Understanding How Trade Deficits Arise

Given that trade and tariffs are so much in the news, I explain how trade imbalances arise, and therefore why tariffs make no sense.

Video Length: 00:04:47

Economists who broadly understand that trade deficits accompany budget deficits express it in terms of national accounts, in this equation. (Imports – Exports) = (Investment – Savings) + (Government Spending – Taxes) This is why a trade deficit is usually accompanied by an excess of government spending over taxes, or when there is net investment over savings. But we need a better explanation than just a mathematical identity, which, quite frankly, leaves most of us still wondering why.

The easiest way to understand why is to imagine an economy with sound money, whose quantity neither expands nor contracts. Because we have to pay for imports with hard money, our imports are restricted to the hard money we are prepared to pay. Of course, we can allocate some more of our money to imports, but we will have to sell something else to do so. Normally, this would mean attracting foreign buyers for our exports, because if we don’t match extra imports with extra exports, we will soon run out of money. In other words, we cannot live beyond our means. So, with sound money, there can be no persistent trade deficit, and nor can there be a persistent budget deficit. For all practical purposes, deficits cannot exist in a world of sound money.

Savings, other than relatively unimportant changes in our day-to-day cash balances, must also match investment, because there is no expansion of bank credit in our sound money example. Now let’s address the current situation. If we want to import some goods without having the money to hand, we just go to the bank and the bank creates credit money out of thin air. This is because banks loan money into existence. So, we no longer have to sell something to pay for our imports. And if our government spends more than it receives in taxes, it simply adds extra money into the economy. Again, this is an extra source of money no one has earned, created out of thin air, this time by the government. It allows us as a nation to import more goods than we export.

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