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Policy Brief 06-9

Can America Still Compete or Does It Need a New Trade Paradigm?

by Martin Neil Baily, Peterson Institute for International Economics
and Robert Z. Lawrence, Peterson Institute for International Economics

December 2006


The relentless increase in the US trade deficit since the early 1990s has raised concerns about America’s ability to compete in international markets and given rise to calls for new ways to think about international competition and new ways of responding to US trade deficits. This policy brief challenges such views. It reports evidence that indeed it has become harder for the United States to sell its goods overseas over the past decade. However, the change has been modest and well within historical experience. The exchange rate of the dollar is the major factor leading to the trade deficit rather than any structural inability of US manufacturing or services to compete in the new global environment. Accordingly, we judge that there is no need for a new trade paradigm, and it would be a mistake to adopt protectionist trade policies. Two simultaneous adjustments are required to bring about a smaller trade deficit. First, spending must switch from foreign to US goods. In addition, since the United States must reduce its borrowing from abroad, spending must fall relative to income. This expenditure switching can be induced by a decline in the dollar. An increase in national saving, public and private, or alternatively and less desirably, a reduction in investment could both slow spending. Trade restrictions, on the other hand, are either ineffective, more costly, or both.

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