Are Trade Deficits a Problem?
Are trade deficits a bad thing?
No. A trade deficit is not inherently a bad thing. There can be pros and cons, and the effects depend on the situation.
A trade deficit occurs when a country imports more than it exports. In other words, it purchases more goods and services from foreign countries, than it sells to them.
A country has two halves that make up its balance of payments: the current account and the capital account. The sum of the current account and capital account should always balance to zero, essentially cancelling each other out (in reality, this isn’t always exact due to data errors, but we won’t go into that here).
In practice, the current account can be thought of as trade, and the capital account can be though of as capital (financial) investment. This means that if a nation has trade deficits, they will also have net capital inflows to balance it out.
Let’s use an example. The United States has a large trade deficit with Mexico. This means that the United States purchases more good & services from Mexico, than Mexico buys from the US. To pay for these goods & services, the US sends US Dollars (USD) to Mexico. As a result, Mexico accumulates a surplus of USD. But Mexico doesn’t want to just hold onto these dollars without using them — otherwise, they’ve traded their goods & services for random pieces of paper from another country. The only practical way to use that surplus USD is to invest it in the US. This results in net capital investment into the US.
In other words, the dollars that leave the US due to the trade deficit will return in the form of capital investment. This investment typically happens in the form of buying US Treasury bonds or investing in US assets (real estate, stocks, etc.).
In the case of the United States, where this topic has become a common talking point, running a trade deficit helps fund government spending. The US government spends more than it collects in taxes — this is known as deficit spending. Because the US is a highly desirably destination for foreign investment, it can run trade deficits knowing these dollars will return through investment, especially into Treasury bonds. In effect, the US is borrowing money from foreigners.
From an economic standpoint, this can be advantageous, as tapping foreign savings can have a pro-capital growth effect, especially if domestic saving and spending is insufficient. As we explained before, this can only be done by running trade deficits.
We can see that this relationship is true this is true by looking at national account identities:
GDP = Consumption + Government Spending + Investment + Exports - Imports
GDI = Consumption + Gross Savings + Taxation
Setting them equal to each other yields
Consumption + Gross Savings + Taxation = Consumption + Government Spending + Investment + Exports - Import
Gross Savings + Taxation = Government Spending + Investment + Exports - Imports
(Gross Savings - Investment) + (Taxation - Government Spending) = (Exports - Imports).
The trade deficit (exports – imports) is thus equal to the sum of the public and government deficits. In other words, when investment is high and savings are low, trade deficits naturally occur to balance out the equation.
All of that being said, trade deficits do have the potential to be harmful.
One potential problem is that running trade-deficits means a country is relying on foreign capital to support its level of spending and investment. This is risky in terms of long-term stability. If global investors ever lose confidence — for example, due to political instability or a weakening economy — they may pull back their investments. This could lead to sudden financial stresses that cascade down the country’s economic systems. Some tangible effects would be a drop in the value of the nation’s currency or higher interest rates. It could also lead to a sudden shock in government services, which can profoundly impact the everyday lives of the country’s citizens. Read about Mexico’s Tequila Crisis in 1994 or Argentina in 2001 for examples of this.
Another problem is that long-term trade deficits can lead to a sort of economic colonization. When foreigners accumulate USD from trade and then invest it back into the US, they may use that to buy up American businesses, natural resources, or other assets like property. This can exacerbate issues like high housing costs, or pose a concern for natural security if foreigners own critical assets and resources.