How Budget Deficits Grow Due to Trade Deficits

There is always plentiful discussion of the U.S. federal budget deficit from politicians, economists, pundits, newspaper commentators and others. One driver of our budget deficit that is rarely mentioned is it is in large part a consumer stimulus to offset our persistent trade deficit which reduces growth. Stated another way, excessive imports siphon demand for goods and services away from American producers and drive the government to run a budget deficit to cover that gap.

Since the year 2000, our trade deficit has continued at around 3% of gross domestic product (GDP). That’s 3% of national spending that is going not on American goods and services but on foreign goods and services instead. This shortfall in demand in the U.S. produces a recession-like effect because it means that the dollars earned by Americans are not being re-spent into the U.S. economy to employ people here but instead go to foreign producers. The economic forecasts generated by the government and private sector economists even incorporate this demand shortfall into their models and forecasts for the U.S. economy. There are several ways to counteract this shortfall but the most commonly used tactic is for the government to run a federal budget deficit. If the government spends more money than it takes in, that will make up for some or all of the shortfall caused by an adverse trade balance. 

Let’s look at the basic economics of our national income accounts. The trade deficit is a subtraction from national GDP figures. As anyone who took undergraduate economics should recall, GDP, usually represented by Y, is defined this way:

Y=C+I+G+X-M

In this equation, C is consumption, I is investment, G is government consumption of goods and services, X is exports of goods and services and M is imports of goods and services. The expression (X-M) is the trade deficit. A larger trade deficit reduces GDP. This is not just a mathematical equation but represents real impact on the wellbeing of our economy. 

If trade is in surplus, then aggregate income or what economists call aggregate demand is greater than total production capacity or aggregate supply, leading industry to expand and hire more workers. But with a persistent trade deficit, aggregate demand is less than aggregate supply, which would lead industry to reduce capacity, unless other countervailing forces enter the picture. Reducing capacity means reducing growth and employment. Running a federal budget deficit is the most obvious way to increase spending. It’s not the only way. For example, the government could cut interest rates to juice demand for items bought on credit like houses or cars. But the impact of government budget deficits is more certain and predictable than trying to raise consumer or business spending through tools like interest rates.

All the components of GDP move over time, subject to many influences such as consumer confidence, competitive pressure, and shocks from unexpected events like (for example) a pandemic or a sudden rise in oil prices. It’s the responsibility of the Federal Reserve Board and the administration to try to moderate recessions or excessive booms, so the economy can stay on a relatively stable course. Since the end of World War II, elected officials from either political party have used fiscal and monetary policies to try to keep the economy growing steadily and particularly to minimize or avoid recessions. They don’t always work and politicians and economists may have different opinions about how and when to use the tools, but they all try. 

The persistent large trade deficit means that aggregate demand repeatedly falls below aggregate supply. The government injects demand or spending power into the economy via a budget deficit to make up for the loss of demand due to the trade deficit. The government need not spend money directly in the industries suffering from import competition. Any deficit spending by the government serves to pump up U.S. spending and helps to create revenue and jobs inside the U.S.

We can see this clearly in the events surrounding the recession of 2001, which was when the trade deficit had its biggest jump in percentage terms. 

In the year 2000, the U.S. trade deficit rose by a full percentage point, from 2.7% to 3.7% of GDP. The 2000 trade deficit of $381 billion reflected an 18% jump in imports to a record $1.48 trillion. The loss of sales by domestic producers to imports was a major factor in a downturn in manufacturing production. In January 2001, Federal Reserve chairman Alan Greenspan gave a series of briefings to Congress and to the press in which he said that the federal budget surplus was too high. It was not yet clear that 2001 would be a recession year, but there were worrying signs on the horizon. “Should current economic weakness spread beyond what now appears likely, having a tax cut in place may, in fact, do noticeable good,” he told the Senate Budget Committee (1). By a tax cut, Greenspan meant that the administration should turn the then-existing federal budget surplus into a deficit, boosting demand.

Greenspan’s words helped newly-elected President Bush win congressional support for the tax cuts he had discussed in the election campaign. With the broad-based tax cut package of 2001, the record federal budget surplus of $153 billion in 2000 vanished in 2001 and by 2002, the budget recorded a $311 billion deficit. 

In 2002, recession was confirmed as a reality for the previous year. Using the intentionally vague language beloved by Federal Reserve officials, and never once mentioning the R-word (for recession), Greenspan made it clear that global conditions, i.e. the trade deficit, was an important factor in the 2001 recession.  In January of 2002, Greenspan told the same committee: “a striking feature of the current cyclical episode relative to many earlier ones has been the virtual absence of pricing power across much of American business, as increasing globalization and deregulation have enhanced competition.” (2)

Greenspan advocated for budget deficits as well as lower interest rates to counteract the forces of recession.

The federal budget deficit has persisted every year since 2001, reaching an all-time high of $3.1 trillion in 2020 and its third-largest level ever of $1.7 trillion (6.3% of GDP) last year. Figure 1 groups our national economic accounts by decades. In the 1960s, the U.S. ran a small trade surplus and the federal budget was close to balance. In the 1970s, our trade moved into deficit and the federal government began to run larger budget deficits. The budget deficits reflected the shortfall in demand due to the trade deficit as well as the need to fight the two recessions of the 1970s. The same pattern continued in the 1980s through to today. In the four years of this decade so far, the U.S. has run virtually a wartime-level budget deficit, reflecting the Biden administration’s desire to fight the COVID-related downturn and the subtraction of the trade deficit from domestic demand. 

If the trade deficit were to shrink, the government would find it easier to reduce the budget deficit. That’s because a declining trade deficit would mean more spending going to U.S. producers of manufactured goods, services, and agricultural products, generating more domestic demand and making it easier to maintain full employment.