The Budget Deficit and the Trade Deficit: What Is Their Relationship?

^Pr^ep^ar^{ed f}^o^r^M^e^m^b^ers^an^d^Com^mⁱ^t^t^ees^of^C^ong^r^e^ss

In the 1980s expansion, the trade deficit and budget deficit moved together. This pattern re-
emerged in the recession and subsequent expansion beginning in 2001. This is the opposite of
what happened in the last half of the 1990s, when the budget deficit fell as a fraction of gross
domestic product (GDP) and the trade deficit rose sharply as a fraction of GDP. From this
experience it is clear that international capital flows, which drive the net balance of trade, do not
depend solely on movements in the budget deficit. During the last half of the 1990s, real gross
domestic investment rose as a fraction of real GDP. This resulted from the rise in U.S.
productivity and the related rise in the real yield on U.S. assets. This drew in additional private
capital from abroad. If the twin deficits theory is correct, it has an adverse implication for the
efficacy of fiscal policy as a stimulus tool. It suggests that in an environment of highly mobile
international capital, the effect of policy induced increases in the structural budget deficit (e.g.,
tax cuts) on short-run economic growth would be largely offset by increases in the trade deficit.
The experience during both the 1980s and 1990s demonstrates that a large and growing trade
deficit need not be an impediment to overall job creation even though it may have had an effect
on the type of jobs that were created since it affected the composition of U.S. output. This report
will be updated periodically.

Introduc tion ............................................................................................................................... 5
The Mainstream Explanation for the Twin Deficits..................................................................5
The 2000s Experience.........................................................................................................6
The 1990s Experience—A Contradiction to Mainstream Theory?...........................................7
Conclusion ................................................................................................................................ 8
Table 1. The Two Deficits, 1981-1989............................................................................................6
Table 2. The Two Deficits, 1995-2005............................................................................................7
Table 3. Real Gross Domestic Investment as a Percentage of GDP................................................8
Author Contact Information............................................................................................................9

One of the most lively debates among economists and policymakers during the 1980s was the
relationship between the federal budget deficit and the international trade deficit. When the dust
settled those arguing that the two deficits should move together seemed to have carried the day,
although doubters remained. This prediction was based on mainstream macroeconomic theory. As
the 1990s unfolded, the two deficits did not move together. As the federal budget deficit came
down as a fraction of gross domestic product (GDP), the trade deficit rose as a fraction of GDP. Is
this evidence inconsistent with theory? The analysis will suggest that the answer is no. There are
other forces besides the federal budget deficit that can influence the U.S. trade deficit. They were
not decisive during the 1980s. They appear to have been operative during the 1990s. With the
onset of the recession in 2001 and subsequent move to expansion, the coincident shift back to
budget deficit, the two deficits began to move together again.
Mainstream macroeconomic theory explains the twin deficit phenomenon as follows. An increase
in the federal budget deficit (measured as an increase in the structural deficit as a percent of full
employment GDP) will—all else held constant both in the United States and abroad—put ¹
upward pressure on U.S. interest rates, raising them above comparable rates abroad. This occurs
because the position of the government’s budget influences the national saving rate. When the
structural budget deficit shrinks, the government adds to the national saving supplied by
households and businesses and interest rates fall. When the structural budget deficit grows, it
represents a claim on those savings, and interest rates must rise for the market to remain in
equilibrium. In a world in which U.S. assets are good substitutes for foreign assets, foreign ²
investors will be tempted to buy more of the now higher yielding American assets.
Before they can buy these assets, they must first purchase dollars. Thus, the net demand for
dollars in the foreign exchange market rises and the dollar increases in value and it is said to
appreciate. Dollar appreciation reduces the price of foreign goods and services in America and
increases the price of American goods and services abroad. The net result is that Americans spend
more on foreign goods and services (the value of American imports rise) and foreigners spend
less on American goods and services (the value of U.S. exports fall). If the trade accounts were in ³
balance to begin with, the United States now has a trade deficit. And, indeed, the data during the ⁴
1980s, shown on Table 1, conform to what the theory predicts. The full employment or structural
deficit rose from 0.6% of full employment GDP in 1981 to an expansion high of 4.8% in 1986, a

