[Economic Report of the President (1996)]
[Administration of William J. Clinton]
[Online through the Government Publishing Office, www.gpo.gov]

[DOCID: f:erp_c8._]
Economic Report of the President - - - - - - - - - - - - H. Doc. 104-161
[From the online service of the U.S. Government Printing Office]
[wais.access.gpo.gov]


CHAPTER 8

The United States in the World Economy

AMERICA HAS LONG LED THE WORLD in championing open trade and
competition. The result has been an unprecedented period of worldwide
growth in incomes and trade. The expansion of international trade that
supported postwar growth in incomes has been accompanied by dramatic
transformations in the economies of the United States and other
countries. In 1960, trade--exports plus imports--was equivalent to just
9 percent of U.S. gross domestic product (GDP); that figure is now 23
percent. Twelve million American workers now owe their jobs to exports,
and the opportunities for global sales represent a critical part of
firms' investment, research and development, and hiring decisions. The
importance of exports to the U.S. economy has been strikingly apparent
in the last 3 years; U.S. exports of goods and services have grown by 20
percent, accounting for about one-third of real GDP growth.
Not only the size but also the geography of the international market
has changed since the 1950s. Developing countries that adopted market-
oriented policies grew significantly faster than those that clung to
closed markets and statist policies. Now many of these successful
emerging economies have become major markets. Whereas in 1970, 29
percent of U.S. exports went to developing countries, in 1995 these same
countries absorbed 41 percent of U.S. exports. These will be the major
growth markets into the next century and will generate huge demands for
capital goods, infrastructure, and an increasing variety of consumer
goods.
But a high-income, highly competitive economy poses challenges as
well as opportunities. Technological change, business reorganization,
and international competition have at times required painful adjustments
of workers and firms. Critics of international trade often point to the
trade deficit, ``lost'' domestic production due to imports, or expanding
income differentials as evidence that foreign trade and investment are
harmful to the United States.
Americans have legitimate concerns about job security and standards
of living, and the Administration is strongly committed to fostering
better jobs and greater economic security. But neither job security nor
future income growth will be enhanced by closing the American economy to
foreign competition. As the 21st century approaches, the Administration
firmly believes that economic isolation would lead only to economic
decline, and that the most promising way forward is to rise to the
challenges of the international market. We can and must compete, not
retreat, in the face of global competition.
The Administration has pursued an aggressive trade policy to open
markets abroad. Despite historic reductions in trade barriers and the
striking growth in U.S. exports, many countries still maintain formal
trade barriers, or more subtle administrative or collusive barriers,
that prevent other nations' firms from competing on an equal basis. This
Administration has insisted that other countries live up to their
obligations under international and bilateral agreements and has
attacked remaining barriers that discriminate against U.S. exports.
This chapter explains why outward-looking, competitive policies
remain the best choice for America and examines the Administration's
record in promoting open competition across the globe. Special attention
is given to the role of trade policy and to the proper measure of its
success. This chapter also discusses the causes and consequences of the
trade deficit and effective policy for reducing it.

THE BENEFITS OF OUTWARD-LOOKING, MARKET-OPENING POLICIES

Open, competitive trade promotes the economic welfare of all
countries that engage in it, and does so in four ways. It secures the
benefits of national comparative advantage, allowing each trading
economy to devote more of its resources to producing those goods and
services that it can produce most efficiently. It sharpens domestic
competitive pressures, spurring productivity gains. It quickens the flow
of technology and ideas, allowing countries to learn from each other.
And it broadens the variety of inputs available to producers and final
goods available to consumers, boosting efficiency and standards of
living.
Nations that engage in trade benefit from the logic of comparative
advantage, as each imports those goods that are produced more cheaply
abroad, and exports those goods that are produced more cheaply at home.
Box 8-1 offers a simple example that illustrates this traditional
argument favoring free trade. Critics argue, however, that many
industries of increasing importance in the world economy (including many
high-technology industries) are characterized by economies of scale in
production, and that these scale economies undermine the simple
comparative advantage argument. But although economies of scale do
complicate the story, they do not invalidate the principle of
comparative advantage or lessen its importance, as Box 8-2 explains. Now
more than ever, unimpeded access to a world market is crucial.

Box 8-1.--Comparative Advantage and Living Standards

The classic argument for free trade is based on the principle of
comparative advantage. Suppose U.S. workers are much better at producing
computer software and somewhat better at producing shoes than workers in
Thailand. Comparative advantage states that trade between the two
countries--with the United States exporting software and Thailand
exporting shoes--can still boost living standards in both.
A simple analogy may help illustrate this abstract and seemingly
implausible intuition. Imagine a lawyer who happens to be a very good
typist--so good that she is somewhat faster than her secretary. Even
though the lawyer is better than her secretary at both practicing law
and typing, it makes sense for her to spend all her time on the law and
leave the typing to her secretary. A greater combined total of lawyering
and typing will get done in the same amount of time than if each did
some or all of the other's work, and the incomes of both workers will be
greater than they would otherwise.
Similarly, by allowing countries to focus their resources on what
they do relatively well, international trade boosts living standards.
Especially when an economy is near full employment, the primary impact
of trade is on the allocation of jobs among industries rather than the
overall number of jobs. Trade allows employment to be shifted into
relatively more productive, better jobs. This effect is manifest in U.S.
wage data: jobs in the United States supported by goods exports pay 13
percent more than the national average. This is not surprising, given
that U.S. comparative advantage lies in highly specialized manufacturing
and service activities, not in low-skill, low-wage sectors. Comparative
advantage in high-skill industries, however, appears to provide only a
partial explanation for the higher wages paid in export jobs. Even after
plant size, location, industry, and skill category are controlled for,
exporting plants seem to pay higher wages than nonexporting plants.
The second argument in favor of open competition is that exposure to
the challenges of the international marketplace strengthens competitive
pressures in the domestic economy, stimulating efficiency and growth. An
open trade regime effectively increases the number of both actual and
potential competitors in the domestic market by including those located
beyond the Nation's borders. This encourages domestic producers to
innovate and become more

Box 8-2.--The New Trade Theory

Over the past 15 years, economists have formalized new models of
international trade that offer theoretical justifications for
protectionism. These models, often referred to collectively as the ``new
trade theory,'' have prompted a reexamination of the costs and benefits
of open trade.
The new trade theory assumes that certain industries enjoy
increasing returns to scale or generate positive spillover benefits to
society as a whole, for which the industry is not compensated.
Increasing returns actually raise the gains from trade: they make it
even more efficient to sell to a global market. But in some cases,
unilateral protection can raise social welfare. Under the right
conditions, for example, temporary protection can secure a permanent
cost advantage for a domestic firm by discouraging foreign producers
from entering the market. If the monopoly rents that then accrue to the
domestic firm are large enough to offset the costs of capturing them,
the nation as a whole benefits.
These sophisticated arguments for protectionism do not necessarily
invalidate the case for free trade. Even with scale economies, if all
countries adopt protectionist policies in the hope of making their
national champion the global monopolist, the costs will be even higher
than in the absence of increasing returns. With access to foreign
markets blocked, all hope of any firm exploiting the increasing scale
returns is lost; the traditional losses from protectionism (arising from
ignoring comparative advantage) are then compounded by the failure to
produce at efficient scale. In a sense, therefore, protectionism is even
more costly with increasing returns than without them.
But perhaps the greatest challenge in the new trade theory
sweepstakes is targeting only those industries and firms that best meet
the theory's narrow conditions. In practice, selection would be
complicated by political pressures from special interests, who are
likely to exaggerate the positive spillovers their industries
contribute. And the costs of an erroneous choice may prove
counterproductive: granting protection in inappropriate cases may
outweigh the benefits of granting it in appropriate ones. In sum, the
new trade theories provide a possible theoretical justification for
protectionist policies in some limited cases. But practical
considerations suggest that the potential gains, if any, are likely to
be small.
competitive. Consumers, both at home and abroad, reap the benefits.
A third, related argument is that access to international markets
stimulates the flow of information across borders. Domestic firms
engaged in international competition assimilate new ideas about
production methods, product design, organizational structure, and
marketing strategy, allowing them to employ their resources more
efficiently. Open competition thus boosts productivity.
Finally, trade expands the menu of goods and services available to
both producers and consumers. Firms gain access to a wider variety of
inputs, and consumers get to choose from a broader assortment of final
goods and services. By expanding the choices available to all, trade
boosts efficiency and improves living standards.
One can also gauge the benefits of open markets by assessing the
cost of the alternative, namely, protectionism. It is impossible to
protect all industries; protecting some inevitably distorts market
signals and imposes higher costs on other industries and on domestic
consumers. For example, extending protection to the steel industry
imposes a cost on automobile manufacturers, who pay more for steel, and
on consumers, who pay more for a new car than they would if steel were
available at the lower world price. Because the impact of such
restrictions is both indirect and spread over a large number of
consumers, the total cost may be difficult to discern. But it is
nevertheless quite real, and it is likely to grow over time. By raising
the relative price of the protected sectors' output, and thus drawing
capital and labor into those sectors and away from others, protectionist
policies prevent the most efficient long-run use of an economy's
resources. These distortions may be particularly harmful when
restrictions are imposed on inputs used by industries that are
characterized by economies of scale in production (that is, by lower
average costs per unit at higher levels of output; Box 8-2).
Finally, every protectionist action invites retaliatory reaction.
The costs of a tit-for-tat escalation are so high that in the long run
all countries are likely to lose from the adoption of restrictive
policies. The experience of the 1930s provides a grim demonstration: the
major industrial countries responded to the onset of the Great
Depression by raising trade barriers against each other, which provoked
retaliation in kind and succeeded only in weakening their economies
still further. A better strategy is for all to strive for a regime of
open and fair competition, rather than to focus on any possible (and in
any case usually illusory) short-term gains from protection.
Many of the same advantages that accrue from an open trade regime
also accrue from international investment flows. Inward flows of foreign
direct investment can boost efficiency and cross-border learning. Direct
investment in the opposite direction--that by domestic firms in
countries overseas--also promotes such learning and is closely linked to
export expansion: approximately three-fifths of U.S. exports are sold by
U.S. firms with operations abroad, and several recent studies have
confirmed that foreign direct investment is more likely to increase
trade than reduce it.

