International trade continues to grow in importance for the world economy as well as for the U.S. economy, enhancing economic well-being generally, but also imposing costs on trade sensitive sectors of national economies. The importance of trade has been recognized by Congress, which in recent years has paid close attention to many dimensions of U.S. international trade performance as part of its oversight of economic policy. Persistent large U.S. trade deficits raise a number of concerns among the public and in Congress. There are concerns that trade deficits slow economic growth, increase unemployment, generate deindustrialization, and raise the risk of economic and financial instability. To address those concerns, this report examines the trade deficit from the context of mainstream economic analysis. The first part of the report explains the fundamental macroeconomic forces that cause a trade imbalance (deficit or surplus). In light of those fundamental forces, the report then evaluates the most common economic concerns about trade deficits. Finally, the report examines the efficacy of alternative policy responses to trade imbalances and the economic forces that generate them. The current account balance is the nation's most comprehensive measure of international transactions. It has three component balances: the goods and services balance, the investment income balance, and net unilateral transfers. Goods are tangible items in the form of raw materials, intermediate products, and final products. Services are intangible output that cannot be stored and are usually produced and consumed at the same time. Income transactions are the payments and receipts on international investments such as dividends and interest. Unilateral transfers are the transfer of a good, service, or asset for which the receiving country does not provide anything of value in return, such as foreign aid, charitable contributions, or the payment of Social Security benefits to a U.S. citizen living abroad. The three types of transactions measured in the current account balance are thought by economists to be closely related to current production, consumption, and income. For the United States, the size of the current account deficit is largely the refection of a similarly sized goods and services deficit (i.e., trade deficit). In 2009, the United States had a current account deficit of $378.4 billion, composed of a goods and services deficit of $374.9 billion, an investment income surplus of $121.4 billion, and a net unilateral transfers deficit of $124.9 billion. Therefore, for the United States, the terms current account deficit and trade deficit can be used interchangeably with little inaccuracy. Such equivalence is not always the case, however. Australia, for example, has a relatively large current account deficit but a relatively small goods and services deficit (trade deficit) because it also has a relatively large investment income deficit (an outflow of retained earnings and interest payments). In talking about trade balances, it is also important to distinguish between multilateral and bilateral balances. A bilateral balance is the balance between any pair of countries, whereas a multilateral balance is the balance between several or all of the country's trading partners. The current account balance is a multilateral balance across all trading partners. It is very likely that even if the United States' current account was in balance it would still have sizable bilateral imbalances (surpluses and deficits) with individual trading partners. Such bilateral imbalances would typically be a reflection of differences between countries in comparative advantage and in the structure of production and trade between economies and not necessarily a matter of economic concern. In all but three years between the end of WWII and 1970, the United States had modest current account surpluses. During the 1970s, modest deficits occurred more frequently. However, in all but three years between 1981 and 2009, current account deficits have occurred and their typical size, both in dollar terms and as a share of GDP, has been rising as well. A necessary corollary of rising U.S. deficits over this period has been rising current account surpluses abroad. The U.S. current account (trade) deficit, decreased to just above $378 billion in 2009, down substantially from $706 billion in 2008, and from a high of $803 billion in 2006. As a percentage of GDP, the 2009 trade deficit stands at 2.7%, down from 4.9% in 2008, and a record high of 6.1% in 2006. The sharp fall of the trade deficit in 2009 is largely the short-term consequence of the recent recession. With economic recovery, more enduring economic forces are likely to determine the size of the trade deficit. From the end of WWII to 1973, the Bretton Woods international monetary system of fixed exchange rates constrained the United States and other nations to maintain more or less balanced trade. With the collapse of the Bretton Woods system in 1973 that constraint was removed. But that by itself is not sufficient to account for why, from the 1980s to the present, the United States experienced a steady growth of current account deficits, while other nations experienced a steady growth of current account surpluses. Nor is the tendency toward persistent large current account deficits in recent decades the consequence of rising trade barriers abroad, increased foreign dumping of exports, or any inherent inferiority of U.S. goods on the world market. Rather, trade imbalances occur because of underlying macroeconomic spending and saving behavior at home and abroad. Since the early 1980s, there is a strong tendency in the United States to spend beyond current output, with the excess of demand met by a net inflow of foreign goods and services that manifests itself as the U.S. current account deficit. To understand the economic forces generating these persistent current account deficits (and surpluses abroad), it is helpful to have familiarity with basic balance of payments accounting conventions: specifically, two accounting identities (i.e., conditions that must always be true) that the current account must conform with. The first identity defines the necessary condition for the economy's external balance . The second accounting identity is the necessary condition for the economy's internal balance . External balance requires that the balance in the current account (CA), whether deficit or surplus, be equal to the negative of the balance in the financial account (FA): CA = -FA The current account tallies trade in goods and services, whereas the financial account tallies international trade in assets—the inflows and outflows of various forms of financial capital such as bank accounts, stocks, bonds, and ownership of real property. A financial account surplus means that there has been a net inflow of capital (i.e., borrowing from abroad), and a financial account deficit means that there is a net outflow of capital (i.e., lending to other countries). The external balance identity requires that a country with a current account deficit (i.e., it is buying more goods and services from the rest of the world than it is selling to the rest of the world) also have an equally sized financial account surplus (i.e., a capital inflow because it is selling more assets to the rest of the world than it is purchasing from the rest of the world) . Similarly, a country with a current account surplus (i.e., it is selling more goods and services to the rest of the world than it is buying from the rest of the world) will also have an equally sized financial account deficit (i.e., a capital outflow because it is buying more assets from the rest of the world than it is selling to the rest of the world). The necessary balance between the current account and the financial account is due to imports of goods and assets having to be paid for, and the export of either goods or assets being the only means of making that payment. It becomes then, just a matter of double-entry bookkeeping. If the earnings from goods and services exports are insufficient to pay for goods and services imports, then the earnings from asset exports must exceed the cost of asset imports (i.e., there must be borrowing) in the same amount in order that all imports are paid for . The external balance identity is informative for two reasons. First, it establishes a necessary link between the current account balance (largely transactions in goods and services) and international capital flows (transactions in various types of assets). Second, although the current account balance and the financial account balance are likely determined by different economic factors, in the end they must be reconciled and offset each other. The internal balance identity requires that the current account balance always be equal to the difference between a country ' s gross saving and investment . Therefore, if a country has a current account deficit, its gross domestic saving is less than its gross domestic investment; or if a country has a current account surplus then its gross domestic saving is greater than gross domestic investment. The internal balance identity follows directly from the basic identity of the national income and product accounts. Namely, that total domestic output, known as gross domestic product (GDP) equals the sum of consumption (C), government spending (G), investment spending (I), and exports (X) minus imports (M) or: GDP = C+ I + G + (X-M) This identity can be rewritten as: (X-M) = (GDP – C - G) – I Because exports minus imports (X-M) is equivalent to the current account balance (CA) and because GDP minus spending by consumers (C) and government (G) equals saving (S), the expression can be simplified to the internal balance identity: CA = (S – I) That is to say, a current account imbalance is always exactly matched by an imbalance between domestic saving and investment. This is exactly equivalent to saying that deviations of domestic spending above or below domestic output are only possible if there is a balancing net inflow or outflow of output from or to the rest of the world. The internal balance identity is informative because it establishes a linkage between the current account and domestic spending and saving activity.