million dollars the United States has in its trade deficit, it costs about thirty-three American jobs, assuming that the average worker earns $30,000 a year (that is, $1,000,000/$30,000 = 33.33). So this implies that the July 1996 trade deficit of $11.7 billion cost around 390,000 jobs.5 This calculation, however, is based on the fallacious assumption that capital inflows do not find their way into productive activity. Because a trade deficit is associated with capital inflows (to finance the deficit), the jobs lost by the deficit would be restored by the inflows of capital in expanding sectors of the economy. Gould, Ruffin, and Woodbridge (1993) corre- lated unemployment rates of the twenty-three OECD (Organization for Economic Cooperation and Development) countries with their import penetration ratios (the ratio of imports to GDP) and their export performance ratios (the ratio of exports to GDP) over thirty-eight years. They found that, for about half the countries, the correlation between import penetration ratios and unemployment rates (future or present) is negative (that is, higher imports are related to lower unemployment).

More importantly, however, they found that there is no instance of a significant positive or negative correlation of import penetration ratios with unemployment rates that is not the same for export performance ratios. In other words, exports and imports always had the same type of correlation with unemployment rates. Exports and imports are more related to each other than they are to other macroeconomic

factors like unemployment rates because, ulti- mately, exports must pay for imports.

International capital movements and the balance of payments

From a public policy viewpoint, the funda- mental question is: Do trade deficits reflect a malfunctioning of the economic system? If they do, perhaps limiting their size can improve a country’s future standard of living. What is known, however, is that trade deficits or sur- pluses ultimately depend on a country’s prefer- ences regarding present and future consumption and the profitability of new capital investments. In understanding movements in the balance of trade, it helps to see their connection to move- ments in the balance of international capital flows. In a world of international capital mobil- ity, trade deficits and international capital move- ments are the result of the same set of economic circumstances.

As first discussed by J. E. Cairnes (1874), international capital flows go through certain natural stages. The capital account balance (or the trade balance) should be seen as balancing a country’s propensity to save with a country’s investment opportunities and its resulting in- come payments, rather than as negative or positive indicators. The benefit of international capital flows and trade imbalances is that, in ordinary circumstances, they can lead to an effi- cient allocation of resources around the world. Net capital importers get their scarce capital more cheaply, and net capital exporters receive a higher return on their investments. In turn, capital imports finance trade deficits and trade surpluses finance capital exports.

In fact, under the right circumstances, a country can run a perpetual trade deficit or surplus. What matters for the balance of trade is how long a country has been a borrower or lender in international capital markets. How can countries maintain a perpetual trade deficit or surplus? Over time, the longer a country imports capital, the larger the interest rate payments on that capital. Eventually, a long-term debtor country will be borrowing less than its interest payments on existing debt to other countries and, in the steady-state, necessarily will have a trade surplus to pay these interest payments. A long-term creditor country will be lending less to other countries than its income receipts from other countries and will have a perpetual trade deficit. (For a fuller description of this mechanism, see the box entitled International Capital Flows and the Balance of Trade and the appendix.)

FEDERAL RESERVE BANK OF DALLAS 13 ECONOMIC REVIEW FOURTH QUARTER 1996

Countries also can be in transition from a long-term creditor or debtor country to a short- term creditor or debtor country. The United States, for example, was a long-term creditor country throughout the 1970s, with trade deficits partly or wholly financed by net income pay- ments from foreigners. However, in the 1980s, the U.S. trade deficit ballooned as both capital imports and income payments financed the deficit. The country was in transition until the net income account turned negative in 1994. Today, the United States must be regarded as a short-term debtor country. Japan, on the other hand, represents a major short-term creditor country.

Table 1 shows a snapshot of the 1994 balance of payments for several major countries. We show the net capital account, the net income account, and the trade and transfers account (the sum of net exports of goods and services and net transfers from the rest of the world). The current account (not shown) is the sum of the first and last columns; we separate the two components to illustrate the forces at work. It is very difficult to find examples of long-term creditor countries. The United Kingdom comes close, with its trade deficit and large net in- come from foreign investments, but the country may be entering a transition period. Austria is another example. There are more examples of long-term debtor countries, such as Canada and most of the Scandinavian countries.

Today, the United States has a relatively small obligation as far as investment income is concerned. But as we continue to be a debtor nation, the accumulated debts with the rest of the world will grow so large that the debt- service payments become larger than any amount of fresh capital borrowed by the country. If the United States continues to borrow, it will be- come a long-term debtor country. At this point,

we will be in a perpetual balance-of-trade sur- plus. This must happen in order to pay the foreigners who own assets in the United States. Thus, the U.S. trade deficit in the future should completely turn around.

