You may hear about the “trade deficit” on the news from time to time and wonder what that means. While it may sound like a big issue that doesn’t affect individuals, there can be a significant impact on the economy, which in turn affects how much money you make, how expensive things become for you, and how difficult it can be to get a job.
At the same time, we sometimes hear the impact of the trade deficit overrated and described as if it’s a terminal problem that could sink the US economy. Let’s get some perspective.
What Is a Trade Deficit?
A trade deficit occurs when a country imports more than it exports during a given period. This is also called a negative balance of trade. The simplest way to think of a trade deficit is to say a country is spending more than it takes in.
The United States buys goods from Japan, Canada, Mexico, Germany, the E.U., and China and sells other goods to those countries.
So in evaluating the trade relationship with any single country—let’s say China—the U.S. may buy more from that country than it sells.
In that case, the U.S. would have a trade deficit with China.
Or, America may total up sales to all countries and purchases from all countries and find that it has an overall trade deficit.
As of June 2022, the United States had a trade deficit of $79.6 billion. This was an improvement from the deficit of $107.7 billion in March.
Common Question: What do you call a trade balance where exports exceed imports?
This is called a trade surplus.
How to Calculate a Trade Deficit
To calculate a trade balance start with the total value of exports and subtract the total value of imports. If such a result is positive, it is a trade surplus, but if it is negative, it is a trade deficit.
Every country has its unique way of calculating, accounting, and keeping records of exports to other countries and what it, in turn, imports from this same country. Within each global entity pair, there will be one that will have a surplus and another that will have a deficit.
Here is an example from the U.S. Bureau of Economic Analysis released Tuesday, February 8, 2022.
The total export value – The total import Value = Trade Surplus/Deficit
$228.1 - $308.9 = -$80.7 billion (trade deficit)
Note: The trade balance isn’t only based on a country’s goods but also on its services.
History of the U.S. Trade Deficit
The United States trade balance moved from positive to negative in the 1970s and has remained negative since then. The deficit increased significantly beginning in 1990 but rebounded in 2009 and has become more severe gradually since then.
In the chart below, the deficit gets larger as the line gets lower.
And here’s a short video showing the trade deficit by country and how it changed from 1960 to 2022.
A country with a negative trade balance typically sees its currency depreciate compared to other currencies worldwide. Its economy suffers adverse effects, ranging from price inflation to loss of jobs. In contrast, a trade surplus typically results in a strong economy.
This pattern is not universal, and there can be important exceptions, as we’ll see later.
Causes of a Trade Deficit
Several factors can drive a trade deficit. More than one of these factors may be in play at any given time.
A General Drop in Productivity
When a country lacks productivity and growth compared with others, it becomes less competitive. Other nations are becoming more productive and are producing goods for less. A trade deficit occurs as buyers turn to products from less expensive countries.
The declining country loses export opportunities and must increase imports because it can’t produce enough to meet its needs.
A trade deficit may occur when a country has a limited supply of a necessary resource and must import it. Countries that have to import all or most of their oil, for example, may be forced into a trade deficit when oil prices are high if they don’t export enough goods to cover the cost of their oil imports.
High Production Costs
High production costs can be driven by several factors. Countries with high wages or high taxes may have difficulty producing goods that can compete in export markets, which can limit their exports.
Some countries (Germany, for example) maintain a trade surplus despite high wages and high taxes by focusing on high-value goods that buyers are willing to pay for and competing on quality rather than price.
Many people assume that a strong currency is a good thing, but a high-value currency is actually a liability for a trading country. When a currency’s value is high the country’s exports become more expensive and imports become cheaper. This can create or worsen a trade deficit.
In theory, free trading of currencies should correct these distortions. It doesn’t always work that way. China has deliberately intervened in currency markets for decades to keep the value of the yuan low and promote its exports. The value of the US dollar, meanwhile, has been artificially inflated by demand from global trade.
The consistent strength of the dollar makes US exports expensive and US imports cheap and has a significant impact on the US trade deficit.
Effects of Trade Deficits
A trade deficit has multiple effects on a country. Initially, some of these may be positive. Over time, more negative impacts may creep in.
If imported goods are cheaper than locally produced ones, imports may rise, generating a trade deficit. That may not be a bad thing for consumers, who benefit from lower prices. The availability of low-cost imported goods helped to hold US inflation at below-average levels from the late 90s through 2020.
A trade deficit typically means increasing reliance on imported commodities and/or manufactured goods. This, in turn, means fewer commodities or manufactured goods manufactured domestically, and fewer jobs available.
If domestic production costs are high, manufacturers tend to move to other countries, bringing prices down but moving jobs out.
A country that consistently sends money out reduces the available money supply inside the country. Less money and fewer jobs can cause weak demand leading to deflation.
If a country imports more than it exports, it will typically see the value of its currency fall. It is buying more of other countries’ currencies than others are buying of its own currency. That pushes the value of the currency down.
That process is to some extent self-correcting. A trade deficit pushes the value of a country’s currency down, which makes that country’s products cheaper and discourages imports, helping the trade deficit to stabilize.
Why the US Is Different
The US has maintained a trade deficit since the 1970s. At the same time, the US dollar has retained a high degree of strength, the US economy has grown consistently, unemployment has remained generally low, and there has certainly been no deflation.
This seems contradictory. Why hasn’t the US trade deficit, sustained over so many years, damaged the US economy?
It’s All About the Dollar
The answer lies in a unique feature of the US dollar. The dollar is not just the US currency. It’s a global currency used in a large majority of trade transactions.
The US dollar is used in a large majority of global trade transactions. In 2019, the US dollar was involved in 88% of global FX transactions, indicating that almost 90% of world trade transactions are conducted in US dollars.
If a South Korean utility buys oil from Kuwait, they pay in dollars. If a Thai construction company buys excavators from South Korea, they pay in dollars. A German company that imports bananas from Ecuador will pay in dollars.
If a country has a trade deficit, they have to buy more dollars than they are earning. This depletes their dollar reserves and leaves their currency less valuable since there are more sellers than buyers.
For the US, of course, this isn’t a problem. Other countries have to earn their dollars by selling goods and services. The US doesn’t have to earn its dollars because it can simply print more of them.
Will Printing More Dollars Weaken the Dollar?
In theory, printing more dollars should devalue the currency. As we see in this chart of the US dollar index, which compares the value of the dollar to that of a basket of other currencies, that hasn’t happened.
The value of the dollar has held up despite continuous growth in the money supply because demand for dollars, driven by rising global trade, has expanded even faster than supply.
This means that the US can run a persistent trade deficit without seeing the dollar lose value.
The high demand for dollars to underwrite global trade also sustains the US trade deficit. Because the dollar is in high demand its value remains despite the deficit, making American exports more expensive and imports cheaper and sustaining the deficit.
Where Is the Deficit Now?
The US trade deficit has steadily increased since 2014. In the last few months, the deficit fell for the first time in many years, dropping from close to $110 billion n March 2022 to just under $80 billion in June. The drop was driven primarily by record US exports of Natural Gas and very high prices for that commodity. Exports were up 1.7% and imports dropped 0.3%
It is not clear whether this trend will continue. The US deficit will vary with import and export levels and with prices of key commodities, but it seems unlikely that the US will move to a trade surplus any time soon.
Fortunately, the impact of persistent deficits has traditionally been muted. After all, the US economy has consistently expanded despite running deficits for many decades. In short, don’t expect the deficit to end, but don’t listen to people who say the deficit will break the US economy!
The post What Is the U.S. Trade Deficit and Why Does It Matter? appeared first on FinMasters.