Don't Be Afraid of the Trade Deficit

Monday 06/11/18

It has been a while since I have last posted a newsletter so I thought that I would jump back into the swing of things and discuss the changes to trade policy so far. Let me first disclose my biases: I’m an unabashed free trader, I think that tariffs, subsidies and other forms of protectionism are detrimental to everyone involved. My greatest economic concern with the Trump administration was his attitude towards trade. For the first year of his presidency it didn’t seem as though there would be a major break in policy, but following the ouster of economic advisor Gary Cohen, protectionist rhetoric and actions have increased markedly. This week I will take a look at the trade deficit and why it isn’t nearly as scary as you might think.

Trade Deficit

To many in the United States, the idea of a trade deficit conjures up images of money coming out of the pockets of American workers in a game where the other side is winning and we’re losing. Presidential Candidate Ross Perot once described a “giant sucking sound” of jobs moving south to Mexico if NAFTA were enacted. Indeed we now have a trade deficit with Mexico, but many don’t really understand what a trade deficit is. Here’s an example:

Let’s assume that Frozenland only produces ice cream and Firestan only produces air conditioners. It’s really hot in Firestan so they like to eat ice cream and Frozenland happens to make the best ice cream, so Firestan imports $10 million worth of ice cream every year. Because of the climate in Firestan they have perfected the art of making air conditioners. It’s usually pretty cold in Frozenland so they don’t have any air conditioning companies, but a few residents still import about $1 million of air conditioners each year. The two countries don’t trade anything else with each other so Frozenland has a $9 million trade surplus and Firestan has a $9 million trade deficit.

A trade deficit is simply when a country imports more than it exports. There is no rule or any particular reason why trade should be balanced among countries, in fact that would be pretty much impossible. Continuing with this example:

The government of Firestan now wishes to impose a Tariff on ice cream in order to balance their trade with Frozenland. So to offset the cost of the tariff Frozenland’s ice cream exporters raise their prices. When the overheating citizens of Firestan run to the ice cream truck they are shocked to see how much ice cream costs now and opt for domestically produced desserts instead. As a result they only import $1 million of ice cream now. Hooray trade is balanced.

Of course, this doesn’t make any sense. Everyone loses in this example. Frozenland’s exporters make less money and Firestan’s people can’t afford delicious ice cream on a hot day. This was obviously an extreme and silly example, but it helps show the silliness of tariffs.

Losing to Mexico

Those in favor of protectionism often rely on bogeymen to push their view. “We’re losing jobs to Mexico” is the refrain and at the same time, usually from the same people, you’ll hear, “Mexican’s are coming illegally to the United States and taking all our jobs!” Excuse me, but if all the jobs are going to the worker’s utopia to the south, why are they coming here to find better jobs? In 2017 we had a $71 million trade deficit with Mexico which has led some to say that we are losing the trade war. Perhaps instead they might consider that we are winning because we are getting $71 million more of their stuff than we are giving to them.

Finding Balance

It doesn’t make any sense to think about the dreaded trade deficit in isolation and of course economists don’t. According to Reuters, when polling economists about steel and aluminum tariffs, “Nearly 80 percent of 60 economists who answered a question on the tariffs said they would do more harm than good and the rest said it would do nothing or very little. Not one respondent said they would benefit the world’s largest economy. ”

Every country has a current account and a capital account. A current account mostly measures the trade in terms of goods and services (it also is affected by foreign aid and income). There also exists a capital account that measures changes in assets. The two accounts must balance. If you have a current account deficit then you have a capital account surplus

Conclusion

There is nothing inherently bad about a trade deficit. It is often best to think of things in terms of global competitive advantage. If you’re in Germany, you probably import more wine from France than you export, but if Germans were forced to only drink German wine that wouldn’t be a good thing for Germans. Certain countries will make specific products better than other countries. There is a lot more tourism to Bermuda than to North Dakota, but a lot more oil in North Dakota. But it would be absurd for Bermuda to start drilling for oil domestically to find balance or for North Dakota to focus their efforts on building up their tourism industry (no offense North Dakotans), no matter how hard either country tries it’s not a good use of their resources. The point I’m trying to make is that trade is a good thing and it isn’t a zero-sum game, everyone can win.