Problems with Trade Deficits

The U.S. is currently experiencing “twin deficits” -- we are running a federal deficit which is causing our trade deficit to increase.  The federal deficit is causing the interest rate to rise, which encourages foreign investors to put their money into U.S. banks.  For example, if the interest rate in Japan is 2% and it is 4% in the U.S. an investor would prefer to place their money in a U.S. bank versus a Japanese bank because of the promise of a higher return on their investment.  A boost in the demand for dollars causes the value of the dollar to increase.

 In turn, with the dollar being valued higher than other currencies, American goods become more expensive abroad, and foreign goods become cheaper in the States. Therefore, Americans realizing that their dollars buy large amounts of foreign goods, purchase more imports.  Conversely, American producers suffer because their goods then appear more expensive. 

 According to the CIA World Factbook, the trade deficit for 2005 was estimated to be $829.1 billion.¹⁵ This creates a plethora of problems for the U.S. economy, among others, increased economic dependency on foreign nations, which could destabilize the economy.

 With so many dollars held abroad, the U.S. runs the risk of foreigners selling all of their US dollars to buy other currencies. If foreigners think the U.S. economy is no longer a good place to invest, they will invest their money in another country. Also, if they lose confidence in the American market foreign investors would flood the markets with their U.S. stocks and bonds. Foreign investors may feel that the value of the U.S. dollar will eventually fall and therefore desire to sell their stocks and bonds, denominated in U.S. dollars, before they depreciate.   Depending upon the quantity, such actions could undoubtedly lead to a domestic recession.

As the value of the U.S. dollar falls relative to foreign currencies, the price of imports in U.S. dollars increases.  For example if the value of the dollar falls by 20%, the price of oil will also rise by 20%.  This inflation will cause interest rates to rise. Therefore borrowing money becomes more expensive so businesses expand at a slower rate, hence creating fewer jobs. A historical example of this was the capital flight in Mexico during the 1990’s, also known as the “Tequila Crisis.”

 Finally, our demand for foreign goods has also led to many nations, namely China, setting their currency artificially low in comparison to the dollar. In doing so, China is able to increase demand for its goods in American markets, and thus capable of exporting far more goods to the United States. A number of other nations participate in the same sort of currency manipulation in order to increase demand for their goods and keep their economies afloat [see co-dependency].¹⁶