Are Trade Deficits Inherently Bad?

So my last 4 posts have been on subjects related to the Trade Deficit, thanks to Mr. Trump. This current post should probably have come before them, since it answers a rather fundamental question - Are Trade Deficits inherently Bad?

The answer to this question is complicated. In a nutshell - it depends.

Let me explain.

I will start by explaining what factors determine whether a country runs a Trade Deficit or Surplus, before moving on to the subject of whether a Trade Deficit is good or bad. 

We know that for any open economy:

Savings - Investment (or the Net Capital outflow) = Net Exports 

I’ve explained why in detail in my post, Why are the Net Exports of a Country = its Net Capital Outflow?. 

While many policy observers tend to believe that the Trade Deficit depends primarily on trade policy (this is the belief of many protectionists), in reality, the Trade Deficit isn’t impacted much by trade policy. It depends on two key factors: the levels of Savings and Investment in an economy. The impact of trade policy on these two variables is negligible. This is why trying to reduce the Trade Deficit through protectionist measures is a losing proposition. Read my post, Why Protectionism Doesn’t Reduce Trade Deficits for more. 

Why Does China run a Trade Surplus?

I’m going to employ some examples to explain how the savings and investment realities of a country tend to dictate whether it runs a Trade Surplus or a Trade Deficit.

Let’s look at China first. The savings rate in China is rather high (~50% of GDP). While the Chinese investment rate is also quite high (~45% if GDP), it is lower than the savings rate, which is why capital from China flows abroad i.e. China has a capital account deficit.

Whenever a nation has a Capital Account Deficit (i.e. capital flows out of that country on a net basis), it will have a Current Account Surplus or a Trade Surplus - this is ensured by adjustments in the real exchange rate. Why? Because the real exchange rate adjusts to ensure that the supply of domestic currency in the forex market (net capital flowing out of the country) = the demand for domestic currency in the forex market (when the country exports on a net basis, foreigner demand domestic currency to pay for imports).

Hence, the primary reason that China runs a Trade Surplus with the world is because its domestic savings are higher than investment (there are many structural reasons for this which are beyond scope of this post), and not so much because of its trade policy (currency manipulation etc. like many suggest). 

The Chinese government is taking steps to transition China towards a consumption driven economy (China’s consumption is ~35% of GDP vs. a world average of ~60% of GDP), but this will take time. 

Why does the US run a Trade Deficit? 

The primary reason the US runs a Trade Deficit is because unlike China, it saves less than it invests (Saving ~19% of GDP; Investment 20%+). To fund this gap, capital flows in from the rest of the world. Net capital inflows into the US (Capital Account Surplus), automatically imply a Current Account Deficit/ Trade Deficit. 

Hence (again), contrary to what Trump suggests, currency manipulation by China is not the cause of America’s long running Trade deficit. 

Why is everyone so scared of Trade Deficits anyway? 

So as I've mentioned above, running a Current Account Deficit or Trade Deficit (I use both terms interchangeably here) automatically means that the country is running a Capital Account Surplus.

A capital account surplus means that foreigners are investing in domestic government debt, corporate debt etc. (along with making equity investment) and will eventually have to be paid back in their own currency. If the country in question is not able to earn enough forex through exports, it may not have enough forex to pay back the loans taken from these foreigners when the time for repayment comes.

In case a majority of foreign investors decide that they want to want to exit their investments and get their money back, they will sell all their assets, exchange local currency for their own currency and exit. If this happens at once, the domestic currency will crash. 

With the domestic currency much weaker, exports will become more competitive (on the international stage) and imports will become much expensive to buy. As a result, the country will experience an acute reversal of its Current Account Deficit to a Current Account Surplus.

Y = C + G + I + NX

Now look at the National income identity above. When foreign capital inflows/funds are suddenly not available and net exports (NX) go from negative to positive, investment spend (I), government spend (G) and even consumption (C) fall sharply (assume Y or total output is fixed). 

No country wants to be in this situation. Persistent Trade Deficit increase the chances of such an eventuality, which is why they are considered dangerous.

