Free Term Paper on Trade Deficit

Trade DeficitTrade is the basis of much of the economic activity we see around us. Most of our day-to-day activities involve trade. Examples abound—trading cash for food at the grocery store and trading our time and effort (working) for income. The government regularly accounts for the result of all this trading with quarterly readings on the pace of economic activity in the United States. In those reports, one category of trade is singled out. Trade with foreigners is highlighted and measured separately.

What Is So Special about Foreign Trade?

Essentially, we trade because doing so makes us better off. One of the first lessons we learn in economics is that we are not all equally proficient at the same things. For example, one person may be a better cook and another a better carpenter. Individually, one would be ill fed but well housed and the other well fed but ill housed. By trading services, each could—in theory, at least—be both well housed and well fed. The added benefits from trading make both better off.

So trading is good, because people engage in it only when it makes them better off. And we recognize the benefits of trade and economic activity within our borders. Every third month, when the latest report on the gross domestic product (GDP) of the U.S. economy is released, the nightly news blares the rate of growth over the airwaves. Politicians take credit or pass blame. Stock traders rejoice or moan. Bond traders take notice. A big increase in GDP suggests that production and trade among Americans has increased, translating into stronger economic growth and cause for celebration.

But a big increase in trade with foreign interests is often met with far less enthusiasm. On the face of it, the reason is not apparent. As noted above, we only trade with others— domestic or foreign—if it makes us better off. This activity gives U.S. consumers more products from which to choose and products that are, in some cases, less expensive. The same is true for foreign buyers of U.S. goods and services. An increase in trade with foreign interests should be good news. So why not view it that way? Well, probably because if we buy more things from foreigners than we sell to them (as is usually the case), our measured economic activity tends to shrink. And lower measured economic activity in the U.S. economy is generally frowned upon.

In contrast, if we as a nation trade more with foreigners by selling them more than we buy from them, then more trade with foreigners is viewed as good because it raises measured economic activity in the United States.

So we generally view trade with other Americans as nearly always good but trade with foreigners as only good if we sell more to them than we buy from them. In other words, trade is not always viewed as good, even though both parties voluntarily engage in it, which presumably makes each better off.

Deficits, Surpluses, and Balance

As mentioned earlier, a lot of trade takes place each day, both among domestic residents and with foreigners. On the foreign trade front, domestic residents typically both trade their dollars for foreign goods and services (buy) and receive dollars from foreigners for U.S.-made goods and services (sell). If we buy more than we sell, we are said to have a trade deficit. If selling outweighs buying, a trade (or current account) surplus emerges. When buying and selling perfectly match one another, the result is balanced trade.

If voluntary trade makes parties better off, why separate foreign trade in the economic accounting, and why distinguish between deficits, surpluses, and balance? In a nutshell, trade with foreign interests is often viewed as having a dark side, in that sending more dollars abroad than we receive (a deficit) means some of our domestic consumer demands are met by foreign firms, which causes a drag on demand facing U.S. firms and reduces the demand for workers in the United States. Of course, consumers are made better off in that they have a broader array of goods from which to select. This benefit to consumers is widely recognized but typically is not publicized as a precisely measured benefit. Far more publicity is garnered by the estimated size and presumed costs imposed on U.S. citizens from trade deficits. A second concern is how long the U.S. economy can sustain trade deficits. Under the assumption that deficits create a drag on the economy, how much of a drag is required to slow the economy substantially? Let’s address each of these questions in turn.

How Big Are Trade Deficits?

The U.S. trade balance is measured as the net difference between the dollar value of the goods and services we buy from abroad (imports) compared to the dollar value of goods and services we sell abroad (exports). In late 2009, exports were averaging almost $135 billion per month, seasonally adjusted. Imports at that time were over $165 billion a month.

As shown in Figure 1, it is clear that the value of both imports and exports is typically rising over time, recessionary periods excluded. This is not surprising given the diverse nature of goods produced in the United States, the prominence of the currency, and the well-developed infrastructure, which makes the physical transportation of goods (and services) relatively easy. But with the value of imports rising faster than exports, the U.S. trade sector is increasingly in deficit, to the tune of about $33 billion per month, or roughly $375 billion per year, according the most recent reports.

