Policy Note 2000/1 Explaining the U.S. Trade Deficit Anwar M. Shaikh Conventional theory makes the curious assumption that, in international trade, movements in the real exchange rate negate cost differences so as to make all countries equally competitive. But quite the contrary, it is absolute cost advantages that determine competition between countries, just as they determine the relative price of two sets of goods within one country. The recent rise in the absolute level of the U.S. trade deficit has generated much worry. However, it is important to note that as a percentage of GDP, the current trade balance, at about 2.5 percent of GDP, is about the same as it was in the late 1980s (Figure 1). That fact may allay some fears, but, in any case, our primary concern should not be the absolute level of the deficit but the overall trend of the trade balance. To examine that trend, we must distinguish between the trade balance's components: the structural trade balance, which is related to long-term patterns in relative competitiveness and growth, and the short-term balance, which is linked to cyclical and historical fluctuations in exchange rates and relative growth rates. The structural balance has been improving because the United States has been closing the cost gap between itself and other advanced nations. Thus, in spite of the substantial fluctuations in the trade deficit over the last decade, the trend (the dotted line in Figure 1) has stabilized. The fluctuations, on the other hand, can be traced back to the short-term balance--movements in the relative growth rate of the United States (most notably the import-boosting effect of its sustained expansion since 1992 and the export-reducing effect of the more recent Asian crisis) and to the extraordinary gyrations of the U.S. exchange rate in the mid 1980s. In this paper, I first show that the cause of the long-term decline in the U. S. trade balance is substantially a decline in its terms of trade. I argue that, contrary to conventional economic theory, the terms of trade of a nation are regulated by the real costs of its tradable goods relative to those of its trading partners (a much fuller development of the thesis is provided in Shaikh and Antonopoulos 1998). I will show that the United States has been catching up to its trading partners in terms of its relative real unit labor costs, which is why the trend of the trade deficit has stabilized. But, an absolute gap still remains, and this gap, combined with shorter-term factors arising from the U.S. boom and the Asian crisis, accounts for the existence of a trade deficit. A central policy implication of my alternative thesis is that it is crucial to maintain a high rate of productivity growth in the United States, so as to turn the present cost disadvantage into a cost advantage, which would, in turn, convert the structural trade balance from deficit to surplus. The Trade Balance and the Terms of Trade A country's trade balance is the difference between the value of its exports and the value of its imports, which can equally well be captured by the ratio of the value of exports to the value of imports, or the trade balance ratio. When the trade balance ratio is greater than one, the country is running a trade surplus; when it is less than one, the country is running a trade deficit. The trade balance ratio has the virtue that it can be written as the product of two components: the terms of trade or trade price ratio (export price/import price) and the ratio of real exports to real imports or trade quantity ratio (export quantity/import quantity). trade balance ratio = value of exports/value of imports = (terms of trade) . (real export-to-import ratio) = (export price/import price) . (export quantity/import quantity) Slower growth at home tends to raise the real export-to-import ratio (the trade quantity ratio) because the demand for imports from abroad grows relatively more slowly. A decline in a country's terms of trade also stimulates the trade quantity ratio, since a fall in the terms of trade signifies that exports are relatively cheaper and imports relatively more expensive. But, a decline in the terms of trade also worsens the balance of trade. What then has been the dominant factor contributing to the decline in the U.S. trade balance ratio? Between 1960 and 1985, the U.S. terms of trade (trade price ratio) declined sharply and then stabilized (Figure 2); the