by William C. Dudley, Chair, Bretton Woods Committee; Former President, Federal Reserve Bank of New York 

Why does the U.S. have a large trade deficit?

The answer is not simple. While unfair foreign trade practices—countries subsidizing exports and imposing barriers to imports—have played a role, another important factor is the significant US shortfall of domestic savings relative to investment. By definition, a country’s current account balance (trade + net investment income + transfers) must equal its capital account balance (mainly the net change in the country’s financial assets held by foreigners). When a trade deficit inevitably leads to a current account deficit, then there has to be a corresponding capital account surplus—that is, dollars recycled back to the U.S. in the form of increased foreign holdings of US assets. In 2024, the US current account deficit was 3.9% of GDP.

The US saving shortfall that necessitates these large capital inflows is due mainly to two factors: the personal saving rate in the U.S. is low—currently around 4% of personal income—and the U.S. runs a large federal budget deficit—more than 6% of GDP.

How did this come about?

There are several factors at work. First, some foreign countries deliberately encouraged export-led economic growth by subsidizing investment in manufacturing and intervening to keep their currencies undervalued and, in turn, their exports cheaper. Many in the U.S. have criticized China as the example of this model. Second, as import penetration into the U.S. increased and the trade imbalance widened, this was a drag on US economic activity. Partly in response, the US federal government cut income taxes and increased federal spending to support growth. The US federal budget balance moved from a surplus in the late 1990s to a deficit of more than 6% of GDP today—the post-Covid deficit is unprecedented in peacetime. If US fiscal policy had been tighter, US interest rates and the value of the U.S. dollar would likely have been lower. All else equal, this would have made US exporters more competitive, and the trade deficit smaller. 

What were the negative consequences?

There has been sharp decline in US manufacturing employment. Although a reduction in manufacturing jobs is virtually inevitable because productivity growth in manufacturing is far higher than it is in services, trade has also played an important role. Many US manufacturing firms went bankrupt or shifted activity abroad, while foreign importers made significant inroads into US markets. Domestic industries such as textiles and furniture manufacturing have largely disappeared. This contributed to a loss of manufacturing jobs and the stagnation of real wages for lower and moderate-income households. The burden has fallen disproportionately on smaller towns and cities that were reliant on manufacturing. 

Further, the large current account deficit means that the U.S. has become more reliant on foreign investors to fund US investment and the budget deficit. Currently, about 30% of U.S. Treasury debt is owned by foreign investors.

What were the positive consequences?

Low-cost imports held down goods price inflation—this helped to boost living standards for those employed in areas largely insulated from the surge in low-cost imports. Despite a growing trade deficit, the US standard of living has continued to increase and US productivity growth has outpaced most other developed economies.

Is the large trade deficit sustainable?

As long as foreign investors view dollar-denominated assets as attractive to hold relative to other financial assets, the U.S. can continue to run a large trade deficit. The fact that the dollar is the reserve currency for the world helps sustain the demand for dollar-denominated assets. 

The U.S. dollar is attractive as a reserve currency for four reasons: the U.S. has a deep and liquid capital market, capital can move freely into and out of the U.S., the rule of law has been enforced in a consistent manner over time, and the Federal Reserve is viewed as trustworthy with respect to controlling US inflation and thereby maintaining the dollar’s store of value. 

Nevertheless, as the U.S. continues to run trade deficits and increases its dependence on foreign investors, there is a risk that collective investment preferences could shift away from dollar-denominated assets. In that case, the dollar would likely fall in value.  This would make foreign goods and services more expensive and US producers more competitive in foreign markets. At the same time, a decline in foreign investors’ appetite for US financial assets could also cause the dollar to weaken, pushing up longer-term interest rates.

How can one bring down the trade deficit?

Trade deficits can only narrow if the savings shortfall also shrinks. This can be facilitated by raising incentives for households to save more or, more directly, by cutting spending and/or raising taxes to shrink the US budget deficit. 

Can tariffs be used as a tool to reduce the trade imbalance?

It depends on the circumstances. Tariffs increase the cost of imported goods and services; this will reduce demand for them. Still, if the domestic savings shortfall remains unchanged, the trade deficit will not shrink. Instead, the dollar would likely appreciate in value. This would be the mechanism (along with foreign retaliation) that would make US exporters less competitive. Ultimately, as long as the US savings shortfall is unchanged, US exports would need to drop to match the decline in imports.

Tariffs make the most sense in three circumstances: 1) For national security purposes, as they can help ensure domestic supply of key materials such as rare earth metals; 2) To protect nascent industries from unfair foreign competition that might prevent them from achieving the economies of scale needed to become globally competitive; and 3) As a tool to negotiate the end of unfair foreign trade practices that discriminate against US producers. 

In contrast, broad-based tariffs are a blunter instrument that, by pushing up import prices and the domestic prices of those shielded by tariffs from foreign competition, fall mainly on the consumer. They also distort manufacturing by shifting production into areas shielded by tariffs from foreign competition away from areas where the U.S. is more competitive. Because higher tariffs on commodities and intermediate goods lead to higher input costs for domestic manufacturers, this can also undermine their competitiveness. Simply put, as an economic tool, broad-based tariffs are less effective than tariffs used selectively. Tariffs could be used as a negotiating tool to open up access to foreign markets. But this strategy would need the tariffs to be unwound once negotiations had been completed.  

Featured author: 

William C. Dudley, Chair, Bretton Woods Committee; Former President, Federal Reserve Bank of New York