Trade deficits are often perceived as a problem, but they are not inherently bad.

According to a report from the Federal Reserve Bank of Dallas, trade deficits frequently reflect foreign capital inflows. They can indicate strong domestic investment, fiscal flexibility through access to global capital markets, and the ability to finance higher levels of investment or mitigate the costs to the private sector of fiscal expansion.

Understanding trade deficits

Trade deficits occur when a country imports more goods and services than it exports. Trade deficits also reflect the gap between national savings and investment.

When national investment exceeds national savings, the difference likely comes from additional goods and services that are imported. These goods are often financed by borrowing “foreign savings” from other countries, which then shows up as a trade deficit. Conversely, if a country saves more than it invests, it lends to the rest of the world, generating a surplus.

Looking for closely, trade imbalances can also signal an economy’s ability to borrow internationally to finance investment and consumption without increasing domestic interest rates. Savings tend to rise with the real interest rate, as higher returns encourage deferred consumption by households and firms. Conversely, investments tend to fall with the real interest rate, as the cost of capital increases and that fewer investment projects remain profitable. Because the US is an open economy that’s integrated into the global financial system, interest rates aren’t just determined by domestic saving and borrowing, but are also influenced by the world market rate.

This means that US borrowers, public and private, can access foreign savings at a lower rate than what the rate would be if the US had to rely only on national savings. As a result, the US can spend and invest more than it saves without pushing US interest rates up, maintaining living standards and supporting credit, housing, and economic growth, while also funding critical infrastructure, research, and other long-term projects. Furthermore, trade deficits can accompany periods of strong economic growth or when the government is spending more. For example, a favorable policy shock, like a corporate tax cut, can increase the expected return on capital and spur firms to invest more. If this rise in investment outpaces saving, the economy turns to foreign capital to bridge the gap, resulting in a trade deficit.

However, this deficit reflects economic dynamism, supported by access to global markets, rather than underlying weakness. A similar dynamic occurs with big government spending programs such as the Coronavirus Aid, Relief, and Economic Security (CARES) Act in 2020 and the American Rescue Plan Act in 2021, which increased budget deficits and foreign borrowing.

Tariffs and trade deficits

The report also examines whether taxes on imported goods reduce trade deficits. It notes that while tariffs undeniably affect trade flows, their net impact on trade balances is ambiguous because multiple offsetting factors are at play.

For example, many tariffs target intermediate goods like parts or raw materials. This raises costs for domestic producers, diminishes output, and undermines export competitiveness, partially offsetting the trade balance reduction from lower imports.

Meanwhile, tariffs on final consumption and investment goods can raise prices for consumers and businesses, which might reduce imports and narrow the trade deficit. But this impact depends on whether domestic substitutes are available and how foreign producers adjust their prices because of these tariffs. Finally, tariffs can also affect currency markets. If tariffs reduce demand for imports and consequently demand for foreign currency, the US dollar may appreciate. A stronger dollar makes exports more expensive and imports cheaper, which can increase deficits or offset reductions achieved through tariffs.

But overall, the broader impact of tariffs depends on how tariff revenue is used and whether trading partners retaliate, which can harm exports. For firms and households, this may delay investment and spending decisions, temporarily reducing imports but also slowing down overall economic growth.

The US’s persistent trade deficits

The US has run persistent trade deficits since the mid-1970s. These deficits largely stemmed from three macroeconomic and structural forces. First, the US has consistently outperformed its peer in economic growth, and productivity growth, making it an attracting destination for global investors. Second, after the 1990s, rapidly growing economies like China started saving a lot of money, while aging populations in many countries increased global savings overall.

This pushed down interest rates, and increased global savings, enabling the US to borrow more money and increase its trade deficit. Finally, the US dollar has consistently been a dominant reserve currency, ensuring persistent demand for dollar-denominated assets, especially during global crisis. This demand supports capital inflows, and makes US exports less competitive and imports cheaper, reinforcing the trade deficit.

Trump’s US tariff policy

President Donald Trump has sharply increased tariffs on goods reaching the US from countries around the world. Between January and April 2025, the average applied US tariff rate rose from 2.5% to an estimated 22.5%, the highest level in over a century. After changes and negotiations, the rate was estimated at 17.4% as of September 2025.

Trump claims that the tariffs will promote domestic manufacturing, protect national security, and substitute for income taxes. He also says they will reduce the US trade deficit, which he views as inherently harmful. Currently, a patchwork of different rates is in place. They comprise 50% tariffs on Indian goods, including a 25% penalty for trade with Russia; 50% tariffs on Brazilian goods; 30% tariffs on South African goods; 20% tariffs on Vietnamese goods; 15% tariffs on Japanese goods; and 15% tariffs on South Korean goods. Negotiations continue with a number of countries.

China and the US had threatened tariffs of more than 100% on each other’s goods, but have extended a truce until November. Canada and the US are also continuing their negotiations, and Mexico was given a reprieve from tariffs of 30% or more until the end of October to allow time to strike a deal. In Europe, the UK has negotiated the lowest tariff rate so far at 10%. The European Union (EU), meanwhile, secured a 15% rate, half the rate Trump initially threatened. The trading bloc would charge US firms 0% duty on certain products, subject to approval by its 27 member states.

 

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