That said, just the mere existence of a Trade or Current Account Deficit, does not mean that it needs to be reversed or that the country is in trouble. We’ll discuss why in the next section.

Is a Trade Deficit Good or Bad? 

There is no universal answer to this question. Whether a country’s Trade Deficit is good or bad depends on the reasons for the Deficit, how the capital flowing in from abroad is utilized, and how this impacts output/employment/investment/growth trajectory/currency/inflation etc. 

The Case of the US

For the US, many economists believe that the Trade Deficit’s effect on output (GDP) is compensated by capital inflows, which enable investment in US productive capacity and allow the economy to continue to grow. Half of US’s imports are used as intermediate inputs in the production of final goods, which are then exported all around the world - these support US jobs. Cheaper imports offer US consumers a wide range of options and help keep the price level in the US low. Despite the Trade Deficit, the US dollar continues to remain strong. Given the strength and stability of the US dollar and its status as the world’s reserve currency, it is unlikely that foreign capital will swiftly leave the country. Given all these reason, US’s Trade Deficit isn’t the evil that it is made out to be. 

That said, the low domestic savings rate in the US (the primary cause of the US Trade Deficit) should be raised over time, so the US’s dependence on foreign capital is reduced. 

The Mexico Peso Crisis - 1994-95

Now I will discuss the Mexican Crisis of 1994 when monetary and currency mismanagement in the backdrop of a Trade Deficit and Capital Account Surplus led to a full-fledged financial crisis, marked by capital flight and the sudden move from a Trade Deficit in 1994 to a Trade Surplus in 1995, to help pay back foreigners the dollars they were promised. This is the kind of disaster that every country wants to avoid!

Lets understand what happened. During 1994, the Mexican government decided to attract foreign investors by issuing short-term debt denominated in Pesos, with a guaranteed repayment in US dollars. This can be dangerous since it is incumbent on the government actually having the requisite amount of dollars at the time of repayment. Note: the Peso at this time was not a free-floating currency; it was pegged to the US dollar. 

The subsequent assassination of Presidential candidate Colosio and violence in the country put pressure on the Peso. To maintain the Peso’s peg to the dollar, the Mexican Central Bank had to buy Pesos in the market. How they did this was by issuing dollar denominated public debt through which they borrowed dollars, which were then used to buy Pesos in the forex market. This raised the price of the Peso (within the band allowed around the peg), but this meant that the dollars would have to be paid back at some point - dangerous again. 

Given that the Peso was stronger than what the market intended it to be, the Trade Deficit increased (strength in a currency means imports become cheaper). A higher Trade Deficit meant Mexico needed more dollars to pay for imports, which started to put pressure on the Peso. At the same time, investors/ speculators realised that the Peso was over-valued. This led to capital flight out of Mexico i.e. foreign investors began to pull their funds out of Mexico (sell pesos, buy dollars) since a devaluation of the Peso would mean that Peso denominated assets would become less valuable in dollar terms. This led to even more pressure on the Peso. 

Added to all this was the fact that the Mexican government had to service the debt it had issued with repayment guaranteed in dollars. Trying to support the Peso (by selling USD and buying Pesos in the forex market) and repaying debt in dollars led the Central Bank to completely run out of dollars in December 1994. 

On December 20th, the Peso was devalued by ~15%. A couple of days later, it was allowed to float freely. In a few months, the Peso had fallen by almost 50%. It did recover subsequently. Mexico experienced hyperinflation given the dramatic currency depreciation; investors fled; there was an acute recession; unemployment was rampant. Also, the Mexican crisis sparked off crises in other countries of Latin America and Asia as well. 

I have provided a more detailed review of the Mexican crisis than I originally intended, because I feel that a clear understanding of the catastrophe that can result from excessive dependence on foreign capital, which is usually accompanied by a Trade Deficit, is paramount if one is to appreciate what economists fear most about Trade Deficits. 

Ofcourse there were other culprits involved in the Mexican debacle - bad monetary management, fiscal profligacy, the currency peg - but there always are. 

