What Does a Persistent Trade Deficit Cause?

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A trade deficit results when a country buys more than it sells to other countries. The trade deficit is typically measured as the current account balance, or the sum of the balances of the trade of goods and services, income from foreign investment and unilateral current transfers. Using this measure captures more than just material products. It captures financial flows and other types of money transfers like remittances as well. The consequences of trade deficits are different in each case, but can be significant. One fundamental consequence of a trade deficit is high levels of foreign investment into the deficit country.

Effect on GDP, Wages and GNP

  • A trade deficit, which brings more foreign investment into a country that would come in under neutral conditions, actually has the effect of raising wages and Gross Domestic Product (GDP). This is because foreign investment usually translates into more domestic investment, generating more physical capital to stimulate the economy. The addition of capital tends to make labor more productive, which increases wages and output. Gross National Product, which accounts for the interest payments made to foreign investors, does not show the same increase under a trade deficit because of this offsetting factor.

Effect Across the Economy

  • Trade deficits always have different effects on different sectors of the economy. The manufacturing sector is often hurt because consumers are buying cheaper goods from abroad rather than buying homemade goods. On the other hand, because consumers are able to buy cheaper goods, they are able to increase their standard of living without increasing their income. If workers are able to switch industries quickly, the effect on heavily-hit manufacturing will be minimal because workers can find jobs in other sectors. If, however, workers are regionally bound to one industry, like the car industry in Detroit, a trade deficit can severely hurt their standard of living.

Effect on Interest Rates

  • As a trade deficit grows, the question of when foreigners will stop financing the deficit begins to emerge. One way to keep foreigners investing in the deficit country is to boost interest rates. Doing so, however, will eventually hurt local investment as locals find it advantageous to save their assets, rather than investing them. A side concern is that foreign investors might for some reason become disinterested in the deficit country's assets. For example, if the deficit country were to change political leadership or start a war, outside investors might pull out, causing severe economic hardship.

Effect on Stability

  • Countries with high trade deficits tend to be more vulnerable to international fluctuations in prices and output. In Latin America in the 1980s and East Asia in the late 1990s, several countries were subject to these fluctuations. Investors flocked to these economies, only to pull out rapidly when faced with higher-than-expected risk. This vulnerability is often short-lived; countries with sound fundamentals can recover from a financial exodus. Nonetheless, such instability can cause serious short-run hardship.

References

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