Bear Mountain Capital Inc.

What’s (not) in a Word: Trade Deficit

| November 15, 2017

Behavioral Finance | Economy


Last month, we wrote about the sometimes misleading terminology used to describe relative currency values: the “strong” and “weak” dollar. Another example of labels that can mislead us about economic issues is one that has been in the news of late: the so-called “trade deficit.”

The United States runs a trade deficit with another country when it imports more from that country than it exports to it. The opposite situation, when we export more than we import, is called a trade surplus. As with currency, the language suggests that a trade “surplus” is good, while a trade “deficit” is bad. Politicians widely adopt this implication, and often complain about trade deficits, regardless of their ideology. Many politicians blame the U.S. trade deficit for the loss of manufacturing jobs, the rise of the national debt, and various other ills.

This view was once widely held by statesmen and economic thinkers, and in fact it underlies the dominant economic philosophy of the colonial era, known as mercantilism. But modern economists largely agree that running a trade deficit is not necessarily a bad thing, and that there are compelling reasons to believe it is both inevitable and in fact desirable that the U.S. maintains a trade deficit.

For centuries, leading world powers vigorously sought to maintain a trade surplus with foreign powers, largely because they wanted to hoard as much gold and silver (widely used as currency at the time) as possible. They viewed the money supply (i.e. the supply of gold and silver) as limited, and thus, control of that money as a zero-sum game in which global power flowed to the empire with the most bullion in its vaults. There was a practical element to this view—the main strategic use of all that gold and silver was to raise and supply large military forces, used both to subjugate colonial peoples and make war with competing colonial powers.

In the late 18th century, however, Adam Smith debunked this simplistic economic theory, arguing persuasively that labor, not currency, is the source of national wealth. Modern economists recognize mercantilism as a deeply inequitable and shortsighted economic policy that kept governments wealthy and the population poor. High tariffs and restrictions on the export of gold and silver limited the markets people could sell to, and limited the goods they could buy. The nineteenth and twentieth centuries saw the drastic reduction in barriers to trade, leading to an unprecedented rise in standards of living around the globe. Poor countries were able reach broader markets for their raw materials and low priced labor, and rich countries found new markets for their services and finished goods.

The U.S. has run a trade deficit (imports more than it exports) since the mid-1970s. Yet that period has also seen two of our longest periods of economic growth. Conversely, during the Great Depression, the U.S. maintained a trade surplus.

Today, trade deficits are commonly blamed for job losses, on the theory that imports represent goods that could have been made by an American, and were instead made by foreign labor. But while foreign competition has been a factor, it is not the predominant cause of the decline in U.S. manufacturing jobs. Rather, a radical increase in efficiency, largely due to automation, has changed the nature of manufacturing. For example, in 1980, it required 10 man-hours to produce a ton of steel. By 2014, U.S. steel plants had cut that to less than 2 man-hours—meaning it takes 80% less labor to make the same amount of steel. Steel is also recycled at very high rates, which creates an ever-increasing downward pressure on manufacturing demand. [1] It is true that China, often blamed for the decline in U.S. steel jobs, vastly increased its own steel production during this period. But China did not become a net exporter of steel until 2005. And efficiency is taking its toll there as well. China’s steel industry also faces over capacity and large-scale labor layoffs.[2]

Beyond the narrow impact that an industry specific trade deficit can have, a nation as a whole benefits from imports, not exports. As Milton Friedman, the most influential economist of the late 20th century, once pointed out, the way we use “surplus” and “deficit” with respect to trade is “upside-down”:

What we send abroad, we can’t eat, we can’t wear, we can’t use for our houses. The goods and services we send abroad, are goods and services not available to us. On the other hand, the goods and services we import, they provide us with TV sets we can watch, with automobiles we can drive, with all sorts of nice things for us to use. The downtown skyline of Seattle, WA is a constant reminder of the benefits of imported goods. The amount of cranes building brand new skyscrapers would be greatly decreased if we tried to cut down our steel trade deficit. In 2017 we ran a steel trade deficit of -24.6 million metric tons. [3] This keeps prices down so Seattle can keep sending new buildings up.

The gain from foreign trade is what we import. What we export is a cost of getting those imports. And the proper objective for a nation as Adam Smith put it, is to arrange things so that we get as large a volume of imports as possible, for as small a volume of exports as possible.

All of this being said, some of the policy prescriptions recommended under the umbrella of reducing the trade “deficit”, are entirely sensible. Enforcing trade agreements, for example, so that our trading partners are playing by the same set of rules as we are, makes sense, independent of the effect it might have on the balance of trade. Using trade agreements to raise labor and environmental standards to a common level, while more controversial, is a reasonable policy position advanced by many trade experts. But treating the balance of trade like a football score, and rooting for a surplus because it sounds better than a deficit? That’s outdated economics that should be consigned to the history books along with gold coins and three-masted schooners.