A key conclusion from this analysis and an examination of the relationship between capi- tal flows and economic growth (see the appen- dix) is that, in the long run, there should be no link between economic growth and the trade

The trade balance is a reflection of how long a country has been a borrower or lender in international capital markets. To see this relationship, it is helpful to examine the basic structure of a country’s balance of payments. Let X = exports, M = imports, T = net gifts or unilateral transfers to foreigners, ∆B = net new borrowing from abroad, B = net indebtedness to the rest of the world, and r = the rate of interest on foreign indebtedness. A country’s balance of payments must be

X + ∆B = T + M + rB.

The left-hand side of the equation refers to receipts from foreigners; the right-hand side refers to payments to foreigners. These must always balance. If ∆B > 0, a country is borrowing; if B > 0, a country is a net debtor. If ∆B < 0, a country is lending, and if B < 0, a country is a net creditor. A country is considered to be a relatively short-term borrowing nation when its net indebtedness, B, is small compared with its net new borrowing, ∆B. In this case, imports will be greater than exports (M > X ). A country is considered to be a relatively long-term borrowing nation when the interest it pays on foreign indebtedness, rB, is larger than its net new borrowing from abroad, ∆B. Here, exports are greater than imports (X > M ). The opposite is true for a short-term or long-term creditor country.

International Capital Flows and the Balance of Trade

Table 1 The Balance of Trade and Net Capital and Income Accounts, 1994 (Millions of U.S. dollars)

Trade and Capital Income Country transfers account account

Australia $ –5,604 $ 15,860 $ –11,876 Austria – 630 –1,822 2,804 Belgium – Luxembourg 8,167 –10,452 4,853 Brazil 7,938 7,965 – 9,091 Canada 3,754 8,331 – 21,242 Chile 1,016 4,541 –1,773 Denmark 7,980 – 5,537 – 5,320 Finland 5,294 4,286 – 4,226 France 19,051 – 5,015 –10,962 Germany – 28,584 24,501 4,704 Japan 88,910 – 86,190 40,330 Korea – 2,301 10,610 –1,554 Mexico –17,039 12,754 –11,754 Netherlands 11,826 – 6,485 1,546 Norway 5,413 –1,321 –1,769 Spain 1,496 4,449 – 7,923 Sweden 6,690 6,390 – 5,874 Switzerland 9,949 16,469 8,545 United Kingdom –18,520 – 24,562 16,129 United States –140,440 120,806 –10,494

SOURCE: International Financial Statistics — capital account, line 78bjd; income account, line 78agd + line 78ahd; balance of trade and net transfers, line 78afd + line 78ajd + line 78akd.

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balance. The long-run trade balance is jointly determined with the net creditor or debtor status of the country, while the long-run growth rate is determined by the growth rate of the population and technological progress. The next section is devoted to the empirical relationship between economic growth rates and trade imbalances, after controlling for other factors determining the rate of growth.

Are trade balances related to long-run economic growth?

Although the theoretical exposition above concludes that trade balances should not be related to long-run economic growth, the rele- vance of that theory has yet to be empirically examined. Moreover, there are other possible elements of trade balances, not discussed above, that may have implications for long-run eco- nomic growth. For example, large trade deficits imply large inflows of international capital. But international capital inflows may be subject to dramatic reversals, due to external shocks to a country’s export sector and changes in foreign sentiment. In such cases, large trade deficits may be seen as an indicator of a country’s vulnerabil- ity to external shocks. If large inflows of capital and trade deficits make a country more vulner- able to external economic shocks, long-run eco- nomic growth may be hampered.

While several studies have found that freer international trade (exports and imports) is an important determinant of cross-country growth rates, trade balances (the difference between exports and imports) have yet to be explored. This section examines the question of whether overall and bilateral trade balances are related to long-run rates of economic growth.

Overall trade balances. Empirically, one can imagine circumstances in which the trade bal- ance is correlated to a nation’s rate of economic growth, even though it may not cause it. Sup- pose, for example, that a nation is moving from a relatively closed economy to integration with the world economy—perhaps East Germany after the Berlin Wall fell in 1989. A country just opening up to world markets, like East Ger- many, would have a relatively high potential for future growth and would likely experience net capital inflows. But large capital inflows would be associated with large trade deficits. Conse- quently, there would appear to be a positive relationship between trade deficits and higher rates of economic growth. The higher rates of economic growth, however, are not caused by the larger trade deficits but by the opening up of domestic markets.