Conclusion

A Trade Deficit in itself is not good or bad. The causes of the Trade Deficit, how the capital that flows in as a result is utilized (Is the country just financing consumption instead of investment? Is the money being use to bankroll risky investments?), and the impact of the Deficit on various economic indicators together determine whether a nation’s Trade Deficit is virtuous or troubling.

Why Protectionism Doesn’t Reduce Trade Deficits

I’m talking an awful lot about Trade Deficits, aren’t I?

It’s just that Mr. Trump has vocalized so many controversial economic policy prescriptions for reducing the US Trade Deficit which he considers symbolic of all the jobs America has lost to foreigners, that I (and many others who have a background in economics) feel compelled to talk about Trade Deficits and the common misconceptions and untruths that plague this subject. 

In my last post, What the "Value-Added" Trade Deficit means for US Trade Policy with China, I talked about some of the problems that the US would encounter if as Trump has promised, tariffs are imposed on all Chinese imports. Here is an excerpt below:

1) Around 55 cents of every dollar spent by American consumers on products “Made in China”, go to American producers, mostly service providers. This means that if Trump imposes tariffs on Chinese imports, these will end up hurting American businesses and American workers will end up losing jobs.

2) China won’t remain passive if America imposes tariffs on its exports. It will impose taxes on American imports as well. Hence, the supposed gain in output from reduced competition from Chinese imports might be counter-balanced or more than reversed by the loss of exports to China.

3) Finally, this won’t impact just final goods i.e. final exports or imports. There are many American products that source components from/are assembled in China, the iPhone being a popular example. In case tariffs are levied on Chinese imports, goods such as the iPhone will become much more expensive. Their sales will suffer which will ultimately harm American producers and workers. 

In this post, I will explain the underlying theory behind what really happens when a large, open economy such as the US imposes tariffs on imports, and whether this actually reduces the Trade Deficit. 

The Theory: What happens when an economy imposes Tariffs on Imports

We know that for any open economy (one that trades with other nations) lets say economy “A”, Savings (S) - Investment (I) = Net Exports (NX). I’ve explained why in detail in my post, Why are the Net Exports of a Country = its Net Capital Outflow?. 

This equality is preserved through movements in the Real Exchange Rate (e). Let’s see how this happens. (Look at the chart below)

When a Country imposes Tariffs on Imports, the Real Exchange Rate rises; Net Exports remain unchanged

Let’s assume that economy “A” is at equilibrium at E1. The real exchange rate is = e1 and S - I = NX1. Now let’s assume that country A imposes a 45% tariff on all imports from the ROW. What happens now?

The Net Exports curve NX1, moves rightward to NX2. This is because at every real exchange rate, the tariff causes imports to fall, which automatically raises the value of Net Exports. 

At the original exchange rate e1, Net Exports are now greater than S - I, or the Net Capital Outflow from country A (the gap between Savings and Investment in a country gives us the net capital that flows out of that country to others). Since Net Exports raise demand for country A’s currency (because foreigners need A’s currency to pay for these) and net capital outflows from country A increase the supply of A’s currency, when NX > Net Capital Outflows (S - I), demand for A’s currency will be greater than supply, which will cause A’s currency to appreciate. This will cause the real exchange rate to rise, reducing A’s net exports.

(Note: When country A’s currency appreciates i.e. it becomes more expensive vis-à-vis other foreign currencies, A’s exports become more expensive for foreigners. Imports on the other hand, become cheaper. Overall, A’s net exports fall.)

A’s real exchange rate with rise and net exports (NX2) will fall, until S - I is once again = net exports at E2. This happens when the real exchange rate has risen to e2. 

The important thing to notice is here is that at the new equilibrium E2, while the real exchange rate is higher, Net Exports are the same as they were at the initial equilibrium E1, before the tariff was levied.

What has happened after the levying of the import tariff is that along with imports, exports have fallen as well (with the rise in the real exchange rate), so that the value of the Net Exports of country A is the still same as it was before the tariff was levied.

Has country A gained anything? No. Infact, it has actually lost. While the value of net exports is the same, the volume of imports and well as exports has fallen. A’s trade with the ROW the world has reduced. Reduced trade means lower output which means lesser jobs. 

