Reducing the U.S. Deficit by Recycling Capital Inflows

Abstract

The United States has been running large and persis tent trade deficits with other economies, especially emerging markets such as China, for decades. Per sistent trade imbalances imply that the United States has been consuming more than it produces or, equivalently, saving less than it invests. This means that the United States has been borrowing heavily from foreigners (especially China) to finance its domestic investment. Critics say that to rebalance its current account the United States needs to either increase its saving rate or lower its investment rate. Both approaches are painful for the U.S. economy and will lead to lower aggregate demand and hence slower economic recovery. However, the very nature of the trade deficit itself offers a solution. A trade deficit in a country’s current account is the same thing as a surplus in its capital account. For example, China’s trade surplus with the United States must be balanced by its investment in U.S. assets (or by holding dollars as foreign reserves). This accounting identity suggests a solution for resolving the U.S.-China trade imbalance prob lem without lowering U.S. aggregate demand.