United States Suffers Its First Trade Deficit Since 1888 Summary

  • Last updated on November 10, 2022

In 1971, the United States suffered its first trade deficit since 1888, importing more than it exported. It would become a net debtor nation by the end of 1987.

Summary of Event

In 1971, the United States suffered its first balance-of-trade deficit since 1888, importing $2.26 billion more in goods and services than it exported. The United States recorded a surplus on its trade account in only two of the following fourteen years. In 1973 and 1975, the United States exported $911 million and $8.9 billion more, respectively, than it imported. Between 1980 and 1987, the U.S. trade deficit virtually exploded, growing at a compound annual rate of 29.7 percent, from $25.5 billion in 1980 to $159.5 billion in 1987, the year in which the United States became a net debtor nation, owing more to the rest of the world as a whole than it was owed. Trade deficits, U.S. Balance of trade, U.S. [kw]United States Suffers Its First Trade Deficit Since 1888 (1971) [kw]Trade Deficit Since 1888, United States Suffers Its First (1971) Trade deficits, U.S. Balance of trade, U.S. [g]North America;1971: United States Suffers Its First Trade Deficit Since 1888[00120] [g]United States;1971: United States Suffers Its First Trade Deficit Since 1888[00120] [c]Trade and commerce;1971: United States Suffers Its First Trade Deficit Since 1888[00120] [c]Economics;1971: United States Suffers Its First Trade Deficit Since 1888[00120] Nixon, Richard M. [p]Nixon, Richard M.;trade deficits Reagan, Ronald [p]Reagan, Ronald;tax cuts

To understand the causes and significance of these developments and events, it is necessary to understand the rudimentary elements of balance-of-payments accounting and theory. The balance of trade is a part of the overall balance of payments. The balance of payments is a bookkeeping system that records all transactions between nations, including the flows of physical goods and services as well as the financial flows between nations. As a flow concept, the balance of payments must have a time dimension. In general, balance-of-payments statements are reported on an annual or quarterly basis. They can be reported in terms of the country in question versus the rest of the world or versus a particular region or a particular country. For example, the U.S. Department of Commerce reports the balance of payments for the United States in its Survey of Current Business on a quarterly and annual basis. The U.S. balance of payments is reported relative to the rest of the world and relative to various regions and countries.

A nation cannot simply import more than it exports. It must pay for any excess of imports over exports in one of several ways. It can use up foreign assets that were the result of past investments, spend foreign currency reserve balances or gold reserves it had accumulated in the past, or borrow. A relatively small percentage of imported goods takes the form of gifts or aid from one country to another; these imports do not have to be paid for.

Concern about trade deficits centers on the fact that they cannot continue indefinitely. Eventually, reserves of foreign currency and assets will be used up, and other countries eventually will become resistant to lending to trading partners that, because of persistent trade deficits, show little evidence of being able to earn the foreign currency to pay back loans through selling goods and services on the international market. Persistent trade deficits may indicate the need for a reduction in living standards in the deficit country. In simple terms, a trade deficit indicates that a country is consuming and investing more than it produces. Reducing the trade deficit could require reducing consumption of goods and services, thus lowering the standard of living.

The above information about the balance of payments should aid in understanding the history of the balance of trade in the United States. In 1960, the United States had a surplus on its balance of trade of $4.9 billion. The value of U.S. exports in that year was one-third higher than the value of its imports. By 1964, the surplus on the U.S. balance of trade had peaked at $6.8 billion. Exports in that year were 37 percent greater than imports.

In 1960, imports and exports were only 2.9 percent and 4.0 percent of the gross national product of the United States, or total value of all goods and services produced in the country that year. U.S. imports and exports were 11 percent and 16 percent, respectively, of world trade, making the United States an important part of the international marketplace.

This asymmetric position—the United States was important to the world economy, but the converse was not true—allowed the United States, the largest trading nation in the world, to operate as though it were a “closed economy” for purposes of domestic macroeconomic policy. A closed economy is one that is closed off from international markets. Because foreign trade was so small relative to the level of U.S. production, policy makers could ignore the effects of international transactions on the U.S. economy when analyzing proposed policies.