Bottom-line: The import tariff has actually hurt country A’s growth and caused job losses for its labour force. 

Trump’s proposed Tariffs are a Bad Idea 

The theoretical framework described above shows that if Trump is elected President and imposes tariffs on imported goods from China and other countries, he will end up hurting American workers, while doing nothing towards reducing the American Trade Deficit. Infact, he could actually make it worse if China imposes counter tariffs - which they most definitely will. 

What the "Value-Added" Trade Deficit means for US Trade Policy with China

In my previous post, Why the US Trade Deficit with China is Lower than you Think, I talked about the “Value Added” measure of the US Merchandise Trade Deficit with China and how this is more than 50% lower than the “Gross” measure published by the government. I recommend that you read this post - it’s a quick read - before sinking your teeth into this one. 

In a nutshell, the reason that value-added measures of trade are more representative of reality than gross measures is the ubiquity of complex supply chains in today’s manufacturing. Today, countries assembling a final product source inputs and components from all over the world. While the country that ships the final product or exports to it to final customers gets credit for the entire value of the export, in reality the true “value added” by this country (in terms of actual production/assembling /packaging etc.) may only be a small fraction of total export value. I’ve explained this in detail in my previous post - Why the US Trade Deficit with China is Lower than you Think - using the example of the iPhone 7. 

“Value added” measures of Trade Balances with China are especially relevant since China being the “factory of the world”, is in many ways the poster-child for today’s complex, multi-national, supply chain driven, manufacturing world. China assembles a lot of products especially in the consumer electronics space, where the value it adds is actually pretty small compared to the value of the final product exported to consumer markets, yet it gets full credit (100%) for the value of these exports.

Now Mr. Trump has been fixated on the large “Gross” US Merchandise Trade Deficit with China ($367 Billion for 2015 or half of America’s total Merchandise Trade Deficit with the world) and how this is evidence of all the jobs that Americans are losing to Chinese workers and the cheater that China is (Trump has accused them of currency manipulation) in the sphere of international trade. He has announced that he will tax Chinese imports at 45% if he is elected President. He believes this will help America increase it exports/output and save/add jobs. 

The “Value-added” measure of US’s Merchandise Trade Deficit with China however, is less than half of the “gross” measure or less than $184 Billion (quarter of America’s total Merchandise Trade Deficit with the world)! What does this mean especially while evaluating Trump’s rhetoric and policy stance with respect to trade with China? 

1. The fact that the value-added Merchandise Trade Deficit with China is really just half of the gross figure means that in reality, other nations from where China is sourcing intermediate products (materials, components etc.) should get credit for half of all US imports from China. This is indeed what happens under the value added approach. While the US Merchandise Trade Deficit with China halves under the value-added approach, Merchandise Trade Deficits with other Asian countries more than double based on OCED-WTO TIVA (Trade in Value Added) figures for 2009. We’re assuming these TIVA indictors are in the ballpark even today.

In the chart below, we compare USA’s 2015 Merchandise Trade Deficit with China, Japan and Asia (excluding China and Japan) on a “gross” and “value added” basis (remember these are just rough estimates based on TIVA indicators).

It’s clear from the chart above that if Mr. Trump has to worry about USA’s bilateral trade deficits, he needs to also consider Japan with whom the Value Added Merchandise Trade Deficit is approximately three-fourths as large as China! Even more important, is US’s Value Added Merchandise Deficit with Asian countries ex Japan and China (~30% of its total Merchandise Trade Deficit), which is larger than its deficit with China! 

Bottom-line: This singular focus on China as far as the Trade Deficit is concerned, is an unwarranted exaggeration.

2. Here’s another important statistic. Around 55 cents of every dollar spent by American consumers on products “Made in China”, go to American producers, mostly service providers. This means that if Trump imposes tariffs on Chinese imports, these will end up hurting American businesses and American workers will end up losing jobs. Trump probably believes that these losses will be compensated by increased American output since domestic consumers will end up buying more American goods. But this is not guaranteed either.

