What is a trade deficit?

Posted on Tuesday, March 19th, 2019 MarketBeat Staff

Summary - Since the beginning of 2018, the trade deficit of the United States has received a lot of attention due to the tariff policy of the Trump administration. In an effort to correct our current trade imbalance with many countries, it’s fair for investors to wonder how a trade deficit might affect the overall economy and their investments.

The short answer is, it depends. Although the balance of trade between many countries is measured in billions of dollars, a trade surplus does not indicate a healthy economy, nor does a trade deficit indicate a recession.  A country’s balance of trade is really just a statement of account that shows the difference at a period of time between a nation's imports and its exports. In the United States, the trade deficit is released for the prior month in a Trade Balance report by the Bureau of Economic Analysis and the Census Bureau. This report also gives the revised number for the prior month. In this way, the Trade Balance Report is a lagging indicator since it is reporting numbers that are already being manifest in the economy.

Prior to the 1970s, the United States economy would go back and forth between trade deficits and trade surpluses. Since 1975, we have tended to run a trade deficit. One of the reasons the United States has had a trade deficit for the better part of fifty years is that it is a developed country that has a high demand for goods that is either impossible to meet with our current manufacturing base or the goods can be manufactured cheaper abroad. One of the drawbacks to our nation's trade imbalance is the effect it has on our manufacturing companies. By importing cheaper goods, it can lead to job losses which can, in turn, lead to an increased need for imports.

Free and fair trade is vital to a global economy. Efforts that will reduce trade barriers and promote healthy trade should always be encouraged.

Introduction

Global trade reflects the spirit of bartering that has existed since the dawn of time. If your neighbor produces firewood and you own chickens that produce eggs you and your neighbor may barter to get the goods each other needs. During the winter, you may have an increased need for wood and your chickens may not be laying as many eggs. You are operating at a trade deficit. During the warmer months, you may be providing an increased supply of eggs, and you don’t need as much firewood. Now your neighbor is operating at a trade deficit. In either case, the trade deficit is simply an accounting of what one party was importing (receiving) as opposed to what they were exporting (sending).

For most countries, trade may mean oil and steel; automobiles and soybeans, and the scale is much larger in terms of dollars. Many times a developed country, such as the United States, requires more goods and services to be imported from its trading partners than it can export. This leads to what is called a negative balance of trade or, in simpler terms, a trade deficit. Although it tends to grab a lot of headlines because it is measured in billions of dollars, a trade deficit is, by itself, neither good nor bad.

In this article, we’ll break down the idea of a trade deficit. We’ll also define how a country’s current account deficit is related to a trade deficit and what factors account for a country’s trade deficit. As part of the article, we’ll also go over the positive and negative features of a trade deficit, review why the United States maintains a lingering trade deficit, highlight our largest trade partners and look at the reason unfair trade practices are at the heart of the current trade conflict with China.

What is a trade deficit?

In simple terms, a trade deficit is a condition in which one country is importing more goods and services from all the other countries it trades with than it is sending to other country’s (i.e. exporting). When imports outweigh exports a country is said to have a negative Balance of Trade (BOT) or a trade deficit.

However, a trade deficit is also an economic measure that shows more of the country’s domestic currency being given to foreign countries than it is receiving. This has effects on the value of that country’s currency which can have a small effect on a country’s overall budget deficit.

As a math equation, a trade deficit is as follows:

Trade Deficit = Total Value of Imports – Total Value of Exports

A country will track its balance of trade in its balance of payment (BOP) ledgers. This ledger includes their current account which tracks exports and imports as well as foreign aid they have received and asset income they receive from foreign direct investment (FDI).

In the United States, the U.S. Bureau of Economic Analysis and the U.S. Census Bureau produce a monthly report called the Trade Balance Report. Their last report as of this writing showed the U.S. with a monthly deficit of $59.8 billion in December, which was up from an adjusted $50.3 billion in November. In addition to breaking out the deficit as it relates to both goods and services, the monthly report shows any adjustment made to the prior report. In the case of the report listed, the November deficit was revised upward from $49.3 billion.

How is a trade deficit similar to a country’s current account deficit?

A country's current account deficit is one component of a country's balance of trade. Like a trade deficit, a current account deficit indicates that a country has negative net sales to foreign countries. A country's current account includes net income received from items such as interest payments and dividends as well as transfers in the form of things such as foreign aid.

What factors account for a country’s trade deficit?

A balance of trade is frequently looked at in terms of goods and services. Many developing countries have a trade imbalance with the United States. They need the agricultural products of our country to feed their population, but they have few resources to provide to our country. The only way such an imbalance is managed is by having countries willing to finance the deficit spending of other countries. In this way, government borrowing in the form of foreign investment plays a large role in a country’s trade balance. In fact, in addition to the availability of raw materials, currency exchange rates and bilateral and unilateral taxes are two of the largest influencers on a country’s balance of trade.

Can trade deficits be good?