THE EVIDENCE ON OPEN ECONOMIES

Trade affects growth through various channels, but the cause-and-
effect relationship is difficult to establish in practice: even if
expanded trade is statistically associated with growth in income, does
the expansion in trade cause the expansion in income, or vice versa?
There can be no definitive answer, but careful studies generally
conclude that trade liberalization establishes powerful direct linkages
between the domestic and the world economy, unencumbering the flow of
ideas and technology across borders, bolstering competitive pressures.
A recent economic analysis, which controlled for other national
characteristics such as education, starting income, and political
instability, found that the open economies in a sample of 79 countries
grew by an average of 2.5 percentage points more per year (over a 20-
year period) than did the closed economies. A comprehensive study of
productivity across manufacturing industries in Germany, Japan, and the
United States recently concluded that trade restrictions generally hurt
productivity by reducing competitive pressures; productivity growth is
the single most important factor underlying sustained increases in
income. Other studies have found that protection of industries that
produce intermediate inputs reduces growth. For example, one recent
study found that, across a sample of over 70 countries, a 10-percentage-
point increase in the tariffs on capital goods and intermediate products
was associated with a decline in real growth of GDP per capita of 0.2
percentage point per year. For the United States, such a reduction in
growth over the 10-year period through 1994 would have lowered GDP per
capita by $500 from its actual 1994 level of $26,558.
Even when trade restrictions are used to curtail unfair foreign
competition, they can still impose costs on consumers. The U.S.
antidumping and countervailing duty laws, for example, are intended to
offset the effects of unfair foreign competition: antidumping laws seek
to counter unfair pricing by foreign firms, while countervailing duties
seek to compensate for the anticompetitive effects of foreign government
subsidies. The concern is a legitimate one: U.S. living standards could
be diminished by certain types of predatory foreign behavior. But many
analysts believe that many of the cases filed under these statutes have
little to do with preventing unfair competition, and the duties make
consumers and domestic businesses pay higher prices for imported goods
and inputs. In any case, a recent study found that the net cost of the
163 antidumping duty orders and 76 countervailing duty orders in place
in the United States in 1991 was $1.6 billion.

TRADE AND WAGE INEQUALITY

Over the past 15 years the real earnings of low-skilled U.S. workers
have fallen sharply while those of highly skilled workers have risen:
between 1980 and 1994, real average annual earnings for high school
dropouts aged 25 to 34 fell by 18 percent, while those for college
graduates rose by over 3 percent. Over the same period, imports have
risen as a percentage of GDP. Are these two trends related? Is increased
trade hurting low-skilled workers, and if so, is this an argument for
protectionism?
In theory, increased trade could worsen inequalities in wages even
while raising aggregate income. The U.S. economy has a relative
abundance of skilled labor, and so U.S. comparative advantage is in
producing skill-intensive goods. Traditional models of trade therefore
suggest that the United States would tend to export goods requiring
relatively large amounts of skilled labor and import goods requiring
relatively large amounts of unskilled labor. International trade would
in effect increase the supply of unskilled labor to the U.S. economy,
lowering the wages of unskilled American workers relative to those of
skilled workers, thus aggravating wage inequality.
Economic theory does not, however (except under extremely
restrictive assumptions), tell us how great the resulting gap in wages
will be. Moreover, careful examination of the channels through which
trade should affect wages suggests that other factors bear a larger
responsibility for the widening of wage differentials. Foreign workers
do not compete with American workers directly, but rather through the
products that they produce and sell. The argument that imports drive
down wages for unskilled labor is predicated on a relationship between
the relative prices of goods and the prices of inputs used to produce
them. If competition from developing countries lowers the prices of
goods requiring unskilled labor as their major input, the wages of
unskilled workers will be driven down, widening income disparities. The
problem with this argument is that there has been no such change in
relative goods prices: over the 1980s the average relative price of
goods that require substantial inputs of unskilled labor actually
increased.
If trade, or factors such as immigration that affect the relative
supply of workers, were the predominant cause of wage disparities, one
would expect to see domestic producers taking advantage of the lower
cost of unskilled workers by using more of them. Yet just the opposite
has occurred. In almost all industries, employment of skilled workers
has increased relative to that of unskilled workers, despite the higher
cost of skilled workers. This suggests that factors affecting the demand
for different kinds of workers, such as technological changes that have
increased the demand for skilled workers, have been the more powerful
force in influencing relative wages.
Yet even if the effect is small, trade may indeed have some adverse
impact on wage inequality. In many ways the effects of trade are similar
to those of technological advance: both raise national income but can
worsen inequality. Yet just as a neo-Luddite crusade against technology
is not the solution to increased inequality due to technological
progress, neither is protectionism the answer to wage inequality
resulting from expanded trade. Several recent studies show that
protection can impose costs on the economy that far outweigh the
targeted benefits. Moreover, import protection cannot promise continuing
reductions in inequality over time. At best, a strategy of import
protection would narrow the wage gap temporarily at the risk of slowing
the rate of productivity and income growth generally.
Ultimately, the only lasting solution to the increase in wage
inequality that results from increased trade is the same as that for
wage inequality arising from any other source: better education and
increased training, to allow low-income workers to take advantage of the
technological changes that raise productivity. In addition, programs
such as the earned income tax credit and the minimum wage can be
effective in raising the after-tax wages of low-income workers.

U.S. TRADE POLICY IN THE 1990s

Governments play a decisive role in determining the rules of
competition in international markets. Just as governments must be
responsible for regulating domestic markets, they must also be
responsible for the rules that govern international trade and
investment. This is a responsibility that cannot be shirked--even the
absence of a formal trade policy is itself a policy. The objective is
therefore to structure government involvement so as to help, not hurt
economic performance.
The United States has led international efforts to liberalize world
trade and investment, and this Administration has actively sought to
eliminate foreign market barriers to U.S. exports. Regardless of their
effects on the overall trade balance, these market-opening policies
raise U.S. incomes by securing the gains from international trade. As
already noted, the expansion of market opportunities is especially
important in industries characterized by economies of scale (e.g., those
with high fixed costs). The opportunity to sell in a larger market
allows these fixed costs to be spread over a larger number of units,
reducing average cost.
Opening up markets to U.S. exports also increases world demand for
our products by removing artificial barriers to their consumption by
foreigners. Stronger demand raises the prices that our products command
on world markets, and so improves our terms of trade with the rest of
the world. The terms of trade (defined as the ratio of the average price
of our exports to that of our imports) affects U.S. real incomes. An
increase in the terms of trade means that, for any given volume of
exports, Americans can purchase more foreign goods. Even a small change
in the terms of trade can have a huge effect: a 1 percent rise in the
terms of trade corresponds to a real increase in income of more than $7
billion.
Open markets benefit all participants in international trade, even
those whose own national markets are closed to foreign competition. Open
markets are a public good, the benefits of which are available to all.
As with any public good, countries have some incentive to ``free
ride''--to seize a share of the benefits without assuming any of the
costs (the case of trade may be special, however, in that every country
may have an incentive to adopt open trade policies regardless of what
other countries do). The negotiators in the Uruguay Round of the General
Agreement on Tariffs and Trade (GATT) recognized the importance of
ensuring every nation's participation in lowering trade barriers: in
almost all respects, membership in the new World Trade Organization
(WTO), created under the 1994 Uruguay Round agreement, requires
adherence to all of its rules. Indeed this is one of the reasons why the
Administration strongly supported the Uruguay Round agreement.
Even those nations that have adopted the general rules of the
trading system often come under pressure to intervene in particular
instances--to protect industries going through difficult adjustments to
foreign competition, to skew the rules in favor of domestic companies,
or to try to influence foreigners to purchase from domestic firms. An
aggressive policy to protect American interests from such practices
abroad helps ensure that U.S. firms do not lose out, and that foreign
governments are less inclined to try to bend the rules. The strengthened
dispute settlement process within the WTO, together with the United
States' own Section 301 legislation, which addresses unfair or
unjustified foreign practices, are the most important tools that the
United States uses to enforce our rights in the trade and investment
arenas.