3. China won’t remain passive if America imposes a 45% tariff on its exports. It will impose taxes on American imports as well. Hence, the supposed gain in output from reduced competition from Chinese imports might be counter-balanced or more than reversed by the loss of exports to China.

4. Finally, the situation isn’t as simple as it seems above. This is not just about final goods i.e. final exports or imports. There are many American products that source components from/are assembled in China, the iPhone being a popular example. In case tariffs are levied on Chinese imports, goods such as the iPhone will become much more expensive. Their sales will suffer which will ultimately harm American producers and workers. 

Tariffs/protectionism seem attractive to workers who have lost their jobs to competition from cheaper imports (I understand their motivation and appreciate the hardships they suffer), but unfortunately, these don’t really help. Tariffs and protectionism lead to trade wars, which lead to lower international trade. Lower trade is harmful for everyone. It reduces output, raises costs for consumers and leads to the misallocation of national resources. 

Why the US Trade Deficit with China is Lower than you Think

Trade agreements and the Trade Deficit have come under acute focus during Trump’s campaign. The subject matter of international trade is fairly complicated and consequently, not very well understood. There is so much to talk about and clarify here. In this short note, I will talk about China’s Merchandise Trade Deficit (includes only goods, not services) with the US, which has been one of Trump’s pet subjects on the campaign trail.

Note: US runs a surplus in its trade of services with China, which is why it's the trade in goods i.e. the Merchandise Trade Deficit with China which has been Trump's focal point of assault. 

I’m not going to challenge Trump’s view of international trade in this post (I’ll do that in others). I’m simply going to explain why the Gross Trade Deficit measure of bilateral trade (especially with China) can be misleading. 

Let’s use the iPhone 7 for Illustration 

The unsubsidized cost for a 32GB iPhone 7 in the US is $649. IHS Markit estimates the Bill of Materials (BOM) for the iPhone 7 at ~$220/unit. 

What is the “Bill of Materials” or BOM, you ask? It is the list of raw materials, components and assemblies required to manufacture a product. 

This BOM for the iPhone 7 does not include labor costs. These costs are pretty hard to estimate. Based on an audit carried out by the Fair Labour Association (FLA) at a Foxconn (a top Apple supplier in China) factory in 2012, ABC news reporter Bill Weir, who was invited to tour along with the FLA representatives, estimated labor costs per iPhone at ~$12.5. IHS Markit estimates labor costs/iPhone 7 at just $5. Other experts have also estimated these at <$10/unit. 

Let’s assume an average labour cost of $10. After adding factory costs etc. to the labor cost, let’s assume the production cost for the iPhone 7 is $15/unit. This implies a total cost per unit of $220 + $15 = $235. 

So each time a fully assembled iPhone 7 is shipped to the US from Foxconn’s Chinese factory, USA’s Trade Deficit with China rises by $235. The problem here is that China is basically just assembling the iPhone 7. The components are sourced mainly from other countries such as Taiwan, Malaysia, South Korea, Japan and the US. This means that the Gross Export Value of $235 greatly exaggerates China’s export contribution to the US. In terms of “value added”, China is responsible for just ~6% ($15) of this Gross Export Value. 

Enter “Value Added” as a Measurement of Trade 

Most published trade statistics measure trade on a “Gross” basis. They record the total value of the good exported/imported. While this method is easy to follow, as we explained above, it can be misleading since it does not account for the global, multi-national supply chains that are in place for manufacturing today. Country A could be assembling a car using materials from country B and engines from country C, and exporting to country D. Assigning the entire export value of the car to country A greatly exaggerates the value added by country A, while not giving country B or country C their rightful credit in exports to country D. 

The “Value Added” method breaks down the value added at each stage of the manufacturing process and helps one get realistic measures of the true contribution of each country in international trade. The “Trade in Value Added” (TIVA) database, a joint venture of the Organisation for Economic Co-operation and Development (OECD) and the World Trade Organization (WTO), provides value-added trade data for many nations. 

America’s “Value Added” Merchandise Trade Deficit with China is >50% lower than the Gross measure !

China runs the largest Trade Surplus in the world. It sources components and materials domestically and internationally, assembles these into final products and exports these products to meet global demand. It truly is the “factory of the world”. 

