"Surprising Truths About Trade Deficits" is the title of an excellent article written by Greg Mankiw and published in the New York Times. You can find it here. There is a reason why Greg's textbooks are so popular: his ability to simplify complex issues is admirable. I hope he won't mind, however, if I use my own example to elaborate a bit further on why it is a mistake to think of trade surpluses as good and of trade deficits as bad.
Assume that there are two people located in the US: Jane and Bob. Jane sells bread, while Bob sells machinery. Assume also that there are two people located in China: Ai and Huan. Ai produces wheat and Huan produces clothes. Now suppose that in the course of the year, Jane buys $100 worth of wheat from Ai to make her bread. Ai uses $80 of these dollars to buy bread from Jane and lends the other $20 to Huan, who uses it to buy machinery from Bob and expand his business. In this case, there is a balanced trade between the two countries. The Americans bought $100 worth of goods from the Chinese (wheat) and the Chinese bought $100 worth of goods from the Americans ($80 of bread and $20 of machinery). Suppose that next year, Jane buys again $100 worth of wheat from Ai, who uses $80 to buy bread from Jane. This time, however, Ai takes a look at how Huan is managing his business and decides that she is not comfortable with his decisions. Instead of lending Huan the remaining $20, she decides to lend it to Jane because she sees more potential there. Jane borrows the $20 and uses it to buy machinery from Bob. The Americans are now running a trade deficit. They bought $100 worth of goods from the Chinese (wheat), but the Chinese only bought $80 worth of goods from the Americans (bread). Note that Bob still sells $20 worth of machinery but instead of selling it to Huan, he is selling it to Jane. Are the Americans worse off for running a trade deficit? Well, the deficit means that Jane is able to invest in and expand her business. This is a good thing, not a bad thing for the Americans. Are the Chinese better off for running a trade surplus? The surplus means that Huan is unable to borrow from Ai and invest in his business. This is a bad thing, not a good thing for the Chinese.
The above example illustrates that a trade deficit can be a sign of strength; it may mean that foreigners have a strong desire to invest in our economy. To do so, they must sell us products and use part of the revenue not to buy our own products but to lend to us so that our firms can buy the additional equipment they need to expand. Similarly, a trade surplus can be a sign of weakness; it may mean that foreigners have little desire to invest in their own country so they lend whatever they save to us. In essence, running a trade deficit means that we are borrowing from the rest of the world, and as Greg points out, whether this is good or bad depends on what we are borrowing for; whether we are borrowing to expand our productive capacity or instead to increase our consumption and have a good time, like Greece did for much of the 1980s with unfortunate results.
The paradox is that several of President Trump's policies are likely to increase our trade deficit. Cutting taxes without reducing government spending implies that the US government will have to borrow more. If it borrows more from abroad, the result will be a bigger trade deficit, which is the opposite of the President's stated goal. And to the extent that the tax-cut is used by households to increase consumption rather than investment, it may spell trouble in the long run when households will have to pay more taxes to service the bigger government debt without having a higher income to cover the additional tax burden.
Assume that there are two people located in the US: Jane and Bob. Jane sells bread, while Bob sells machinery. Assume also that there are two people located in China: Ai and Huan. Ai produces wheat and Huan produces clothes. Now suppose that in the course of the year, Jane buys $100 worth of wheat from Ai to make her bread. Ai uses $80 of these dollars to buy bread from Jane and lends the other $20 to Huan, who uses it to buy machinery from Bob and expand his business. In this case, there is a balanced trade between the two countries. The Americans bought $100 worth of goods from the Chinese (wheat) and the Chinese bought $100 worth of goods from the Americans ($80 of bread and $20 of machinery). Suppose that next year, Jane buys again $100 worth of wheat from Ai, who uses $80 to buy bread from Jane. This time, however, Ai takes a look at how Huan is managing his business and decides that she is not comfortable with his decisions. Instead of lending Huan the remaining $20, she decides to lend it to Jane because she sees more potential there. Jane borrows the $20 and uses it to buy machinery from Bob. The Americans are now running a trade deficit. They bought $100 worth of goods from the Chinese (wheat), but the Chinese only bought $80 worth of goods from the Americans (bread). Note that Bob still sells $20 worth of machinery but instead of selling it to Huan, he is selling it to Jane. Are the Americans worse off for running a trade deficit? Well, the deficit means that Jane is able to invest in and expand her business. This is a good thing, not a bad thing for the Americans. Are the Chinese better off for running a trade surplus? The surplus means that Huan is unable to borrow from Ai and invest in his business. This is a bad thing, not a good thing for the Chinese.
The above example illustrates that a trade deficit can be a sign of strength; it may mean that foreigners have a strong desire to invest in our economy. To do so, they must sell us products and use part of the revenue not to buy our own products but to lend to us so that our firms can buy the additional equipment they need to expand. Similarly, a trade surplus can be a sign of weakness; it may mean that foreigners have little desire to invest in their own country so they lend whatever they save to us. In essence, running a trade deficit means that we are borrowing from the rest of the world, and as Greg points out, whether this is good or bad depends on what we are borrowing for; whether we are borrowing to expand our productive capacity or instead to increase our consumption and have a good time, like Greece did for much of the 1980s with unfortunate results.
The paradox is that several of President Trump's policies are likely to increase our trade deficit. Cutting taxes without reducing government spending implies that the US government will have to borrow more. If it borrows more from abroad, the result will be a bigger trade deficit, which is the opposite of the President's stated goal. And to the extent that the tax-cut is used by households to increase consumption rather than investment, it may spell trouble in the long run when households will have to pay more taxes to service the bigger government debt without having a higher income to cover the additional tax burden.
