First, because the trade deficit is so large now, to actually narrow the gap between exports and imports will require a dramatic change in the growth differential. For example, one combination of changes that would narrow the gap is if import growth slowed markedly to about one-quarter the average rate of growth in the 1990s and export growth rose significantly to about four times the rate of growth in the 1990s. There are two related frameworks for investigating the causes of the external deficit. The second framework focuses on how the trade imbalance is related to imbalances internal to the US between savings and investment, that is, between production and spending. The two frameworks yield consistent views, but they put the deficit in different perspectives.
Capital markets play key roles in both frameworks.
The global framework of income and relative prices From a global perspective, the dramatic widening of the deficit in the late 1990s is fundamentally of a cyclical nature, being driven by a continued robust US economy while the rest of the world stagnates or drops into recession. Moreover, the impact of the differential in rates of growth of GDP on the trade balance has been augmented by an appreciation of the dollar from mid-1995 of some 25 percent, which has not fully worked through to affect relative prices even as the dollar has depreciated in recent weeks against the currencies of some of its major trading partners. What is clear for the most recent period is the overwhelming role for differentials in income growth in driving the external deficit. How capital markets affect the external deficit In 1997 and 1998, the global financial crises played an important role in both dampening income growth abroad as well as in bidding up the dollar. In addition to the obvious impact on growth, this period illustrates how capital flows are transmitted to exchange rates and interest rates to affect the trade account and thus highlights the importance of the capital accounts in understanding today's current account deficit.