Figure 1. U.S. Imports and Exports (U.S. Commerce Department/Haver Analytics)

Trade Deficit Figure 1

The United States has experienced trade deficits in recent decades, as shown in Figure 2. These deficits grew relatively large in 2006, reaching around 6 percent of the nation’s economy as measured by GDP. However, with the sharp recession in 2008 and early 2009, the trade deficit moderated to about 3 percent of GDP. Even with this moderation, the current deficit remains sizeable and—if sustained or enlarged—is cause for concern. The mid-decade bulge partly reflected soaring prices of imported oil, and the moderation partly resulted from sharp declines in oil prices. With future oil prices uncertain, further improvement—or deterioration—in the deficit might be in the cards. Of course, the persistence of a negative trade balance has spurred discussion over the drag these large trade deficits could potentially exert on the U.S. economy and the long-term consequences of this drag.

Figure 2. U.S. Trade Balance (U.S. Commerce Department/Haver Analytics)

Trade Deficit Figure 2

In part, deficits’ impact on the economy depends on their causes. Since exports and imports—the two components of the trade balance—are measured in U.S. dollars, changes in the value of the dollar compared to the value of other currencies can affect the deficit’s size. As of mid-2010, the dollar’s value had strengthened compared to the values of the currencies of the United States’ major trading partners. This made the price of U.S.-produced goods relatively less attractive than the prices of foreign goods. Initially, an increasing value of the dollar can potentially compress the measured trade gap, as foreigners pay more for U.S. goods and U.S. consumers pay less for foreign goods. This can occur especially when the volumes of the goods traded change little. Over time, however, the less attractive prices of U.S. goods would be expected to cool demand for our products, constraining U.S. export volume and possibly widening the trade gap.

Another reason the U.S. trade deficit may widen is that, as the United States emerges from recession, stronger demand for imported goods typically emerges. As incomes in the United States strengthen, consumers respond by ramping up spending, including spending on foreign-produced goods. Typically, this strength is not matched by foreign demand for U.S. goods—pushing the deficit deeper into negative territory.

Has Domestic Economic Activity Been Harmed by Trade Deficits?

It is difficult to assess whether trade deficits have affected the U.S. economy in a precise fashion (recall the earlier discussion of the arithmetic of consumer benefits, for example). However, data from U.S. labor markets and trade accounts do not make a compelling case for a strong near-term relationship between a rise in deficits and a drag on U.S. economic activity—at least through the labor market channel. Since the early 1990s, for example, the trade deficit has generally grown markedly but has not trimmed domestic production enough to persistently raise the unemployment rate. As shown in Figure 3, there have been fluctuations in the unemployment rate since 1992, but the periods of large increases have been tied to recessions that were largely independent of foreign trade. In the early 1990s, a recession occurred after the real estate and stock markets unwound following run-ups in activity in each. In the early 2000s, a recession followed a reversal of the sharp increases in stock market prices in the preceding years. Most recently—in 2008 and early 2009—a deep recession occurred in the wake of an episode of home overbuilding and the attending difficulties in financial markets. Domestic demand for foreign goods softened more than demand for U.S. goods overseas. The trade deficit lessened, but again, because of the broader weakness in domestic economic conditions, unemployment soared.

Figure 3. U.S. Trade Balance and Unemployment Rate (U.S. Commerce Department/Haver Analytics)

Trade Deficit Figure 3

In fact, the recent recessionary period aside, the unemployment rate has mostly trended lower throughout the period, with the tightest labor markets often occurring during times when trade deficits were on the rise. From this perspective, it is not at all obvious that running a trade deficit has led to a pronounced loss of jobs and higher unemployment in the overall economy.

This is not to suggest, however, that trade deficits have had no impact on jobs in the United States. With the expanded global market in recent years, not only have global trade volumes increased, but the location of global production has been more dynamic. That is, firms have increasingly shifted their production among countries in an ongoing effort to contain costs and to match the location of production to that of emerging market demand. Through these channels, individual job categories in the United States have been affected. Jobs have declined in industries like textiles, for example, but have risen in other categories. This is textbook comparative advantage at work—with foreign producers making more of the world’s fabric, U.S. producers can develop more pharmaceuticals.

What Do Trade Balance Figures Tell Us?

