The Balance of Trade

President Trump has regularly called for bilateral trade balances with our trading partners. Though he prudently gave up his campaign promise to declare China a currency manipulator on his first day in office because of China’s large trade surpluses with the U.S., he more recently criticized Germany’s even larger surplus. The Trump administration’s objectives in renegotiating the North American Free Trade Agreement (NAFTA) published July 17th also call for reducing U.S. bilateral trade deficits with Mexico and Canada. Economists recognize these objectives as nonsensical, but it might be worthwhile to spell out to the broader public (if not to Trump’s protectionist White House wing) why that is so.

Let’s start with the U.S. trade balance with the rest of the world. As we pay for what we import with what we export, we would generally expect a balance between imports and exports over time, just as we expect a rough balance between our income and expenditures over time. But uniquely in the case of the U.S., we need to have a deficit (imports exceeding exports) paid for with U.S. dollars, because the rest of the world holds and uses our dollars to finance many international transactions. The dollar is the world’s primary international reserve currency and our trade deficit is the primary means by which we supply them to the rest of the world.

This is an over simplification, however, because dollars are also supplied to the rest of the world via our capital account, i.e. Americans investing abroad. At the end of 2016 Americans had invested about $24 trillion USD equivalent. However, the rest of the world had invested over $32 trillion USD in the U.S. Roughly $5 trillion of this net investment in the U.S. of $8 trillion represented official foreign exchange reserves held by foreign governments in U.S. dollars out of total foreign exchange reserves of about $8 trillion.

Something also needs to be said about the relationship between foreign holdings of dollars and changes in those holdings. Any increase in the demand for foreign exchange reserves by foreign governments, something that tends to happen naturally as economies grow, must be met by the balance of payments deficits of the countries supplying those reserves. Thus the U.S. trade deficit last year (2016) of about $500 billion USD more or less reflects the addition to the dollar reserves of foreign governments.

So the use of the U.S. dollar in foreign exchange reserves implies that the U.S. will have, and need to have, a balance of trade deficit of a similar amount. But let’s simplify and assume that U.S. trade with the rest of the world is balanced (zero trade balance as well as zero current and capital account balances), perhaps because the U.S. dollar is replaced in international reserves by the SDR as I have long recommended. See my: Real SDR Currency Board What about the trade balance with Mexico and Canada? Should we want and expect each bilateral trade relationship to be balanced?

The error of such thinking can be easily illustrated with a simple, hypothetical example. Assume that within NAFTA the U.S.’s comparative advantage is in manufacturing all the pieces that make up an automobile and growing wheat, Mexico’s comparative advantage is using its “cheap” labor to assemble those pieces into cars, and Canada’s is growing and milling lumber. Assume that that is all they do that crosses their borders. The U.S. sells its car parts to Mexico, which puts them together and sells the cars to the U.S. and Canada. The value of the parts sold to Mexico is less than the value of the cars (which incorporates the parts from the U.S.) Mexico sells to the U.S. so that on net the U.S. has a trade deficit with Mexico. The U.S. sells wheat to Canadians buying a lesser value of lumber in return and Canada sells its lumber to the U.S. and to Mexico buying a few cars but of less value. Looking at bilateral trade balances, Mexico has a surplus vs. the U.S. and a deficit vs. Canada. Canada has a surplus vs. Mexico just sufficient to cover its deficit vs. the U.S. These bilateral deficits and surpluses are not a problem because the U.S. has a trade balance vs. Mexico and Canada combined and indeed with all of the rest of the world. The same is true for Mexico and Canada. What really matters is whether the value of a country’s exports to the rest of the world match and thus pay for the value of its imports from the rest of the world. As someone noted, no one worries that you have a large trade deficit with the grocery store as long as your total spending everywhere is covered by your income (the sale of your labor to your employer).

Being the eternal optimist, I trust that there are enough people in the Trump administration that understand that seeking bilateral trade balances with each and every country would be a terrible mistake to keep him from trying to do so.

About wcoats

Dr. Warren L. Coats specializes in advising central banks on monetary policy, and in the development of their capacity to formulate and implement monetary policy. He is retired from the International Monetary Fund, where, as Assistant Director of the Monetary and Financial Systems Department, he led missions to over twenty countries. Before then, he served as Visiting Economist to the Board of Governors of the Federal Reserve System, and to the World Bank, and was Assistant Prof of Economics at the Univ. of Virginia from 1970-75. Most recently he was Senior Monetary Policy Advisor to the Central Bank of Iraq; an IMF consultant to the central banks of Afghanistan, Kenya and Zimbabwe; and a Deloitte/USAID advisor to the Government of South Sudan. He is currently a member of the Editorial Board of the Cayman Financial Review and until the end of 2013 was a member of the IMF program team for Afghanistan. His most recent book is entitled "One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina."
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One Response to The Balance of Trade

  1. Joe Cobb says:

    I do not think purchases of residential or commercial real estate in the United States by non-US persons or businesses is reported in the National Income and Product Accounts, other than the small “services” component of such sales. Yet, clearly in terms of how the statistics are measured those “exports” and being paid for by the proceeds from some earlier “import” sold to Americans who paid the dollars, ownership of which paid for the pricey real estate so many wealthy Chinese and Indians are buying. I think a better job might be done accounting for the tuition payments received by universities from foreign students, who pay (unlike mendicant American students).

    Politicians focus on the “jobs” associated with exports instead of the capital-import surplus enjoyed by the US economy. Of course all those real estate transactions are a version of “immigration,” so the nationalists may get upset over “trade deficits” for other reasons.

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