When a country runs a trade deficit is that a good or bad thing? It depends. Learn why in this episode.
In this episode you’ll learn:
- Why the gold standard prevented the U.S. from running a trade deficit.
- How trade involves exchanging money with no intrinsic value for real wealth.
- Why trade deficits are unsustainable unless a country runs a budget deficit.
- What is a comparable advantage when it comes to trade.
- Why it’s better for countries to diversify rather than specialize when it comes to trade.
Are Trade Deficits Good or Bad?
Imagine you are shopping looking for a new pair of pants. You find two pairs you like at your favorite store. They are made of a similar fabric and have a similar design. One costs $85 and is made in the U.S.A. The other costs $50 and is made overseas. Which do you buy?
According to an Associated Press / GfK poll, 67% of Americans would buy the cheaper pair of pants. 30% would buy the more expensive “Made in the USA” pair. People in households earning $100,000 or more are no more likely to buy the expensive pair of pants than those in lower income households.
Is it better to buy the more expensive American made pants? That is not an easy question to answer.
Presidential Candidate Donald Trump in a debate last August said, “Our country is in serious trouble. We don’t win anymore. We don’t beat China in trade. We don’t beat Japan, with their millions and millions of cars coming into this country, in trade. We can’t beat Mexico, at the border or in trade.”
How does a country win at trade? How do you even keep score?
The Gold Standard and Trade
The U.S. ran close to an even trade balance through most of the twentieth century up until the mid 1970s. That meant the value of imports roughly equaled exports. The exceptions were during and immediately following the First and Second World Wars when the U.S. ran a large trade surplus.
The U.S. adherence to the gold standard ensured the U.S. did not run significant trade deficits.
Under the gold standard, if the U.S. ran a large trade deficit with households and businesses importing more goods and services than they exported, then foreign holders of U.S. dollars had two choices. They could invest the dollars in the U.S. or they could exchange them for their own currency at a fixed exchange rate at their country’s central bank. The foreign central bank could then exchange the accumulated dollars for gold at the Federal Reserve, the U.S. central bank, for $35 per ounce.
A large demand to convert U.S. dollars into gold would cause the U.S. government’s gold reserves to leave the country.
The only way the U.S. could stop the outflow of gold was to raise interest rates so that foreign holders of its currency would want to invest in the U.S. rather than cash in dollars for gold.
Throughout the fifties and sixties, the supply of U.S. dollars rose faster than gold. The primary way the dollar supply increases is through bank lending. With the rise in private sector debt, the dollar supply increased putting upward pressure on gold prices even though the official price was fixed at $35 an ounce for dollar conversion purposes.
In 1971, the U.S. alleviated the pressure on its gold reverses by abandoning the gold standard and allowing the dollar to freely float in value relative to gold and other currencies.
Getting Real Wealth
Within a few years of abandoning the gold standard, the U.S. began to run a persistent trade deficit.
That means on a net basis U.S. households and businesses receive real goods and services in exchange for dollars that are not backed by anything, and those dollars are primarily created by banks out of thin air through their lending activities.
Countries send U.S. households and businesses real wealth in the form of goods and services in exchange for electronic digits with no intrinsic value.
By that scorecard, the U.S. is winning at trade.
Then why should the U.S. worry about a trade deficit? We receive real physical wealth in exchange for money that can be created out of nothing.
How Trade Deficits Are Funded
The problem arises because households and businesses need income in order to pay for imports or they at least need income to qualify for bank loans so they can pay for imports.
How do households and business get income? They get income when other households and businesses spend money. Every dollar spent is someone else’s income.
When a business spends a dollar to pay for a worker’s salary that dollar is the worker’s income.
When that worker spends that same dollar at a business to buy groceries then that dollar becomes the business’ income.
What that means is across the entire domestic economy the total amount of income received by households and businesses in a given year equals the total amount of money spent by households and businesses. This assumes the country runs an even trade balance and the federal budget is also balanced.
When a country runs a trade deficit and the federal budget is balanced, then households and businesses spend money that isn’t tied to that year’s income. They either spend prior years’ income that has been saved. Or they spend future years’ income by borrowing money that will need to be paid back with interest.
This is fiscally unsustainable as savings would eventually be depleted and private debt levels would be too high.
The only way a country can run a persistent trade deficit is if the federal government also runs a budget deficit.
A budget deficit is when the government spends more than its receives in tax revenue (i.e. its income). That excess spending flows to households and businesses, which then have additional income they can use to buy imports without dipping into past savings or future income through borrowing.
In fact, Americans’ appetite for imports can help push the federal government into a budget deficit situation.
When households and businesses significantly increase their purchases of imports and there is not an offsetting increase in exports, then over time domestic businesses get hurt as their income falls. Lower income means they pay less in taxes. These businesses in turn lay off workers, who pay less in taxes and collect unemployment benefits. The combination of lower tax revenues and higher social safety net spending leads to a higher federal budget deficit.
So as a consumer should you purchase the cheaper imported pants or the more expensive American made pants? It’s a difficult choice.
Purchasing the imported pants contributes to the U.S. trade deficit, which in turn contributes to the federal budget deficit and increases the national debt. On the other hand, the pants are cheaper and the overseas business that produced them is willing to exchange something real for a currency that has no intrinsic worth.