In contrast, trade deficits may be nega- tively related to economic growth if they reflect impediments to the market mechanism. Here again, however, the trade deficit itself is not causing lower growth but is itself determined by another factor that affects growth and the trade deficit. For example, it has been shown that the share of government consumption in GDP is negatively correlated to economic growth across countries (Barro 1991, and Levine and Renelt 1992). If a large share of government consumption tends to stimulate the demand for imports, generates a trade deficit, and reduces growth, this would show up as a negative corre- lation between trade deficits and economic growth, even though there is no causal relation- ship between the two. What is really decreasing growth is the large share of government con- sumption in total GDP, not the trade deficit.

Bilateral trade balances. While a country’s overall trade may be balanced, a country may have bilateral deficits with many of its trading partners. Consequently, the relationship between overall trade balances and economic growth (discussed earlier) should not necessarily be the same as that between bilateral trade balances and economic growth. Nonetheless, we exam- ine the empirical relationship between bilateral trade balances and economic growth because much popular attention has focused on this aspect of our trade account. To do the analysis, we develop a summary measure of bilateral trade balances that indicates the degree to which a country’s bilateral trade flows are imbalanced (that is, bilateral exports and im- ports are unequal).

As is the case with overall trade imbal- ances, there is no theoretical reason bilateral trade imbalances should be related to economic growth. It is likely that countries that specialize in primary products will have higher bilateral imbalances than countries that specialize in manu- factured goods. The reason is that a primary product producer cannot sell much to another country that produces the same primary prod- uct. On the other hand, a country that exports manufactured goods can easily sell manufac- tured goods to another country that exports manufactured goods because of the diversity of manufactured goods and intraindustry trade.

In fact, the correlation between our mea- sure of bilateral imbalances (see note 12) and per capita real GDP is – 0.62. This may be ex- plained by the fact that countries with lower per capita GDPs tend to export fewer manufactured goods. Moreover, if protectionism rises with greater bilateral imbalances, bilateral imbalances

FEDERAL RESERVE BANK OF DALLAS 15 ECONOMIC REVIEW FOURTH QUARTER 1996

may be negatively related to economic growth. For example, U.S. protectionism against Japa- nese products may rise as the U.S. bilateral trade deficit with Japan increases. Because several studies on the determinants of economic growth have found that protectionism tends to decrease long-run growth rates, there may be a negative correlation between bilateral imbalances and economic growth.6 The next section attempts to empirically determine whether there is any relationship between overall and bilateral trade balances and economic growth when taking into consideration the underlying fundamental determinants of economic growth.

Trade balances and economic growth The benchmark model. Before examining

the role of trade balances in economic growth, we first present the results of a basic benchmark growth model. The model utilizes a formulation that is common to many of the recent cross- country empirical examinations of growth and attempts to control for the underlying determi-

nants of long-run economic growth.7 Equation 1 of Table 2 presents the estimation results of the benchmark model.8 The dependent variable is the average annual real per capita GDP growth rate between 1960 and 1989,9 and the explana- tory variables are (1) the log of real GDP per capita in 1960, ln(Y 60); (2) physical capital savings, which is the log of the share of in- vestment in gross domestic product, ln(I/ Y ); and (3) a proxy for human capital savings — the log of secondary-school enrollment rates in 1960–89, ln(School ).

The results of the benchmark model are consistent with most recent growth studies. Real GDP per capita in 1960 is negative and highly significant, suggesting income convergence con- ditional on human capital.10 Physical capital sav- ings and the proxy for human capital savings, ln(I/Y ) and ln(School ), are positive and signifi- cant at the 1-percent level, consistent with the empirical findings of Levine and Renelt (1992).

Equation 2 of Table 2 examines the role of capital controls, as proxied by black market

Table 2 The Role of Trade Balances in Growth

Dependent variable: average yearly real GDP per capita growth, 1960 – 89

(1) (2) (3) (4) (5)

Constant 15.327 15.653 15.187 15.17 14.279 (3.602) (4.236) (2.902) (3.336) (3.818)

ln (Y60) –.837 –.933 –.801 –.863 –.943 (– 3.852) (4.354) (– 3.546) (– 3.636) (– 4.404)

ln (I /Y ) 3.251 2.970 3.048 2.963 3.149 (8.521) (7.634) (7.897) (7.486) (7.651)

ln (School ) .904 .922 .850 .893 .843 (6.651) (6.973) (6.185) (6.447) (5.607)

Exchange controls –.005 –.004 –.005 –.005 (– 2.495) (–1.956) (– 2.231) (– 2.414)

Share of all years .007 in deficit (1.657)

Trade deficit as a –.004 share of trade (–.703)

Bilateral imbalance –.895 as a share of trade (–.601)

R – 2 .684 .681 .664 .679 .663 RMSE 1.092 1.061 1.081 1.064 1.092 Observations 91 91 91 91 91

NOTES: t values are in parentheses. Real per capita growth is the least squares estimate; Y60 is real per capita GDP in 1960; I /Y is investment as a share of GDP, 1960– 89; School is secondary-school enrollment rates, 1960 – 89; exchange controls is the black market premium.

