There is currently a big debate occurring among economists about the trade deficit. Some argue we are in a new age and the trade deficit is irrelevant and others argue it is very important and we need to deal with it or it will deal with us. Regardless of that perspective, a trade deficit that comprises 7% of US GDP with little chance of decreasing this year always has the possibility of correcting on its own. Below is the standard economically considered chain of events that would occur it the markets take the initiative. These are found in a
paper titled
"Sustained Budget Deficit: Longer-Run US Economic Performance and the Risk of Financial and Fiscal Disarray" by Robert Rubin, Peter R. Orzag and Allen Sinai.
In the paper, the authors argue that sustained federal budget deficits lead to increased current account deficits. As federal deficits widen, the trade deficit widens to finance the federal budget deficit. As the trade deficit widens, the following events occur:
As traders, investors and creditors become increasingly concerned that the government would resort to high inflation to reduce the real value of government debt or that a fiscal deadlock with unpredictable consequences would arise, investor confidence may be severely undermined.
The fiscal and current account imbalances may also cause a loss of confidence among participants in foreign exchange and international credit markets, as participants in those markets become alarmed not only be the ongoing budget deficits but also the related current account deficits.
The loss of investor confidence, both at home and abroad may cause investors and creditors to reallocate funds away from dollar-based investments, causing a depreciation of the exchange rate, and to demand sharply higher interest rates in US government debt.
Confidence is immeasurable, but vitally important to financial markets. If traders think the current participants (government representatives) are unable to deal with a situation (such as the trade deficit), assets (such as the dollar and US government debt) become less attractive. This is why continually reading the financial press - especially daily reports - is so vitally important. When the phrase "twin deficits" starts to occur in daily commentary it means currency traders are concerned the US situation is getting out of control. As a result, trader's confidence in the dollar and US government debt slowly falls, leading them to sell both assets.
The increase of interest rates, depreciation of the exchange rate, and decline in confidence can reduce stock prices and household wealth, raise the cost of financing to business and reduce private sector domestic spending.
When traders sell government debt, interest rates increase. As rates increase, the cost of borrowing increases. This decreases the attractiveness of borrowing from the credit markets to finance future growth. As this process occurs, stock investors note the decrease in investment and start to sell equities. In addition, real estate becomes less attractive because it is usually financed with debt. As a result, overall domestic investment starts to slow.
The disruptions to financial markets may impede the intermediation between lenders and borrowers that is vital to modern economies, as long-maturity credit markets witness potentially substantial increases in interest rates and become relatively illiquid and the reduction in asset prices adversely affects the balance sheets of banks and other financial intermediaries.
When interest rates rise, trading may slow. This makes it harder to sell long-term debt, decreasing the possibility of financing long-term capital projects. As trading in stocks and real estate investment decreases, these assets' prices decrease as well. Financial institutions that purchase and trade these assets see their respective values decrease, making it more difficult for them to participate in financial markets. This slows economic activity.
The bottom line is the host country's economy - here the US -slows as interest rates rise, longer-term debt markets become more illiquid and financial intermediaries slow their participation in financial markets. What's particularly important about this scenario is the negative impact on financial intermediaries. Once they start to pull back their market participation it will probably be awhile before they start to increase their participation again. It takes awhile for a financial company to shore up its respective balance sheet.
This is not a pretty picture.