By itself, a trade deficit is neither a good sign nor a bad sign for a country’s overall economy. For example, the 1930s were marked by the great depression in the United States. However, during those 120 months, the United States only ran a trade deficit for 18 months. And when calculated on an annual basis, there was only one year that the U.S. had a trade deficit.

In some cases, a trade deficit may indicate that a country’s economy is growing faster than its ability to produce the goods and services their consumers desire. Looked at in that regard, a trade deficit could be indicative of economic growth. An increase in the amount of foreign goods entering a country also means that the price of those goods goes down, which can help keep inflation in check. Developed countries, like the United States, tend to have trade deficits. In fact, the United States has the world’s largest trade deficit and has since 1975. At the end of 2018, our trade deficit (for just goods, not services) was $810 billion.

What are the drawbacks of trade deficits?

The largest drawback to trade deficits is job losses in the country that is running the deficit. When prices decline due to imports, it can be difficult for that country to produce items at the same price as imported goods. This is particularly true when it comes to manufacturing jobs. This, in turn, can lead to fewer jobs and lower incomes for the employees who stay with the company. Left unchanged, this pattern can turn into a negative spiral as fewer jobs mean fewer goods are produced, which means more goods need to be imported and the deficit continues to grow.

Why does the United States have a lingering trade deficit?

In many cases, a trade deficit tends to be self-correcting. As our example of the 1930s brought out, the United States had a few months of deficits, offset by longer periods of surpluses. However, since 1975, the country has had far more years of trade deficits than surpluses.

The United States is an example of a company that has seen both the positive and negative of trade deficits. One of the reasons the U.S. runs a trade deficit is because of consumer demand. In fact, one way to reduce the trade deficit would be for Americans to increase their savings rate.

Many countries can produce things that are just as good for a lower price. Paying less to import these goods helps keep the price down for consumers, which helps keep demand strong. In 2018, the United States had some of its highest trade deficits largely due to tax cuts by the Trump administration that spurred domestic demand.

However, in some instances, the trade deficit is a factor of a country not needing the goods and services that the U.S. exports. In other cases, we may trade a lot of goods and services with a country, but simply import more than we export.

Who does the United States have their largest trading deficits with?

The United States has its largest trading deficits with China and Japan. These two countries are examples of countries that produce goods for the United States at a lower price than the country can do domestically and do not necessarily need the goods and services of the United States.

China:

Total volume of trade - $636 billion

Trade deficit for U.S. - $375 billion

Deficit as a percentage of trade – 59 percent

Japan:

Total volume of trade - $204 billion

Trade deficit for U.S. - $69 billion

Deficit as a percentage of trade – 33.8 percent

The United States also does significant trade with Canada and Mexico as part of the NAFTA trade agreement. Currently, the U.S. runs a deficit with both Canada and Mexico. However, the percent difference is far less than in China and Japan. Our deficit with Canada is only three percent of the total trade volume. With Mexico, the ratio is just under thirteen percent.

What are unfair trade practices?

Since the beginning of 2018, the Trump administration has been making noises about unfair trade practices and how they are contributing to our trade imbalance with other countries. One common objection being raised is the practice of dumping. This is when one country overproduces a material and then floods foreign markets with those goods. While driving the worldwide price down, it also has a crippling effect on the economies of the countries in which the products are being dumped. One way the Trump administration has been trying to combat this issue is by the use of tariffs.

Let’s use a thought experiment to illustrate the issue.

If Country A imports steel to Country B without placing a tariff on that steel, Country B would probably buy more of Country A’s steel even if that hurt their own domestic production.

However, if Country B imposes a tariff on Country A’s steel, it would now mean higher prices for Country B. In theory, Country B would then spend less on Country A’s steel and perhaps use more of their own. Continuing the thought exercise further this would mean that Country B would be encouraging more domestic job creation specifically in the areas affected by the tariffs.

Such is the basic rationale of the current tariff conflict between the U.S. and particularly China. The U.S. is looking to place a tariff (which is a form of a tax) on Chinese steel being imported into the United States. In return, China is threatening to tax exports from the United States. Even though most economists believe there will be an equitable agreement reached, the continuing standoff is a large reason that the financial markets remain volatile.

Does the United States trade deficit contribute to the federal budget deficit?

The shorter answer is very little. The current U.S. national debt is over $20 trillion dollars. Even if all the goods and services the country bought were produced in the country, the effect on the national budget would be very slight. Currently, about $6 trillion of that debt is held by foreign countries. Of greater concern is what would happen to the trade deficit if the country’s that hold our debt would decide to sell dollars. This would result in a dramatic decline of the U.S. currency and make not only our national debt but our trade imbalance soar.

The bottom line is that efforts to reduce the deficit (either the trade deficit or the federal budget deficit) would have little effect on the other deficit.

The final word on trade deficits

Trade deficits draw a lot of attention, but in theory and in reality they are only a small measure of economic growth or activity in a country. In fact, the existence of a trade deficit can be a sign of a healthy, growing economy, while a trade surplus can often mean there is less demand for a country’s goods and services. With this in mind, a country’s trade imbalance needs to be looked at with an eye towards other factors.

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