SOURCES OF PRIMARY DATA: Real per capita growth and Y 60, Summers and Heston (1991) Penn World Tables, version 5.6; I/Y, World Bank National Accounts; School, Barro (1991); exchange controls, Levine and Renelt (1992); trade deficit as a share of total trade, bilateral imbalance as a share of total trade, and share of all years in deficit, authors’ calculations based on data from the International Monetary Fund, Direction of Trade Statistics.

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SOURCES OF PRIMARY DATA: Same as Table 2.

Table 3 Trade balances and growth

Bilateral Trade deficit trade imbalance Share of as a share as a share all years

Country Growth of trade of trade in deficit

Angola – 2.7 – 20.7 43.5 25.0 Chad – 2.4 28.9 49.0 89.3 Mozambique – 2.0 39.4 42.8 100.0 Madagascar – 1.8 10.2 35.5 81.8 Zambia – 1.4 –11.1 52.3 21.4 Central African

Republic –.5 –2.5 41.2 46.9 Ghana –.5 6.3 37.2 72.7 Liberia –.5 –15.5 39.3 4.5 Niger –.4 4.5 37.6 86.7 Benin –.2 55.3 39.8 100.0 Senegal –.2 23.3 34.8 96.9 Uganda –.2 –5.1 52.0 24.2 Guyana 0 2.8 33.2 55.2 Sierra Leone 0 11.6 47.5 68.8 Mauritania .1 –12.1 55.8 12.5 Sudan .1 34.4 44.9 90.9 Zaire .2 –16.4 39.1 7.7 Somalia .2 39.4 63.0 93.1 Bangladesh .2 41.0 47.6 95.2 Haiti .3 34.3 30.9 76.7 Mali .3 36.9 47.7 96.8 Uruguay .6 1.6 39.6 45.5 Nigeria .7 –16.5 42.7 21.9 India .8 18.0 31.1 93.9 Ethiopia .8 24.0 47.8 96.3 Papua

New Guinea .8 – 4.8 45.3 48.3

Average –.3 12.2 43.4 63.7

Nepal .9 45.4 48.1 100.0 Bolivia 1.0 – 5.6 41.0 30.3 Chile 1.0 – 5.8 33.0 27.3 Sri Lanka 1.1 16.8 40.0 90.9 Nicaragua 1.1 24.0 36.6 90.3 Argentina 1.1 –15.0 40.1 22.6 Malawi 1.3 17.5 44.3 96.6 El Salvador 1.3 14.1 29.7 78.8 Honduras 1.3 6.9 29.4 90.9 Guatemala 1.5 10.8 27.4 78.8 Burkina Faso 1.6 53.9 43.7 97.0 Kenya 1.6 24.7 43.1 100.0 Zimbabwe 1.6 –1.0 31.3 40.0 South Africa 1.6 –14.5 39.8 21.2 Peru 1.7 –10.7 27.3 15.2 Mauritius 1.7 6.5 60.0 66.7 Burundi 1.7 19.7 56.7 87.5 New Zealand 1.8 .7 25.3 54.5 Togo 1.8 30.8 42.3 90.9 Jamaica 1.9 20.4 34.5 100.0 Pakistan 1.9 24.1 35.9 97.0 United States 1.9 12.5 19.8 69.7 Rwanda 2.0 30.2 50.0 89.7 United Kingdom 2.2 7.3 16.8 100.0 Switzerland 2.2 4.7 22.6 93.9 Venezuela 2.2 – 21.2 34.8 12.1

Average 1.6 11.4 36.7 70.8

Bilateral Trade deficit trade imbalance Share of as a share as a share all years

Country Growth of trade of trade in deficit

Tanzania 2.3 27.7 36.0 69.0 Colombia 2.3 1.9 24.9 57.6 Paraguay 2.3 13.4 38.1 66.7 Philippines 2.3 15.1 26.8 93.9 Australia 2.3 –.8 33.6 42.4 Canada 2.4 – 4.5 13.5 6.1 Costa Rica 2.5 11.9 30.0 100.0 Dominican

Republic 2.5 23.7 39.9 54.5 Iraq 2.5 – 8.9 52.0 50.0 Sweden 2.6 – 2.5 19.5 54.5 Mexico 2.6 0 18.2 75.8 Ireland 2.7 –.3 21.6 75.8 Morocco 2.8 24.4 27.7 100.0 Ecuador 2.8 – 9.2 35.3 39.4 Gambia 2.9 25.0 52.6 64.3 Turkey 2.9 24.1 25.3 100.0 Denmark 2.9 2.5 18.6 81.8 Netherlands 3.0 –.2 20.0 63.6 Iran 3.1 2.3 42.8 60.0 Barbados 3.1 39.7 37.3 100.0 Jordan 3.1 54.6 53.8 100.0 Suriname 3.3 2.1 39.9 58.6 Trinidad and

