Do Trade Deficits Point to a Flaw in Free Trade?

The creation of the U.S. Trade Deficit Review Commission in 1999 reflected concern over the fact that for much of the post-war period the United States experienced a "merchandise trade deficit" (a.k.a. "balance of payments deficit" or "current account deficit") in international trade: The dollar value of goods and services imported into the U. S. exceeded the dollar value of goods and services exported, says Lawrence H. White, a professor of economics at George Mason University.

There are two other ways that the difference might be paid for: with exports of currency or with exports of financial claims.

The cumulative U.S. current account deficit over 2005-2009 inclusive totalled $3.3 trillion.

Only a trivial share, perhaps 3.5 per cent of the deficit, was financed by exporting Federal Reserve Notes.

The other 96.5 per cent of the U.S. trade deficit corresponded to other financial exports, namely sales of IOUs (government and corporate bonds) and sales of ownership claims (shares in corporations, real estate) to assets that remained in the United States.

A current account deficit thus mirrors a capital account surplus under floating exchange rates. The economic forces that create international financial flows (borrowing from abroad) can be thought of as the fundamental drivers, with the merchandise trade deficit only a side effect or symptom, says White.

When foreigners want to buy more financial claims from the United States than Americans want to buy from abroad, that enhances the exchange value of the dollar, making U.S. merchandise exports relatively expensive on world markets, giving rise to a merchandise trade deficit for the United States. Whether it is good for a regional or national economy to be a net borrower from the rest of the world is much like asking whether it is good for a household to be a net borrower. It depends on the reason for the borrowing.

Source: Lawrence H. White, Free Trade, Protectionism, and Trade Deficits, Mercatus Center, April 2011.

For text: http://mercatus.org/sites/default/files/publication/wp1121-free-trade-protectionism-and-trade-deficits_1.pdf

For more on Economic Issues: http://www.ncpa.org/sub/dpd/index.php?Article_Category=17

First published by the National Center for Policy Analysis, United States

FMF Policy Bulletin/ 19 April 2011