Broadly speaking, trade balance figures tell us very little, really. While trade figures imply that the United States consumes more foreign goods than it ships abroad, this interpretation is not particularly important, on balance. First, with well-functioning international financial markets, trade between nations has many implications that influence both the benefits and costs of the trade activity. The measures of trade flows (as imperfect as they are) are just one part of the story. Also important are the financial flows that result from the trade transactions.

When a domestic purchaser buys a good or service produced abroad, the purchase is an import. In this setting, the disposition of the dollars received by the foreign producer is important in determining the impact of the transaction on the U.S. economy. A foreign producer has several options with the acquired dollars: hold them (an interest-free loan to the U.S. government); exchange them for U.S. dollars on the foreign exchange markets (adding to the supply of dollars and pressuring the dollar lower); or invest them in dollar-denominated assets like a U.S. Treasury security or a factory in the United States.

In the first instance, we would like the foreign supplier to stuff its mattress with—or, better yet, burn—the dollars it receives. This way, we would get the goods or services from the supplier and would provide in exchange only paper bills (which cost our country little to print). By either destroying or otherwise not spending the dollar bills, foreign claims to U.S. goods or assets are relinquished. But this is not likely to occur very frequently, because trading of this type is not in spirit mutually beneficial to both parties. More likely, the foreign holders of dollars will delay spending or investing those dollars—while they hold the dollars, they earn no interest on them—effectively providing an interest-free loan to the United States.

In the second case, dollars received by foreign producers are exchanged for their home currency. With a trade surplus (from their perspective, since if we have a deficit, they must have a surplus), they receive a greater amount of dollars than we receive of their currency. To equate the currency amounts on the foreign exchange market, the value of the dollar must fall relative to the value of the foreign currency. This makes goods and services priced in dollars more affordable, driving up the quantity of those goods demanded on international markets. But a falling dollar may jeopardize inflows of foreign capital into the United States and make dollar-denominated investments less attractive—but that’s another story.

In the third instance, the foreign producer accumulates dollars to purchase assets valued in U.S. dollars. Toyota, Honda, and many foreign-based computer firms have large production facilities in the United States, for example, though most are invested in financial instruments. This is good, because these businesses create investment, tax revenues, and jobs here. But foreign investment in the United States leaves some uncomfortable. In the late 1980s, Japanese firms were purchasing farmland in the United States, which led to debate about the impact on the U.S. economy. More recently, some concerns continue to be voiced about who receives the profits on the investments. With global stock markets, we need not be too concerned. If a U.S. citizen wants the profits from a large foreign corporation, then stock in that company—and a share in its profits—is available for purchase.

In addition, in today’s world economy, firms in the United States sometimes have operations overseas. Imagine that a furniture producer in the United States decides to open a factory in China. To open the plant, the U.S. firm buys enough Chinese Yuan (the Chinese currency) to enable it to build the plant. But the output is shipped to the United States (a foreign import that tends to add to our trade deficit) and the profits are dollars, part of which the firm retains in the United States and part of which are converted to Yuan to cover the continuing operating expenses of the plant. In this case, the trade gap has widened, but the Chinese have not substantially increased their claims to U.S. assets in the future.

Is this kind of activity important? In a word, yes. If we receive goods today and exchange only paper dollars, that’s one thing. But if those paper dollars can potentially be redeemed for goods or factories or real estate in the United States at some future date, then that’s another story, and we are a debtor nation, meaning we owe more money to foreigners than they owe us.

Much of the money we owe to foreigners is in the form of Treasury securities. The foreigners bought them, and we will have to redeem them one day. But is being a debtor nation necessarily so bad? As with many other aspects of trade and international finance, the answer is not crystal clear. One way to gauge the United States’ net position as a debtor nation is simply to look at the income the nation earns on assets owned abroad compared to the payments made to foreign entities that own assets in the United States. Figure 4 shows that U.S. payments to foreigners soared in recent years, before pulling back with the 2008–2009 recession. But the chart also shows that, over the period, payments from foreigners have kept pace. In fact, the chart suggests relatively little reason to lie awake at night worrying about our status as a debtor nation.

Figure 4. U.S. International Financial Payments. (U.S. Commerce Department/Haver Analytics)

Trade Deficit Figure 4

What about Future Generations?