Tobago 3.3 – 8.0 49.2 46.9 Tunisia 3.3 22.8 30.2 100.0

Average 2.7 11.9 32.8 68.9

Germany, West 3.4 – 7.3 15.7 0 France 3.4 3.5 17.5 93.9 Norway 3.4 – 2.8 27.6 69.7 Panama 3.5 60.6 46.8 100.0 Congo 3.5 –18.3 57.1 48.5 Cameroon 3.6 2.3 36.7 54.5 Thailand 3.6 12.5 34.6 100.0 Israel 3.6 24.3 30.7 100.0 Finland 3.6 .5 19.0 69.7 Spain 3.6 21.7 25.7 97.0 Algeria 3.7 – 5.4 30.0 46.7 Austria 3.9 10.9 21.1 100.0 Malaysia 4.0 – 6.3 29.2 7.7 Italy 4.0 4.9 17.5 100.0 Syria 4.1 22.6 50.1 90.6 Egypt 4.3 43.7 43.2 93.9 Portugal 4.5 25.5 29.3 100.0 Greece 4.6 38.9 26.3 100.0 Brazil 4.6 – 8.2 29.2 51.5 Gabon 5.2 – 31.2 31.7 0 Malta 5.4 32.8 37.9 100.0 Korea,

Republic of 5.6 2.3 30.8 84.4 Hong Kong 6.1 –.7 41.9 72.7 Japan 6.1 –9.8 31.6 39.4 Singapore 6.6 8.3 30.5 100.0

Average 4.3 – 9.0 31.7 72.8

FEDERAL RESERVE BANK OF DALLAS 17 ECONOMIC REVIEW FOURTH QUARTER 1996

exchange rate premia, in economic growth.11

We include a measure of capital controls in the benchmark equation to account for any negative growth effects due to the lack of capital mobility across nations. Specifically, we do not want to confuse the effects of low capital mobility with the effects of a low trade imbalance. Low capital mobility impedes the development of trade im- balances and is likely to be related to low rates of economic growth.

As model 2 shows, exchange controls de- crease economic growth and the coefficient is statistically significant and economically impor- tant. Holding all else constant, the size of the coefficient suggests that a black market pre- mium of 50 percent, for example, would de- crease a country’s average growth rate in the range of 0.20 to 0.25 percentage points per year.

The effects of trade balances. Can trade balances explain any variation in economic growth once capital controls and the standard determinants of growth are held constant? Before we examine this question, we first pre- sent some simple descriptive statistics on the relationship between trade balances and eco- nomic growth.

Table 3 summarizes the countries in the data set and shows their average yearly growth rate, the trade deficit as a share of total trade, the share of total years in deficit, and a measure of bilateral trade imbalances as a share of total trade. The trade deficit as a share of total trade is imports minus exports divided by total trade (imports plus exports); the share of total years in deficit is the number of years a country has had a trade deficit over the 1960 –89 period divided by the number of years in the period (30); bilateral trade imbalances are measured by sum- ming a country’s bilateral trade deficits and sur- pluses and dividing by that country’s total trade and adjusting for overall surpluses and deficits.12

In other words, our measure of bilateral imbal- ances represents the percentage of a country’s trade that is bilaterally imbalanced (after adjust- ments for total imbalances).

The countries in Table 3 are grouped ac- cording to growth rates; the slowest 25 percent of countries are in the upper left and the fastest 25 percent of countries are in the lower right. Without controlling for the important determi- nants of growth, there appears to be a weak positive correlation between economic growth and the percentage of years in deficit. The fast- est growing countries seem to have more years in deficit than the slower growing countries, although those countries in the middle growth range are not distinguishable as having a higher

or lower share of years in deficit. There is a nega- tive correlation between bilateral imbalances and economic growth. This correlation is stron- ger than the previous one. The greater the bilat- eral imbalance, the lower the growth; there is no ambiguity in the middle growth categories. The overall trade deficit as a share of total trade also appears to be negatively related to growth, although it is not a strong relationship. A priori, it is difficult to see any strong relationship between measures of overall or bilateral trade imbalances and economic growth. However, the other factors determining growth should be taken into account before any conclusions can be properly made.

