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.
The whole world today runs on unsound money, that is to say central banks issue money, and commercial banks expand the quantity of credit. However, some countries have a greater tendency to save than others, and some governments balance their budgets, while others act like crazy spendthrifts. It is the mix of these factors that lead to trade surpluses and deficits. So, in the case of China, a relatively small budget deficit is more than compensated for by a very high rate of personal savings. This contrasts with the United States, which has a low savings rate, and investment is financed by the expansion of bank credit. Furthermore, President Trump is cutting taxes, which will lead to a greater budget deficit in America, at least for the next few years. This is why the US trade deficit with China is so large and will increase, despite President Trump’s desire to reduce it. Tariffs will not change this. I’m afraid President Trump is making a big mistake with his trade policies, which have not been thought through. It’s not China’s fault Americans are borrowing credit to buy Chinese goods.
The fault is America’s low savings rate, expansion of bank credit, and the government’s spending of money it creates out of thin air. I hope this helps you understand why tariffs, even though they are politically attractive, are no solution. Furthermore, it was American tariffs that crashed the world economy in the 1930s. But that’s another story for another time.
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