Is a Trade Deficit Bad?

People point to it in horror. Many politicians claim it manifests the decline of the United States as an economic superpower. Our current president states it is here because of our horrible trade deals. It is our nation’s trade deficit, and it has been the source of much attention and controversy in recent months.

A trade deficit is created when a country has a negative balance of payments. A balance of payments is, simply, the difference in value between payments into and out of a country. It consists of two accounts, a current account and a financial account. The current account records the exports and imports of goods and services, investment income received or sent abroad, and secondary income (current transfers, such as works’ pensions) received or sent abroad. Exports, as well as investment income and secondary income received from abroad, are called credit transactions. Imports, as well as investment income and secondary income paid to foreign residents, are called debit transactions. Therefore, if the credit amount exceeds the debit amount in the current account, there is a current account surplus. On the other hand, if the debit amount exceeds the credit account, the current account is in a deficit.

The financial account records the buying and selling of financial assets such as stocks, bonds, and real estate. Net borrowing is when residents of a country have sold more financial assets than it bought. Net lending is when residents of a country have bought more financial assets than sold. For instance, if foreign residents purchased $50,000 of financial assets in the United States, while residents from the United States only purchased $30,000 of financial assets, the United States would have a financial account deficit. The term deficit is used because selling a financial asset guarantees a liability in the future, whether it is dividends or paying the principal amount invested with interest.  

The current account must equal the financial account, just like the assets must equal the liabilities plus the owner’s equity in accounting. For example, if there is a $10,000 deficit in the capital account, there must be a $10,000 deficit in the financial account. The reason why there must be parity is because no one will trade something if they’re going to receive something less or nothing in return. If person A gives person B 5 cars and person B can only pay for 2 cars, person A will not do the trade unless there is something else person A will receive for the remaining 3 cars. But if person A sells an asset to person B, then person A will have the money to purchase the remaining three cars. However, person A will be bound to the liabilities of the asset sold whether it is a bond or stock etc. Another example is a company that needs money to help grow their business. They thus want to trade for people's money. However, no person will trade his/her money for nothing in return––the company does not have any commodity to give in exchange. The company therefore issues bonds or stock in exchange for money. There is sometimes a discrepancy between the current account and capital account due to large amount of transactions occurring daily between residents of a country and foreign residents, as opposed to accounting where you are solely recording the transactions of one company.

The ability to borrow from abroad allows a country’s total investment to exceed its total savings. In a closed economy, savings must equal investment. Savings is defined as the supply and investment is defined as the demand because the savings satisfies the need for money from borrowers. In economic terms, savings is the same thing as investing, i.e. where an individual is taking their extra money and investing it in stocks, bonds, or other assets, and investment is borrowing––for instance, a company issues stock in order to obtain cash to grow the company. If investment exceed savings, the interest rate increases and puts downward pressure on investment leading to a decrease in investment. But in an open economy, investment can exceed savings because residents can borrow from abroad. Additionally, if savings exceeds investment in a country and residents don’t want to obtain a low interest rate, residents can invest abroad and obtain a higher interest rate. Therefore, a country that invests more than it saves will import savings from abroad; a country that saves more than it invests will export its savings to other countries.

The trade balance is largely determined by the financial account. Exchanges of financial assets occur more often and quicker than the exchanges in the goods market––the current account––due to electronics and technology. Thus, transactions pertaining to the financial account dictate the exchange rate of a country, which itself is determined by supply and demand. When a country increases its exports of goods or foreign residents purchase financial assets in the country, the demand for the currency goes up, causing the country’s currency to appreciate because foreign residents need the country’s currency to purchase exports or financial assets. When a country increases its imports of goods or the residents purchase financial assets, the demand for the currency goes down because the country needs to exchange some of its currency for foreign currency to buy imports and foreign countries’ financial assets. The balance of the financial account largely determines the movement of the exchange rate because it happens more often and quicker. Therefore, if the United States is investing more than it is saving, it will have a net borrowing in its financial account––the dollar will appreciate due to the many different countries purchasing financial assets in the United States. A stronger dollar makes exports more expensive for foreign countries to purchase and it makes imports cheaper for domestic consumers because they can purchase more with their dollar. This leads to an imbalance in the current account as well.

A trade deficit is not necessarily a bad thing and a trade surplus is not necessarily a good thing. The deficit is mainly determined through macroeconomic policy, an imbalance of savings and investment. Generally, when an economy is expanding, it incurs a trade deficit in order to increase growth. This occurs in business as well––when a company takes on debt, it doesn’t mean that the company is necessarily in trouble. Instead, taking on debt is simply a way for the company to raise money to fund future operations and growth. A country is just the aggregate of all of its residents’ investment plus the government’s budget. If the government is unable to balance the budget with taxes, it must import savings from abroad. When the government contributes to the trade deficit it is more likely to have negative consequences because many times the money is not directly used for growth, as opposed to individual companies which mainly borrow to increase revenue.

If a country’s growth is greater than the liabilities it’s owed due to a deficit, than it can be argued that the increase of investment over savings is a good thing. On the flipside, if the country’s growth is less than the liabilities owed, it can be a problem. However, many times the deficit is fixed automatically. In the case where the growth is less than the liabilities incurred through investment, the foreign residents that put their saving in the country will get a lower return which will lead to less foreign residents willing to put their savings in the country. If there is less savings available, investment must decrease which will lower the deficit. This is why a recession is one of the quickest ways to lower the deficit because all savings flood out of the country because people are worried they might lose all their savings. Before you panic when you see a trade deficit and be content when you see a trade surplus, it is critical to look at the underlying macroeconomic policy and GDP growth of the particular country.