Equation 3 in Table 2 adds the share of years a country’s trade account is in deficit to the benchmark model. As the results indicate, the variable is positively related to economic growth, but it is not statistically significant at the standard 5-percent level. However, taking the point estimate seriously, the size of the coefficient suggests that its economic effects are only moderate. For example, the United States, with 69.7 percent of its years in deficit, would experience an increase in its growth rate of about 0.5 percentage points per year.

The weakness of the relationship between trade balances and economic growth is shown by an alternative measure of trade deficit: trade deficit as a share of total trade, shown in equa- tion 4 of Table 2. In this case, the coefficient is negative but is extremely small and statistically insignificant. Taking the point estimate seriously, a trade deficit that is 12 percent of total trade, which is what the United States had over the period 1960 –89, would only decrease average yearly per capita real GDP growth by about 0.05 percentage points.

Equation 5 includes bilateral imbalances as a share of trade. As the results indicate, the coefficient on this variable is negative, but, with a t value less than 1, it is not statistically signifi- cant. Thus, empirical evidence is consistent with the hypothesis that bilateral trade imbalances have no particular impact on economic growth.

Conclusion In this study, we have examined, both

theoretically and empirically, the relationship between trade balances and long-run economic growth. We find that trade imbalances have little effect on rates of economic growth once we account for the fundamental determinants of economic growth.

For the most part, trade deficits or sur- pluses are merely a reflection of a country’s

18

international borrowing or lending profile over time. Just as companies borrow to finance in- vestment and purchases, so do countries. A country can have a perpetual trade deficit or surplus simply because income payments from investments allow it to finance the country’s desired flow of goods. Far too often, the com- mon wisdom is that large trade deficits signal a fundamentally weak economy, when the em- pirical evidence suggests that there is no long- run relationship between the two. Trade deficits and surpluses are part of the efficient allocation of economic resources and international risk- sharing that is critical to the long-run health of the world economy. Neither one, by itself, is a better indicator of long-run economic growth than the other.

Notes 1 Thomas Mun (1664) pointed out that “Our yearly con-

sumption of foreign wares to be for the value of twenty

thousand pounds, and our exportations to exceed that

two hundred thousand pounds, which sum wee have therupon affirmed is brought to us in treasure to ballance the accompt ” [emphasis added]. Interna- tional lending must have been relatively small in the

seventeenth century. 2 In the eighteenth century, precious metals were

referred to as “specie.” 3 In modern times, currency boards, such as those

found in Hong Kong and Argentina, use the U.S.

dollar to back their currency, and many other fixed-

exchange-rate regimes peg the value of their curren-

cies to the U.S. dollar. 4 See Schumpeter (1954, 344– 45 and 356 – 57) for an

excellent discussion of mercantilistic thought. 5 For an example of this type of analysis, see Duchin and

Lange (1988). They argue that eliminating the trade

deficit in 1987 would have increased employment by

5.1 million jobs. This figure represented an increase of

about 5 percent in total employment from a trade

deficit that represented only about 3 percent of GDP. 6 See, for example, Krueger (1978); Bhagwati (1978);

World Bank (1987); De Long and Summers (1991);

Michaely, Papageorgiou, and Choksi (1991); Edwards

(1992); Roubini and Sala-i-Martin (1992); and Gould

and Ruffin (1995). 7 See, for example, Kormendi and Meguire (1985);

Barro (1991); Romer (1990); Levine and Renelt (1992);

Edwards (1992); Roubini and Sala-i-Martin (1992);

Backus, Kehoe, and Kehoe (1992); and Mankiw,

Romer, and Weil (1992). These empirical studies

typically rely on a closed-economy version of the

neoclassical Solow growth model. The closed-

economy model would seem inappropriate in a world

where capital is internationally mobile. However, an

implication of the open-economy neoclassical model

is that countries should experience rapid income con-

vergence because capital can move quickly across

borders and does not have to be slowly accumulated

at home. But fast income convergence is not borne out

by cross-country empirical evidence.

Barro, Mankiw, and Sala-i-Martin (1995) find that

the transition to the long run in an open-economy

neoclassical model may not be instantaneous if there

are some impediments to the flow of capital across

countries. Impediments to the flow of capital are likely,

especially when considering the flow of human capital

across nations. 8 The benchmark model utilizes a log-linear formulation

for two reasons: it has a basis in Cobb – Douglas pro-

duction technologies (such as Backus, Kehoe, and

Kehoe 1992 and Mankiw, Romer, and Weil 1992), and

this model is superior to a simple linear formulation in

minimizing the mean squared error. 9 Least squares estimates are used because they are

less sensitive to the end points of the growth period. 10 Although regressing average growth rates against

initial income levels suggests income convergence,

it does not necessarily provide statistical evidence of

convergence. Quah (1990) and Friedman (1992) note

that, because of regression to the mean, a negative

relationship between average growth rate and initial

income does not necessarily provide statistical

evidence of convergence. 11 The black market exchange rate premium is the

percentage by which the official exchange rate

deviates from the market exchange rate and is often a

good proxy for the degree to which countries attempt

to control international capital flows. 12 The formula for the bilateral trade imbalance of country

i is BIM

X M

X M X X

M

X i

ij ij j

n

i i ij ij

i

i

= −

+ = ∗=

∑ * *, ,

1 where X i is total

exports of country i, M i is total imports of country i, X

ij

is exports of country i to country j, and M ij is imports to

country i from country j.

