The Trade Deficit is Falling. Should We Care?

March 3rd, 2010

A few weeks ago, The Wall Street Journal announced that the U.S. trade deficit had fallen for the second consecutive month. Should we care about that datum? The trade deficit is one of several economic indices that receive stylized media treatment: They are solemnly reported, their accuracy is taken for granted and their importance is assumed. In the case of the trade deficit, none of this is appropriate.

 What is the Trade Deficit?

The term “trade deficit” relates to a line item on the U.S.’s balance of international payments. The balance of payments is a double-entry accounting summary of aggregate economic transactions between residents of the U.S. and residents of the rest of the world, expressed in terms of dollar value. One line of the balance of payments is called the current account. It is devoted to trade in tangible goods and in services. (Gifts, such as money sent by immigrants to relatives back home, are also included.) This balance of trade will be positive if the value of goods and services bought from us by the rest of the world exceeds the value of goods and services we buy from them. Otherwise it will be negative. This line has been negative every year since 1972, which explains repeated references to the “deficit.”

 Why is the Trade Deficit Supposed to be Important?

In the 1500s, 1600s and 1700s, trade was conducted primarily using gold or silver money. A trade deficit meant a net outflow of gold and/or silver from the home country to foreign countries. This was supposed to be bad. In the 20th century, a trade deficit was supposed to represent a net reduction in income to the home country, with money “injected” from selling exports outweighed by the money “leakage” of imports purchased from abroad. The net reduction in income stemmed from the fall in “aggregate demand” for home-country output. More recently, the trade deficit is supposed to denote a decline in “competitiveness” of the home country’s industries.

 Which of These Views is Correct?

None of them. The ancient view was correct as far as it went, but the analysis stopped too soon. The net outflow of money would cause a reduction in prices of the home country’s output, which would make home-country goods more attractive in international trade. Meanwhile, the monetary inflow abroad would raise prices there, making foreign goods less attractive. Increased exports and reduced imports would eventually restore trade to balanced status.

 The 20th-century Keynesian view of a trade deficit as a net leakage of aggregate demand neglected the rest of the balance of payments – specifically, the capital account, which measured trade in securities and other assets. An offsetting surplus on capital account (such as the U.S. has enjoyed along with its trade deficit) stimulates aggregate demand and offsets the effects of the trade deficit. And indeed, trade deficits and prosperity have coexisted in the U.S. for many of the last 40+ years.

 The “competitiveness” argument is wrong for many reasons. Exchange rate changes can change a home country’s prices wholesale without any change at all in the efficiency of its industries. Changes in income will affect the balance of trade for reasons having nothing to do with competitiveness.

 Does This Mean That a Trade Deficit is Not Necessarily Bad or that its Bad Effects are Offset by Other Effects?

Both. When the home country’s income rises, its citizens will buy more goods – this is a very basic truth of economics. Some of those goods will be imported from other countries. After all, what people want is the happiness the goods provide. They don’t care whether the goods are produced in their neighborhood, their city, their state, their country, or Outer Slobovia.

 This increase in imports can cause a “worsening” of the trade balance even though good things, not bad things, are happening. In bad times, when incomes and employment fall, the opposite happens – imports fall, “improving” the trade balance. In every early-stage recession during the last 50 years, imports have fallen and the trade balance has improved. Consumption is the entire purpose behind economic activity. Falling consumption, whether of domestic goods or foreign ones, is bad news. Contrariwise, the U.S. trade deficits of the 1980s and 1990s were good news because they were symptoms of prosperity during the famous “Great Moderation.”

 On the other hand, it would be possible to envision a trade deficit accompanying economic adversity. In poorly-developed, Third World countries, businesses are sometimes so badly organized – and often so hamstrung by government monopoly, cronyism, and corruption – that they can produce little fit for export. This can certainly produce a “bad” trade deficit, because it is a symptom of economic malaise. The countries may be rich in natural resources, however. This attracts foreign investment. The combination is a trade (or current-account) deficit and an offsetting surplus on capital account. The overall balance of payments, a double-entry accounting document, is always in accounting balance; a deficit in one place is always offset by a surplus somewhere else.

 A Better Welfare Index Than the Trade Balance

Commentators of every stripe want the trade balance to serve as some sort of overall welfare index. But that makes no sense, since the trade balance can deteriorate in good times and improve during bad times.

 Import consumption benefits practically everybody in the home country. Exports benefit the owners and employees of exporting firms, at the expense of consumers of the exported goods. Thus, the logical index of welfare is the volume of trade. The worldwide volume of trade fell precipitously during the current recession for the first time in decades. Now, with recovery apparently underway, it is rising again. In the U.S., both exports and imports are rising. As it happens, exports are rising faster than imports because the demand for the rest of the world for our products is catching up with our demand for theirs. This is why the trade deficit is falling. But the key to the welfare effects of international trade is the volume of trade, not its algebraic sum.  

 Why is it Important for Investors to Know These Things?

Investors are bombarded daily with information. The less they know, the more insecure they are about what they don’t know. They may assume that because the news media report on the trade deficit with monotonous regularity, it is something they should know and even care about.

 They may even allow their everyday actions to be affected by it. For example, they may “buy American” so as not to worsen the U.S. trade deficit and thereby exacerbate the recession. This is downright crazy. Economic adversity is not the product of consumers making smart buying decisions in order to enhance their well-being. The entire basis for international trade is that efficient production and trade benefit everybody even if the geographic range of trade overlaps political boundary lines.

 Even worse, investors may decide to trade based on knowledge conveyed by the trade deficit. The foreign exchange market (FOREX) is a likely venue for professional currency traders because its volatility presents trading opportunities. That same volatility makes it a great market for average investors to stay out of.

 The last thing investors should do is trade on the basis of balance of payments reports. Those reports reflect data that is months old, while market prices reflect the up-to-the-second reality regarding the supply of and demand for foreign currencies. Not only is the data old, it is inaccurate. The total of world exports and imports does not match; it implies that the world has a balance of payments surplus with itself! (In fact, imports are underreported.)

 Twain’s Dictum

Mark Twain observed that “it ain’t the things you don’t know that hurt you; it’s the things you know that just ain’t so.” News reports of economic and financial data – the money supply, the unemployment rate, Gross Domestic Product and international trade – are ubiquitous. Their accuracy is questionable at best. They are usually written and read by people who know little or nothing of the logic underlying them. Take them with a boulder of salt.

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