In defence of trade deficits

Explaining how trade deficits work

By Dr Andrew Lilico, Economics Fellow at the Institute of Economic Affairs

Politicians and general non-economist commentators often talk as if a “trade deficit” were a bad thing. Donald Trump talks of a trade deficit as being almost a kind of theft – if if the deficit were stolen money with nothing provided in return. Others talk of a trade deficit as if it indicates something about trade barriers – that, say, it’s reasonable to assume that the higher a country’s trade deficit is the higher the barriers to that country’s exports must be. These are both deeply confused ideas reflecting a misunderstanding about a fundamental piece of international macroeconomics.

Photo by Jamie Street on Unsplash

Suppose a country has a stable floating exchange rate and a stable domestic money supply. That must mean that inflows of money and outflows of money must be in balance. If, for example, people were buying more of the currency than they were selling, it would appreciate in value. Since that isn’t happening, purchases and sales must be equal.

There are two types of financial flow into and out of a country. They are called the “capital account” and the “current account”. The capital account covers international transfers of capital and the acquisition or disposal of non-produced, non-financial assets, such as land. For our purposes here, let’s think of the capital account as the net investment position. If foreigners are investing more in your country than your own citizens are investing abroad, your capital account is in surplus. And if the reverse is true your capital account is in deficit.

The current account covers the balance of trade and of “invisibles”. For our purposes, let’s think of the current account just in terms of trade. If you sell a higher value of goods and services than you buy, then the money coming in for your exports is more than the money going out to pay for your imports. That’s a trade surplus. If you run a trade deficit then there is a net outflow of money (and a net inflow of products).

Let’s return to our case of a country in which the net inflows and outflows are in balance. If you have a net inflow of funds on capital account – if foreigners want to invest more in your country than your citizens want to invest abroad – that must be balanced by a net outflow of funds on current account – i.e. you must be running a trade deficit.

That’s all a “trade deficit” is or means, if you have a floating exchange rate: that foreigners are keen enough to invest that that creates a net capital inflow. That net investment inflow and the trade deficit are simply mathematical counterparts, two sides of the same coin.

If you want to get rid of your trade deficit without devaluing your currency or having a period of rapid money growth (boosting inflation), you need to eliminate those net investment inflows. There isn’t another thing that can happen. Since the trade deficit is, in this case, precisely the same thing as net investment inflows, that’s your only option.

Next let’s understand what causes what. Is it that net investment inflows cause a trade deficit, that a trade deficit causes net investment inflows, or a bit of both?

The usual answer is that it is net investment flows that cause the net trade flows, not the other way around. The reason is that it’s much easier and quicker to adjust investment flows. There are large volumes of internationally mobile capital. They can be moved between US Treasuries and UK government bonds in nanoseconds, either at the flick of a switch or through the automated decisions of a high-speed trading algorithm. By contrast, trade flows adjust much more slowly (at least in volume terms; in value terms they change instantly as exchange rates change). Trade flows change when firms change where they source products, as consumer tastes evolve or as new innovations come along.

So the causation works something like this. A shock occurs. That leads to a shift in investment flows (e.g. an increased net inflow of investment). That leads to a change in the exchange rate (e.g. an appreciation). That exchange rate change changes the value of trade (e.g. making the country’s exports dearer and imports cheaper, widening the trade deficit). To see how important this point about what reacts quicker is, imagine a shock that would, in isolation, increase net investment or net exports. Typically what will happen is that, because investment flows adjust quicker, net investment inflows lead to a sufficient appreciation of the currency that net exports fall (instead of rising).

Net investment inflows are usually thought of as a good thing. Governments go to considerable efforts to attract Foreign Direct Investment. Since a trade deficit is simply the counterpart of success in attracting net investment, one should question why a trade deficit should be seen as bad at all. On the other hand, net investment does mean that one’s country’s assets are being acquired by and created by foreigners. Perhaps there are political circumstances in which that could seem unattractive (e.g. if one anticipated going to war with those foreigners). So it is of interest to ask what one might need to do in order to deter net investment inflows, other than the option of damaging one’s economy so much that foreigners don’t want to invest there (not typically considered an optimal policy).

One interesting and often important form of net investment inflow is foreign money coming in to buy government bonds. These often tend to be amongst the assets most attractive to foreigners. So a reduction in the government’s budget deficit will often lead to a reduction in capital inflows and thence, in consequence, to an increase in net exports (i.e. a reduction in the trade deficit or increase in the trade surplus).

Another way to reduce net investment inflows without damaging one’s domestic economy so much as to make investing there unattractive would be to make investing abroad more attractive. That could be done by helping foreign countries grow faster, if that were feasible. But an alternative could be to persuade foreign governments to set their interest rates higher.

That might have negative consequences for those countries – e.g. perhaps deflation, or perhaps social unrest as salaries were cut. But if the alternative were tariffs and huge trade dislocations, the negative consequences might be even worse.#

So, if Trump wants to eliminate trade deficits, he has a number of options:

• He could devalue the dollar.

• He could cut the US federal budget deficit.

• He could boost international GDP growth.

• He could persuade other countries to maintain higher interest rates.

In themselves, tariffs may reduce the US trade deficit but only by damaging the domestic economy more than foreign economies, thus reducing net investment inflows. Other than that, Trump is simply using the wrong tool to achieve his objectives.