40% of US container traffic moves through Los Angeles’ ports; traffic we can get behind. (Photo by wpd911/iStock.)
We’ve spilled a lot of ink over the years debunking trade deficit myths, but since they don’t go away—and because trade policy is back in the news—once more unto the breach! The ever-present false fear is that trade “imbalances” are bad and unsustainable. But this completely misunderstands trade. It isn’t as if countries that export more than they import—net exporters—are stockpiling IOUs to put countries that import more—like the US—in a disadvantageous position.[i] Both are doing what’s in their best interests, i.e. trade. Besides, those IOUs are US dollars, and the only things US dollars are good for are buying US products, services, investments and paying US taxes. Countries with which the US runs a trade deficit aren’t bleeding America dry. Rather, they’re investing a ton here, supporting future growth and earnings for US firms. Everyone wins.
At its core, foreign trade is really no different from interstate commerce. No one bats an eye about free trade between Texas and California (or between any other states). If one state runs a consistent trade surplus with another state, it isn’t like the exporting state is somehow draining the economic vitality of the importing state. It’s just trading more goods and services for cash. Why? Because the net-exporter state wanted[ii] to sell more and the net-importer state wanted to buy more. That is all! No nefariousness needed or involved. Putting up trade barriers to stop these “imbalances” from occurring would just be silly.
Trade Deficits Are a Sign of Robust Growth
Some suggest running a trade deficit is a sign of economic weakness. If we’re always importing more than we’re exporting, won’t it all eventually come crashing down as money leaks out of the country? No! We’ve had a supposedly unsustainable trade deficit since 1976. That’s 41 years running. Meanwhile, the S&P 500’s total return since then exceeds 8,300%.[iii] Markets are telling you this isn’t a problem. Those who fear otherwise are fixated on an unfortunate naming convention, not to mention a too-simplistic take on trade, forgetting about foreign investment in the US. It isn’t as if money spent on imported goods leaves the country forever and ever. A better way to think about the trade deficit is as America’s investment surplus.
A trade deficit by its very name implies the US is somehow lacking in some functional capacity—say, manufacturing prowess[iv]—which, even if true (and it isn’t),[v] ignores that trade outflows are matched by investment inflows. That is, dollars earned through trade by foreigners abroad are necessarily invested back in the US,[vi] which incidentally speaks to the US’ investing prowess.
Among the US’s many competitive advantages are its vast consumer and asset markets, business- and investment-friendly institutions and high rates of return. A rising trade deficit not only means US consumers are healthy, but that foreign demand to invest in the US is robust, presumably because US businesses continue to grow and innovate. In short, the US’s persistent trade deficit is a good indicator America is a great place to invest!
Trade “imbalances” for goods and services simply reflect a choice among trading partners about whether they’d like to hold more cash (foreign exchange to be saved or invested) or consume more goods and services from abroad. Different countries make different choices for their own reasons and nothing about it is inherently unstable or concerning—or even really decided at the national level. Rather, it amalgamates the commercial decisions of millions of individuals. For each person involved, it’s just a trade—on the consumer side and the investment side—and the more of it, the better. When looked at as a whole, everything balances.
More Trade Is Good, Less Trade Is Bad
Another antidote to the “trade deficits, bad” myth is to treat imports and exports as equally good. One way to do this is to add exports and imports together, instead of subtracting imports from exports the way GDP does. Exhibit 1 shows gross total trade (blue line) and how it correlates well with US GDP (orange line). Whereas subtracting imports from exports—the trade deficit—has no clear relationship with economic growth.[vii] In other words, if we’re selling more to the world, great. If the rest of the world is selling more to us, just as great! More trade strongly suggests greater growth.
Exhibit 1: Exports Plus Imports Correlate Well With GDP
Source: St. Louis Federal Reserve, as of 2/7/2017.
It’s easy to see why more exports are good for the US, but what about imports? To put a fine point on this, consider America’s largest import: crude oil. The US imported $101 billion of the stuff last year. Would America be better or worse off, pray thee, if the US
cut off its nose blocked all crude oil imports from the rest of the world? Though circumstances were different, the 1970s strongly suggest otherwise. Well, the same goes for any other import.
Imports Don’t Subtract From GDP
What’s more, imports don’t actually subtract from GDP. Yes, they are a negative in the GDP calculation formula, but they do not diminish growth. Rising imports mean domestic demand is strong. Although it’s mathematically true that Gross Domestic Product (GDP) = Consumption + Investment + Government Spending + (Exports - Imports), imports are included in consumption and investment. When you measure the pure private sector components of GDP—spending, business investment and real estate—imports are a positive. Subtracting them in the trade section of the calculation merely cancels that out, bringing their net contribution to zero. Now, that doesn’t make GDP math sensible or GDP a wonderful reflection of the economy, but don’t let an accounting identity fool you into believing imports are a negative.
Let’s work through the math! If the US were to suddenly export $100 billion in littoral mass and, at the same time, import $200 billion in linoleum and linoleum products, the trade deficit will have increased by $100 billion, but the total effect would be to increase GDP by $100 billion. It wouldn’t look that way at first blush, because net trade would be negative, but when you run through the entire calculation it’s a wash. Imports have no net effect on GDP, because they’re “hidden” in US consumption and investment. Whatever is subtracted in trade is added in domestic demand.
Beware protectionist rhetoric. Economies thrive—and consumers win—with more trade, and the US is no exception.
[i] Similar false fears abound about being a net borrower in hock to and at the mercy of “unscrupulous” lenders.
[ii] In the aggregate sense.
[iii] Source: FactSet and Global Financial Data, Inc., as of 2/9/2017, S&P 500 Total Return 12/31/1975 – 2/9/2017.
[iv] Another false media narrative du jour.
[vi] US goods and services trade—whether a deficit or surplus—are just a part of the wider balance of payments accounts which, as the name suggests, always balance.
[vii] Charting this in the same way doesn’t work, but just looking at the raw trade deficit and economic growth, there is little relationship. If anything, periods of shrinking deficit or even surplus correspond more with recessions, which wreck demand for imports.