Much of the discussion here has focused on the near-term implications of the U.S. trade position. But critics point out that the impacts of today’s trade actions may affect future generations. The argument is that trade deficits occur when society consumes more than it produces. This behavior, if left unchecked, will eventually leave the nation with large unpaid bills for the goods and services consumed. This is like dining out excessively on a credit card. These critics correctly note that to eventually pay off the debt, the country will have to sell off some assets, leaving the next generation with fewer assets and potentially reducing its ability to produce goods and services.

This argument is plausible and probably correct if sizeable trade deficits persist over a long period. But it is far from a foregone conclusion. For one thing, the trade deficit may fluctuate as energy prices rise and fall and the dollar rises and falls in value. But there is another consideration. Just as running up a credit card balance sometimes makes sense, so does running a trade deficit. Imagine that some large nations are ramping up production but still have a lot of underutilized capacity. For a time, the goods produced in these nations may be a bargain. In this case, taking advantage of the sale prices may be worth reducing one’s asset holdings temporarily. Later, when assets are cheaper relative to consumer goods, the logical choice could be to accumulate capital goods relative to consumer goods.

Conclusion

This entry began by asking what all the fuss concerning foreign trade is about. If trade with your neighbor is good, then isn’t trade with your neighboring nation also good? The answer to this and other trade-related questions—unfortunately—is not clear-cut. While most agree that trade with other nations has many substantial benefits for the United States, measuring these benefits is difficult. In addition, many people are comfortable with trade as long as the value of exports exceeds that of imports—a trade surplus.

But aside from a surplus, the U.S. trade position with other nations often elicits mixed feelings. These feelings turn to concern as the trade balance moves deeper into deficit territory. Such movements have occurred in recent years, aside from the recent recession-related compression. But the general widening of the trade deficit has not resulted in especially troubling effects on the U.S. economy. Economic growth in the United States has fluctuated widely along with domestic housing activity in recent years, and labor markets have reflected those fluctuations. However, during some of this period, relatively long periods of solid economic growth and tight labor market conditions have occurred while trade deficits grew. There are no compelling signals yet that trade deficits are costing Americans jobs in the aggregate. In fact, labor markets were arguably becoming too tight in late 2007, as labor cost pressures emerged and complaints of a worker shortage were being heard.

In addition, concerns that trade deficits lead to outsized foreign ownership of U.S. assets and debt may also be a bit overblown. More of our assets are in foreign hands, but so too are we holding many foreign assets. On balance, earnings from those assets are about matching the interest and payments we make to foreign holders of U.S. assets.

In fact, as long as foreign interests want to hold more U.S. dollars, we can buy goods from abroad and foreign interests can get the dollars they want to hold. We want their goods, and they want our dollars. Their use of those dollars can have somewhat differing impacts on our economy, but no uniformly bad impacts appear to be occurring. We need to remember that consumers reap large benefits when they buy goods and services from foreign firms. But we can also increase trade deficits when our dollars flow to companies located abroad that are owned by U.S. parent firms. Such arrangements can offer these firms flexibility and profitability while containing the outflow of dollars that concerns some.

The bottom line may be that it does not matter so much with whom we trade. The real issue may be whether the United States is consuming more than it is producing. If we, as a society, persistently consume more than we produce, we will eventually have to draw down our accumulated wealth to pay for the excess consumption. Whether we transfer that wealth to another nation or to someone in our nation, the bottom line is that future generations will have a lower stock of capital, and that could, under some circumstances, constrain their ability to produce goods and services in the future. But this is not to suggest we are at or near that point. It is not obvious that we are consuming substantial amounts of our capital base or seed corn. In addition, eating some seed corn today may be reasonable if some categories of goods and services currently are a bargain that is not expected to persist. So one possibility is to refocus the discussion to worry more about whether we, as a society, are properly balancing our consumption and savings and worry less about where production is located.

 

Raymond Owens

 

Bibliography:

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  2. Dunway, Steven Vincent, Global Imbalances and the Financial Crisis. Washington, DC: Council on Foreign Relations, 2009.
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  4. Little, Jane Sneddon, ed., Global Imbalances and the Evolving World Economy. Boston: Federal Reserve Bank of Boston, 2008.
  5. Preeg, Ernest H., The Trade Deficit, the Dollar, and the National Interest. Indianapolis: Hudson Institute, 2000.