February 2012, Dean Baker

Debates over economic policy tend to be enormously confused. It is often the case that even high-level officials and well-known economists seem ignorant of basic accounting identities. This leads them to make claims that literally do not add up. This seems to be especially common in the case of debates on trade policy. This paper is intended to clarify some of the key issues.

The first part is a simple accounting exercise showing that a large trade deficit implies that a country must either have a large budget deficit, negative private savings, or some combination of the two. Since both large budget deficits and negative private savings are generally viewed as undesirable, this means that a lower trade deficit should be a top policy priority. Furthermore, as a practical matter, a lower-valued dollar is the only plausible mechanism for getting the trade deficit closer to balanced.

The second section shows the implications of a lower trade deficit for the economy in terms of the sectors that will expand. While some analysts have implied that in the future the United States will no longer be engaged in manufacturing, this is not a plausible economic scenario. If the United States will continue to consume manufactured goods then it will have to produce the bulk of these goods itself. There is no sector of the economy where exports can reasonably be expected to expand enough to pay for the country's consumption of manufactured goods.

The final section discusses mechanisms for lowering the value of the dollar. In public debates, the value of the dollar is often treated as being beyond the control of the U.S. government. This is not true. The government certainly has the ability to influence the value of the dollar; however it may be necessary to sacrifice other policy goals to achieve a desired exchange rate for the dollar.

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