Trade Deficits: Not Good. Not Bad. Just Complicated.

Since the last election cycle, there’s been a great deal of political discussion about trade deficits and the negative impact they’ve had on the U.S. economy. Though I don’t wish to fuel or refute any particular political perspective, I would like to shed some light on this complex — and often misunderstood — subject, as well as the factors that influence it.

To determine the impact of trade deficits, you must first understand how they work. A trade deficit occurs between two countries when one imports more goods and services to its trading partner than it exports. Trade deficits are nothing new to the United States, which has had the largest trade deficit in the world since 1975. Of frequent discussion in political circles are the deficits the U.S. holds with China and Mexico: $379 billion and $73 billion, respectively.

Seemingly, having a trade deficit for such a long period is a bad thing, akin to borrowing money for too long. In actuality, despite what many in political circles contend, a trade deficit is neither good nor bad. It is, however, complicated, for many reasons.

When a trade balance exists between two countries, it’s considered mutually beneficial; both nations are able to draw on their past and emerging strengths and unique advantages to increase productivity and stimulate economic growth. It’s this synergy that has historically created our global economy.

However, due to changing economic circumstances, nations may sometimes alter their plans for growth. Faced with its long-term decline in oil revenue, the nation of Saudi Arabia took this course when it began making significant investments in various overseas industries.

Since historical times, many nations have sought to operate with a trade surplus, exporting more than they import — a belief that Adam Smith, the Father of Modern Economics, tried to discourage. Smith believed that wealth was created solely on the basis of trade specialization and improvement in productivity because it’s “always advantageous, though not always equally so, to both.” Further, he believed any trade forced by government policy was “disadvantageous to the country in whose favor it was established.”

Under this theory, trade and GDP data are not based on the profitability of a nation’s government, but rather on the aggregate performances of the businesses that reside in that nation. Setting aside political beliefs, we can see an example of this with the United States/Mexico border wall. In theory, Mexico could finance the border wall with the $73 billion trade surplus it has for trading with the United States. But does that trade surplus mean Mexico actually has the extra $73 billion to pay for that wall?

Taking that example a step further, let’s look at the company Apple. In Q4 2018, Apple generated $37 billion in revenue from the sale of 46.9 million iPhones. Theoretically, Apple could step into Mexico’s shoes and pay for a portion of the wall. However, doing so would bring up a series of complicated issues, including the cost of producing those iPhones, the revenue portion Apple reinvested in research and development, the taxation of the revenue, and the amount of tax revenue that remained after existing obligations. According to members of the highly regarded Cato Institute and the Peterson Institute for International Economics, scenarios such as this are political in nature and have no basis in accepted economic theories.

Another factor impacting the U.S. trade deficit is the U.S. dollar, the world’s reserve currency against which much of the world measures its wealth. International demand for the dollar is significant and as such, any conversations about a country’s trade balances with the United States must consider that dollars are desired to be saved and invested more than any other currency. Robert Triffin, a 1960s economist, believed that the dollar’s role as the global reserve currency would most likely lead to a U.S. trade deficit. It’s easy to understand this rationale, since if a currency is the most widely used in global transactions, the demand for it places a bias for the currency that would result in a trade deficit.

It’s important to note that much of the money sent abroad as a result of trade deficits does flow back into the United States, most commonly as investments in U.S. Treasuries. China and Japan, for example, are the largest foreign holders, combining for more than $2 trillion of U.S. Treasuries.

Another factor is the dynamic nature of trade deficits. Consider the volatility of energy prices and their impact on the global economy. In 2014, when energy prices soared, the United States had a significant trade deficit — often in excess of $100 billion — with OPEC nations. After the substantial energy collapse in 2014, that deficit narrowed to a more moderate level following increased U.S. production.

It’s clear that despite what political rhetoric may lead investors to believe, trade deficits are not so much good vs. bad, but made up of complicated factors. As such, investors should exercise prudence in their judgments of global trade.

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