A Simple Explanation Why the Trump Theory on Trade Deficits Is Wrong

 

This explainer from Mike Feroli at JPMorgan does a pretty good job showing why a focus on trade deficits as a measure of US economic vitality is wrongheaded (bold is by me):

When each worker in the economy does a narrow task efficiently, the overall economy is more productive than if each of us tried to grow our own food, sew our own clothes, and produce our own economic research. The basic case for free trade among nations rests on a similar argument—when each country can specialize in the activities at which it is most efficient, the overall size of the global pie will be larger. If trade were to be substantially restricted, we would expect to see lower levels of productivity and GDP in the long run, as workers and countries are forced to make things they are not especially good at making.

Of course, the same textbooks would caution that trade can have important effects on the distribution of income. As one example, low-skilled workers in rich countries can lose from being thrust into competition with workers in low-wage countries. But, although theory suggests that the overall gains from trade should be more than enough to compensate for these losses, nothing guarantees that this redistribution will occur.

President Trump brought the labor market effects of trade to the forefront of the policy debate during his campaign and has maintained focus on them after the election. But we note that his rhetoric often differs from the textbook concerns about losers from trade. In particular, he and his advisors focus on trade deficits as a measure of the nation’s losses from trade. Economists view the trade deficit differently: as a measure of our borrowing from the rest of the world. Every dollar by which US purchases from abroad exceed sales to abroad is matched by a dollar that is borrowed by someone in the US from someone overseas, who has chosen to invest that dollar in the US. Thus, the US trade deficit also reflects how eager foreigners are to invest their savings in the US.

It is possible that a large trade deficit could signal problems if such borrowing and lending become excessive, at which point it might make sense to reduce government deficits or encourage households to consume less and save more. But, in general, the trade deficit is not a measure of the losses created by trade. More relevant measures of the costs of trade would include unemployment, wage stagnation, or low labor force participation among workers affected by trade (which also receive attention, of course).And in our view efficient policy responses to these concerns would address them directly rather than by attempting to reduce trade and its many benefits.

We also note that bilateral trade deficits are a particularly poor measure of losses from trade. Bilateral tradedeficits are a natural outcome of specialization—just as each of us runs a trade surplus with our employers and a trade deficit with the stores where we shop, any given country might sell things on net to certain countries and buy things on net from others.

I guess the big question is whether President Trump and protectionist advisers such as economist Peter Navarro are educable or persuadable on this issue. Anyway, the alternative is not to ignore the losers from trade or hand-wave away harmful trade practices. And perhaps “trade deficit” is used as simple political shorthand for those issues. It’s pretty easy to make a chart showing big trade deficits.

But a focus on trade deficits leads one to propose the wrong fixes and reforms. Like broad tariffs. And they provide a poor metric of success and failure. Indeed, these supposed fixes and reforms can make the economy and workers worse off.

Published in Economics
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Members have made 15 comments.

  1. Profile photo of Jamie Lockett Reagan

    This is exactly right. The problem I’ve long had with Trump is the same one I have with most progressives – they are attempting the wrong solutions to address real issues.

    • #1
    • March 20, 2017 at 12:14 pm
    • Like3 likes
  2. Profile photo of Spin Inactive

    A chief contributor to economic growth is specialization.

    • #2
    • March 20, 2017 at 2:07 pm
    • Like3 likes
  3. Profile photo of I Walton Member

    Of course Trump has a lot backwards, at least in his rhetoric, but I don’t think econ 101 arguments about the benefits of trade and specialization will move the debate. Rather we can join in the focus on regulatory barriers that make adjustment difficult and slow, on all the potential workers who consume but do not produce, on barriers to entry and risk taking and, of course, on government deficits and weak savings that translate directly into current account deficits. Persistent current account deficits and growing external debt are symptoms of internal imbalance and structural problems that get fixed in normal countries by financially rooted balance of payments constraints. We do not face such constraints so we must look at specific structural microeconomic problems before we face our B of P constraints because when we do reach such a point the world economy will be on the brink of total collapse. We’re not a normal economy so the general theory that pertains to all other countries is not good enough.

    • #3
    • March 20, 2017 at 2:25 pm
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  4. Profile photo of Jamie Lockett Reagan

    Spin (View Comment):
    A chief contributor to economic growth is specialization.

    I would replace “chief” with “only”.

    • #4
    • March 20, 2017 at 2:52 pm
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  5. Profile photo of Spin Inactive

    Jamie Lockett (View Comment):

    Spin (View Comment):
    A chief contributor to economic growth is specialization.

    I would replace “chief” with “only”.

    Not me. I think there are other contributors. Like laziness.

    • #5
    • March 20, 2017 at 3:46 pm
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  6. Profile photo of HobGoblin Member

    Every dollar by which US purchases from abroad exceed sales to abroad is matched by a dollar that is borrowed by someone in the US from someone overseas…

    Just one quibble – “trade deficits” do not necessarily lead to US indebtedness. If Ikea sells $1,000,000 in imported furniture, then uses that to build their next store, there’s no increase in debt.

    • #6
    • March 21, 2017 at 8:51 am
    • Like1 like
  7. Profile photo of Jamie Lockett Reagan

    HobGoblin (View Comment):
    Every dollar by which US purchases from abroad exceed sales to abroad is matched by a dollar that is borrowed by someone in the US from someone overseas…

    Just one quibble – “trade deficits” do not necessarily lead to US indebtedness. If Ikea sells $1,000,000 in imported furniture, then uses that to build their next store, there’s no increase in debt.

