In light of this silliness in the WaPo today (which Dean Baker already jumped on), I’m compelled to repost this piece from a little while back, explaining why and when trade deficits are problematic and when they’re not.
Summarizing, it’s just as wrong to claim trade deficits of any magnitude are always a negative as that they’re always a positive. Like Neil Irwin said, motivating my earlier piece, “they’re not scorecards.”
When are they problematic? In two situations: first, when we’re not at full employment, and policy makers can’t or won’t make up the slack. The GDP identity–GDP=Cons + Inv + Gov’t spending + Trade balance–provides a simple way to show that a negative trade balance drags down growth.
Other components can make up the difference. However, in recent years, in periods of slack, the monetary authorities–central banks–have been increasingly likely to be stuck at zero on their interest rate, undermining their contribution to offsetting a trade deficit. And the fiscal authorities have been either stuck in austerity ideology (Europe), dysfunction, or both (that would be us).
The figure below shows that, in fact, trade deficits have been the norm over the period when we’ve been at full employment less than 30 percent of the time, so in this regard, our persistent trade deficits have been problematic more often than not in recent years. Note that I’m not drawing any causality here between trade deficits and the absence of full employment. My point is that the former (trade deficits) are more of a problem when we’re not at full employment and neither fiscal nor monetary policy is working to offset them.
The second way in which trade deficits are harmful is a bit more subtle. When we consume/invest more than we produce, we must borrow from abroad to make up the difference. On the other side of the ledger from the trade deficit is the “capital account surplus,” which simply represents the flow of capital into deficit countries to finance their spending beyond production.
The trade-deficits-are-always-and-everywhere-benign team argues that this is a feature, not a bug. Hey, if foreigners want to lend to us so we can spend more than we produce, that’s great!
But it’s only great if there are truly productive uses for the capital. If there aren’t, those flows can inflate…oh, I dunno…let’s say a real estate bubble. Or a dot.com bubble. See both Michael Pettis and Ben Bernanke on this point. No less a mainstream stalwart than the Lord Mervyn King, former governor of the Bank of England, recently held forth on the macroeconomic problems of persistent trade imbalances, linking them to countries that manipulate their exchange rates to preserve their trade surpluses (and therefore, other countries’ trade deficits; the system has to balance).
I think both of these conditions at which trade deficits are problematic–labor markets that are slack more often than not and the absence of productive investments–can be hard for people to wrap their heads around. We’re taught, against fact, that full employment is the natural state of affairs, and that productive investments are always there for the taking.
But especially in the age of financial engineering, where non-productive but potentially high ROI investment opportunities abound, that assumption just doesn’t hold.
What about now? We’re closing in on full employment so I wouldn’t invoke the trade deficit as a negative in that regard, though it took us too long to get here, due to the combination of the zero lower bound at the Fed, inadequate fiscal policy, and yes, the trade deficit, which has averaged -3.1% of GDP in this expansion.
On the investment side, if you believe we’re in a period of secular stagnation, which implies too much savings given desired investment (and remember, trade deficits occur when countries export their excess savings to us), then that’s a problem right now, putting downward pressure on interest rates, inflation, and demand. BTW, the logic of this suggests a smart solution to this part of the problem: investment in public infrastructure. On that, see dysfunctional Congress.
Finally, of course, our trade deficits are always in manufactured goods, so they invoke a sectoral problem for communities and families that depend on factory jobs. It is left as an exercise for the reader to connect the dots between that problem and our current political sh__show.