“With all the negativism about the U.S. economy, it's easy to forget its attractiveness. Foreigners are as eager to invest in the U.S. as we are to buy goods and services from them -- it's a two-way street.”

-David Malpass, “Embrace the Deficit” Wall Street Journal, December 21, 2006

There isn't much that excites most economists, but mention the trade deficit and you might start an economic riot. Well, perhaps not a riot - most economists are civilized after all - yet, the thought of continually importing more than exporting will ignite an intense debate, sending many into preaching about America's looming economic downfall. To all the pessimists out there, a contrarian would point out that the economy is still booming even though last year recorded a record high trade deficit of $716 billion. They suggest that the pessimists have it wrong and that the large trade imbalance is simply an indication of our thriving economy. We agree with this pro-growth view, with one major caveat. It cannot last forever.

For the past three decades Americans have been in the mood to indulge. They have consumed everything in their massive economy along with billions of dollars worth of imports, resulting in record trade deficits. David Malpass puts forth that “though widely criticized as an imbalance, the trade deficit and related capital inflow reflect US growth, not weakness.” It reflects growth because the business resulting from foreign trade leads to dollars being reinvested into our attractive economy by foreign entities. Lately, these investments have been parked in corporate bonds or US treasuries, increasing foreign ownership of both corporate and US debt.

This is precisely what sends adversaries of the deficit into a rage. Supporters advocate this increase is not as detrimental as opponents suggest. Malpass counters, "rather than paying the debt back, the growing company rolls the debt over and adds more, just as the US has been doing throughout most of its prosperous history. Part of each additional bond offering puts the company and the US in the position of investing more than we save, drawing in foreign investment and contributing to the trade deficit." Thus, the cycle of economic success continues forever into the future, right? Wrong!

The trade deficit is not the cause of a successful economy, but instead is an outcome of a successful economy. As an economy evolves and prospers, consumer spending will increase and eventually domestic supply will no longer satisfy consumer demand. Consequently, imports are required to meet the increase in consumer demand, thus, a trade deficit. Of late, the deficit has led to an increase in foreign investment helping to fuel the economy while simultaneously increasing foreign owned debt. Though there is nothing inherently wrong with this cycle, it is not sustainable.

Currently, the US economy is driven by the Baby Boomers, a generation living through their peak spending years. As the Baby Boomers age in the near future, transitioning to the life stage of lowest spending and highest savings, consumer spending will drop dramatically. The result will be a decrease in consumer demand, thus, a decrease in the demand for imports and a smaller deficit.

The Other Side of the Coin

If the trade deficit is to be reversed, then should we look forward to a trade surplus? Let’s take a look at China and Japan. Both run a trade surplus, yet the two have two vastly different economies. China's economy is currently profiting from its surplus. Japan in contrast, has been running a surplus for years, yet has watched its economy stagnate due to an aging society. Additionally, in spite of Japan’s trade surplus, Japan's public debt is currently absurdly high at 176% of GDP. It appears running a trade surplus is not the key to success in an economy either.

In the debate on the trade deficit, both sides miss a critical point. The deficit is not so much a cause as it is an effect. The “cause” is predictable consumer demand that is at an all time high due to the baby boomers. Unfortunately, this trend will not last forever. Consumer demand will wane with the cresting of the Spending Wave, thus cutting American demand for all products, both domestic and import. The end result should be a gradual shrinking of the trade deficit and a gradual depreciation in the dollar. Therefore neither a trade deficit nor a trade surplus is an indication of an impending financial disaster, but at the same time it is also not a ringing endorsement of long-term growth prospects.

WSJ "Embrace the Deficit"