THE ADMINISTRATION'S TRADE STRATEGY

This Administration has embraced an outward-oriented, protrade,
progrowth economic strategy. In its first 3 years in office, this
Administration has concluded over 200 trade agreements and done more to
promote trade and open markets abroad than any previous Administration
(Box 8-3). We are using all the tools available to us--multilateral,
regional, and bilateral--to advance our protrade agenda. This multilevel
approach to trade policy has become particularly important as the
nontraditional aspects of trade policy have assumed increasing
importance (Box 8-4), and as global trade patterns have shifted toward
emerging markets. Recognizing that success is measured not by the number
of agreements signed, but by concrete results, the Administration has
taken great pains not only to reach mutually beneficial agreements with
our trading partners, but also to follow through in implementing,
monitoring, and enforcing those agreements.
In assessing the results of the Administration's trade policies to
date, it is important to recognize what trade policy can and cannot do.
Trade policy can raise U.S. income and productivity, but it cannot
significantly affect the overall trade balance. That is determined by
domestic saving and investment and by government fiscal policy. Although
the overall trade balance may not change, trade policy can alter the
composition (both the sectoral breakdown of products traded and the
shares of individual trading partners) and the overall level of trade.
But U.S. trade policy should not be judged by whether our trade is in
balance in any particular product or with any particular country. Even
if our overall trade were balanced, there is simply no reason to expect
(or desire) that our imports of cabbages or computers will match our
exports of cabbages or computers, or that our sales to Japan or Zambia
will cancel out our purchases from those countries, in any given year or
even over an extended period. As we have already seen, it is precisely
the ability to specialize, to concentrate on what we produce most
efficiently, and to sell it in those markets that offer the highest
returns, that is the fundamental source of the gains from international
trade.

Multilateral Initiatives

The Uruguay Round trade agreement was signed in April 1994. The
agreement went into force on January 1, 1995, with some provisions
phased in over a 10-year period. The 1995 Economic Report of the
President describes the agreement in detail.
Over nearly five decades, a series of GATT negotiating rounds has
developed basic principles for the international trading system, which
have guided trade negotiations in other spheres and have informed (and
been informed by) U.S. trade policy. These principles include
nondiscrimination, transparency, and reciprocity. Nondiscrimination is
defined by two precepts: the most-favored-nation (MFN) precept requires
that the most favorable concessions that a country gives to any trade
part-

Box 8-3.--The Administration's Trade Achievements

Over the last 3 years the Administration has:
 Brought the Uruguay Round of multilateral trade
negotiations to a successful close after 7 years. The Uruguay
Round agreement cuts global tariffs by an average of 40 percent
and extends international trade rules to agriculture, services,
and intellectual property rights. The United States will
eventually gain an estimated additional $100 billion to $200
billion in income per year from the agreement.
 Through the North American Free Trade Agreement (NAFTA),
created a free-trade area encompassing our largest and third-
largest trading partners. NAFTA has helped maintain and indeed
increase U.S. exports to Mexico despite a financial crisis and
recession there.
 Reached agreement with 33 other countries--including some
of the world's biggest emerging markets--to seek a Free Trade
Area of the Americas by 2005. Trade with countries in the
hemisphere already accounts for roughly 40 percent of U.S.
exports.
 Articulated a vision for achieving free trade and
investment by 2020 in the fastest-growing region of the world:
the Asia-Pacific. At the 1995 Asia-Pacific Economic Cooperation
summit in Osaka, Japan, the leaders of the 18 member countries
detailed the steps they will take to make this vision a reality.
 Negotiated 20 bilateral trade agreements with Japan. In
those goods sectors covered by these agreements for which
precise data are available, U.S. exports to Japan have grown
nearly 80 percent since this Administration took office.
 Established a National Export Strategy under the leadership
of the Trade Promotion Coordinating Committee, which for the
first time coordinates the Federal Government's efforts to
assist U.S. exporters through advocacy, export financing, and
business counseling.
 Promoted macroeconomic and trade policies that have
contributed to strong export growth. Exports of goods and
services have grown 20 percent in real terms since the
Administration took office.

Box 8-4.--Trade and Intellectual Property Rights

A major nontariff barrier to U.S. exports is the lack of adequate
protection for intellectual property rights (IPR) in certain countries.
The nature of intellectual property has always made it vulnerable to
piracy: theft of intellectual property costs U.S. exporters billions of
dollars in lost sales and royalties annually. Many of the top U.S.
export earners--including copyrighted products such as films, sound
recordings, and computer software, and patented products such as new
pharmaceuticals--are among the most vulnerable. Piracy not only reduces
U.S. export earnings but also discourages the development of new
products by lowering the returns to innovation. Efforts to establish
strong IPR protection abroad have therefore been an essential element of
this Administration's trade policy, advanced through multilateral,
regional, and bilateral mechanisms.
The Uruguay Round Agreement on Trade-Related Aspects of
Intellectual Property Rights (TRIPs) makes significant progress in
securing stronger protection for IPR worldwide. It is the first
international agreement to protect a full range of intellectual property
and to provide for the establishment of the legal and judicial
structures needed to enforce IPR protection. The TRIPs agreement
requires all WTO members to set improved rules for the protection of
copyrights, integrated circuits, patents, trademarks, trade secrets, and
designs. The new rules will then be subject to the WTO's improved
dispute settlement system.
ner be applied to all its trade partners; national treatment requires
that a country's laws and regulations treat foreign products no
differently from domestic products. Transparency ensures that the rules
governing trade are explicit and that due process is followed in
applying them, and reciprocity refers to the balancing of concessions
from different countries. In addition, the GATT process has endorsed the
use of safeguards--escape clauses and other forms of temporary relief
from import surges--to protect against job dislocation during
transitions.
The Uruguay Round agreement called for negotiations in three service
sectors to be extended beyond the Round's conclusion: financial
services, telecommunications, and maritime transport. The WTO's major
negotiating effort in 1995 focused on the first of these. As the
extended negotiating period for financial services drew to a close, the
United States concluded that many offers--especially those from several
emerging economies--provided inadequate new market access or did not
formally protect even existing market access. The United States
therefore announced that it would take an MFN exemption (that is, that
it would not apply MFN treatment to all WTO members), allowing the
United States to grant differential market access for new entrants and
the new activities of foreign financial services suppliers. The United
States also indicated that, while reserving its legal right to do so, it
had no intention of imposing new restrictions on foreign firms. The
participants in the negotiations nonetheless reached an interim
agreement on July 28, to be reconsidered by the end of 1997. The United
States is a party to the agreement and is entitled to all the
commitments made by all participants.
WTO negotiations on telecommunications liberalization were initiated
at the meeting of trade ministers of the WTO member countries in
Marrakesh in April 1994. The talks are scheduled to conclude by April
30, 1996. As of January 1996 there were 48 WTO members participating, 33
of which had submitted offers detailing the liberalization they are
prepared to undertake. The telecommunications negotiations are taking
place at a critical point in the evolution of the global
telecommunications industry. As Chapter 6 has described, the
telecommunications sector was long considered a natural monopoly and has
been heavily regulated or state owned in most countries. In recent
years, however, technological change has greatly increased the scope for
entry and competition. At the same time, systems of regulation and
public ownership that were designed to protect consumers have in many
cases become obstacles to competition and further progress, from both
domestic and foreign firms. Thus deregulation and trade liberalization
are closely intertwined, and the outcome of the trade negotiations
depends on legislative reform in the major participating countries.
The goals of the United States in these negotiations are to ensure
market access and national treatment for U.S. telecommunications firms
abroad and to secure agreement on procompetitive regulatory principles
in the participating countries. Competition in this sector requires that
all entrants be able to connect to existing networks on equal terms. It
also requires safeguards to ensure competition and the independence of
regulators from the operating companies they oversee. The United States
has indicated that if there is a critical mass of high-quality offers
from industrial and developing countries, it will be willing to lift
restrictions on foreign ownership in the U.S. telecommunications
industry and to guarantee national treatment for foreign firms operating
in the United States. However, if offers of sufficient quality are not
forthcoming, the United States has reserved the right to amend or
withdraw its existing offer or to take an exemption to the MFN
requirement, as it did in financial services.

