The United States, like most other countries, uses the method of double-entry bookkeeping to track certain aggregate statistics known as national income accounting. One of the statistics tracked is the balance of trade. The trade balance reports the difference between imports and exports. When imports exceed exports, there is said to be a trade deficit. When exports exceed imports, it is said to have a trade surplus. When both are equal, trade is said to be balanced. Technically, the trade balance refers to the import and export of goods and services, but attention tends to focus solely on trade in goods, the so-called “merchandise trade balance.”
There is widespread confusion over what the trade balance is. Even David Hume and Adam Smith pointed out that this concept does far more harm than good. Hume discusses how the balance of trade is misunderstood by people who are “ignorant of the nature of commerce” (see his essay “On the Balance of Trade”). In The Wealth of Nations, Smith goes further, calling the entire concept “absurd” several times (see pages 377 and 488 of the Freedom Fund edition). Many of his arguments against protectionism and mercantilism in Volume 4 are directed toward the balance of trade as a whole.
Confusion ensued as the trade balance was incorporated into national income calculations. The connotations of the words “surplus” and “deficit” (combined with positive and negative accounting conventions) give the impression to those who do not understand trade balances that deficits are bad and surpluses are good. But if you dig a little deeper into accounting, you’ll see that 1) “deficits” and “surpluses” have no value, and 2) calling them “trade deficits/surpluses” is something of a fallacy.
The important thing to note here is that the trade balance has surprisingly little to do with merchandise trade. It is actually the result of the relationship between national savings and national investment. Considering accounting identity
GDP = consumption + investment + government savings + net exports,
You can demonstrate it by doing a little algebra
Net exports = savings – investment
In other words, if the demand for investment funds exceeds the supply of savings funds (savings), the country must import savings from abroad. As a result, foreigners buy fewer exports and prefer to buy assets.
Both savings and investment are determined by factors that are very different from the number of goods that cross borders. Real interest rates, growth expectations, confidence, institutions, and other macroeconomic factors are far more important. In fact, as stated in the textbook International Economics, Robert Carbaugh shows that approximately 98% of transactions in the foreign exchange market involve people exchanging currencies for investment purchases rather than for the purchase of goods and services. Considering that around $6 trillion is traded every day in the foreign exchange market, that means a lot of dollars (and pounds, yen, French, euros, etc.) are being exchanged to coordinate investment opportunities with savers.
Therefore, the trade balance is the result of macroeconomic factors. This means that the trade balance is, at best, a symptom rather than a cause of macroeconomic phenomena. Additionally, trade is done by individuals, not nations, so to properly understand trade deficits, you need to understand why there is a difference between saving and investing. Investments will come from businesses (note: they can, but need not, be financed by borrowing) and individuals making large capital purchases, such as homes. A trade deficit is a good sign if these individuals are using their investments to realize long-term productivity gains. But if borrowing is being done without such productivity gains, a trade deficit could be a sign of bad things. In any case, and this is the big point here, the trade balance has nothing to do with trade. It depends on much larger macroeconomic factors.
Hence the reason why I titled this post like this. Perhaps it would have been better to call the trade balance something like ‘savings balance’, but there would still have been considerable confusion. No nation, government, or entity is legally responsible for the balance of trade. A trade surplus does not indicate a profit, and a trade deficit does not indicate a loss. The trade balance does not have to be “financed” in the colloquial sense, nor does a deficit imply an increase in debt. These terms are not used for reasons other than accounting convention. These are just historical accidents of incorporating trade into accounting systems.
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