Trade Deficits: Bad or Good?

Many LinkedIn readers facilitate trade flows and help rack up many of the numbers seen in the nation’s trade ledger known as the balance of payments. The U.S. trade deficit is a part of what’s known as the current account of the balance of payments. And this deficit is but one outflow of U.S. dollars which is--- roughly--- balanced by an inflow of foreign investment (shown in what’s called the financial account of the balance of payments). 

Most of the fuss concerning the trade deficit involves tangible goods and downplays the role of trade in services. This is unfortunate and distortionary since the U.S. economy is becoming more service-based and knowledge-based. But there is another distortion as well. The net imports which make up the trade deficit only count final goods. This means the balance of payments does not explicitly take into account the inflow and outflow of inputs and intermediate goods which the U.S. enjoys as part of its global supply chain connectivity. Indeed, when a final good is imported to the U.S. it is entered into the balance of payments as f.o.b. (port of entry). As many shippers and carriers know, port of entry need not be the final destination. So, if a U.S.-based carrier moved the import (which is now cleared through U.S. Customs) to the importer’s final destination, U.S. economic activity has been created. But what of the money paid to foreigners for the import instead of “buying American”? Well, presumably, this foreign purchase was a better deal and, consequently, the importer spent less money. There are two benefits in this: (1) the savings allows the importer to operate more efficiently and expand its business; and (2) the foreign competition incentivizes domestic producers to up their own game if they want the importer’s business. Of course, to be fair, I’ve assumed that the foreign producer did not “dump” its product on the U.S. market at some price below reasonable cost. Basically, trade barriers are a more pressing issue than trade balances. 

There is a self-correcting nature to trade deficits. Basically, purchasing imports requires having foreign currency at home in order to make payments. Since the price of import flows exceeds exports there must be an excess demand for foreign currency at home--- and, conversely, an excess supply of U.S. dollars abroad. Thus, the value of the U.S. dollar should drop and the price of imports will rise and the price of exports will fall. This relative price change will tend to lower any current account deficit. Of course, this is expected over the long run (i.e., some indeterminate amount of time when the system settles into a stable equilibrium). Of course, there are always shocks to the system which can throw off this natural progression. Even so, in the short run strange things can happen. Suppose, importers and exporters anticipate this eventual fall in the U.S. dollar due to our huge trade deficits. U.S. exporters may see their foreign customers seek to delay payment because the price they’ll pay will be dropping. Similarly U.S. importers will want to make their payments quickly because the price they’ll pay in the future will be rising. What this means is that the cash outflow is increasing while cash inflow is decreasing. Thus, the trade deficit will rise in the short run even though it’s expected to fall in the long run. To those who worry about trade deficits and wish to see the U.S. dollar depreciate, things could get worse before they get better. Trade economists call this a J-Curve effect because the trade balance initially falls into further deficit before it begins to rise into eventual balance (in the long run). The J-Curve effect may even occur if the domestic importers simply take their time in switching out of imports as they become more expensive. Why would they do this? It may be that domestic products are not an adequate substitute as yet.

Finally, suppose the Trump Administration has its way and all the countries the U.S. has a trade deficit with decide to revalue their currencies (in effect, depreciating the value of the U.S. dollar and making our exports cheaper for these countries to import). Trade deficit solved? Well, it’s not that simple. There’s a phenomenon we trade economists call the Marshall-Lerner Condition. Technically, if the sum of the price elasticities of demand for exports and imports are (in absolute values) less than one, the volume of trade will increase; but not by enough to outweigh the fall in the value of trade. Remember, the trade deficit measures the value of trade and not the physical volume. The implication of this is that a depreciating currency will not improve the current account in the long run if the price elasticities of the imports and exports are very low. Is the U.S. economy highly dependent on its imports? Does it really need to import petroleum, steel, foodstuffs, etc.? If so then these demands are price-inelastic. And that is bad news for the current account. On the other hand, are U.S. export markets very sensitive to our export prices? Would the lowering of prices (though, for example, improved logistics and supply chain management) actually increase the value of U.S. export flows? If so then foreign demand is price-elastic. And that is good news for the current account. In other words, the structure of export and import markets must be examined very carefully when analyzing trade deficits. Supply chain management and logistics are very important ingredients.