Regional Initiatives

The Administration has promoted the creation of regional trade
agreements as stepping stones toward global free trade. The
Administration has set ambitious goals for free trade in the two most
dynamic markets of the world: the Asia-Pacific and Latin America. The
combination of rapid growth and unprecedented liberalization is likely
to make export and investment opportunities in these markets a key
engine of growth for the U.S. economy over the next decade, and
developing countries already account for over 40 percent of U.S.
exports.
Regional initiatives founded on the principles of openness and
inclusivity serve to strengthen the multilateral trading system. The
principle of inclusivity encourages members of a regional agreement to
pursue additional liberalization with nonmembers, including possible
accession to the agreement. Regional free-trade agreements that do not
raise external barriers and that welcome new members can set off a
virtuous cycle of liberalization. As the market encompassed by a free-
trade area expands and becomes increasingly dynamic, other countries
become more interested in joining.
The GATT has always recognized the ``desirability of increasing
freedom of trade by the development, through voluntary agreements, of
closer integration between the economies of the countries parties [sic]
to such agreements'' (Article XXIV), as long as such agreements do not
result in an increase in the parties' external barriers. This
restriction helps to ensure that preferential regional agreements create
more trade among the participants (and others) than they divert from
nonparticipants. In general, cheaper imports improve the well-being of
the member countries and create trade. But regional liberalization may
reduce trade with nonmember countries, since imports from such countries
do not benefit from the reduction of trade barriers. Trade diversion
arises when countries within a regional agreement switch from importing
goods from the lowest-cost nonmember to importing from other members.
Minimizing such distortionary trade diversion is a key objective in
well-designed regional agreements.
Regional agreements often achieve deeper and broader economic
integration than multilateral agreements because, as neighbors, members
have substantial interests in common. Such agreements therefore often
become models for future multilateral liberalization in new areas such
as services, investment, and environmental and labor standards. The
expansion of regional free-trade areas has also encouraged nations to
find more common ground in multilateral negotiations. The U.S. regional
initiatives in North America and the Asia-Pacific, for example, were an
impetus for the successful conclusion of the Uruguay Round.
The North American Free Trade Agreement. NAFTA liberalizes trade
with our two closest neighbors--who are also our largest and third-
largest trade partners--over a period of 10 to 15 years. The impact of
NAFTA on bilateral trade flows is difficult to isolate because Mexico
experienced a severe financial crisis during 1995 (Box 8-5). In NAFTA's
first year U.S. merchandise exports to Mexico and Canada grew by 16
percent--over twice as fast as U.S. exports to the rest of the world.
Although U.S. exports to Mexico fell as Mexico entered recession, they
remained higher during 1995 than they had been in 1993, before NAFTA.
And despite the recession Mexico continued to honor its commitments to
the United States, cutting tariffs on U.S. products in accordance with
NAFTA's provisions--even as it increased tariffs on many goods from non-
NAFTA partners by 15 percentage points. In part because of this, the
U.S. share of Mexico's imports has grown from 69 percent in the first 9
months of 1994 to 74 percent over the same period in 1995. The
performance of U.S. exports to Mexico in 1995 stands in sharp contrast
to what happened after the previous Mexican financial crisis, in 1982,
when the Mexican Government imposed 100 percent duties and import permit
requirements on products from the United States and other countries.
U.S. exports to Mexico were cut in half during that episode, and it took
6 years for U.S. exporters to recover their pre-1982 position. In
contrast, U.S. exports to Mexico during the current episode fell by less
than 10 percent and remain higher than before NAFTA.
In some instances, expanded trade with Mexico and Canada has
displaced workers in the United States. Consequently, the President made
it a priority to include a strong transitional program of trade
adjustment assistance as part of the legislation implementing NAFTA.
This program provides support to displaced workers in industries
experiencing large increases in imports from, or whose plants have
relocated to, Mexico or Canada, regardless of whether the job losses are
directly related to NAFTA. In addition, the Department of Commerce's
Economic Development Administration, through its Trade Adjustment
Assistance program (which predates NAFTA), has provided assistance to a
significant number of firms adversely affected by increased imports from
Mexico and Canada.
NAFTA will serve both as a model for future multilateral
liberalization in areas such as investment and as a vehicle for further
regional liberalization. The Administration is committed to conducting
negotiations with Chile on accession to NAFTA. Since Chile's population
is only about one-seventh the size of Mexico's, the economic impact on
the United States from Chile's accession is likely to be comparatively
small. But Chile's accession will provide opportunities for American
businesses to expand operations in this fast-growing market (which has
grown by 7 percent per year on average

