Balance of trade

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The balance of trade (or net exports, NX) is the difference between the monetary value of exports and imports in an economy over a certain period of time. A positive balance of trade is known as a trade surplus and consists of exporting more than your imports; a negative balance of trade is known as a trade deficit or, informally, a trade gap.

The balance of trade is sometimes divided into a goods and a services balance; especially in the United Kingdom the terms visible and invisible balance are used.

The balance of trade forms part of the current account, which also includes other transactions such as income from the international investment position as well as international aid. If the current account is in surplus, the country's net international asset position increases correspondingly. Equally, a deficit decreases the net international asset position.

The trade balance is identical to the difference between a country's output and domestic demand (the difference between what a country produces and what it spends).

Measuring the balance of payments can be problematic because of problems with recording and collecting data. As an illustration of this problem, when official data for all the world's countries are added up, exports exceed imports by a few percent; it appears the world is running a positive balance of trade with itself. This cannot be true, because all transactions involve an equal credit or debit in the account of each nation. The discrepancy is widely believed to be explained by transactions intended to launder money or evade taxes, and other visibility problems. However, especially for developed countries, accuracy is likely to be good.

Factors that can affect the balance of trade figures include:

The balance of trade is likely to differ across the business cycle. In export led growth, the balance of trade will improve during an economic expansion. However, with domestic demand led growth the trade balance will worsen at the same stage in the business cycle.

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[edit] Economic impact

Since the falling from favour of mercantilism, most economists do not believe that trade deficits are inherently good or bad, but must be judged based on the circumstances in which they arose. Large imbalances may sometimes be a sign of underlying economic problems or rigidities. An example includes a situation where exchange rates have been fixed or pegged for political reasons at levels impeding a correction of a trade imbalance.

In order to maintain a negative balance of trade, it must be financed either by income or transfers, or by running down the country's net international assets. This may be done for example by selling assets, through foreign direct investment or by international borrowing. An increase in net foreign liabilities tends to lead to an increase in the net outflow of income on international investments. Such payments to foreigners have intergenerational effects: by shifting consumption over time, some generations may gain at the expense of others ([1]). However, a trade deficit may lead to higher consumption in the future if, for example, it is used to finance profitable domestic investment, which generates returns in excess of that paid on the net foreign liabilities (a situation that might arise if a country experiences an unexpected gain in productivity). Similarly, a surplus on the current account implies an increase in the net international investment position and the shifting of consumption to future rather than current generations.

However, trade imbalances are not always indicative of the smooth operation of the market given differences in international productivity and intertemporal consumption preferences. Trade deficits have often been associated with a loss of international competitiveness, or unsustainable 'booms' in domestic demand. Similarly, trade surpluses have been associated with policies that inefficiently bias a country's economic activity towards external demand, resulting in lower living standards. An example of an economy in which a positive balance of payments was regarded as a bad thing by some was Japan in the 1990s. The positive balance was partly the result of protectionist measures that also caused the price of goods in Japan to be much higher than they would have been, had imports been freely allowed. The foreign currency Japanese companies earned overseas remained largely unconverted into yen in order to suppress the yen's value, further preventing Japanese consumers from benefiting from the trade surplus. In addition, the potential benefit from the trade surpluses were partly squandered by spending it on prestige real estate purchases in the United States that often proved unprofitable.

[edit] Milton Friedman on trade deficits

Milton Friedman has argued that many of the fears of trade deficits are unfair criticisms in an attempt to push macroeconomic policies favorable to export industries. He states that these deficits are not harmful to the country as the currency always comes back to the country of origin in some form or another (country A sells to country B, country B sells to country C who buys from country A, but the trade deficit only includes A and B). He continues by informing readers that the "worst case scenario" of the currency never returning to the country of origin is actually the best possible outcome; as the country just purchased goods by exchanging pieces of cheaply made paper. The same result would happen if the exporting country burned the dollars it earned, never returning it to market circulation.

From a mainstream perspective, Friedman's argument is believed to be correct but incomplete. In particular it ignores the intergenerational consequences of deficits. If country A has a trade deficit because of large imports of consumer goods, other countries accumulate cash from country A. That money can be used to purchase existing investment assets and government bonds within country A. As a result, the return from those assets will accrue not to citizens of country A but to foreigners. The consumption standard of future generations in country A may therefore potentially decline as a result of the deficit. In particular, Americans are increasingly paying taxes to finance the interest on federal bonds held by foreigners. A criticism of that argument notes that all transactions are win-win. In the case of foreign investment in American assets, it helps fuel American economic growth and keeps US interest rates low.

Friedman also believes that deficits will be corrected by free markets as floating currency rates will rise or fall with time to encourage or discourage imports in favor of the exports, and then possibly reverse again in favor of imports as the currency gains strength. A potential difficulty however is that currency markets in the real world are far from completely free, with government and central banks being major players, and this is unlikely to change within the foreseable future.

Friedman and other economists also point out that a large trade deficit (importation of goods) signals that the currency of this country is strong and desirable. To Milton Friedman, a trade deficit simply means that consumers get to purchase and enjoy more goods at lower prices; conversely, a trade surplus implies that a country exported goods that its own citizens did not get to consume and enjoy, while paying high prices for the goods that were consumed. However, this may only be true in the short run[citation needed].

Friedman also contends that the current structure of the balance of payments is potentially misleading. In an interview with Charlie Rose, he stated that "on the books" the US is a net borrower of funds, using those funds to pay for goods and services. He points to the income receipts and payments showing that the US pays almost the same amount as it receives, thus US citizens are paying lower prices than foreigners for capital assets to exchange roughly the same amount of income. The reasons for why the US (and the UK) appear to earn a higher rate of return on their foreign assets than they pay on their foreign liabilities are not well understood.

Milton Friedman presents his analysis of the balance of trade in Free to Choose, and his simple points are re-examined by Reed (see [2])

[edit] United States trade deficit

The United States has posted a trade deficit since the 1970s, and it has been rapidly increasing since 1997 (see chart below). The trend indicates that the trade deficit increases most rapidly during times of economic expansion, and slowly during times of contraction.

The persistence of the trade deficit has been attributed to a number of factors, including:

  • The dollar's role as a reserve currency and strength
  • Continued growth in the US economy
  • Continued high demand for American investment asset
  • Rising oil prices
  • Globalization, including a rise in imported products from countries such as the People's Republic of China
  • Dependence on foreign countries for sufficient food, energy, raw materials, and natural resources.

The growth of the US trade deficit is of particular interest, among developed nations, for the issues of sustainability it raises.

[edit] Physical trade balance

Monetary trade balance is different from physical trade balance (which is expressed in amount of raw materials). Developed countries usually import a lot of primary raw materials from developing countries at low prices. Often, these materials are then converted into finished products, and a significant amount of value is added. Although for instance the EU (as well as many other developed countries) has a balanced monetary trade balance, its physical trade balance (especially with developing countries) is negative, meaning that in terms of materials a lot more is imported than exported. That means the ecological footprint of developed countries is larger than that of developing countries.

[edit] External links

es:Balanza comercial fr:Balance commerciale it:Bilancia commerciale nl:Handelsbalans sv:Handelsbalans zh:贸易逆差

Balance of trade

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