At last week's meeting in Washington by the group of 7 leading economic nations in the world, finance ministers were told not to talk about the large trade deficit that currently exists in the U.S.  This is because host Treasury Secretary O'Neill is convinced that trade deficits are not a risk to the U.S. economy. 

Surprisingly, the ministers did talk about the U.S. trade deficit after the meeting.  They believe the dollar could fall sharply because of the deficit.  Not surprisingly, the dollar did lose some of its luster following these comments. 

Who is right about the importance of the U.S. trade deficit, and why did the ministers publicly disagree with our Treasury Secretary after the meeting?

Secretary O'Neill could be correct in his assertions under certain conditions.  Every nation must have a balanced flow of goods, services and capital with every other nation.  If one country sends more goods and services then they receive from another nation, then the difference creates a financial obligation.  

Those financial obligations may be converted into ownership of assets in the trade deficit country.  Thus, profits or interest payments must be made by the deficit country over time.  If the trade deficit gets large enough, these profits and interest payments might impoverish the trade deficit country. 

Such an example suggests that the accumulation of assets from the trade deficit country is passive.  In fact, in the past few years, the world has wanted to get American assets.  Indeed, the prevailing trade deficit still was not sufficient to get all the dollar claims needed to buy the desired assets. 

As a result, the dollar has increased in value against other currencies.  This made American goods more expensive abroad, thus increasing the trade deficit.  Slowly, the ability by the rest of the world to earn dollars through trade to buy the desired U.S. assets has approached balance.  

How do I know that it was the world's desire for U.S. capital that led to a larger U.S. trade deficit and not the trade deficit that forced the world to hold U.S. assets?  I know because the value of the dollar rose even as the deficit soared. 

Under the scenario where the value of the dollar and the trade deficit rises simultaneously, then we have the outcome indicated by Secretary O'Neill.  In the past three years, the Secretary has been correct in his lack of concern about the trade deficit. 

Nevertheless, the other finance ministers know economics, and they are not wrong in worrying about the size of the trade deficit.  For one thing, the deficit is exceptionally large relative to U.S. economic activity.  It is approaching 4.5 percent of our activity.

Secondly, the U.S. has been able to tolerate large international ownership of our assets, because U.S investors abroad have been more efficient in investing than international investors.  Despite a nearly $1 trillion difference between what America owns abroad and what the world owns in the U.S., the earnings on our international investments is only slightly smaller than what we pay to the world. 

This occurs because Americans invest in international equity while many international investors buy our bonds.  However, the ownership gap is growing and even those anemic returns on what is owned in the U.S eventually will mean a growing gap between profits and interest flowing into the U.S. in comparison to what is being paid abroad. 

Thus, the earnings from U.S. capital soon will be able to provide enough dollars abroad to meet the desires of international investors without pushing up the value of the dollar. 

Frankly, the dollar only strengthened further last year because additional uncertainty raised the world's demand for our assets at the same time that an inventory liquidation temporarily reduced the U.S. trade deficit. 

Now that the inventory liquidation is dissipating (causing our trade deficit to grow), investors no longer are seeking safety in U.S. capital markets, and  the dollar's value is becoming suspect, I expect that rising trade deficits will lead to a substantial reduction in the dollar's value. 

In other words, the Treasury Secretary was right but no longer is correct in his lack of concern for the trade deficit.  Soon, we will be providing more dollars to the world through our trade deficits and earnings from asset ownership than the world will want.  Then the size of the trade deficit will matter a great deal.

The finance ministers know that dollar instability could develop soon, and they would like something to be done about our trade deficit before the necessary dollar value correction gets out of hand.