In 1964, there was little evidence to indicate that in just seven years the United States would suffer its first deficit in eighty-three years in its balance of trade. The balance-of-payments problem of the moment was a capital outflow from the United States. The subsidiaries of U.S. multinational corporations, foreign corporations, international agencies, and foreign governments were using the U.S. capital markets to raise funds to finance foreign projects. Dollars were flowing out of the United States, and the rest of the world was becoming more indebted to the United States. From 1964 to 1971, U.S. imports grew at a compound annual rate of 13.3 percent, while its exports grew at only a rate of 8.3 percent. In 1971, the United States suffered a $2.6 billion deficit in its balance of trade, the first such deficit since 1888.

The reversal in trading position of the United States can be traced to at least one cause. In the late 1960’s, the international competitive position of the United States deteriorated as the country’s domestic inflation rate, the rate of increase of prices, accelerated. Americans were willing and able to pay higher prices for American goods. Because foreign prices as a whole did not rise as rapidly as did American prices, goods produced in the United States became relatively more expensive. This caused potential foreign buyers to shun American goods, reducing U.S. exports. At the same time, foreign goods appeared increasingly attractive to American buyers because of their relatively lower prices. Imports therefore increased. A combination of falling exports and rising imports led naturally to a balance-of-trade deficit. The trade deficit thus can be traced to the relatively high inflation rate in the United States.

Significance

The worsening balance-of-trade position of the United States led to worldwide concern. In May of 1971, a wave of speculation began that the deutsche mark was going to be allowed to increase in value relative to the dollar. Confidence in the dollar waned, and by early summer the fundamental weakness in the U.S. balance of payments became apparent. A widespread belief developed that even though the United States suffered from a high rate of unemployment and sluggish growth, inflation was not being brought under control. Normally, policy makers perceive inflation as a cure for unemployment and vice versa; the problems are not supposed to coexist. Confidence in the dollar ebbed further. On August 15, 1971, President Richard M. Nixon announced his Economic Stabilization Program. Economic Stabilization Program The United States would suspend the privilege of converting U.S. dollars into gold as well as imposing a 10 percent tax on imports. Major world currencies at the time were all convertible into gold at fixed prices; suspension of convertibility meant that the United States recognized that the dollar had fallen in value relative to gold and relative to other currencies. Suspension of convertibility lowered the desirability of the dollar. Foreign countries would not be as willing to take dollars in exchange for goods knowing that dollars could no longer be traded for gold on demand. This effect, combined with the tax on imports, was intended in part to lower the trade deficit.

The dollar was the world’s principal reserve currency at the time, meaning that it was the primary currency used in international exchanges and in settling debts. The exchange rates, or values, of most of the world’s currencies were defined in terms of the U.S. dollar as part of the Bretton Woods system, Bretton Woods system under which countries had agreed to maintain the values of their currencies within narrow bands. It was clear that the dollar had become overvalued relative to most major currencies, with the agreed-upon fixed rates of exchange making the dollar appear more valuable than it in fact was. The questions were how much the dollar’s value had to fall and how the fall could be achieved. Two alternatives were to allow the dollar to find its own value in the world market, thus eliminating fixed exchange rates, or to negotiate a new set of fixed exchange rates.

The latter alternative was chosen. The Smithsonian Conference was convened in Washington, D.C., in December of 1971 in an attempt to save the Bretton Woods system of fixed exchange rates. Representatives of the ten largest industrial nations in the Western world reached an agreement, known as the Smithsonian Agreement, Smithsonian Agreement (1971) to devalue the U.S. dollar by 8.57 percent, which was accomplished by raising the official price of gold from $35 to $38 per ounce. The Smithsonian Agreement, moreover, allowed currency values to fluctuate 2.25 percent above and below the fixed rates, allowing some flexibility before the rates would need adjustment. After signing the agreement, Nixon announced the removal of the 10 percent surcharge on imports.

In June of 1972, the new regime of exchange rates established only six months earlier began to collapse. By the second quarter of 1973, the world’s major currencies were “floating.” Rather than being fixed in terms of relative values, the world’s major currencies traded for each other at rates determined by daily market transactions in the international market for foreign exchange. The Bretton Woods system, which had been dying a slow, agonizing death, finally collapsed.

The early 1980’s witnessed the United States moving very rapidly from being the world’s largest net creditor nation to being the world’s largest net debtor nation. At the end of 1980, the United States was a net creditor to the rest of the world in the amount of $393 billion. By 1987, the United States had become a net debtor; this debt was incurred to pay for excesses of imports over exports.

