Don’t use the trade deficit to keep score
Published 23 February 2017
Americans like to play to win. When it comes to international trade, however, we shouldn't use the size and trend of the national trade deficit as a way of scoring trade policy. It's like using the size of players' salaries to evaluate whether you had a winning season.
Things, Not Words
Americans like to play to win. When it comes to international trade, however, we shouldn’t use the size and trend of the national trade deficit as a way of scoring trade policy. It’s like using the size of players’ salaries to evaluate whether you had a winning season.
To start with, the way we talk about the deficit throws us off our game. Renowned economist Thomas Sowell insists that the language around economic principles should serve to clarify, not obfuscate. He thinks the trade deficit is perennially misunderstood owing both to the language we use to describe it and to the political rhetoric used to decry it.
The basic facts about international trade are not difficult to understand. What is difficult to untangle are all the misconceptions and jargon which so often clutter up the discussion. The great U.S. Supreme Court Justice Oliver Wendell Holmes said, “we need to think things instead of words.” Nowhere is that more important than when discussing international trade, where there are so many misleading and emotional words used to describe and confuse things that are not very difficult to understand in themselves.
For example, the terminology used to describe an export surplus as a “favorable” balance of trade and an import surplus as an “unfavorable” balance of trade goes back for centuries. At one time, it was widely believed that importing more than was exported impoverished a nation because the difference between imports and exports had to be paid in gold, and the loss of gold was seen as a loss of national wealth. However, as early as 1776, Adam Smith’s classic The Wealth of Nations argued that the real wealth of a nation consists of its goods and services, not its gold supply.
Too many people have yet to grasp the full implications of that, even in the twenty-first century. If the goods and services available to the American people are greater as a result of international trade, then Americans are wealthier, not poorer, regardless of whether there is a “deficit” or “surplus” in the international balance of trade.
– Thomas Sowell, 2015. Basic Economics, 5th Edition, p. 476-477
It’s Just an Accounting Convention
The balance of trade is not a good way to measure the effectiveness of trade policy. Here’s why: it confuses accounting theory with economic theory. To understand the accounting, start with double-entry bookkeeping where both sides of the ledger must be equal.
The trade balance is typically the largest component of the “current account.” For an economy like the United States, the current account is always in balance with the “capital account.” The total amount of dollars bought for foreign currency must equal the total amount of dollars sold. If dollars bought are used to buy stocks, bonds, or property, they cannot be used to buy goods for export. A so-called “surplus” in the capital account must be balanced by a so-called “deficit” in the current account.
The current account is a bookkeeping device which records trade in goods and services and net earnings on foreign investments, while the capital account records the international investments themselves. Because buyers must match sellers for the foreign exchange markets to clear, exchange rates and interest rates adjust to ensure capital flows match trade flows.
All Trade is Free Exchange – You Only Do It if You Stand to Gain
Confusing accounting theory for trade theory generates two misunderstandings. First, it obscures the essence of free exchange. The nature of trade is that each party will make the exchange only if the good received is of greater value to the trader than the good surrendered. Said another way, trade is always a positive-sum event; each party gains from the transaction.
Second, focusing on the trade deficit alone presumes that dollars that do not return to the United States in the current account do not return at all. But this can only be the case if one ignores the existence of the capital account. Trade balances are determined by the balance between savings and investment.
The Deficit Doesn’t Correspond with Unemployment
The conventional rhetoric is that trade deficits subtract from GDP and therefore must result in lost jobs. But this argument is entirely inconsistent with actual experience of the U.S. economy.
Thanks in part to the Smoot-Hawley Tariff Act of 1930, the United States ran large trade surpluses from 1930 to 1935 and again from 1937 through 1941, while unemployment frequently exceeded 25 percent. Fewer imports did not bring economic success.
In contrast, beginning in 1975, the United States began running trade deficits every year. During those four decades, the U.S. economy tripled in real terms, manufacturing value added quadrupled, and the number of jobs in the economy more than doubled.
For the last 40 years, an increasing trade deficit has correlated with lower rates of unemployment. Faster economic growth increases demand for both labor and material inputs (domestically-produced as well as imported inputs). Growth in demand pushes up the trade deficit while it pushes down unemployment.
Source: Bureau of Economic Analysis
So Is The Trade Deficit A Good Thing?
A growing trade deficit seems to be associated with good economic results — why is this? Dan Ikenson explains it this way. “Rather than weakness or …foreign malfeasance, the trade deficit is a global endorsement of the relative strength of the U.S. economy.” Because of the strength and stability of our economy, and because the dollar became the predominant reserve currency after the gold standard was eliminated, the demand for dollar-denominated assets grew steadily (leading to a surplus in the capital account). Our economy was attractive to investors.
On the flip side, a declining trade deficit usually is a sign of recession. The deficit fell substantially in 2009 versus the previous year, as the downturn caused by the financial crisis reduced aggregate demand for goods, services and labor.
A Solution in Search of a Problem
The critics of trade deficits have failed to produce a factual, convincing argument that the trade deficit is an economic problem which needs a solution. The reason is simple—it’s an accounting identity, not a scorecard for trade policy.
After over 200 years, Adam Smith’s advice is still sound; focus on consumer welfare and growth, and let the current account measure what it measures.
Recommended: Thomas Sowell’s book, Basic Economics, Fifth Edition: A Common Sense Guide to the Economy