Explainer

Trade deficits and their impact on a nation

Trump blames them for US' economic woes but a deficit is not inherently a problem

United States President Donald Trump believes trade deficits are the central cause of the US' economic woes and has made them a key focus of his economic policy.

If the US sold more to the rest of the world than it buys overseas, he argues, its economy would take a dramatic turn for the better.

He has also claimed factories, in particular, have been hit by imports from their foreign counterparts and been forced to shed millions of US jobs.

Mr Trump has ordered officials to do the first country-by-country, product-by-product review of the causes of US trade deficits.

The deficit was US$502 billion (S$696 billion) last year, or about 2.5 per cent of economic output. Since 2000, it has averaged US$535 billion. Is Mr Trump right about its damaging effects?

Q What is a trade deficit?

A A country's balance of trade refers to the relationship between the goods and services it imports and those it exports

A nation has a trade deficit if the total value of goods and services it imports is greater than the total value of exports. If the total export value exceeds the total import value, there is a trade surplus.

The balance of trade is the largest component of the current account, a broader trade measure.

A country's current account is one of the two components of its balance of payments, the other being the capital account.

When Americans buy imports from abroad, for instance, foreigners must do something with the US dollars they earn.

They can either use the dollars to buy US exports or invest in US assets, such as Treasury bonds, stocks, real estate and factories.

If the investment capital entering the US exceeds the sum flowing out, the extra money entering the country can then be used by Americans to buy imports.

This means a current account deficit is simply the mirror image of a capital account surplus.

The current account can also be expressed as the difference between national (both public and private) savings and investment.

A current account deficit may therefore reflect a low level of national savings relative to investment, or a high rate of investment.

Some countries, such as the US, are net importers of capital and hence run a trade deficit. To finance the deficit, the US must either look to foreign lenders or attract investment from abroad.

Q Is there a link between the trade deficit and economic growth?

A One reason for a trade deficit could be that the country is growing faster than its trading partners. Faster growth attracts investment, which, along with rising incomes, allows the country with the deficit to buy more imports.

When growth is slower, demand for imports slides and capital flows to greener pastures.

Trade deficits have tended to grow in times of relative prosperity, and shrink in recessions.

But trade deficits do not in themselves result in slower growth. Both the trade deficit and economic growth are outcomes of other underlying factors.

There is no simple link between the size of a trade deficit and the level of overall economic activity.

For instance, if growth picks up pace because of increased spending on infrastructure, this will lift incomes and, by extension, result in more demand for imports.

This would be a situation where faster growth is associated with an increase in the trade deficit.

Or the trade deficit could fall in a recession that cuts consumption of all goods, including imports.

Q Are trade deficits good or bad?

A While the trade deficit has become a punching bag in US politics, it is not inherently a problem.

Economists who see trade deficits as bad believe they result from borrowing from abroad or selling off a country's long-term assets to finance current purchases of goods and services.

Economists who consider trade deficits good link them to positive economic developments, specifically, higher levels of income, consumption and investment.

Sometimes, a rising trade deficit might indeed be bad news. A growing trade deficit in specific sectors could signal that companies in that industry are falling behind their foreign counterparts.

In addition, a trade deficit financed by international capital flows means foreign investors take home the dividends, interest and capital gains they earn from their investments in the country.

But these investments also lift a country's supply of capital, which, in turn, tends to lower interest rates and stimulate job creation.

The country would be worse off without the foreign investments.

In the grander scheme of things, trade deficits are largely meaningless - neither good nor bad. They occur because people in the country are buying things from abroad.

In essence, the saving, investment and consumption behaviour of people and firms ultimately determine the trade deficit.

Q Should governments try to reduce trade deficits?

A Efforts to cut trade deficits - for instance, by taxing imports - have broader results, such as leaving consumers paying higher prices worse off, and also hurting firms that depend on imported inputs.

Policies to cut the trade deficit would likely interfere with the free movement of goods, services and capital across borders - with negative long-run consequences.

Trade benefits economies by promoting higher productivity and living standards. Trade policies should, instead, focus on helping individuals and companies gain freer access to goods and services from all over the world.

A version of this article appeared in the print edition of The Straits Times on June 02, 2017, with the headline 'Trade deficits and their impact on a nation'. Print Edition | Subscribe