The United States, like many other countries, uses a double-entry accounting system to track certain aggregate statistics known as National Income Accounting. One of the statistics tracked is the trade balance. The balance of trade reports the difference between imports and exports. If imports exceed exports, we are said to have a trade deficit. If exports exceed imports, we are said to have a trade surplus. When the two are equal, the trade is said to be equal. Technically, the balance of trade refers to the import and export of both goods and services, but most attention tends to fall on the trade in goods, or the so-called “Merchandise Balance of Trade.”
Confusion abounds as to what a trade balance is. Even David Hume and Adam Smith note that this idea does more harm than good. Hume discusses how those “ignorant of the nature of commerce” misinterpret the balance of trade (see his essay “On the Balance of Trade”). Of The Treasure of NationsSmith goes even further, calling the whole idea “absurd” several times (see pages 377 and 488 in the Liberty Fund edition). Much of his case against protectionism and mercantilism in Book IV is aimed at balancing absolute trade.
With the inclusion of trade balance in National Income Accounting, the confusion continued. The meaning of the words “surplus” and “deficit” (combined with the accounting conventions of addition and subtraction) gives the impression to those who do not understand the balance of trade that deficits are bad while surpluses are good. But, a little digging into accounting shows that 1) “deficits” and “surpluses” have no value and 2) referring to these as “trade deficits/surpluses” is something of a misnomer.
What is important to note here is that the trade balance is not surprisingly related to commodity trade at all. It is actually the result of the relationship between National Savings and National Investment. Given the ownership of accounting
GDP = Consumption + Investment + Government Savings + Gross Domestic Product,
we can do a little algebra and show that
Net Assets = Savings – Investments
In other words, if the required amount of Investment funds is more than the amount provided by Savings, the nation must import savings from abroad. That leads to foreigners buying exports, preferring to buy goods.
Both saving and investment are determined by very different factors and how many goods cross borders. Things like real interest rates, growth expectations, confidence, institutions, and other macroeconomic factors are very important. Indeed, as noted in his textbook International EconomicsRobert Carbaugh shows us that about 98% of the activity in the foreign exchange markets is related to people exchanging currencies to buy investments, not purchase of goods/services. Given that the foreign exchange market handles approximately $6 trillion daily, that’s a lot of dollars (plus pounds, yen, francs, euros, etc) being exchanged for savings and investment opportunities.
As a result, trade balance is a result of macroeconomic factors. That is, at best, trade balance is a symptom, not a cause, of macroeconomic events. Furthermore, since nations do not trade, but rather individuals do, to properly understand any trade deficit, we must understand why there is a difference between Savings and Investment. Investments will come from firms (note: it can be financed by borrowing, but not necessary) and people who buy capital, such as a house. If these people are using Investments to make long-term productivity improvements, trade deficits are a sign of good things. But, if borrowing continues in the absence of such productivity growth, then a trade deficit can be a sign of bad things. It doesn’t matter, and this is a big step here, trade balance has nothing to do with trade. It is determined by the largest macroeconomic factors.
Hence why I worded this post as I did. It would probably be better to call the trade balance the “savings balance” or something like that—although there would still be a lot of confusion. No nation, government, or organization has legal responsibility for the balance of trade. A trading surplus does not indicate a profit, nor does a deficit indicate a loss. The balance of trade does not need to be “financed” in the sense of the word, and a deficit does not mean an increase in debt. These terms are used for no other reason than accounting convention. It is a historical risk to include trading in the accounting system, nothing else.
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