Economic Principles

Balance of Trade

We have made the blanket assertion that free trade, in currency if not utility (think overall happiness, we’ll get to this later) terms, is as mutually beneficial between countries as it is internal to a country, and for the same reasons. How is this assertion affected by the “balance of trade”?

The balance of trade refers to the difference between how much a country exports and how much it imports. In 2019, the United States had the following trade volume and balance of trade deficits with its top trading partners[1]:

Canada $727 billion traded with less than a billion deficit. Exports and imports of goods and services were both $363 billion.
Mexico $682 billion traded with a $104 billion deficit. We bought $393 billion worth of goods and services from Mexico and sold $289 billion worth.
China $638 billion traded with a $304 billion deficit.
Japan $306 billion traded with a $56 billion deficit.
Germany $260 billion traded with a $67 billion deficit.

If we buy more goods and services from another country than we earn from selling them goods and services, the difference has to be financed somehow. It’s just like a family buying more than it earns in a year. How does this happen?

There are two major ways to finance a deficit in the balance of trade:

  • Selling assets such as companies, real estate, and stock
  • Borrowing money through sales of government and corporate bonds

A few hypothetical examples of how this happens will help to clarify. Let’s say Toyota sells cars made in Japan in the United States and is paid for those cars in US dollars. What can Toyota do with these dollars?

  • Toyota can park the dollars in a Citibank account in New York. The bank account is a US financial asset that is now owned by a Japanese company which it can cash out at a later date. We sold an asset.
  • Toyota could use the dollars to build a factory in the US. This is also an asset and represents an increase in wealth for a Japanese company. Since the factory could be sold, it also is a form of savings.  
  • Toyota could buy a US car parts company with dollars. Again, this is a US asset which is sold to a foreign company.
  • Toyota could also sell dollars for yen on the foreign exchange markets. If there isn’t an equal quantity of dollars bought for yen by US companies (i.e. balanced trade), there will be a glut of dollars and a shortage of yen. The Japanese Government may buy US treasury bonds with Japanese tax revenue to stabilize the exchange rate. This is savings by Japan through the purchase of a US asset. From a US perspective it is a loan from Japan.

In the end, the combination of asset purchases and loans must balance the trade deficit. If it doesn’t there will be a surplus of dollars on the currency exchanges, and as we know a surplus of anything will make its value fall on the market. If the trade deficit with Japan were not balanced by the sale of assets to Japan and loans from Japan, the dollar would fall in value against the yen which would make Japanese goods and services more expensive in the US and US goods and services less expensive in Japan. That would tend to decrease the US trade deficit with Japan. But for a large, rich, creditworthy country like the United States, selling assets and borrowing money can go on for a very long time. The same is not true for smaller emerging economies.

We will go into more detail on the numbers in Part II, but the net difference between US assets abroad and foreign holdings of US assets has grown to keep pace with the trade deficit and was around $16 trillion dollars in 2019, or about $4 trillion dollars less than the 2019 GDP of $20 trillion[2]. This is like having a mortgage of $100,000 on your house, and an annual income of $125,000. With low interest rates (2019) this was not an unmanageable burden for the US, but as interest rates rise and the debt increases, the burden will increase.

Oddly, there isn’t a strong consensus among economists about whether trade deficits are always good or bad. When Toyota opens a factory in Tennessee it creates jobs in the US. The fact that the profits “belong” to Japan is really not terribly germane in an era when capital flows easily around the world. General Motors is as likely to build a factory abroad as Toyota and both do so to maximize profits.

Building or buying factories is called “foreign direct investment” (or FDI) and this type of investment is actually sought after by many less-wealthy countries as a way to increase capitalization. The other component of US debt to the rest of the world is “portfolio investment” such as government and corporate bonds. This borrowing can finance current consumption but also finances investments which hopefully yield a return which exceeds the borrowing cost.

For a smaller country, high net foreign debt poses a clear danger as investor loss of confidence can precipitate a crisis. For the United States, large trade deficits financed by borrowing and asset sales help drive the world economy during hard times and foreign direct investment in producing products and services create jobs and help drive productivity increases here. On the other hand, payments on foreign loans (e.g. foreign purchases of US Treasury bonds), dividend payments on US equities and other “portfolio” debt act as a drag on the economy. It is clear that borrowing to finance current consumption benefits current consumers at the expense of future ones (our kids) who are saddled with the resulting debt.  


[1] “International Trade in Goods and Services.” n.d. Accessed December 29, 2021. https://www.bea.gov/data/intl-trade-investment/international-trade-goods-and-services.

[2] “U.S. International Investment Position, Third Quarter 2021.” n.d. Accessed February 8, 2022. https://www.bea.gov/news/2021/us-international-investment-position-third-quarter-2021. This article also contains more details on the composition of US and foreign holdings.

Can Trade Hurt Wages?
Immigration
Subscribe
Notify of
guest
0 Comments
Oldest
Newest Most Voted
Inline Feedbacks
View all comments

Relevant Articles

Scroll to Top