Macro Signposts | 28 May 2025

The U.S. Current Account: Trade and Fiscal Deficits Are Closely Linked

Rebalancing trade and reducing the U.S. trade deficit has been a central focus of the Trump administration. Presidential executive orders on tariffs and trade policy have consistently conveyed the view that persistent U.S. trade deficits reflect unfair trade practices of other countries in contrast to the U.S., which operates as a relatively open market economy.

While there is compelling evidence that industrial policies have led to large surpluses in some countries, such as China, this isn't the entire story. Ongoing fiscal deficits in the U.S. have contributed to elevated U.S. consumption of foreign goods, contributing to the trade deficit. Given this economic reality, the outlooks for the U.S. federal fiscal deficit and the trade deficit go hand in hand.

U.S. political polarization has challenged even bipartisan plans to implement fiscal reforms that would put U.S. fiscal deficits and debt on a more sustainable course. Congress is negotiating a tax and spending bill that could keep federal fiscal deficits around 6.5% to 7% of GDP for the foreseeable future. (For details, please read last week's Macro Signposts, "Moody's Downgrade Underscores Tensions Over U.S. Debt Outlook.")

Without fiscal consolidation, policies focused on eliminating the trade deficit risk higher interest rates and lower domestic investment, outcomes counter to the Trump administration's goals. As a result, the U.S. trade deficit, like the fiscal deficit, is likely here to stay.

Trade deficits: theory and practice
Globalization has accelerated over the past half-century, bringing explosive growth in global trade alongside persistent imbalances. Trade balances are not just about trade; they reflect aggregate savings and investment trends among countries, and the fiscal, industrial, and regulatory policies that influence them. Countries with the highest trade surpluses tend to have economies with large manufacturing sectors and high savings rates, while deficit countries show the opposite.

Persistent U.S. trade deficits, which worsened after the pandemic, have been mirrored by surpluses in China, Germany, Japan, and other countries. The U.S. trade deficit reflects the economy's propensity to consume more goods than it produces, driven in part by increased competition from low-cost Chinese goods, but also by persistent fiscal deficits. In essence, a set of simple transactions aggregate to a massive scale: U.S. consumers buy less expensive foreign goods, and then the U.S. dollars acquired by foreign businesses in these transactions are invested back into the U.S.

The U.S. government bond market - and U.S. capital markets in general (both public and private) - have been major beneficiaries of foreign excess savings. Global demand for U.S. dollars - and for U.S. Treasuries as a perceived "safe" store of account - has strengthened the value of the U.S. currency over the long run, as has the more recent outperformance in U.S. assets. Following the pandemic, greater U.S. labor mobility, a culture of innovation, and a lighter regulatory touch - especially in frontier technology fields - have also contributed to the U.S.' generally better productivity and growth performance. (For more on global trade imbalances, please read our 17 December 2024 Macro Signposts, "Will We See Bold Policy Choices in the U.S.?")

Based on this logic, if the U.S. tries to reduce its trade deficit without also cutting fiscal deficits, the domestic private sector must make up for the lower foreign savings - this is the basic current account arithmetic (the "current account" includes both the trade balance and income balance and equals a country's domestic investment rate less its savings rate). To do this, the U.S.' post-pandemic standout economic performance would likely need to diminish, as either U.S. business investment rates or household consumption rates (or both) slow. Whether this process is smooth or disorderly likely depends on markets and on how much and at what pace financial conditions tighten (e.g., higher interest rates and higher risk premiums across assets).

This is the theory, but we can also draw practical lessons from history. Analyzing 32 industrial economies' current account adjustments since the 1970s confirms the theoretical risks are practical challenges as well. Specifically, five stylized facts (i.e., broad empirical observations drawn from hard data) and a few lessons emerge from past experiences. The stylized facts:

  1. Real GDP growth rates historically have tended to fall after a current account adjustment. More specifically, the 3.5% average growth rate in the three years leading up to a current account adjustment declined by 1.5 percentage points (ppts) to a 2% average rate in the subsequent three years. Excluding a handful of cases, growth rate declines occurred across nearly all the 32 samples.
  2. The larger the current account deficit, the larger the growth drag during and after the adjustment. Specifically, a 4% of GDP current account deficit was associated with a 1.0 ppt - 1.5 ppt growth decline.
  3. Lower real GDP growth rates were primarily due to a decline in investment to GDP rates. Savings rates declined as well, initially, but investment fell by more. The fiscal deficit usually deteriorated a little bit, implying private savings rates did go up.
  4. Current account adjustments by and large coincided with currency depreciation. The average depreciation across the samples was 15%, coinciding with 4 ppts of GDP current account adjustment. The currency appears to play an important role in buffering the growth drag. Indeed, evidence suggests that the greater the currency declines, the less that growth declines.
  5. Most current account adjustments aren't disorderly. Rather, inflation and policy rate peaks have tended to coincide with current account troughs. Short-term interest rates tend to rise ahead of a current account trough because the economy more generally is operating above capacity, and inflation is high and rising. Higher interest rates eventually contribute to economic cooling, resulting in lower inflation, lower rates, and currency depreciation, coinciding with current account adjustment.

Now to the lessons: Although most current account adjustments weren't disorderly, there were a handful that were. These adjustments were associated with large currency depreciations and foreign portfolio investment outflows that led to high and rising inflation and necessitated tighter monetary policy after the adjustment. This more restrictive policy stance then resulted in a more prolonged period of flat equity performance and sluggish economic growth. In our sample, these disorderly adjustments occurred around 15% of the time.

There were also a handful of episodes that (seemingly miraculously) realized higher average growth rates after the current account adjustment. These adjustments - we could call them successful "beggar thy neighbor" episodes - were characterized by low growth or even recession before the adjustment, followed by large currency devaluations and a growth acceleration after the adjustment. Another commonality of these "success" episodes was fiscal consolidation, which contributed to falling inflation and lower interest rates, which - combined with the currency adjustment - contributed to growth acceleration and significantly better equity market performance. These adjustments represented 13% of our sample.

Finally, it's also worth noting that meaningful tariff increases did not coincide with any of the current account adjustments in our sample - in that respect, we are in largely uncharted territory in the U.S. this year.

For more detailed charts and data on lessons learned from historical current account adjustments, please see this presentation.

Bottom line
What can we learn from all of this? Policy-driven adjustments to a country's current account face significant economic, political, and legal constraints. Both theory and practice suggest that successful adjustments that lead to higher post-adjustment growth rates need to encompass fiscal consolidation, lower interest rates, and significant currency depreciation. Without fiscal consolidation, a period of higher interest rates that leads to lower growth and investment rates is the most likely path. Otherwise, a significant currency depreciation without fiscal adjustment would likely be inflationary and coincide with higher interest rates and significantly higher costs to the economy.

For the U.S., with meaningful fiscal consolidation unlikely, any current account adjustment would likely be painful, both economically and politically. The Trump administration has shown a much greater tolerance for market and economic volatility than most observers expected. However, given these realities and the outlook for a stagflationary economic adjustment to the tariff increases, we may be seeing the limits of political will for further bold change.

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