Are Trade Deficits Always Harmful to a Country’s Economy?

Economics, Long Reads
Reading Time: 5 minutes

A trade deficit is when a country spends more on imports than it receives in exports in a given period of time. This is financed by a net inflow of financial investment, with foreigners holding domestic assets, such as bonds, stocks, firms and currency. Perhaps the most notable example of trade deficits causing concern is in the USA, where President Trump has repeatedly described the USA’s trade deficit as equivalent to it losing money. In order to understand whether a trade deficit is inherently harmful, it is worth starting at the perspective of what a trade deficit means in terms of savings and investments and then proceed to the approach involving the exchange of goods and services.

We can understand the trade deficit by looking at the national income identity. Based on that, and the fact that savings is simply national income subtract spending, we get that savings equals investment.

Y=C+G+I+(X-M)

S=Y-(C+G+(X-M))

S=I

Savings can be separated into private savings, the fiscal budget position and the trade surplus.

S=SP+(T-G)+(M-X)

I=SP+(T-G)+(M-X)

M-X=I+(G-T)- SP

In this way, the trade deficit equals the private investment and government budget deficit subtract domestic private savings. This gives rise to the idea that a trade deficit is when we are spending more than we save and living beyond our means.

However, this ignores the fact that a country could be importing more than it is exporting in order to invest in capital goods and produce further goods for future export. This effect is buttressed further if we consider the international context. This is because when we run a trade deficit, it requires money to leave the country, and the trade partners with a trade surplus will have to do something with that money. They could leave that money within their borders, which could push up the value of their currency until their exports are so expensive that the trade deficit disappears. Alternatively, they must take that surplus and invest back into our assets, such as by FDI or buying up various stocks and bonds. As such, the question of whether we want a trade deficit is the same as whether we want capital inflow. The money flowing in can not only drive down interest rates as savings increase, allowing for cheaper borrowing and stimulating growth, it can also be spent on capital goods that would increase the productive capacity of the country and lead to greater employment. Indeed, Reinbold and Wen (2019, 1, figure 1 and 2) showed the USA running a trade deficit for most of 1800-1875, and the capital goods it imported allowed it to improve its manufacturing during its industrialisation, with the USA’s trade balance of manufactured goods going from being a net import to a net export by 1880. In fact, the USA was able to sustain a trade surplus between the late 1870s to early 1970s based on these foundations. Similarly, Valderrama (2007) observed that the growth of the USA’s trade deficit since 1996 occurred in parallel to its labour productivity growth rate almost doubling, and this increased productivity could sufficiently increase investment at the expense of savings, growing the deficit.

By contrast, Japan, which had trade surpluses in the 1990s, faced low GDP growth and rising unemployment, precisely because the surplus reflected a high rate of domestic savings due to insufficient investment opportunities. As such, it is possible for a trade deficit not to be a sign of irresponsible spending in a country with a savings rate that is far too low. Rather, it can be a sign of a country that is attractive to foreign investment, whether due to its high returns on investment or safety of the investments.

There are, however, several caveats to this picture of the trade deficit being useful in the context of savings, investment and financial flows. For one, if the trade deficit, where a country is on net borrowing from the rest of the world, is composed of bonds and loans rather than FDI, this could make the interest payments larger, and potentially unsustainable. In addition to that, the benefit of lower interest rates is unsurprisingly only useful when interest rates are high, and in countries where they are already near the zero lower bond, the effect this capital influx has on lowering it is likely to be fairly trivial. Finally, it is by no means guaranteed that the investment is productive, and this is easily seen in Mexico’s current account during the 1970s and 1980s. Due to increasingly large interest payments from the trade deficit beforehand, and with no way of paying it back due to subpar investments, the current account deficit reached 5% of GDP by 1980, forcing Mexico to seek help from the IMF. Another way the investment of the trade deficit can be squandered is when it fuels bubbles, with a notable example being the housing bubble in the USA in the mid-2000s. As such, it is in these cases where a trade deficit may indeed be a detriment, since the investment is not productive, and the trade deficit is caused by insufficient savings.

Another approach to the trade deficit is to view it explicitly as the difference between imports and exports. The most obvious problem with a deficit in this sense is that of employment, since a trade deficit would suggest that there are fewer imports and more exports, thus shifting jobs overseas. This is particularly pronounced when the trade deficit is concentrated in a certain sector, and Rasmussen (2016) suggests that if the USA had not had a trade deficit, manufacturing could potentially have employed an extra 18% more employees. However, the financial account surplus that balances a trade deficit means domestic assets are being purchased, and as per the analysis above, this will drive spending in the economy, creating more jobs. As such, what a trade deficit could do, is not increase unemployment in aggregate, but rather shift which sectors people are being employed in. However, the fact that labour is not perfectly mobile means that it is likely that unemployment will increase in the short-term, as individuals change careers.

The fact that imports are in greater demand than exports might suggest a lack of international competitiveness, which is a cause for concern. However, the fact that Bolivia ran a trade surplus from 1980 to 1986 despite per capita output falling by 26% exemplifies why the balance of trade is uninformative on whether a nation is competitive, since it is affected by so many other factors. For example, Bolivia’s trade surplus was because it was compelled to service the large international debts it had, thus sacrificing the productive capacity and competitiveness of the economy.

Ultimately, perhaps the simplest way of viewing a trade deficit is as capital inflow. In and of itself, it doesn’t decrease employment and isn’t detrimental towards competitiveness. In a country investing more without cutting current consumption, a trade deficit displays the signs of a healthy and growing economy. However, the converse can also occur, if the investment is unproductive and results in expensive financial payments. As such, trade deficits are not always harmful to a country’s economy, and that instead depends upon the fundamentals of the economy in question.

List of References

Reinbold, Brian and Yi Wen. “Historical U.S. Trade Deficits.” Economic Synopses 13 (2019)

Valderrama, Diego. FRBSF Economic Letter 2007-08. Federal Reserve Bank of San Francisco, 2007

International Monetary Fund. International Financial Statistics Yearbook 1997. International Monetary Fund, 1997

Rasmussen, Chris. Jobs Supported by Exports 2015: An Update. US Department of Commerce, 2016

Hatsopoulos, George, Paul Krugman and Lawrence Summers. “US Competitiveness: Beyond the Trade Deficit.” Science 241 (1988)

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