Box 8-5.--Mexico's Financial Stabilization

In December 1994 Mexico faced a balance of payments crisis.
Investors lost confidence in Mexico's ability to maintain the exchange
rate of the peso within its trading band, in part because of Mexico's
large current account deficit, which had reached almost 8 percent of GDP
in 1994. Intense pressure on the peso in foreign exchange markets
threatened to exhaust Mexico's international reserves, compelling the
Mexican Government to float the peso.
The President responded swiftly to Mexico's crisis, leading a $50
billion multilateral effort to assist in Mexico's stabilization and
making available $20 billion in U.S. credit. This effort helped
attenuate the impact of the crisis on other emerging markets. At the
same time, the newly inaugurated Mexican President took the difficult
steps essential to restoring stability and growth in Mexico. Government
spending was cut, resulting in a budget surplus of 1.5 percent of GDP in
the first three quarters of 1995. The Mexican Government also
implemented a tight monetary policy, and because a lack of timely
information was seen as having contributed to the crisis, Mexico took
steps to make key financial and economic data more transparent and more
widely available to investors.
Together these measures have begun to work, setting the stage for
a return to growth. Nearly all of the $29 billion stock of tesobonos--
short-term, dollar-denominated government debt--has been retired.
Mexico's international reserves have risen from $6 billion at the
beginning of 1995 to $16 billion at year's end. Monthly inflation has
fallen to 2 to 3 percent from a high of 8 percent. As of mid-January
1996 the peso had stabilized, after an additional sharp decline in
November, and the stock market had staged a partial recovery. Interest
rates have declined from over 80 percent at the height of the crisis to
below 40 percent. In addition, Mexico appears to have largely regained
access to the international capital markets after only 7 months--far
less than the 7 years it took Mexico to regain the trust of foreign
investors after the debt crisis of 1982.
The financial crisis engendered a severe recession in Mexico,
leading to a contraction of 7 percent in the first three quarters of
1995. But U.S. support, Mexico's tough stabilization policies, and the
strong economic foundation that had been laid by the preceding 7 years
of structural reform in Mexico should accelerate a return to sustainable
growth.
since 1988), help encourage sound economic policies in the region, and
serve as an important step on the road to creating a Free Trade Area of
the Americas.
The Free Trade Area of the Americas (FTAA). In December 1994 in
Miami, leaders from 33 Western Hemisphere countries joined with the
President in embracing the goal of achieving free trade in the Western
Hemisphere by 2005. Even though the FTAA will take years to achieve, by
securing a commitment to work toward a hemispheric free-trade area now,
hemispheric leaders set a high standard for the region, ensuring that
subregional trade agreements will evolve in a manner consistent with the
FTAA and the multilateral system.
The United States should reap significant benefits from
establishment of the FTAA. It will create a market of over 850 million
consumers with a combined income of roughly $13 trillion. Latin America
is one of the fastest-growing regions in the world. Total exports of
countries in the hemisphere grew nearly 17 percent on a year-over-year
basis in the first half of 1995. Import growth was also strong at over
18 percent. Total trade flows in the hemisphere are estimated to have
reached over $2 trillion in 1995. The FTAA will also level the playing
field for U.S. exporters, reducing Latin American trade barriers that
are currently three times higher on average than U.S. barriers. The
increase in growth and improved access to new ideas that freer trade
will bring should also promote U.S. goals of development and democracy
in the region.
Trade ministers from throughout the hemisphere met in Denver in June
1995 to lay out a road map for achieving the leaders' vision of regional
free trade. They agreed that trade liberalization should be consistent
with WTO principles and comprehensive in scope. The Denver Ministerial
established working groups in seven important areas: tariffs and
nontariff barriers, customs procedures and rules of origin, investment,
standards and technical barriers, sanitary and phytosanitary measures,
antidumping and countervailing duties, and smaller economies. Each
working group is responsible for compiling an inventory of regulations
and regimes in its assigned area and undertaking a variety of other
projects to prepare the foundations for the negotiated dismantling of
trade and investment barriers. In March, trade ministers will meet again
in Cartagena, Colombia. At the Cartagena Ministerial four additional
working groups will be established, covering government procurement,
IPR, services, and competition policy.
Asia-Pacific Economic Cooperation (APEC). The 18 members of APEC
include some of the largest and most dynamic economies in the world
today. Indeed, APEC is a unique combination of some of the world's most
important established markets and some of its most important emerging
markets. With a combined population of 2.1 billion and $13 trillion in
combined annual income (over half of world income), the members make up
the largest consumer market in the world. More than 30 percent of global
trade takes place between APEC countries. The Asia-Pacific region
continues to grow at a faster pace than any other region in the world:
in 1994 China grew by 12 percent in real terms, Singapore by 10 percent,
and South Korea, Malaysia, and Thailand by more than 8 percent. Over the
next decade the developing East Asian economies are projected to invest
between $1.2 trillion and $1.5 trillion in infrastructure, generating
enormous opportunities for sales of American goods and services. Already
APEC accounts for over 60 percent of U.S. merchandise exports, and these
exports have grown 35 percent since the beginning of the Administration.
U.S. exports to the Asian countries of APEC have grown 55 percent since
the beginning of this Administration.
APEC was formed in 1989 as an informal group of 12 nations focused
on increasing economic cooperation in the region. Initially only the
members' designated APEC ministers attended the group's meetings. In
November 1993, however, the President hosted the first summit of the
leaders of the APEC countries. At that meeting, held at Blake Island in
Washington State, the Asia-Pacific leaders embraced the President's
vision of a Pacific community based on shared strength, peace, and
prosperity, as well as his determination to make APEC relevant to the
everyday problems of businesses throughout the region. Having set their
course in 1993, APEC leaders again met in Bogor, Indonesia, in 1994,
where they made a momentous commitment. The Bogor Declaration set a goal
of achieving free trade and investment between the member economies over
the next 25 years. For the industrialized countries in APEC the benefits
come even sooner: full implementation is scheduled to occur within 15
years.
This year at Osaka, Japan, the APEC leaders put in place a work
program and a liberalization process to make the vision of freer and
fairer trade a reality, and meanwhile to deliver some concrete measures
of immediate value to business. The leaders adopted an Action Agenda for
implementing free trade and investment in the region by 2020 (Box 8-6).
The Action Agenda covers 15 broad areas for liberalization and sets out
135 specific actions that members should take to open their markets and
reduce the costs of doing business. The agenda's broad scope covers
market access issues such as tariffs, quotas, and services. It also
includes new areas that are the source of some of the most pernicious
market barriers in Asia, such as IPR protection and investment, and
other issues of growing importance to the region such as competition
policy and deregulation. In each of these areas the Action Agenda sets
out key objectives, benchmarks, time frames, and specific actions. The
principles embodied in the Action Agenda ensure that liberalization in
each country will be comprehensive, covering all products, services, and
investment, and require each country to achieve results that are
balanced and comparable to those of other APEC members. In the coming
months, each member will detail the specific steps it will take to begin
implementing the Action Agenda, to be presented at the next meeting of
the APEC leaders in Manila in 1996. Implementation could begin as early
as January 1997--only 2 years after APEC leaders made the commitment to
achieve free trade.
The Transatlantic Trade and Investment Initiative. The U.S.-European
relationship is one of the oldest and most durable in international
affairs. To further strengthen this partnership, the United States and
the European Union initiated a Joint Action Plan at their Madrid summit
in December 1995. The summit declaration included the commitment to
foster a Transatlantic Marketplace. As part of this effort, the United
States and the European Union have pledged to seek agreements on mutual
recognition of testing data and standards certification, to cooperate
and assist each other on customs procedures, to begin work on a
comprehensive agreement on cooperation in science and technology, and to
initiate a joint study on market barriers confronting transatlantic
trade. The two sides will draw heavily on the advice of the private
sector. Their cooperation will also extend to environmental and labor
issues.
The OECD Multilateral Agreement on Investment. After 4 years of
intensive work, the ministers of the member countries of the
Organization for Economic Cooperation and Development (OECD) agreed in
May 1995 to launch negotiations toward a multilateral agreement on
investment. The aim is to conclude negotiations by 1997. At the
negotiators' first meeting in September 1995, broad consensus was
reached on ensuring a high standard of principles (including full
national and MFN treatment of investment). Exceptions to such treatment
will be limited in number and narrowly drawn. In future negotiations the
United States hopes to establish international legal standards governing
expropriation, freedom from performance requirements (such as the
requirement that a foreign subsidiary's products contain at least a
specified minimum local content, or that a specified minimum quantity be
exported), guaranteed access to binding international arbitration of
disputes between private investors and national governments, and the
right to unrestricted investment-related transfers across borders. If
these principles are adopted, the multilateral agreement on investment
would establish a high standard for future work on investment issues in
Asia.

Bilateral Initiatives

Disputes and negotiations between one country and another are
inevitable in international trade relations. The United States ac-

Box 8-6.--The APEC Action Agenda

The Action Agenda details steps that APEC members will take to
dismantle key trade barriers that currently impede foreign businesses.
Examples include:
 Tariffs: According to one estimate, automobile sales to
Indonesia, Malaysia, and Thailand combined could equal U.S. auto
sales to Canada and Mexico combined by 2000. Under NAFTA, U.S.
car exports to Canada face no tariffs; those to Mexico face a 10
percent tariff, which will be eliminated by 2003. But tariffs on
U.S. car exports to Indonesia, Malaysia, and Thailand range
between 30 and 60 percent. The Action Agenda stipulates that
members will progressively lower these tariffs. Some members
will start reducing tariffs as early as January 1997.
 Air transport: Demand for air transport services in Asia is
projected to grow by 8.5 percent annually through the end of the
decade. This is a key opportunity for U.S. carriers, whose costs
per passenger-mile are half those of their Japanese competitors.
Yet barriers are high. APEC has commissioned a group of experts
to develop options to lower barriers to competition in this
fast-growing market.
The Action Agenda also contains a variety of measures that will
reduce the cost of doing business in the region:
 Infrastructure database: APEC is assembling an
infrastructure opportunity database, which will provide
information on the Internet--in English--on all government
procurement open to foreign bidding. APEC has already launched a
pilot home page on the World Wide Web that includes projects
from Hong Kong, the United States, Japan, and Australia.
 Customs harmonization: APEC is working to promote uniform
customs classifications and procedures and to establish common
forms for manifests, travel documents, and the electronic
transmission of business documents. Businesses can look forward
to the day when a single customs form is accepted in all APEC
countries.
 Standards harmonization: APEC is developing so-called
mutual recognition agreements in toys and some food products,
which will enable companies to sell their products throughout
the APEC countries after a single laboratory test.
tively engages in bilateral consultations, negotiations, and dispute
settlement procedures to defend U.S. commercial interests and to ensure
that trade agreements are implemented, market access is expanded, and
offending foreign practices are addressed. The focus of U.S. bilateral
agreements is to open foreign markets to producers from all countries,
not just those from the United States. These agreements are designed to
support a more open, less distorted world trade regime. This
Administration has also insisted on agreements that lead to tangible
market opening, not simply agreements in form. The Administration's
trade agreements specify qualitative and quantitative indicators of
progress, agreed to by both countries, and the Administration has
actively reviewed and monitored the agreements it has reached, comparing
actual progress made against these indicators.
Japan. Japan remains among the most important of our economic
partners. The Administration's goals in our relationship with Japan are
to increase both access for and sales by non-Japanese firms in the
Japanese market, to stimulate demand-led growth in the Japanese economy,
and to raise standards of living in both Japan and the United States. To
these ends, in 1993 the Administration signed the Framework for a New
Economic Partnership with Japan. The Framework laid out macroeconomic
goals and identified areas for sector-specific and structural
negotiations. In the past year alone the Administration has signed new
agreements under the Framework in automobiles and auto parts (discussed
below), financial services, and investment. These agreements bring to 20
the number of trade agreements that the Administration has concluded
with Japan.
The sectoral agreements with Japan are beginning to produce results.
The Framework set up mechanisms, including qualitative and quantitative
criteria, for both countries to use in reviewing the progress made on
these agreements. Although it is still too early to judge the effects of
the 1995 agreements, the results from the agreements concluded in 1993
and 1994 have generally been positive. By any measure, growth of U.S.
exports to Japan has been striking, especially given that country's
continuing economic stagnation. Overall U.S. exports to Japan were 20
percent higher in the period from January through November 1995 than in
the previous year, and 47 percent higher than when the Administration
took office. Growth of U.S. exports to Japan has been even stronger in
those goods sectors covered by the Administration's trade agreements
with Japan (Chart 8-1).
After 2 years of negotiations to open Japan's markets in automobiles
and auto parts to U.S. and other foreign suppliers, an agreement was
reached in the summer of 1995 to increase Japanese purchases of foreign
automobiles and parts. Under the agree-