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rise of 4.2 percentage points. The trade balance rose over this period from a surplus of 0.2% of
GDP to a deficit of 2.5% of GDP, a rise of 2.7 percentage points (thus, the rise in the trade deficit ⁵
was about 59% of the rise in the structural budget deficit).
Table 1. The Two Deficits, 1981-1989
^{(as a per}^{centage of}^GD^P)
¹⁹⁸^{1 198}^{2 198}^{3 198}⁴¹⁹⁸^{5 198}⁶¹⁹⁸^{7 198}^{8 198}⁹
^Budget^Deficit^{-0.6 -1.3}^{-3.0 -3.6}^{-4.3 -4.7}^{-3.3 -2.5 -2.2}
^Trade^Deficit^0.2^-0.2^{-1.1 -2.1}^{-2.3 -2.5}^{-2.3 -1.6 -1.1}
^Sources:^Struct^{ural Budget Defi}^{cit data are from the}^{Congressional Budget Office (Ja}^nuar^{y 2}⁰⁰^{8). Trade deficit}
^{and GDP data are in c}^{hained 2}⁰⁰⁰^{dollars from the Depa}^rtment^{of Commerce.}
^Note:^{Budget deficits are for the}^{fiscal year.}
Further, as the structural budget deficit fell from 4.7% of GDP in 1986 to 2.2% in 1989, the last
full year of the 1982-1990 economic expansion, a fall of 2.5 percentage points, the trade deficit
fell from 2.5%, of GDP to 1.1% of GDP, a fall of 1.4 percentage points (or about 56% of the ⁶
decline in the structural budget deficit).
As seen in Table 2, events subsequent to the recession in 2001 have mirrored the 1980s
experience: as the budget deficit rose, the trade deficit rose. This occurred despite a major easing
in monetary policy by the Federal Reserve which should have discouraged foreign capital from
coming to the United States. However, unlike the 1980s, in this episode, the growth of the trade
deficit is coincident with a fall in the international exchange value of the dollar which should
signal a net decrease in the inflow of foreign capital. And, indeed, during 2002-2004 the inflow of
private capital did abate. The trade deficit did not fall because the decrease in the inflow of
private capital was offset by the inflow of official capital (from foreign central banks and ⁷
treasuries).
If the twin deficits theory is correct, it has an adverse implication for the efficacy of fiscal policy
as a stimulus tool. In the mainstream model, policy induced increases in the structural budget
deficit (through tax cuts or increases in government spending) boost aggregate spending by
generating more government spending than the government’s revenue intake. This outcome is
predicated on the absence of foreign capital mobility. But if foreign capital flows are highly
sensitive to changes in interest rates, then any increase in aggregate spending caused by the larger
budget deficit would be largely offset by an increase in the trade deficit caused by the upward
pressure placed on interest rates by the budget deficit. In other words, tax cuts or increases in
government spending would not have much effect on the short-run growth in output and
employment under this view.

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Before looking at developments during the late 1990s, it should be noted that mainstream
macroeconomic theory has never excluded an independent causal role for international capital
movements. That is, international capital movements can occur independent of any change in the
federal budget deficit. Foreign capital may come to the Untied States for a variety of
circumstances unrelated to the pressures the federal budget deficit puts on U.S. interest rates. A
change in U.S. tax law which increases the after tax rate of return on capital could attract foreign
funds even if it had no effect on the federal budget deficit. Rising prospects for profit because of
boom conditions in the U.S. economy or an increase in productivity could increase domestic
investment relative to GDP, and could attract foreign capital even as the federal budget moves
toward balance or into surplus. Similarly, fears of inflation, currency devaluation, or political
repression could induce foreigners to seek the safety of U.S. assets. Moreover, if a falling federal
deficit in the United States occurs with the onset of an economic downturn abroad such that
yields on foreign assets fall relative to comparable U.S. yields, the emerging differential in favor
of the United States could serve as a magnet attracting additional capital that could forestall a fall
in the trade deficit or lead to a rise in that deficit. In this instance, it would be possible to have a ⁸
falling budget deficit and a rising trade deficit. Other possibilities also suggest themselves.
The data on Table 2 show a very different pattern in the last half of the 1990s from the twin
deficits of the 1980s. As the structural budget deficit fell from 2.0% of GDP in 1995 to a surplus
of 1.1% of GDP in 2000 (a shift of 3.1 percentage points), the last full year of the 1991-2001
expansion, the trade deficit rose over the same period from 0.9% to 3.9% of GDP (a shift of 3 ⁹
percentage points).
Table 2. The Two Deficits, 1995-2007
^{(as a per}^{centage of}^GD^P)
¹⁹⁹^{5 199}^{6 199}⁷¹⁹⁹^{8 199}^{9 200}⁰²⁰⁰^{1 200}^{2 200}³²⁰⁰^{4 200}^{5 200}⁶²⁰⁰⁷
^Budget^{-2.0 -1.2 -1.0}^-0.4^+0.0^+1.1^+1.0^{-1.2 -2.6}^{-2.5 -1.9 -1.8}^-1.1
^Deficit
^Trade^{-0.9 -1.0 -1.2}^{-2.2 -3.1 -3.9}^{-4.0 -4.7 -5.0}^{-5.6 -5.6 -5.5}^-4.7
^Deficit
^Source:^Struct^{ural Budget Deficit data are from t}^{he Congres}^{sional Budget Office (Jan}^uary²⁰^{08). Trade deficit}
^{and GDP data are in c}^{hained 2}⁰⁰⁰^{dollars from the Depa}^rtment^{of Commerce.}
^Note:^{Budget deficits are for the}^{fiscal year.}
These data show clearly that changes in the magnitude and direction of the net inflow of foreign
capital can occur independently of changes in the federal budget deficit. The data in themselves
do not explain why these movements occur, however. Yet, there are some interesting clues in the

