What causes trade deficits and how they can both help and hurt a country’s economy.
In this episode you’ll learn:
- How GDP is calculated.
- How imports can both help and hurt an economy.
- How the balance of payment components of the current and capital accounts offset each other.
- How trade deficits can be caused by the amount of investment capital flowing into a country..
Gross Domestic Product = Consumption + Investment + Government Spending + Exports – Imports
Trade Deficits Aren’t Always Bad
At the beachfront hotel where we are staying in Tulum, Mexico, every day around seven AM workers go out to the beach and rake the seaweed and garbage that washed ashore overnight.
I mean garbage in the literal sense as there is a conveyor belt of trash that floats along prevailing ocean currents until it washes up on the Mexican coast.
The beach where we are staying is well maintained, but if you walk a stretch of beach that isn’t constantly cared for such as in the Sian Ka’an biosphere just south of here you will find water bottles, motor oil containers, paint cans, shoes, toys, Coke bottles, cups, and bowls from Jamaica, Haiti, Puerto Rico, Honduras, and the Dominican Republic mixed in with the seaweed.
When I stayed at this hotel five years ago, there was one groundskeeper who spent all day raking up the debris, loading it in a wheel barrel and then taking it to a hole he had dug on the beach where he dumped it.
On this trip, there are three to five workers raking and the task only takes about thirty minutes because instead of loading the debris into wheel barrels, they pile it on the truck bed of a John Deere Gator all terrain vehicle. Then a groundskeeper drives the John Deere to a far off lot where he dumps it.
Do Imports Help or Hurt?
Here’s a question. When the hotel purchased the John Deere Gator all terrain vehicle that was manufactured in Horicon, Wisconsin, did that help or hurt the Mexican economy? What about the U.S. economy?
Peter Navarro, an economics professor at University of California at Irvine, and the head of President Trump’s newly formed White House National Trade Council would argue the sale of the John Deere ATV hurt Mexico’s economy and helped the U.S.
In September 2016, he wrote the following in his analysis of Trump’s economic plan, “When net exports are negative, that is, when a country runs a trade deficit by importing more than it exports, this subtracts from growth.”
An Accounting Identity For Determining GDP
Navarro is basing his analysis on the accounting identity that states:
Gross Domestic Product (“GDP”) = Consumption + Investment + Government Spending + Exports – Imports.
GDP measures the monetary value of a country’s output in terms of its production of goods and services. Government statisticians estimate the value of output produced by looking at the level of consumption and investment by households, businesses, governments and foreign entities. GDP can also be estimated by looking at a nation’s income.
When John Deere produced and sold the ATV to the Mexican hotel it boosted the U.S. economy as it was an export per the accounting identity.
But from Mexico’s perspective, importing the ATV didn’t automatically hurt the Mexican economy. The purchase of the ATV would have been reflected in GDP as consumption or perhaps an investment by the hotel.
The accounting identity subtracts out the ATV import to offset the fact it was included in consumption and/or investment.
Imports Don’t Automatically Reduce Growth
In other words, the formula neutralizes import purchases so they have no impact on GDP since the point of the accounting identity is to estimate the value of goods and services produced domestically which by definition excludes goods and services produced in other countries.
Imports don’t automatically subtract from GDP growth. It is a little more nuanced than that.
If the hotel bought the John Deere instead of a suitable replacement ATV that was made in Mexico then the John Deere purchase would have hurt the Mexican economy.
But if there wasn’t a suitable Mexican made replacement then the hotel might not have purchased an ATV at all.
In that case, the workers would be less productive and the seaweed and trash would stay on the beach longer, potentially discouraging guests from returning to the hotel or they might give negative reviews.
This in turn could lower occupancy at the hotel which would hurt Mexico’s economy because GDP would be reduced by a lower amount of hotel services exported to U.S. nationals visiting Mexico.
Substitutes Versus Complements
Here is how Noah Smith, Bloomberg columnist and assistant professor at Stony Brook University describes this concept, “If I buy a Japanese-made laptop, does that mean I decide not to buy one made in the U.S.? If Intel buys a German-made machine tool, does that mean it chooses not to buy a different tool made domestically? The answers to these questions will determine how trade affects the economy.”
“If imports substitute for domestic-made goods and services, then reducing trade deficits really might boost the economy – not via the simple accounting fallacy described above, but by boosting domestic producers.”
“But if imports are complements to U.S. production, then trade restrictions could backfire severely. Foreign-made parts are often essential to U.S. manufacturing. Foreign call centers and other business services help many U.S. businesses concentrate on doing what they do best. Foreign-made industrial tools are essential for many U.S. manufacturers. If these imports prove very expensive to replace with domestic equivalents, then trade restrictions could create huge costs for many American businesses, forcing those businesses to be less profitable, shrink or shut.”
Michael Pettis, professor of finance at Peking University’s Guanghua School of Management, puts it this way, “A higher trade deficit doesn’t have to make the United States poorer. It can make the country poorer, but it can also make the country richer, and it turns out that whether the United States is richer (that is, more productive) or poorer depends on whether what causes the deficit, also causes productive investment to rise.”
Richer or Poorer
If imports make a country more productive and complement existing goods and services that can increase a nation’s wealth. Conversely, if imports don’t increase productivity and simply substitute for domestically produced goods and services then that makes a country poorer.