The twin deficits theory Twin deficits theory argues that the tax cuts of the early 1980’s, promoted by President Ronald Reagan, were not followed by spending cuts of equal magnitude. The U.S. government therefore ran huge fiscal deficits and had to borrow to finance its spending. The increased demand for funds by the U.S. government put upward pressure on interest rates, attracting foreign investors in search of higher interest rates. The inflow of capital into the United States and the increased demand for U.S. dollars resulted in an increased value of the dollar as measured against the major currencies of the world. The high value of the U.S. dollar made U.S. exports expensive to the world and made imports cheaper to Americans. A product with a given dollar price becomes more expensive to a foreign buyer as the value of the dollar increases relative to other currencies. This change in the prices of American goods relative to prices in the rest of the world continued the tendency for the U.S. trade deficit to increase.

The U.S. dollar rose in value throughout the early 1980’s, and imports grew at astounding rates. The United States ran ever-larger trade deficits, and the value of the dollar kept rising, contrary to accepted theory, which predicts that a country running a trade deficit will find the value of its currency declining. As other countries accumulate a currency, the theory predicts, they will find it less attractive to accumulate even more and will be less willing to take it in trade for goods. That currency therefore should fall in value, rather than rise in value as the U.S. dollar did. Government borrowing apparently offset the effects on the dollar that resulted from trade deficits.

The trade deficit of 1971 thus signaled the beginning of a variety of problems in the U.S. economy. Policy makers faced increasingly unpleasant choices in overcoming trade deficits, debt to foreign countries, government budget deficits, inflation, unemployment, and slow economic growth. The multitude of goals and problems meant that some would have to be ignored. Trade deficits, U.S. Balance of trade, U.S.

Further Reading
  • citation-type="booksimple"

    xlink:type="simple">Duncan, Richard. The Dollar Crisis: Causes, Consequences, Cures. 2003. Rev. ed. Washington, D.C.: Institute for International Economics, 2005. Argues that trade imbalances, particularly in the United States, have resulted in excessive credit creation and have destabalized the global economy.
  • citation-type="booksimple"

    xlink:type="simple">Federal Reserve Bank of Atlanta. “Atlanta Fed Research Points to Validity of Twin Deficits Notion.” Economics Update 4 (July-September, 1991): 6-7, 10. Presents arguments for the twin deficits theory, reviews previous research, and presents a review of the Atlanta Fed’s research on this topic.
  • citation-type="booksimple"

    xlink:type="simple">Howard, David H. “Implications of the U.S. Current Account Deficit.” Journal of Economic Perspectives 3 (Fall, 1989): 153-165. Reviews some of the contemporary empirical literature, concluding that the trade deficit was caused by an insufficiency of domestic savings. Concludes that the United States went from the position of a large net creditor to one of a large net debtor. The Feldstein Horioka Puzzle, the high correlation of saving and investment across countries, is discussed. Concludes that evidence indicates that capital is not very mobile internationally.
  • citation-type="booksimple"

    xlink:type="simple">Mann, Catherine L. Is the U.S. Trade Deficit Sustainable? Washington, D.C.: Institute for International Economics, 1999. Addresses questions about external balance (such as “Why has the external deficit continued to worsen even as the budget deficit became a surplus?”), answering each question chapter by chapter. Includes data tables to support the analysis.
  • citation-type="booksimple"

    xlink:type="simple">Scholl, Russell B., Raymond J. Mataloni, Jr., and Steve D. Bezirgaian. “The International Investment Position of the United States in 1991.” Survey of Current Business 72 (June, 1992): 46-59. Discusses the difficulties in determining the net international investment position of the United States, concluding that the country became a net debtor in 1987, rather than in 1985 as reported earlier.
  • citation-type="booksimple"

    xlink:type="simple">Solomon, Robert. The International Monetary System, 1945-1981. New York: Harper & Row, 1982. This book is excellent, well written, and easy to understand. Solomon spent many years at the Federal Reserve system. His perspective, as both a participant in and an objective observer of developments in the international monetary system, is unique.
  • citation-type="booksimple"

    xlink:type="simple">Yeager, Leland B. International Monetary Relations: Theory, History, and Policy. 2d ed. New York: Harper & Row, 1976. An excellent source for anyone interested in international finance. Contains a wealth of information.

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