Balance of trade

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The balance of trade (or net exports, NX) is the difference between the monetary value of exports and imports in an economy over a certain period of time. A positive balance of trade is known as a trade surplus and consists of exporting more than your imports; a negative balance of trade is known as a trade deficit or, informally, a trade gap.

The balance of trade is sometimes divided into a goods and a services balance; especially in the United Kingdom the terms visible and invisible balance are used. The balance of trade forms part of the current account, which also includes other transactions such as income from the international investment position as well as international aid.

If the balance of trade is positive, the country's net international asset position increases correspondingly. Equally, a deficit decreases the net international asset position.

Measuring the balance of payments can be problematic because of problems with recording and collecting data. As an illustration of this problem, when official data for all the world's countries are added up, exports exceed imports by a few percent; it appears the world is running a positive balance of trade with itself. This cannot be true, because all transactions involve an equal credit or debit in the account of each nation. The discrepancy is widely believed to be explained by transactions intended to launder money or evade taxes, and other visibility problems. However, especially for developed countries, accuracy is likely to be good.

Factors that can affect the balance of trade figures include:

The balance of trade is likely to differ across the business cycle. In export led growth, the balance of trade will improve during an economic expansion. However, with domestic demand led growth the trade balance will worsen at the same stage in the business cycle.

Economic impact

Most economists do not believe that trade deficits are inherently good or bad, but must be judged based on the circumstances in which they arose. Large imbalances may sometimes be a sign of underlying economic problems or rigidities. An example includes a situation where exchange rates have been fixed or pegged for political reasons at levels impeding a correction of a trade imbalance.

In order to maintain a negative balance of trade, it must be financed by running down net international assets relative to the case without a deficit. This may be done for example by selling assets, through foreign direct investment or by international borrowing. Potential problems with persistent deficits therefore include the accumulation of foreign debt with associated interest payments or domestic assets passing increasingly into the hands of foreigners. Deficits may also have intergenerational effects: by shifting consumption over time, some generations may gain at the expense of others ([1]). (In other words: citizens of countries that run up cumulative trade deficits leave it to their children to pay the bill, in the form of either interest and dividend payments to the rest of the world, or to seeing more and more assets being owned by the rest of the world.)

A large trade deficit, in general terms, can only be sustained as long as the rest of the world is willing to finance it. If, for whatever reasons, this ceases, a country may find itself unable to meet its obligations. The mere possibility thereof is likely to result in a rise in interest rates and/or a depreciation of its currency.

However, a trade deficit may be good news if it is used to finance profitable domestic investments, or if it is temporary and reflects a boom with strong domestic demand. Further, the consequences of globalization, like the increase of the market share of multinationals and the international merging of stock exchanges decreases the relevance of trade balances of countries according to some sources.

The effects of trade imbalances on employment are controversial. It can lead to the loss of jobs, such as the loss of 1.5 million U.S. jobs to China between 1989 and 2003, though microeconomists point out this has not been a gross job loss (the total employment level has actually increased).

A trade surplus may appear to be a good thing but may not always be so. It is possible for the terms of trade to be lower than before if there is an improvement in the balance of trade (e.g. if an export increase came about by lowering prices). In addition, country with a surplus may come to rely on foreign demand for its industry, which may be problematic once the foreign demand dries up.

An example of an economy in which a positive balance of payments is regarded as a bad thing by some is Japan in the 1990s. The positive balance was partly the result of protectionist measures that also caused the price of goods in Japan to be much higher than they would have been, had imports been freely allowed. The foreign currency Japanese companies earned overseas remained largely unconverted into yen in order to suppress the yen's value, further preventing Japanese consumers from benefiting from the trade surplus. In addition, the potential benefit from the trade surpluses were partly squandered by spending it on prestige real estate purchases in the United States that often proved unprofitable.

Milton Friedman on trade deficits

Milton Friedman has argued that many of the fears of trade deficits are unfair criticisms in an attempt to push macroeconomic policies favorable to export industries. He states that these deficits are not harmful to the country as the currency always comes back to the country of origin in some form or another (country A sells to country B, country B sells to country C who buys from country A, but the trade deficit only includes A and B). He continues by informing readers that the "worst case scenario" of the currency never returning to the country of origin is actually the best possible outcome; as the country just purchased goods by exchanging pieces of cheaply made paper. The same result would happen if the exporting country burned the dollars it earned, never returning it to market circulation.

From a mainstream perspective, Friedman's argument is believed to be correct but incomplete. In particular it ignores the intergenerational consequences of deficits. If country A has a trade deficit because of large imports of consumer goods, other countries accumulate cash from country A. That money can be used to purchase existing investment assets and government bonds within country A. As a result, the return from those assets will accrue not to citizens of country A but to foreigners. The consumption standard of future generations in country A may therefore potentially decline as a result of the deficit. In particular, Americans are increasingly paying taxes to finance the interest on federal bonds held by foreigners.

