An economist explains what trade deficits really mean – San Bernardino Sun

Believing the myth that trade deficits are bad, the Trump Administration imposed global reciprocal tariffs this week. The proposal threatens to derail economic prosperity and trigger a barn burner of a recession. 

The fallacy of this myth can be clearly seen in the U.S. economic data. Over the last half-century U.S. trade deficits shrunk during recessions and increased during economic expansions. This phenomenon could not have persisted for so long if trade deficits harmed economic growth. Instead, there is something else going on.

This myth persists because imports are subtracted from the other major components of the economy when calculating GDP. It seems to logically follow, consequently, that imports are detrimental to growth. But this logic is the epitome of incomplete thinking that ignores economic fundamentals. 

To see the fallacy, imagine a simple economy where there is initially no international trade where consumers can only purchase goods that are produced in the U.S. Now let’s say one consumer decides to spend $100 on a good produced by a company in the U.K. Here an incomplete accounting of the transaction would conclude that this transaction lowers overall GDP as the $100 moved from growth contributing to consumption to imports that allegedly detract from growth. 

But this conclusion is wrong. 

Consumers choose imports over domestically produced goods because they are either better, cheaper, or both. Focusing on the cost savings scenario (a similar argument would hold for purchases of higher quality products), the lower cost imports increase consumers’ purchasing power – they will now have more money to spend on other domestic goods and services. But the benefits don’t stop there because the ultimate uses of the money that the U.K. company has received has not yet been recorded. 

Citizens in the U.K. do not transact in U.S. dollars. Therefore, the dollars must come home. One pathway home is for the U.K. company to either directly purchase goods or services from a U.S. company or invest in a U.S.-based asset (either private assets or government bonds). The result is that either U.S. consumption increases, total investment in the U.S. economy rises, or government financing costs are lower. Regardless of its choice, the offsetting transaction completely counteracts the supposed reduction in GDP when the U.S. consumer purchased the import.

If the U.K. company has no desire to conduct another transaction in the U.S., then it will convert its dollars into pounds so it can transact in the U.K. Whoever is willing to give up pounds to acquire the company’s dollars does so because there is some other entity that wants to purchase either goods, services, or assets in the U.S. The willingness to accept a U.S. dollar implies that there is a demand for a future U.S. transaction that will increase U.S. GDP.

These two facts – voluntarily choosing imports improve consumers’ wellbeing and often purchasing power, and all imports are counterbalanced by either an export of a different good or service, or a capital investment in the domestic economy – demonstrate that trade deficits do not reduce domestic growth, they expand it. 

The persistent U.S. trade deficits mean that, by definition, Americans are purchasing more goods and services from abroad because they prefer the quality and cost combinations offered by these products. Since the dollars must come home, it also means that the U.S. must have a capital surplus, meaning people from other countries, on net, invest more in the U.S. because they prefer the diversity, return, and risk benefits available in the U.S. markets. 

Foreign investors benefit from the greater investment choices and the U.S. economy benefits from an increased capital stock that funds the construction of new buildings, new entrepreneurial ventures, or the large U.S. budget deficit. In short, these investments improve the overall standard of living in both the U.S. and abroad. It is a win-win outcome.