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data on domestic investment that suggest at least a proximate explanation for why the two deficits
have not moved in the same direction in the 1990s.
The data in Table 3 report real gross domestic investment as a fraction of real GDP during the
years 1983-1989 (the expansion of the 1980s) and 1995-2007. There is a noticeable difference
between these two expansions. Unlike 1983-1989, real gross domestic investment during the
1990s expansion was a rapidly rising fraction of GDP. The increase was especially strong in the
period 1995-2000.
The increase in desired investment, motivated by the increase in productivity and the related rise
in the real rate of return on American capital in the last half of the 1990s, served as a magnet for
attracting foreign capital to the United States. And this increased inflow of foreign capital
(saving) made possible the additional investment in the United States.
Table 3. Real Gross Domestic Investment as a Percentage of GDP
¹⁹⁸³^12.2¹⁹⁹⁴^14.0²⁰⁰¹^16.2
¹⁹⁸⁴^14.8¹⁹⁹⁵^14.1²⁰⁰²^15.5
¹⁹⁸⁵^14.0¹⁹⁹⁶^14.8²⁰⁰³^15.7
¹⁹⁸⁶^13.5¹⁹⁹⁷^15.9²⁰⁰⁴^16.6
¹⁹⁸⁷^13.4¹⁹⁹⁸^16.8²⁰⁰⁵^17.0
¹⁹⁸⁸^13.2¹⁹⁹⁹^17.3²⁰⁰⁶^16.9
¹⁹⁸⁹^13.3²⁰⁰⁰^17.7²⁰⁰⁷^15.7
^Source:^Depar^{tment of Comm}^erce.
Upward pressure on U.S. interest rates was the proximate cause of the inflow of capital, and
resulting trade deficit, in both the 1980s and late 1990s. The difference between the two periods
was what caused the pressure on interest rates. In the 1980s, the upward pressure came from the
rise in the structural budget deficit. In the 1990s, it came from the increased productivity and
related rise in the profitability of private investment.
An interesting aspect of both historical periods is that policymakers in the United States have
managed to bring the U.S. economy to full employment with large and even growing trade
deficits. These trade deficits have not hampered the overall creation of jobs. They have, however,
influenced the nature of job creation since they alter the composition of U.S. output, away from
export and import-competing industries toward industries the demand for whose output is
sensitive to interest rates.
During the 1980s, a lively debate occurred, the outcome of which was a convincing case linking
the growth in the structural measure of the federal budget deficit with the growth of the trade
deficit (with cause and effect running from budget deficit to trade deficit via interest rates and
dollar appreciation). Lost in the “small print” of this debate was that the budget deficit is not the
exclusive determinant of net capital flows and trade deficits. International capital flows into and
out of the United States can move in directions contrary to the movements in the position of the
federal budget. They depend not only on economic conditions in the United States, but on similar
conditions and decisions made abroad.

During the 1990s, the U.S. trade deficit did not moved in concert with the structural (or even the
actual) measure of the federal budget deficit (both absolutely and as a fraction of GDP).
Beginning in 1995, real gross domestic investment rose as a fraction of real GDP reflecting the
increase in productivity and related increase in the real rate of return on American capital. This
increase served to attract private capital to the United States. Thus, the trade deficit rose even as
the budget deficit fell.
During the recovery that began in the fourth quarter of 2001 and the subsequent expansion, a
rising structural budget deficit and the recovery of private investment spending once again
attracted foreign capital to the United States, although in this episode the proportion of the inflow
coming from foreign official sources (central banks and treasuries) has been especially important
during 2002-2004 and 2006-2007.
If the twin deficits theory is correct, it has an adverse implication for the efficacy of fiscal policy
as a stimulus tool. It suggests that when international capital flows are highly mobile, the effect of
policy induced increases in the structural budget deficit (through tax cuts or increases in
government spending) on short-run output growth and employment would be largely offset by
increases in the trade deficit.
^{Marc L}^a^bon^t^e ^G^aⁱ^l^E^.^M^a^ki^neⁿ
^Specialis^{t i}ⁿ^Macroecon^o^mⁱ^c^P^o^licy
^m^l^abon^t^e^@^c^rs^.l^oc.g^o^v^{, 7-}⁰⁶⁴⁰