Friedman also believes that deficits will be corrected by free markets as floating currency rates will rise or fall with time to encourage or discourage imports in favor of the exports, and then possibly reverse again in favor of imports as the currency gains strength. A potential difficulty however is that currency markets in the real world are far from completely free, with government and central banks being major players, and this is unlikely to change within the foreseeable future.

Friedman and other economists also point out that a large trade deficit (importation of goods) signals that the currency of this country is strong and desirable. To Milton Friedman, a trade deficit simply means that consumers get to purchase and enjoy more goods at lower prices; conversely, a trade surplus implies that a country exported goods that its own citizens did not get to consume and enjoy, while paying high prices for the goods that were consumed. However, this may only be true in the short run.

Friedman also contends that the current structure of the balance of payments is not really a trade deficit; rather, it is a capital surplus. In an interview with Charlie Rose, he stated that "on the books" the US is a net borrower of funds, using those funds to pay for goods and services, but he said this is because the books are kept in a misleading way. He points to the income receipts and payments showing that the US pays almost the same amount as it receives, thus US citizens are paying smaller prices than foreigners for capital assets to exchange roughly the same amount of income.

Milton Friedman presents his analysis of the balance of trade in Free to Choose, and his simple points are re-examined by Reed (see [2])

United States trade deficit

The United States has posted a trade deficit since the 1970s, and it has been rapidly increasing since 1997. The trend indicates that the trade deficit increases most rapidly during times of economic expansion, and slowly during times of contraction. It is, it should be noted, a matter of "increasing less rapidly" or more rapidly: it has never turned into a surplus.

In recent years, the US trade deficit has risen to between 60 and 70 billion dollars per month. This means that, in effect, every American citizen is borrowing between 6 and 7 dollars from the rest of the world, per day.

The persistence of the trade deficit has been attributed to a number of factors, including:

  • The dollar's role as a reserve currency and strength
  • Continued growth in the US economy
  • Continued high demand for American investment asset
  • Rising oil prices
  • Globalization, including a rise in imported products from countries such as the People's Republic of China
  • Dependence on foreign countries for sufficient food, energy, raw materials, and natural resources.

The growth of the US trade deficit is of particular interest, among developed nations, for the issues of sustainability it raises.

Economists (and politicians) differ greatly on whether this deficit presents a problem, on its causes, and on how it should be addressed.

As to the capital flows resulting from it: assets held "abroad" by American investors were often held in the form of equity, and US assets held by "foreigners" were often held in the form of bonds. Since the equities generally yielded more, the net amount of income derived from those investments resulted in money being received by the US. As of 2006, however, the balance has changed, and there is actually a net outflow from the US.

As to its causes: the "standard" American answer (voiced, for instance, by former Treasury Secretary John Snow) is that it is not a matter of the United States importing too much, but of the rest of the world importing too little (of American goods and services). The solution, according to this view, would be found in higher growth rates in the rest of the world.

Be that as it may, higher growth cannot be forced overnight.

Another point raised is that this imbalance is attributed to exchange rates which other countries, allegedly, keep artificially low. This results in their goods (and, increasingly, services) being produced at "unrealistically" low prices, putting US manufacturers at a disadvantage. While there may be some merit in this view, it should be noted that export subsidies are by no means unknown in international trade. As a countermeasure, import duties are quite often proposed, to protect domestic industries (and jobs). On the other hand, the effect of these duties is that the local (US) prices of these goods rise, importing inflation. In those cases where these goods are manufactured for American companies, the side effect is that these companies are hurt. (For instance: an American manufacturer of computers buys components from Chinese suppliers. An import duty of, for instance, 25% -which is the level of tariff often proposed- would make those components more expensive. Since these components are not manufactured in the United States any more, the American company in unable to switch to an American supplier. The result of imposing a tariff would not be that any American jobs are saved, but that the American consumer has to pay more for his computer, and/or the shareholder in this American company would probably see the value of his shares diminish.)

The size of the US trade deficit has lead to warnings by a variety of organizations, for instance the IMF: "However, there remains some risk of a disorderly adjustment, which could impose heavy costs on the global economy." (World Economic Outlook, September 2006, Executive Summary, p. xiv.)

Physical trade balance

Monetary trade balance is different from physical trade balance (which is expressed in amount of raw materials). Developed countries usually import a lot of primary raw materials from developing countries at low prices. Often, these materials are then converted into finished products, and a significant amount of value is added. Although for instance the EU (as well as many other developed countries) has a balanced monetary trade balance, its physical trade balance (especially with developing countries) is negative, meaning that in terms of materials a lot more is imported than exported. That means the ecological footprint of developed countries is may be larger than that of developing countries, if footprint mainly depends on bulk size.

See also