China runs its largest Trade Surplus with the US, the world’s largest consuming market. From all that we have discussed above, I’m sure that you’ve guessed that US’s Merchandise Trade Deficit with China in valued added terms is substantially smaller than the gross figure. 

You’re right. Based on OCED/WTO TIVA indicators, America’s 2009 Merchandise Trade Deficit with China in Value Added terms, was lower than the gross figure by more than 50%! 

US’s 2015 gross Merchandise Trade Deficit with China was $367 Billion (48% of total Merchandise Trade Deficit; or 2% of GDP). Assuming that the 2009 TIVA indicators mentioned above are still broadly representative of trade today, US’s 2015 Merchandise Trade Deficit with China in value added terms, should be less than $183 Billion (24% of total Merchandise Trade Deficit; or 1% of GDP)!

There are important implications that follow from this especially in relation to Trump's espoused approach to trade with China. I will discuss these in my next post. 

Why Trump is Wrong About NAFTA

In the recent US Presidential debate, candidate Donald Trump said, "NAFTA is the worst trade deal maybe ever signed anywhere, but certainly ever signed in this country".

For context, NAFTA, the “North American Free Trade Agreement” is a trade deal between America, Canada and Mexico, signed in 1993 by President Bill Clinton that eliminates practically all taxes on goods traded between the three nations. 

Trump has been blaming NAFTA for demolishing America’s manufacturing sector. Let’s examine his claim.

1. Trump is factually right in that US’s Merchandise Trade Deficit with Mexico has grown substantially since the signing of NAFTA. Per US government data (link here), the US had a Surplus of $1.35 Bn in the trade of goods with Mexico (services not included) in 1994, while today (first 10 months of calendar 2016) the US has a nominal Deficit of $53 Bn in the trade of goods with Mexico. Admittedly this is large increase.

That said, to conclude that this ballooning of the Merchandise Trade deficit is all due to NAFTA, is far from the truth. One has to take into account how much of this increase is due to the loss of jobs/manufacturing to Mexico and other countries that have lower wages. This unstoppable, global trend would have increased America’s Merchandise Trade Deficit with Mexico whether NAFTA had been signed or not. 

2. It’s true that manufacturing jobs in the US have fallen dramatically over the past couple of decades. Per data from the US Bureau of Labor Statistics (see chart below), workers in the manufacturing sector have dropped from 17.2 Million in Dec 1994 to 12.3 Million in Sep 2016 i.e. almost 30%! That said, the adoption of technology is responsible for a significant portion of these eliminated jobs. Trade or not, the troubling reality is, that while increasing productivity and making products cheaper, technology has killed jobs. For those interested in exploring this subject further, David Rotman’s article “How Technology is Destroying Jobs” in the MIT Technology Review (link here) is a great read. 

All Employees (seasonally adjusted) in the US Manufacturing Sector (in thousands) 

Source: US Bureau of Labor Statistics 

3. While imports from Mexico have increased faster that exports to Mexico, exports have increased by a substantial amount as well since the signing of NAFTA. This has created jobs in the US. According to the U.S. Chamber of Commerce, 6 million U.S. jobs depend on U.S. trade with Mexico, which has been greatly enhanced by NAFTA. Overall, many experts estimate that NAFTA has had “a modest positive” impact on the US economy. 

Bottom-line: 

Trump’s claim about NAFTA destroying US manufacturing exposes a lack of understanding of the forces of global trade. Or maybe he understands these forces, but is banking on the fact that common Americans don’t. Imports from Mexico would have grown anyway, whether NAFTA was signed or not. Jobs would have been lost anyway due to movement of manufacturing to low cost locations like China whether NAFTA was signed or not. Infact, it is the pressure created from low-cost goods produced in low cost nations that has caused US manufacturing to move to Mexico. This would have happened regardless of NAFTA. 

While NAFTA has certainly hurt some American workers (I do sympathise with them) and the government needs to do more to protect the American worker, blaming trade agreements hugely oversimplifies the problem. NAFTA is not the evil that Trump has painted it out to be.