Are Trade Deficits Bad?

Why Trade?

Division of labor increases everyone’s material well-being.

Does Florida gain by buying the cars of Detroit while Detroit buys the oranges of Florida? Or would Detroit be richer growing its own oranges? Both sides gain from trade, both are making sales and growing revenues for their companies.

Trade benefits both parties because both parties voluntarily engage in the transaction.

First, nations don’t trade with nations. People do. America’s trade with the world is the individual choices made by Americans.

So, Why Does A Trade Deficit Happen?

A trade deficit happens when a country imports more than it exports. But, this isn’t harmful. Because a trade deficit is balanced with a financial or capital surplus.

Balance of Payments (BOP)

The BOP is the record of all economic transactions between the residents of one country with the rest of the world. The trade deficit (or surplus) forms only 1 out of the 3 accounts within the BOP. The 2nd and 3rd accounts — which people don’t talk about — are the financial and capital accounts. Let’s define all 3.

The financial account tracks financial transactions in and out of a country (direct investments, treasuries, stocks etc.). The capital account tracks the net change in physical or financial asset ownership (for ex. a tractor). These 2 are sometimes grouped together.

The current account, which includes the trade balance, tracks the flow of goods and services, among other transactions, but trade is the most important.

What people don’t talk about — and the reason a trade deficit isn’t a problem — is because it’s “balanced” by the financial and capital accounts. Meaning, that when all three accounts are added together, they balance out to zero (or near zero). Hence, why it’s called a “Balance” of Payments.

For example, a country with a current account deficit (like the U.S.) will have a financial account surplus. Meaning, money goes out by buying and it returns by being invested back into the United States.

So, Why Does The BOP Balance Out?

To explain this I’ll use China as a net exporter (which it is), and the United States as a net importer (which it is). When we as individuals buy goods from China through Amazon or other businesses, we pay via dollars. However, the employees are paid in yuan. How does that happen?

What happens is the manufacturer exchanges the dollars with its bank for yuan. That bank then exchange the dollars with the People’s Bank of China (PBOC), the Chinese central bank, yuans. The PBOC ends up with a lot of dollars.

Like all banks — and people too — money is worthless if it sits there. The PBOC doesn’t want to exchange the dollars for yuans on the open market because that would depreciate the dollar and appreciate the yuan.

A stronger yuan would cause exports to be more expensive which means less exports. On the American side, a weaker dollar makes export to China be cheaper. This is bad for a China — an export-led country. Why?

Devaluing a currency is good for exporting, not importing. China wants to keep a cheap currency so it can continue being a net export country. Being the weaker currency, means USD will be the stronger currency. Here’s an example:

If 1 U.S. Dollar (USD) is equal to 6 yuans — which it is. But then the dollar loses to be 1 USD is equal to 3 yuans. Americans have a weaker dollar. This is bad for the Chinese because if before Americans could get 1 toothbrush with 1 dollar, now we can only get half a toothbrush. Americans are now disincentivized from buying Chinese toothbrushes and all Chinese products, in fact.

So instead of selling the dollars on the open market, the PBOC prints yuans and invests the dollars — which are now “foreign exchange reserves” — into dollar-denominated assets. They can’t invest in the Chinese economy because that would require exchanging the dollars into yuans — which we said isn’t an option. So, the PBOC uses the dollars to invest in dollar-denominated assets like US treasuries.

This is why China owns $1.05 trillion dollars of U.S. Federal treasuries. Money is lend to the federal, to do government stuff like paying government employees, soldiers and fund social programs. China also has $3 trillion dollars in forex exchange reserves — holding it for a rainy.

The Big Takeaway?

Americans buy goods from the world, the world uses those dollars to buy (or invest) in the United States. Thus, dollars flow back to U.S. soil. This is why the Balance of Payments balances out.

So, Trade Deficits Aren’t Bad?

Nope, trade deficits aren’t bad. These choices, to import or to export, like I said before, only take place if both parties of the transaction believe it will make them better off. Trade deficits aren’t a problem, neither are trade surpluses.

At different phases in economic development, countries go from a manufacturing, export led, industry-centered, cheap currency climate into a more advanced importing climate.

When I buy an apple from Wal-Mart, do I have a trade deficit with Wal-Mart? But, if I bought an apple from the Wal-Mart in the Columbia, it’s suddenly a trade deficit.

If I live in Detroit and go eat in California, does Detroit have a trade deficit with California? When it’s another country, it suddenly becomes a trade surplus or deficit — and subsequently a problem. That’s not true. Trade surplus or deficit is just a measure. Imaginary national borders determine trade deficits or surpluses. It’s not that someone is getting dupped.

If the United States bought China, would we then still have a trade deficit of US from China? Would our problems then suddenly and miraculously go away? No.

Title

Without imports we can have no exports, for foreigners will have no funds with which to buy our goods. When we decide to cut down our imports, we are in effect deciding also to cut down our exports. When we decide to increase our exports, we are in effect deciding also to increase our imports.

The reason a country should have a tariff is to protect your nascent, domestic industry from the more advanced and developed industries from abroad.

To your success,
Nikhil Mahadea

*The US debt owned by China is basically China investing in the United States. And specifically investing in the United States Federal government.

• In a way, America ends up with products while China ends up with dollars and investments. And this is because of our propensity to spend, while the Chinese like to save.
  *The US ran huge trade deficits with the rest of the world, borrowing around $2 billion a day to fuel its insatiable consumerism and the debt-financed wars in Afghanistan and Iraq.