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.