References Backus, David K., Patrick J. Kehoe, and Timothy J. Kehoe

(1992), “In Search of Scale Effects in Trade and Growth,”

Journal of Economic Theory 58 (December): 377– 409.

Barro, Robert J. (1991), “Economic Growth in a Cross

Section of Countries,” Quarterly Journal of Economics 106 (May): 407– 43.

———, N. Gregory Mankiw, and Xavier Sala-i-Martin

(1995), “Capital Mobility in Neoclassical Models of

Growth,” American Economic Review 85 (March): 103 –15.

Bhagwati, Jagdish (1978), Anatomy and Consequences of Exchange Control Regimes (Cambridge, Mass.: Ballinger Publishing Co.).

FEDERAL RESERVE BANK OF DALLAS 19 ECONOMIC REVIEW FOURTH QUARTER 1996

Cairnes, John E. (1874), Some Leading Principles of Political Economy Newly Expanded (New York: Macmillan and Co.).

De Long, J. Bradford, and Lawrence H. Summers (1991),

“Equipment Investment and Economic Growth,” Quarterly Journal of Economics 106 (May): 445 – 502.

Dollar, David (1992), “Outward-Oriented Developing

Economies Really Do Grow More Rapidly: Evidence from

95 LDCs, 1976 –1985,” Economic Development and Cultural Change 40 (April): 523 – 44.

Duchin, Faye, and Glenn-Marie Lange (1988), “Trading

Away Jobs: The Effects of the U.S. Merchandise Trade

Deficit on Employment,” Economic Policy Institute,

Washington, D.C., October.

Edwards, Sebastian (1992), “Trade Orientation, Distor-

tions, and Growth in Developing Countries,” Journal of Development Economics 39 (July): 31– 57.

Friedman, Milton (1992), “Do Old Fallacies Ever Die?”

Journal of Economic Literature 30 (December): 129 – 32.

Gould, David M., and Roy J. Ruffin (1995), “Human Capital,

Trade and Economic Growth,” Weltwirtschaftliches Archiv 131 (3): 425 – 45.

———, ———, and Graeme L. Woodbridge (1993), “The

Theory and Practice of Free Trade,” Federal Reserve

Bank of Dallas Economic Review, Fourth Quarter, 1–16.

Kormendi, Roger, and Philip Meguire (1985), “Macroeco-

nomic Determinants of Growth: Cross-Country Evidence,”

Journal of Monetary Economics 16 (September): 141– 63.

Krueger, Anne (1978), Foreign Trade Regimes and Eco- nomic Development: Liberalization Attempts and Conse- quences (Cambridge, Mass.: Ballinger Publishing Co.).

Levine, Ross, and David Renelt (1992), “A Sensitivity

Analysis of Cross-Country Growth Regressions,” Ameri- can Economic Review 82 (September): 942– 63.

Malynes, Gerard de (1601), A Treatise of the Canker of England’s Commonwealth.

Mankiw, N. Gregory, David Romer, and David N. Weil

(1992), “A Contribution to the Empirics of Economic

Growth,” Quarterly Journal of Economics 107 (May): 407– 37.

Michaely, M., D. Papageorgiou, and A. Choksi, eds.

(1991), Liberalizing Foreign Trade: Lessons of Experi- ence in the Developing World, vol. 7 (Cambridge, Mass.: Basil Blackwell).

Mun, Thomas (1664), England’s Treasure by Foreign Trade: Or, the Balance of Our Foreign Trade Is the Rule of Our Treasure.

Phelps, Edmund S. (1966), Golden Rules of Economic Growth (New York: Norton).

Quah, Danny (1990), “Galton’s Fallacy and Tests of the

Convergence Hypothesis” (Massachusetts Institute of

Technology), photocopy.

Romer, Paul M. (1990), “Human Capital and Growth:

Theory and Evidence,” Carnegie –Rochester Conference Series on Public Policy 32: 251– 85.

Roubini, Nouriel, and Xavier Sala-i-Martin (1992), “Finan-

cial Repression and Economic Growth,” Journal of Development Economics 39 (July): 5 – 30.