ment, Japan promised to improve foreign automakers' access to Japanese
dealerships. U.S. industry expectations are for access to 1,000 new
outlets and the annual export of 300,000 U.S.-made vehicles to Japan by
2000. Also in connection with the agreement, the Japanese Big Five
automakers announced plans for their U.S. assembly plants that are
expected to increase those plants' purchases of North American auto
parts by $6.75 billion by 1998. Japan also agreed to deregulate the
repair and replacement market for auto parts in Japan, which will make
it much easier for foreign firms to sell auto parts in the Japanese
aftermarket. Finally, the Japanese Government will increase the budget
of the Japan Fair Trade Commission and consider U.S. suggestions for
improved antitrust enforcement.
The two countries also signed an investment agreement in July 1995.
Despite the abolition of most formal barriers to foreign direct
investment in Japan, Japan has absorbed only 1 percent of world foreign
direct investment--remarkably little for an economy that accounts for
about 16 percent of world output. A tangible market presence is
increasingly important for overseas sales in many industries, and for
many service industries it is indispensable for conducting business.
Efforts to facilitate foreign direct investment in Japan were therefore
an important part of the Framework negotiations. Under the United
States-Japan Investment Arrangement, Japan will review the few remaining
restrictions on foreign investment, make foreign investors eligible for
low-interest loans from the Japan Development Bank, and ensure that
foreign-owned firms are eligible for government-funded employment
programs. Japan has also pledged to make land available to foreign
investors in designated foreign access zones, and the Keidanren (Japan's
major business organization) has pledged to facilitate foreign contacts
with its members.
China. China is an increasingly important player in the world
economy. China's share of world trade has tripled since market reforms
were launched in the late 1970s, making it the world's 10th-largest
exporter. The Chinese economy has recently recorded some of the fastest
growth rates in the world (12 percent in 1994 and roughly 10 percent in
1995). Already the world's most populous country, China may have the
world's largest economy by early in the next century. U.S. exports to
China continue to grow quickly, as incomes, and hence demand for high-
quality U.S. goods, increase. This Administration is committed to
encouraging further economic liberalization and to integrating China
more fully into the world economy. Success at these efforts will support
U.S. foreign policy objectives of democratization, economic reform, and
development in China. Although great progress has been made on these
fronts, there is still a long way to go.
China's accession to the WTO is an important goal for both the
United States and China, with negotiations under way since 1988. The
United States and other WTO members have stipulated that China must join
the organization on commercial terms. Every country that has joined the
GATT in the past has agreed to adhere to the basic principles of the
multilateral trading regime, such as transparency of the trade regime
and uniform application of trade rules. The United States is working
with China to reach these world trade standards in a variety of forums,
including bilateral trade initiatives on market access, protection of
intellectual property, and services.
In February 1995 the United States reached a bilateral agreement
with China on IPR protection. The new agreement lays out specific
enforcement measures for China to undertake, and consultations between
China and the United States have been occurring frequently to ensure
that these measures are being carried out. In addition to creating a new
enforcement structure, the agreement increases market access for U.S.
audiovisual products, software, books, and periodicals by placing a ban
on quotas and by allowing U.S. companies to set up joint ventures in
several urban areas around the country.
Chinese pirating of U.S. software and audiovisual materials and
infringements of U.S. trademarks and patents had become a concern to the
United States as exports of pirated goods began turning up in Southeast
Asia, Latin America, and even Canada and the United States. China has
more than 29 factories with the capacity to produce 75 million compact
discs annually--in a domestic market that, according to estimates, can
absorb only 5 million. Under the new agreement, task forces have been
set up to raid illegal retail and manufacturing establishments as well
as to provide border control. As of the end of 1995, implementation of
the agreement has been mixed. Although China has attacked piracy at the
retail level, massive production, distribution, and export of pirated
materials continue. In particular, China has yet to halt production of
pirated CDs.
Korea. Although Korea is the fifth-largest manufacturer and a
rapidly growing exporter of automobiles, a variety of barriers have
effectively closed the Korean automobile market to imports. These
barriers include onerous standards and certification procedures, limits
on consumer financing and advertising by foreign firms, and excise and
registration taxes that fall disproportionately on the medium-sized and
larger models that U.S. automakers produce. Until recently, Koreans were
required to report the automobiles that they owned on their income tax
returns, and owners of foreign cars feared tax audits. These barriers,
which help explain why the foreign share of Korea's automobile market is
only 0.3 percent, were serious enough to warrant active consideration as
a ``priority foreign country practice'' in the U.S. Super 301 process
this past year.
Negotiations led to the signing of a memorandum of understanding
with Korea on September 27, 1995. The Korean Government agreed to reduce
significantly the tax burden on larger automobiles and to affirm that
foreign car ownership would not subject Koreans to tax audit or other
harassment. In addition, Korea will substantially reduce the
documentation required to secure safety approval and will allow testing
for a new noise standard to be done outside Korea. Foreign firms will be
able to establish or acquire automobile finance companies and will be
given equal access to television advertising time.
Monitoring foreign practices. One of the principal objectives of
U.S. trade policy has been the identification and elimination of unfair
foreign trade barriers. The Administration has placed a high priority on
enforcing U.S. trade agreements and on ensuring that other countries do
not engage in practices that violate trade agreements they have signed
with the United States. The U.S. Trade Representative, in close
consultation with U.S. firms, its private sector advisory committees,
and other interested parties, monitors the trade practices of other
countries and their compliance with U.S. trade agreements and is
responsible for addressing those practices identified as unfair.

MEASURING THE SUCCESS OF TRADE POLICY

The Administration's protrade policies have been associated with
rapid export growth. Real exports of goods and services have grown by 20
percent since the first quarter of 1993 (Chart 8-2). Real export growth
has risen: from 3.3 percent in 1993 to 8.3 percent in 1994 and 9.0
percent through the third quarter of 1995 (on a year-over-year basis).
The United States is once again the largest merchandise exporter in the
world, accounting for roughly 12 percent of global exports. Moreover,
the U.S. share of industrial-country merchandise exports has grown to 18
percent, from 15 percent in 1986, and now exceeds the shares of Germany
and Japan (at 15 and 14 percent, respectively).



Although U.S. exporters are once again extremely competitive on
world markets, the U.S. trade balance remains in deficit. The next
section explains why the trade deficit is a misleading measure of the
success of U.S. trade policies and the strength of the U.S. economy.
Fundamentally, the trade deficit is caused by macroeconomic factors, not
trade policy, which is capable of making only marginal changes in the
overall deficit. Eliminating or substantially reducing the trade deficit
will require macroeconomic policy measures, such as the elimination of
the Federal budget deficit.

CAUSES AND CONSEQUENCES OF THE TRADE DEFICIT

International trade and competition make a vital contribution to the
growth and well-being of the United States, and U.S. firms and workers
have proved themselves successful in that competition. Yet despite the
rapid growth of U.S. exports and export-related jobs, public commentary
often focuses on the overall trade balance, which shows a large and
seemingly intractable deficit. Many critics point to the trade deficit
as evidence that the United States is not competing successfully and
that international trade is detrimental to the health of the economy.
Therefore, they argue, the United States should modify its longstanding
policy of encouraging open markets and liberal trade.
This focus is unfortunate, because the trade balance is a deceptive
indicator of the Nation's economic performance and of the benefit that
the United States derives from trade. Trade policy is neither
responsible for, nor capable of significantly changing, the overall
trade balance. As noted above, trade policy can have a substantial
impact on the sectoral and geographic composition of trade, but the
aggregate trade balance is determined by larger macroeconomic factors.
Persistent external deficits do entail costs, but effective policies to
reduce these costs by narrowing the external deficit are beyond the
realm of trade policy.

