Tariffs as a solution to chronic trade deficits have dominated the financial news cycle the last few months. There appears to be a lot of confusion around this topic. Therefore, I’d like to offer some clarification in the simplest terms possible.
The United States’ trade deficit over the last 12 months was about $600 billion. That means the U.S. imported (consumed) $600 billion more goods and services than we exported (produced). We’re on track for $800 billion over the next twelve months.
The United States has run a deficit every year, except one, since 1971. Before 1971 we mostly ran surpluses (i.e. we produced more than we consumed), which is how we became such a wealthy country in the first place.
Are Trade Deficits Bad?
So is this situation bad for the economy? The answer, as usual when it comes to economics, is it depends.
Let me illustrate with a few easy-to-understand, small-scale examples:
Imagine you and your family would like to start farming. You have some money in the bank and some land but no equipment. So you spend $1,000,000 to buy farming equipment from a neighboring household. In that first year, you have a $1,000,000 trade deficit because you sent $1,000,000 out of the household to purchase goods and services from other households and did not sell any goods and services of your own to other households.
This particular deficit is neither necessarily bad nor symptomatic of a problem because you’re simply making productive investments for the future. The idea being that those capital investments will eventually allow you to produce food for your family and maybe even surplus food you can sell to others, which will allow you to replenish and grow your savings.
At this stage, your household is an “emerging” economy that is running trade deficits with neighboring households and businesses in order to acquire capital.
Now imagine you and your family are long-established farmers. In fact, you’re such efficient farmers that not only do you produce enough food to feed your family, but you produce a surplus. You sell $200,000 of the surplus to other neighboring households. You use $100,000 of those proceeds to buy stuff from other neighboring households and save the remaining $100,000 in your safe.
In this example, your household has a $100,000 trade surplus ($200,000 of goods “exported” minus $100,000 of goods and services “imported”).
Your household is doing very well. You’re producing more than you’re consuming and saving the difference!
Imagine again you and your family are long-established farmers. You’ve been very successful and diligent about saving money in the good years so your family has become quite wealthy. However, this year, bad weather destroyed your crops. You don’t have any food for your family let alone surplus to sell. So you must take money saved in previous years from your safe to buy food and other things you need from other households.
You’re running a trade deficit again. However, this time, unlike Scenario 1, it’s not the result of buying / replacing productive capital but the result of buying unproductive, consumables. In this particular year, you’re consuming more than you’re producing.
Luckily, you amassed a healthy savings during the goods years so that one bad year is not catastrophic for your family. However, you can see that if bad years continued for a long time (or the family just got lazy living off the savings of past generations) your household would drain its savings and even begin accumulating debt merely to fund your consumption! This is how wealth is squandered and how once-wealthy households (countries) become poor households (countries). Neither a household, nor a nation, can consume more than it produces indefinitely without consequence.
If these trade deficits go on for too long creditors might lose confidence in your household’s ability to pay so they’ll stop lending altogether. If it gets to bad they’ll begin repossessing your assets.
A nation’s creditors will first demand higher interest rates if the creditors begin losing confidence in the nation’s ability to pay. Eventually, the creditors will stop lending altogether. Creditor nations may also begin buying up the nation’s assets (e.g. real estate, companies, houses) in lieu of lending.
Think about what this means for a country that consumes more than it produces. Essentially, that nation is selling off its valuable assets (real estate, companies, houses) simply to fund reckless, irresponsible consumption. It’s like a drug-addict selling off his possessions to a pawn shop to fund his addiction. It’s the same thing. In fact, it’s even the same chemicals in the brain that are triggered.
Perpetual deficits are not good. It means wealth is being spent as opposed to created. A trade deficit in an emerging economy making productive investments is one thing, but after a while those investments should eventually be producing allowing those emerging economies to pay down debt and increase savings.
For instance, when the U.S. was an emerging economy in the 19th century it ran trade deficits as it was making productive investments into the economy (buying goods, services and capital from abroad). Eventually, those productive investments began producing / “paying off” so that the U.S. began running huge trade surpluses ultimately making the U.S. an extremely wealthy country as massive amounts of gold (money of the time) flowed to the U.S. from the rest of the world to buy all the great stuff we were making and to invest in our enterprises. In a very short time the U.S. grew to become the world’s largest economy and largest creditor nation. A stark contrast to today when the U.S. is the world’s largest debtor nation.
Of course, whenever there is a problem, politicians want to do something about it. That’s where tariffs and trade wars come into play. Tariffs are not the answer, but that’s a topic for another day.
Again, this is intended merely as a simple example to help illustrate the point. Obviously, it’s not perfectly realistic as there are other factors not addressed.