Ruffin, Roy J. (1979), “Growth and the Long-Run Theory

of International Capital Movements,” American Economic Review 69 (December): 832– 42.

Schumpeter, Joseph A. (1954), History of Economic Analysis (New York: Oxford University Press).

Solow, Robert (1956), “A Contribution to the Theory of

Economic Growth,” Quarterly Journal of Economics 70 (February): 65 – 94.

Summers, Robert, and Alan Heston (1991), “The Penn

World Table (Mark 5): An Expanded Set of International

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World Bank (1987), World Development Report 1987 (New York: Oxford University Press).

20

Appendix A Simple Dynamic Model of Growth, the Balance of Trade,

And International Capital Movements

It is not obvious that a long-term creditor country must have a trade deficit, or that a long- term debtor country must have a trade surplus. In other words, why should it be that net investment income necessarily exceeds net capital outflows for a long-term creditor country, or that net debt payments must necessarily exceed net capital inflows for a long-term debtor country? To demon- strate this claim, we consider a world consisting of two countries —home and foreign. For the sake of simplicity, both countries produce a single, identi- cal good that can be either consumed or used as capital.1 Moreover, to keep the notation simple, we assume both countries have the same population and that there is no depreciation of capital (capital lasts forever or is used up in consumption). To keep one country from overrunning the other, we suppose the labor forces grow at the same rate. Finally, we suppose that the single good is pro- duced under constant returns to scale by only two factors, labor and capital.

Let k and k * denote the owned capital per unit of labor in the home and foreign countries, respectively. Capital movements take place by the home country’s borrowing B units of capital from the foreign country, so the capital per unit labor located in the home country is k + b, where b = B /L, while the capital per unit labor located in the foreign country is k * – b. If capital is freely mobile, the equilibrium per capita stock of foreign investment, b, is determined by equating the marginal products of capital in both countries — that is,

(A.1) f ′(k + b) = g ′ (k * – b) = r,

where f and g denote the per capita production functions in the home and foreign countries, respectively, and f ′ and g′ denote the derivatives or the marginal products of capital.

Let s and s * denote the constant saving rates in the home and foreign countries, and let n denote the rate of growth of the labor force in both countries. Per capita incomes are f (k + b) – rb in the home country and g (k * – b) + rb in the foreign country. According to the Solow growth model (Solow 1956), the countries will be in steady-state when savings equal required investment:

(A.2) s[f (k + b) – rb] – nk = 0,

and

(A.3) s *[g (k * – b) + r b ] + nk * = 0.

Solving equations A.1– A.3 yields steady-state values of k, k *, and b.2 Thus, in the long run, db /dt = 0.

In the short run, db /dt may be nonzero. Let us look at the short-run and long-run dynamics of the balance of payments as envisioned by Cairnes (1874). Since b = B /L, the rate of change in the per capita stock of foreign investment is

(A.4) db /dt = (dB /dt )/L – nb,

where n = (dL /dt )/L and (dB /dt )/L is the per capita inflow of capital to the home country from the foreign country. Equation A.3 may be used to describe the determinants of the per capita trade balance. By definition, the per capita trade surplus, x – m (exports minus imports), will be per capita foreign debt service, rb, where r is the rate of interest [r = f ′ (k + b) ] – per capita capital inflows. In other words,

(A.5) x – m = rb – (dB /dt )/L.

Combining equations A.4 and A.5 results in

(A.6) x – m = (r – n)b – db /dt.

This is our key equation. The home country’s per capita trade balance equals (r – n)b minus the change in its per capita net indebtedness. In the steady-state, db /dt = 0, the per capita trade sur- plus (x – m ) = (r – n)b. Assuming r > n, if the home country is a net debtor, b > 0, there will be a sur- plus. In contrast, if b < 0, the country will have a long-run deficit. Cairnes claimed that the net creditor’s long-run trade balance would be nega- tive, implying that r > n in the long run. Remark- ably, the condition that r > n is the condition for dynamic economic efficiency (Phelps 1966).

In the above model, the long-run growth rate is simply equal to the population growth rate. This follows because in the steady-state, b, k, and k * are constant; accordingly, per capita income remains constant. If we reinterpreted the model in terms of the effective labor supply and labor- augmenting technological progress, per capita income would increase by the rate of technological progress. Whatever interpretation is made, the model is then so constructed that both countries grow at exactly the same rate.

A key conclusion from this analysis is that in the long run, there should be no link between economic growth and the trade balance. The long- run trade balance is determined by the net creditor or debtor status of the country, while the long-run growth rate is determined by the growth rate of the population and technological progress.

1 This model is based on Ruffin (1979). 2 Ruffin (1979) demonstrates the conditions under which the above

model has a unique solution.