SOURCES OF THE U.S. TRADE DEFICIT

The trade balance is simply the difference between the value of
goods and services sold by U.S. residents to foreigners and the value of
goods and services that U.S. residents buy from foreigners. Most of what
the United States produces (89 percent in 1995) is sold to residents of
the United States; the rest is exported. And most of what the United
States buys (88 percent in 1995) is produced here; the rest is imported.
When we compare total production and total expenditure, those goods and
services that we purchase from ourselves net out, and the difference is
exports minus imports, or the trade balance. A trade deficit thus
results when the Nation's expenditure exceeds its production.
Trade is by far the largest source of foreign income and foreign
payments, but there are other external income flows: the main ones are
interest and other investment earnings, aid grants, and transfers.
Adding these other current flows to the trade balance produces the
current account balance, which is the net income that the United States
receives from the rest of the world. The current account balance thus
represents the bottom line on the income statement of the United States.
If it is positive, the United States is spending less than its total
income and accumulating asset claims on the rest of the world. If it is
negative, as it has been in most recent years, our expenditure exceeds
our income, and we are borrowing from the rest of the world.
The net borrowing of the Nation can be expressed as the sum of the
net borrowing by each of the principal sectors of the economy:
government (Federal, State, and local), firms, and households. In other
words, the current account deficit (CAD) is equal to the government's
budget deficit (G - T, or net borrowing by the public sector) plus the
difference between private sector investment and private sector saving
(I - S, or net borrowing by the private sector):


(G - T)             +               (I             -           S)           =                CAD

Government                       Private                        Private                  Current account
deficit                          investment                     saving                   deficit


The crucial insight of this identity is that the current account
deficit is a macroeconomic phenomenon: it reflects an imbalance between
national saving and national investment. The fact that the relationship
is an identity and always holds true also means that any effective
policy to reduce the current account deficit must, in the end, narrow
the gap between U.S. saving and U.S. investment.

Economic Performance and the Current Account

If the current account deficit has little to do with trade policy,
neither does it necessarily indicate poor economic performance. In fact,
in the short run it may indicate precisely the opposite. Consider two
situations: one in which the economy is operating with fully employed
resources, and one in which the economy is operating with excess
capacity.
When resources are fully employed, a current account deficit does
not constrain the level of economic activity and thus cannot represent
``lost'' production. The U.S. economy in the past 2 years provides a
good example, since it has been very close to full employment and
production capacity. During 1994 and the first three quarters of 1995,
total U.S. production of goods and services (GDP) averaged $7.1 trillion
per year. Total U.S. expenditure was $7.2 trillion. The difference, just
over $100 billion worth of goods and services per year, came from
overseas, as reflected in the trade deficit.
It would have been very difficult to have produced those extra goods
and services ourselves and thus eliminated the trade deficit. The
monthly unemployment rate in 1994 and 1995 averaged 5.8 percent and
twice fell to 5.4 percent, very near the point at which economists
believe inflation begins to accelerate. Both labor force participation
and overtime in manufacturing were at postwar highs. In such a tight
labor market, any attempt to close the trade deficit in 1994 or 1995 by
producing more domestically would undoubtedly have been frustrated by
rising prices, or by an increase in interest rates that would have
reduced output in other sectors. In sum, when the economy is near full
employment, the trade deficit does not affect the level of economic
activity and therefore provides no insight into how well or poorly the
economy is performing.
The second case to consider is an economy operating at less than
full employment. Here trade outcomes can affect the level of economic
activity. Rates of foreign economic growth and the exchange rate of the
dollar have a strong influence on U.S. export sales, and therefore on
the level of U.S. production. And unlike in the case of full employment,
the expansionary impact from export sales in this situation is not
necessarily fully offset. At the same time, the cyclical state of the
U.S. economy exerts a strong influence on the demand for imports. In
practice, this channel is so strong that the trade and current account
deficits have tended to increase when the U.S. economy is growing
rapidly, as it has in the last 3 years, and to diminish when the U.S.
economy is weak. An increasing trade deficit is therefore usually the
result of a strong economy, not the cause of a weak one. Over the past
15 years, U.S. employment growth has tended to be highest when the trade
deficit was large, not when it was small (Chart 8-3).



The same conclusion holds if we look across the other major
industrial countries. In the 1990s trade balances have improved in those
of the seven leading industrial market economies (the Group of Seven, or
G-7) where economic growth and employment creation was weak (Chart 8-4).



Growth of the Current Account Deficit

From 1946 until 1982 the U.S. current account balance fluctuated
around zero but was generally in surplus. Government deficits during
recessions were balanced by weak domestic investment and an excess of
private saving (Chart 8-5). The adoption, early in the 1980s, of tight
monetary policy to combat inflation led to a sharp increase in U.S.
interest rates, an inflow of foreign capital, and an appreciation of the
dollar. At the same time, fiscal (tax and expenditure) policy led to
large budget deficits that did not disappear when the economy was
growing strongly and private investment was high. The so-called
structural budget deficit, which is the actual deficit corrected for
short-term fluctuations in GDP, increased by a full 2 percentage points
of GDP between 1982 and 1984. Econometric simulations indicate that the
shift in fiscal policies, coupled with a move toward more restrictive
budget policies abroad, explains about two-thirds of the deterioration
in the current account in the first half of the 1980s.



Fiscal policy changes in the middle of the 1980s partly reversed the
widening of the Federal budget deficit. But the slight reduction in the
budget deficit was more than offset by a fall in private saving: the
U.S. gross private saving rate (the sum of the saving rates of
businesses and households), which averaged 18.3 percent of GDP in the
first half of the decade, fell to 16.0 percent in the second half. In
broad terms, then, the increase in the budget deficit and the fall in
the domestic saving rate were responsible for the chronically large U.S.
current account deficit. Although the budget deficit (both actual and
structural) has fallen significantly during this Administration, a sharp
increase in domestic investment during the cyclical recovery has driven
the current account further into deficit over the past 3 years.

Current Account Developments in 1995

The current account deficit continued to increase in 1995, driven
largely by high U.S. economic growth relative to our major trading
partners. Although U.S. growth has been below the OECD average for much
of the postwar period, in the period since 1992, the U.S. economy has
grown faster than the economies of most other OECD countries, including
major trading partners such as Germany and Japan (Chart 8-6). Although
U.S. economic growth moderated in 1995, consistent with a desired ``soft
landing'' of the economic expansion, it remained above the OECD average.



Along with relative economic growth rates, changes in relative
prices (most often due to exchange-rate changes) have important short-
run influences on both bilateral trade balances and the overall current
account balance. Beginning in February 1995 the U.S. dollar depreciated
against the currencies of our major trading partners, and most sharply
against the Japanese yen (Chart 8-7). The depreciation of the dollar
went beyond what many viewed as justified by economic fundamentals, and
a statement by the G-7 finance ministers and central bank governors at
the end of April called for an orderly reversal of the preceding
exchange-rate movements. Interest rate reductions in Japan and Germany
and concerted currency market intervention in July and August were
followed by a recovery of the dollar. Between the end of April and the
end of August, the dollar appreciated by 16 percent against the yen and
by 6 percent against the deutsche mark. Although these bilateral moves
are noteworthy and will have a significant effect on bilateral trade,
the movement of the dollar against a weighted average of the currencies
of U.S. trading partners was more modest, particularly when an index
covering a broad range of trading partners is examined.
Relative price and income movements influence bilateral trade
balances in the short run, and there were important developments along
these lines with several U.S. trading partners in 1995. The