    Right, but its a measure of investment in the US economy that Ikea expects a return on, hence debt of a sort.

    • #7
    • March 21, 2017 at 9:16 am
    • Like1 like
  8. Profile photo of Mark Camp Member

    James Pethokoukis: The basic case for free trade among nations rests on a similar argument—when each country can specialize in the activities at which it is most efficient, the overall size of the global pie will be larger.

    I would word it differently, lest it appear that a country should only specialize in activities at which it is more efficient than another country.

    In fact, it should often specialize in an activity at which it is much less efficient than the other country, or eliminate an activity at which it is much more efficient than the other.

    This counter-intuitive fact is explained by the “law of comparative advantage.” Lots of articles on the web about it, for those who are unfamiliar. Even if the US is 100 times as efficient at producing product A, it should still import if it is 101 times as efficient at producing product B.

    • #8
    • March 21, 2017 at 9:46 am
    • Like7 likes
  9. Profile photo of Mark Camp Member

    Jamie Lockett (View Comment):

    HobGoblin (View Comment):
    Every dollar by which US purchases from abroad exceed sales to abroad is matched by a dollar that is borrowed by someone in the US from someone overseas…

    Just one quibble – “trade deficits” do not necessarily lead to US indebtedness. If Ikea sells $1,000,000 in imported furniture, then uses that to build their next store, there’s no increase in debt.

    Right, but its a measure of investment in the US economy that Ikea expects a return on, hence debt of a sort.

    Owed by whom?

    • #9
    • March 21, 2017 at 10:21 am
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  10. Profile photo of Jamie Lockett Reagan

    Mark Camp (View Comment):

    Jamie Lockett (View Comment):

    HobGoblin (View Comment):
    Every dollar by which US purchases from abroad exceed sales to abroad is matched by a dollar that is borrowed by someone in the US from someone overseas…

    Just one quibble – “trade deficits” do not necessarily lead to US indebtedness. If Ikea sells $1,000,000 in imported furniture, then uses that to build their next store, there’s no increase in debt.

    Right, but its a measure of investment in the US economy that Ikea expects a return on, hence debt of a sort.

    Owed by whom?

    Ikea to its shareholders. If they don’t receive a return on investment they won’t invest here next time.

    • #10
    • March 21, 2017 at 10:23 am
    • Like1 like
  11. Profile photo of ModEcon Member

    HobGoblin (View Comment):
    Every dollar by which US purchases from abroad exceed sales to abroad is matched by a dollar that is borrowed by someone in the US from someone overseas…

    Just one quibble – “trade deficits” do not necessarily lead to US indebtedness. If Ikea sells $1,000,000 in imported furniture, then uses that to build their next store, there’s no increase in debt.

    Is the investment of Ikea not included in trade figures? I am not clear on this. Wouldn’t the money spent by Ikea be considered as like an export, or do trade data only include value of goods and services?

    • #11
    • March 21, 2017 at 5:00 pm
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  12. Profile photo of Steven Seward Member

    I have a pet peeve about graphs with little explanation. The y-axis on “Figure 1” seems to represent billions of dollars, but what does “rolling 12m total” mean? I assume the x-axis denotes years in the 21st century, though it is not marked as such. The biggest part I do not understand is why the trade deficits are indicated in shaded areas as a “range” rather than a definite line. And why do the ranges of different countries neatly bump up right to the limit of the other countries?? Am I just dumb???

    • #12
    • March 21, 2017 at 10:44 pm
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  13. Profile photo of ModEcon Member

    Steven Seward (View Comment):

    I agree that the graph is not the best. As for what it means, I would guess rolling 12m total would mean a rolling total over 12 months. That is, instead of calculating for each year individually, they calculate each month what the previous year’s(12month’s, mar to mar, may to may, etc.) deficit was. I assume this creates a smoother graph. It takes changes in seasonal buying out of the picture better.

    The range is interesting, I would guess that since the graph is talking about totals, the shaded regions are representing the amount added by each country. So it is the range of x to y billion dollars of trade that is contributed by each country. China adds say 300b, but Mexico doesn’t add another 350b, but rather just 50b. I think it is actually a good way of relating portions to a total on one graph.

    Of course, the reason it goes downward is probably since deficits are negative, but it does make it look weird.

    • #13
    • March 21, 2017 at 11:34 pm
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  14. Profile photo of Steven Seward Member

    Thanks, ModEcon! I think I can understand the graph a little better now.

    • #14
    • March 22, 2017 at 8:25 am
    • Like1 like
  15. Profile photo of HobGoblin Member

    ModEcon (View Comment):

    HobGoblin (View Comment):
    Every dollar by which US purchases from abroad exceed sales to abroad is matched by a dollar that is borrowed by someone in the US from someone overseas…

    Just one quibble – “trade deficits” do not necessarily lead to US indebtedness. If Ikea sells $1,000,000 in imported furniture, then uses that to build their next store, there’s no increase in debt.

    Is the investment of Ikea not included in trade figures? I am not clear on this. Wouldn’t the money spent by Ikea be considered as like an export, or do trade data only include value of goods and services?

    No, the investment is not counted as an export, only goods and services that actually leave the country. Ikea can build buildings, buy stock, invest in a venture capital fund, whatever, and it would not be counted as an export.

    • #15
    • March 22, 2017 at 9:34 am
    • Like1 like