A trade deficit—that, is, a deficit on flows of goods and services in a country’s international balance of payments—occurs when a country imports more than it exports. Because the concept of the trade deficit depends intimately on its two component flows of exports and imports, what motivates these cross-border, that is, international, transactions? If a country buys more than it sells, how does it pay for the excess purchases? Does the concept of the trade deficit give a complete picture of a country’s international relationships and flows?
People and firms trade because they want different things, have different skills and technologies, and earn different amounts of money. People and firms value goods and services differently, depending on their income, tastes, and needs. Countries are the aggregation of individual actions by firms and individuals. So, countries differ from one another in terms of resources (such as land, minerals, and educated workers) and the techniques firms use to produce goods and services (such as how much information technology is used in the factory or office), and in terms of tastes and preferences for products (due to, for example, the presence of immigrants or to level of income). These differences are reflected across countries as differences in costs of production, and in prices for goods and services. Because costs and prices differ across countries, it makes sense for a country to trade some of what it holds less dear and produces most cheaply to people who want it more and for whom production is costly or even impossible. Although this is most obvious in the case of goods, the concept holds as well for services, and it is applicable to rich and poor, large and small countries alike.
When individuals and firms buy and sell from each other, international trade takes place. When a country, which is the aggregated activity of firms and individuals, sells goods and services across its international borders, these are termed exports. When a country buys goods and services from abroad, these are termed imports. A trade deficit occurs when the cost of imports exceeds the value of exports. A trade deficit can be measured either on a bilateral basis—when country A imports more from country B than it exports to country B—or on a global basis—when country A’s total exports to all countries is less than country A’s total imports from all countries.
What factors can lead to a trade deficit, where one country buys more from abroad than it sells? A country growing relatively more rapidly than other countries in the world tends to import more than it exports, particularly if the country tends to consume and invest a lot at home, if the price of imports is low compared to the domestic price of similar products, if the country’s residents and firms have a particular taste for imported products, and if there are few barriers to inhibit the purchase of imports. A rapid pace of domestic consumption and investment tends to draw in goods and services from other countries in order to satisfy domestic demand. A relatively low price of imports compared to domestic goods and services (which may be a consequence of the international exchange value of a country’s currency) makes it cheaper for residents and firms to buy the imported product than a similar one from the home producer. Some countries have large immigrant populations or intricate supply chains of production, which can boost imports, all else being equal (although these also can support more exports). Finally, as trade barriers fall, so do the cost of imported products.
Which of these factors is most important to increasing imports relative to exports depends on the particular country. For the United States, which has run a trade deficit for more than twenty-five years, the most important factor is its relatively faster growth of domestic consumption and investment. For some periods over this time span, the exchange value of the currency has further augmented imports and restrained exports.
If a country systematically buys more than it sells, it has to pay for the excess by selling financial assets of the country, or by borrowing. These financial inflows are one counterpart to the trade flows in the international balance of payments. But international financial flows also take place because investors want to diversify their wealth portfolios, increasing their rate of return and changing the IR risk profile. Just as countries differ in resources, technologies, and tastes (thus generating trade flows), countries differ in offerings of and preferences for risk and return on financial assets. So, not only are countries linked through international trade flows, they also are linked through international flows of financial assets.
Whereas a trade deficit implies that there must be some international financial inflow as a balancing entry in the international accounts, there are also large international flows of financial assets that are independent of the trade flows. For the United States, international capital flows both into and out of the country amount to trillions of dollars each year—far more than the cross-border trade flows. Moreover, even as the country as a whole borrows to finance the trade deficit, the inflow of financial capital generally exceeds the trade deficit, as foreign investors purchase U.S. assets and U.S. investors buy foreign assets.
A trade deficit that persists implies that borrowing also rises, as does foreign ownership of domestic financial assets. How long such a country can, or should, import more than it exports might be a policy concern. If the imports and net borrowing are invested in such a way as to increase the capacity of the economy to produce and therefore repay its international financial obligations, then there are few worries. However, if imports and financial inflows do not so augment the economy’s capacity to produce, then there is less support for more imports and financial inflows. In such a situation, the country’s ability to attract financial inflows is at risk, and economic forces such as a depreciation in the exchange value of the currency or a rise in interest rates in the domestic market work to change the growth in imports and exports and bring the trade deficit back into trade balance.
SEE ALSO Mundell-Fleming Model; Trade Surplus
Caves, Richard E., Jeffrey A. Frankel, and Ronald W. Jones. 1990. World Trade and Payments: An Introduction. Glenview, IL: Scott, Foresman and Little Brown Higher Education.
Feenstra, Robert C. 1998. Integration of Trade and Disintegration of Production in the Global Economy. Journal of Economic Perspectives 12 (4): 31–50.
Helpman, Elhanan, and Paul R. Krugman. 1985. Market Structure and Foreign Trade. Cambridge, MA: MIT Press.
Levich, Richard M. 1998. International Financial Markets: Prices and Policies. Boston: Irwin/McGraw-Hill.
Mann, Catherine L. 1999. Is the U.S. Trade Deficit Sustainable? Washington, DC: Institute for International Economics.
Catherine L. Mann