The United States, like most other countries, use a method of double-entry accounting to track certain aggregate statistics known as National Income Accounting. One of the statistics tracked is the balance of trade. The balance of trade reports the difference between imports and exports. When imports exceed exports, we are said to have a trade deficit. When exports exceed imports, we are said to have a trade surplus. When the two equal, trade is said to balance. Technically, the balance of trade refers to imports and exports of both goods and services, but so much attention tends to fall just on the trade of goods, or what is called the “Merchandise Balance of Trade.”
Confusion abounds over what the balance of trade is. Even David Hume and Adam Smith note that the concept does far more harm than good. Hume discusses how those “ignorant of the nature of commerce” misinterpret the balance of trade (see his essay “On the Balance of Trade”). In the Wealth of Nations, Smith goes even farther, calling the whole concept “absurd” multiple times (see pages 377 and 488 in the Liberty Fund edition). Much of his case against protectionism and mercantilism in Book IV is aimed against the balance of trade as a whole.
With the inclusion of the balance of trade into National Income Accounting, the confusion has persisted. The connotations of the words “surplus” and “deficit” (coupled with the accounting conventions of pluses and minus) give the impression to those who do not understand the balance of trade that deficits are bad while surpluses are good. But, digging a little into the accounting shows that 1) “deficits” and “surpluses” are value-free and 2) referring to these as “trade deficits/surpluses” is something of a misnomer.
What is important to note here is that the balance of trade has surprisingly little to do with merchandise trade at all. It is actually the result of the relationship between national Savings and national Investment. Given the accounting identity
GDP = Consumption + Investment + Government Savings + Net Exports,
we can do a little algebra and show that
Net Exports = Savings – Investment
In other words, if the quantity demanded of Investment funds exceeds the quantity supplied of saved funds (Savings), the nation must import savings from abroad. That, in turn leads to foreigners buying fewer material exports, preferring to buy assets.
Both Saving and Investment are determined by factors far divorced from how many goods cross borders. Things like real interest rates, growth expectations, confidence, institutions, and other macroeconomic factors matter much more. Indeed, as noted in his textbook International Economics, Robert Carbaugh shows us that some 98% of transactions in the foreign exchange markets deal with people swapping currencies for investment purchases, not goods/services purchases. Given that the foreign exchange market handles some $6 trillion in trades every day, that’s a lot of dollars (and pounds, yen, francs, euros, etc) being swapped to align savers and investment opportunities.
Consequently, the balance of trade is a result of macroeconomic factors. Which means that, at best, the balance of trade is a symptom, not a cause, of macroeconomic phenomena. Furthermore, since nations do not trade, but rather individuals do, to properly understand any trade deficit, we must understand why there is a difference between Savings and Investment. Investment will come from firms (note: it can be financed by borrowing, but doesn’t have to be) and individuals making large capital purchases, like a house. If these individuals are using Investment to create long term productivity enhancements, then a trade deficit is a signal of good things. But, if borrowing is going on where there are no such productivity advancements, then the trade deficit can be a signal of bad things. Regardless, and this is the big takeaway here, the balance of trade has little to do with trade at all. It is determined by much larger macroeconomic factors.
Thus why I titled this post as I did. It probably would have been better to call the balance of trade the “balance of savings” or something like that—although there still would have been much confusion. No nation, government, or entity is legally responsible for the balance of trade. A trade surplus does not indicate profit, nor a deficit indicate loss. A trade balance doesn’t need to be “financed” in the colloquial sense, nor does the deficit imply increased indebtedness. These terms are used for no other reason than accounting convention. They’re a historical accident of including trade in a system of accounting, nothing more.
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