How Bad Are Trade Deficits?

Trade deficits have been in the news because President Trump has talked about international trade quite a bit. He and others think that a trade deficit is a very terrible thing. I mostly disagree.

The heart of free-market capitalism is economic freedom. Freedom is usually beneficial for society, and that includes freedom to trade.

Free trade is beneficial

tradeLet’s start by understanding why free trade is beneficial.

Think about having to make your own clothing from scratch. Planting, tending, and harvesting cotton. Tending and shearing sheep. Processing cotton and wool into cloth. Making buttons and zippers. And so on. For most of us, this would take thousands of hours.

Or you could work a mere handful of hours at your chosen occupation and then use your pay to buy clothing made by people who are good at it. This is called specialization, or the division of labor. You do what you’re good at, I do what I’m good at, then we trade. This is great for prosperity.

But specialization is worthless without trade. We can only capture the benefits of specialization if we trade with each other.

If trade came to a complete stop, and each of us was forced to produce our own products, the economy would shrink and we would all become much poorer. In fact, economic historians believe that some of the world’s ancient empires suffered or collapsed due in part to sharp reductions in trade. The Roman Empire. China starting in the fifteenth century. More recently, the Smoot-Hawley tariffs of 1930 helped cause the Great Depression.

Now the key point: the marvelous benefits of trade do not halt if transactions cross a national border. In fact, prosperity gains are even greater when trade occurs among multiple countries. The wider pool of potential ideas and specialization offers greater opportunities.

Specialization and trade involving only you and one neighbor is less than optimal, right? In a similar way, so is specialization and trade within one country.

Some definitions

Before going further, let’s be sure a couple things are clear.

People often talk about a trade deficit as if it’s one number. At a minimum, it is two: exports minus imports. A trade deficit can go up because exports decline OR because imports increase.

A trade deficit refers to a nation’s current account. Each nation also has a capital account, which reflects the net investment flowing into or out of that country. Whenever a trade deficit exists, the capital account will have an offsetting surplus. For example, if the US has a trade deficit of $100, the US will also have a $100 surplus in the capital account. The capital surplus means that international investment of $100 will flow to the US.

As an aside, just to illustrate why trade deficits are an odd metric to focus on, you should realize that economists don’t even agree on which way the causality runs. i.e., does a trade deficit cause a capital account surplus, or does a capital account surplus cause a trade deficit?

Deficits not so bad

As some proof that deficits are not harmful, consider that the US posted a trade surplus during the disastrous economy of the Great Depression and a trade deficit in the good economy of the 1980s and 1990s. A trade surplus is not necessarily a sign of prosperity.

When the US economy performs poorly, the trade deficit is likely to shrink because we can afford fewer imports. When the economy performs well, the trade deficit is likely to increase because we can afford more imports.

Imports not so bad

Imports tend to get a bad rap. They “steal jobs,” and so on. Imports are not so bad. The economy is not a zero-sum game with fixed amounts of jobs and consumption. The ability of specialization, trade, and innovation to increase the overall pile of jobs, consumption, and prosperity is limited only by human creativity.

Furthermore, lower-cost imports can help domestic companies, workers, and consumers. A company can stay competitive on the global stage by buying lower-cost subcomponents that form part of a larger product. This also helps workers by preserving some domestic jobs. As for consumers, their standard of living is improved because lower prices mean products are more affordable.

That last point matters. A higher standard of living for the broad population should be the main goal of any economy.

Imports are not as bad for the overall economy as you may think:

  • Lower-cost imports leave customers with more money to spend on other things. A consumer that pays $35 for a pair of shoes instead of $45 owns the shoes plus an extra $10 they can spend on other things to help themselves and the economy.
  • Imports still require jobs. Sales jobs, logistics jobs, and perhaps engineering and product design jobs.
  • International capital investment linked with trade deficits helps make the domestic economy stronger. For example, BMW’s largest factory in the world is in South Carolina. It employs 9,000 workers.
  • Imports allow consumers to enjoy otherwise unattainable items such as oranges in winter, French wine, and Japanese silk.
  • Foreign competition keeps US companies sharp and competitive.

Protectionism no great solution

Even if you don’t buy my positive arguments, the stubborn fact is that people and countries cannot avoid economic reality. Reality says this is no longer 1950 and we live in a competitive global economy with global supply chains.

Building a wall of trade protectionism will allow domestic producers to hide behind the wall for a while, but it’s not likely to end well. Other countries may erect new walls of their own, making things worse for all sides. Stagnation will take root behind the wall and companies will become even less competitive.

When unavoidable reality hits, it will just be more painful. Better to accept reality now, embrace free trade, and strive to become or remain competitive.

The narrow view is easy but wrong

Trade, domestic or international, does lead to some companies winning and others losing. When a losing company closes a factory, trade is often portrayed as the villain. A closed factory is highly visible and easy to focus on.

On the other hand, the many beneficiaries of trade tend to be more dispersed and less visible. This dispersed benefit offers less of a story, so it is less noticed or remarked upon.

But it is wrong to focus narrowly on one industry or one closed plant. The wellbeing of the entire economy is what matters.

To illustrate, assume we slap a 25% import duty on steel. This may help domestic steel companies to stay afloat and save some jobs in the steel industry. Politicians will tout this visible success.

But it will also make steel products more expensive, and jeopardize jobs that are spread across far more steel-using companies. Also, consumers that buy steel products will have less money to spend on restaurants, cellphones, etc. These dispersed negatives are less visible, but will likely outweigh the concentrated positives in the steel industry.

Manufacturing misperceptions

The US has lost manufacturing jobs in the past two decades, leading to a couple of misperceptions:

Some blame the loss entirely on trade. Not true. Researchers at Ball State University estimate that only 13% of the job losses are due to trade. Productivity and automation are the main drivers, not trade.

Which brings up the second misperception. Some think that US manufacturing production has declined. Not true. Real manufacturing output is 34% higher than two decades ago, because productivity has improved.

Possible long-term concern

Now, does all this mean that free trade will always be an unalloyed positive? Maybe not. I personally have a nagging concern that a high-wage country could possibly in the long run import so much that it loses most of its manufacturing capability. Despite talk of a future services or information economy, this does not seem like a good outcome.

However, I can also provide four reasons why we should not obsess over this possibility. First, that outcome has not yet occurred, despite many decades of trade. Second, we cannot avoid economic reality anyway. Third, trade has real benefits as described above. Fourth, any attempt by government to ‘manage’ trade will result in excessive politicking, cronyism, and corporate lobbying.

As usual, we should probably err on the side of freedom. Freedom usually provides the greatest good for the greatest number.

I encourage you to enter comments or questions below. Two rules: 1) be reasonably polite, 2) address the issue and avoid personal attacks.


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