most dramatic change was in the balance with Mexico, following a severe
financial and exchange-rate crisis in that country beginning in December
1994 (Box 8-5). The dramatic nominal depreciation of the peso
outstripped the sharp increase in Mexico's price level, and so the real
(inflation-adjusted) value of the peso fell, encouraging exports and
discouraging imports. In addition, the downturn in economic activity
within Mexico greatly affected that country's demand for imports.
Consequently, the U.S. bilateral balance with Mexico fell from a $1.4
billion surplus in the first 11 months of 1994 to a deficit of $14.4
billion for the first 11 months of 1995.
Even so, as was emphasized above, U.S. exports to Mexico have held
up far better than those of Mexico's other trading partners, and the
provisions of NAFTA spared U.S. exporters from the emergency measures
that Mexico imposed on its trade with other countries. Despite the
severity of the crisis, Mexico appears to be adjusting successfully, and
its longer term prospects are encouraging. As Mexican economic growth
resumes, imports from the United States should rebound strongly.
Trends in the U.S. trade balance with Japan over the past year are
the result of income and relative price forces pulling in opposite
directions. The Japanese economy has seen almost no growth in output
since 1991, and the recovery that was expected to occur in 1995 failed
to materialize; current estimates of Japanese economic growth for 1995
are about half a percent. Despite this stagnation in demand, imports by
Japan have surged because of the appreciation of the yen over the past 3
years, coupled with some market-opening measures, and Japan's current
account surplus has narrowed. U.S. exports to Japan have grown rapidly
in the last 3 years, particularly in those sectors covered by Framework
and other trade agreements. The U.S. bilateral deficit with Japan has
declined since mid-1995 and for the first 11 months of the year it was
down 7 percent relative to 1994. Should the long-awaited recovery in
Japan begin this year, the deficit with Japan should decline further.
As the events of the past year illustrate, individual exchange-rate
movements and shifts in economic growth rates have large influences on
bilateral balances. Movements in the overall current account balance are
generally less extreme, because of the averaging that takes place across
various country markets. But the rate of U.S. growth relative to that of
its trading partners, together with overall movements in the dollar's
exchange rate, has a considerable influence on the U.S. external
balance, particularly on a year-to-year basis. Over longer periods
cyclical movements tend to average out, and real exchange rates are
influenced more by the requirements of long-run current account
positions and current account servicing requirements. Over this longer
time frame it makes sense to think in terms of propensities rather than
levels (in other words, the shares of national income devoted to private
saving, to domestic investment, and to financing the government budget
deficit). The emergence of the U.S. current account deficit over the
past 15 years has been the result of a decline in national saving as a
share of GDP (resulting from lower private saving and an increase in the
Federal budget deficit, both as shares of GDP), which has more than
offset a decline in the investment-GDP ratio since the early 1980s.

CONSEQUENCES OF THE CURRENT ACCOUNT DEFICIT

The current account deficits that arose in the 1980s are an
indicator neither of the ability of the United States to compete in the
world market, nor of the efficacy of U.S. trade policy. U.S. export
growth, and more broadly the growth of the U.S. economy, are much more
informative measures of our relative economic standing. The current
account deficit has not prevented a rapid increase in employment, and
the recent increase in the external deficit is primarily the result of
rapid economic growth. Furthermore, given the fiscal policy adopted in
the early 1980s and the subsequent decline in the U.S. saving rate, the
ability to borrow overseas and run a current account deficit has been
critical in maintaining domestic investment and growth over the last 15
years. Had the United States been forced to run a balanced current
account, interest rates would have been higher, and investment and
economic growth lower, than what we experienced.
If this is so, why should one care about the trade and current
account deficits? As explained above, the current account deficit is the
difference between our expenditure and our income, and represents our
net borrowing from the rest of the world. By running a large and
persistent current account deficit we have been borrowing against future
income, building up liabilities to the rest of the world that will have
to be serviced in the future. Estimates show the United States moving
from a net creditor position of over $250 billion in the early 1980s to
a net debtor position of over half a trillion dollars by 1994. The
positive net international asset position that the United States had
built up over 100 years was eliminated in the space of about 6 years
during the 1980s.
The debt-servicing requirements of this buildup of external debt are
already making their presence felt. Net income on U.S. external assets
was over $30 billion per year in the early 1980s. This inflow declined
over the 1980s and eventually turned negative: in 1995 our net overseas
payments are likely to be over $11 billion. Although these numbers are
still quite manageable in an economy that produces $7,000 billion in
income each year, the current trend is for an increasing share of U.S.
income to be paid out to foreigners, and thus to be unavailable to
support U.S. consumption and investment. In a period in which the size
of the retirement-aged population will increase sharply, servicing our
net foreign debt will be a further drain on the future working
population.
The extent to which we rely on foreign borrowing also influences the
terms on which we can borrow. Modern portfolio theory emphasizes the
importance of relative rates of return in determining asset holdings. To
induce foreigners to hold a larger share of their assets as claims on
the United States, we may have to offer a higher interest rate. Very
rough estimates place the share of U.S. assets in foreign portfolios at
about 9 percent, about 2 percentage points higher than in 1982. This
does not appear to be unduly large given the low transactions costs,
high liquidity, and strong investor protection that characterize U.S.
financial markets. In addition, the ratio of U.S. external debt to GDP
is still moderate, and well below the ratios of some other industrial
countries. But as the stock of foreign claims on the United States
increases, U.S. financial markets will inevitably be more sensitive to
foreign perceptions and external considerations.

POLICY OPTIONS TO REDUCE THE CURRENT ACCOUNT DEFICIT

Given that a sustained current account deficit is costly to the
Nation, what policy options are available to reduce it? As we have seen,
trade policy has little impact on the overall current account balance.
To shrink or eliminate the current account deficit, either the
government budget deficit must be narrowed, or private saving must rise
relative to investment, or both. Maintaining and if possible increasing
the rate of investment in the United States is critical for the growth
of American incomes and is a firmly held goal of the Administration. So
the only desirable options are to raise the rate of saving and to reduce
the government budget deficit. Unfortunately, the policy tools to raise
private saving are inherently limited: anything that might strengthen
incentives to save by raising the return to saving would also reduce the
amount of saving required to meet a future wealth or consumption target.
And if private saving incentives take the form of tax expenditures
(``tax breaks''), the induced increase in private saving must be greater
than the loss of tax revenue in order for national (public plus private)
saving to increase. The budget deficit is under far more direct policy
control. The Administration's budget, which would eliminate the Federal
deficit by 2002, provides the most promising way of reducing the U.S.
current account and trade deficits.
Reducing the U.S. current account deficit is primarily, but not
entirely, in our own hands. Since global saving equals global
investment, the sum of all countries' current account balances (when
accurately measured) must equal zero. Thus a reduction in the U.S.
current account deficit must go hand in hand with a decline in the
current account surplus of the rest of the world. Complementary policy
in foreign countries, particularly those with large current account
surpluses, would assist in the transition. That is why an important
component of the Framework negotiations with Japan focused on the
promotion of macroeconomic policies in that country that would encourage
strong domestic demand-led growth. But one should not exaggerate the
foreign responsibility for reducing the U.S. deficit. A reduction in one
country's surplus will not ensure a corresponding fall in the U.S.
deficit. And even without any policy actions by foreign countries,
changes in exchange rates and in world interest rates would accommodate
the elimination of the U.S. current account deficit. Fundamentally, the
U.S. current account balance will be determined by our own saving,
investment, and budget policy, and continued reduction of the Federal
budget deficit is the most effective tool for reducing our external
deficit.

CONCLUSION

A system of liberal international trade and investment boosts
overall living standards by allowing all participants to concentrate on
what they do best, to learn from others, and to ensure competition.
Consumers in open economies enjoy access to a wider variety of goods at
lower prices than those living in economies that insulate domestic
producers from foreign competition. Trade shifts jobs into sectors in
which an economy is relatively efficient, and therefore boosts
productivity and wages. In the United States, jobs supported by goods
exports pay 13 percent more than the national average. Open trade and
investment also have positive dynamic effects: exposure to the
competitive pressures of the international marketplace spurs domestic
firms to improve productivity and boost innovation. At the same time,
exposure to international markets and foreign direct investment
facilitates the flow of technology across borders, allowing producers to
employ domestic resources more efficiently.
Abundant evidence testifies to the advantages of open markets over
protectionism. Countries with outward-looking, liberal trade and
investment policies grow faster, the data show, than countries with
inward-looking, closed policies. The general consensus among economists
is that open markets raise growth and productivity.
Achieving the benefits of trade requires continual change and
adaptation. And even though most studies suggest that the effect has
been small in the United States, trade can worsen wage inequality. The
Administration therefore recognizes that, while outward-looking trade
and foreign direct investment policies are critical to the future
strength of the economy, we must help those injured by the lowering of
trade barriers to make the requisite adjustments. In today's global
economy, there is simply no alternative to competing.
This Administration has been remarkably successful in promoting
competition around the world. A concerted set of multilateral, regional,
and bilateral trade negotiations has produced the Uruguay Round
agreement, NAFTA, and the Framework agreement with Japan. Ambitious
plans have been laid for free trade across the Pacific and throughout
the Americas. Partly reflecting this active trade policy, U.S. exports
of goods and services have grown by 20 percent since this Administration
took office.
The continuing external deficit remains a cause for concern, but it
must be kept in mind that the deficit is caused by macroeconomic
factors, not trade policy. It should not be used as a test of whether
trade is beneficial or whether our trade policy is effective. The most
effective policy option for reducing the trade deficit is the reduction
or elimination of the Federal budget deficit.