Trade Deficit

A trade deficit occurs when a country’s imports exceed its exports during a given time period. It is also referred to as a negative balance of trade (BOT).

The balance can be calculated on different categories of transactions: goods (a.k.a., “merchandise”), services, goods and services. Balances are also calculated for international transactions—current account, capital account, and financial account.

Understanding Trade Deficits

A trade deficit occurs when there is a negative net amount or negative balance in an international transaction account. The balance of payments (international transaction accounts) records all economic transactions between residents and non-residents where a change in ownership occurs.

A trade deficit or net amount can be calculated on different categories within an international transaction account. These include goods, services, goods and services, current account, and the sum of balances on the current and capital accounts.

The sum of the balances on the current and capital accounts equals net lending/borrowing.

This also equals the balance on the financial account plus a statistical discrepancy. The financial account measures financial assets and liabilities, in contrast to purchases and payments in the current and capital accounts.

The most relevant balance depends on the question being asked and the country about which it is being asked. In the U.S., the International Transaction Accounts are published by the Bureau of Economic Analysis.

The current account includes goods and services, plus primary and secondary income payments.

Primary income includes payments (financial investment returns) from direct investment (greater than 10% ownership of a business), portfolio investment (financial markets), and other.

Secondary income payments include government grants (foreign aid) and pension payments, and private remittances to households in other countries (e.g., sending money to friends and relatives).

The capital account includes exchanges of assets such as insured disaster-related losses, debt cancellation, and transactions involving rights, like mineral, trademark, or franchise.

The balance of the current account and capital account determines the exposure of an economy to the rest of the world, whereas the financial account (tracking financial assets, rather than products or income flows) explains how it is financed. In principle, the sum of the balances of the three accounts should be zero, but there is a statistical discrepancy because of source data used for the current and capital accounts is different from the source data used for the financial account.

Trade deficits occur when a country lacks efficient capacity to produce its own products – whether due to lack of skill and resources to create that capacity or due to preference to acquire from another country (such as to specialize in its own goods, for lower cost or to acquire luxuries).

Advantages of Trade Deficits

The most obvious benefit of a trade deficit is that it allows a country to consume more than it produces. In the short run, trade deficits can help nations to avoid shortages of goods and other economic problems.

In some countries, trade deficits correct themselves over time. A trade deficit creates downward pressure on a country’s currency under a floating exchange rate regime. With a cheaper domestic currency, imports become more expensive in the country with the trade deficit. Consumers react by reducing their consumption of imports and shifting toward domestically produced alternatives. Domestic currency depreciation also makes the country’s exports less expensive and more competitive in foreign markets.

Trade deficits can also occur because a country is a highly desirable destination for foreign investment. For example, the U.S. dollar’s status as the world’s reserve currency creates a strong demand for U.S. dollars. Foreigners must sell goods to Americans to obtain dollars. According to the U.S. Treasury Department, foreign investors held over four trillion dollars in Treasuries as of October 2019. Other nations had to run cumulative trade surpluses with the U.S. totaling over four trillion dollars to buy those Treasuries. The stability of developed countries generally attracts capital, while less developed countries must worry about capital flight.

Disadvantages of Trade Deficits

Trade deficits can create substantial problems in the long run. The worst and most obvious problem is that trade deficits can facilitate a sort of economic colonization. If a country continually runs trade deficits, citizens of other countries acquire funds to buy up capital in that nation. That can mean making new investments that increase productivity and create jobs. However, it may also involve merely buying up existing businesses, natural resources, and other assets. If this buying continues, foreign investors will eventually own nearly everything in the country.

Trade deficits are generally much more dangerous with fixed exchange rates. Under a fixed exchange rate regime, devaluation of the currency is impossible, trade deficits are more likely to continue, and unemployment may increase significantly. According to the twin deficits hypothesis, there is also a link between trade deficits and budget deficits. Some economists believe that the European debt crisis was caused in part by some EU members running persistent trade deficits with Germany. Exchange rates can no longer adjust between countries in the Eurozone, making trade deficits a more serious problem.

Real World Example

The U.S. holds the distinction of having the world’s largest trade deficit since 1975. The U.S. imported and consumed significantly more electronics, raw materials, oil, and other items than it sold to foreign countries.