[following thoughts stimulated from reading Barry Eichengreen’s Globalizing Capital]…
The term “trade deficit” is a horrible term, horrible because it’s misleading. It makes it sound like that a country running a trade “deficit” is somehow lacking, losing out.
The term in fact describes a situation almost opposite to what it sounds like: a nation running a “trade deficit” is actually receiving MORE, not less, goods from its trading partner than its trading partner is receiving from it. A better term would be to call such a situation a “goods surplus” or maybe a “money deficit.” There’s no such thing as a “deficit” in a trade in the sense that any voluntary exchange is basically a wash… In a voluntary exchange of items, the two things being exchanged are valued roughly the same (although, by the very nature of the act, each side will feel it’s getting, at least slightly, the better end of the deal– or else neither side would trade).
What about this negative connotation implied by the word “deficit?” Is there truly something wrong with receiving more goods from your trading partner than he is receiving from you? I mean, if– instead of playing marketplace– we were talking about playing marbles, the kid who walks away with the most marbles is naturally considered the WINNER. But this analogy doesn’t take into account the fact that kid giving-up his marbles, to continue the metaphor, has actually received something of roughly equal value in exchange.
A better analogy would be this: Two kids decide to make a trade. Kid China gives Kid USA a box of chocolates he has made. Kid USA gives Kid China an equally valuable amount of sugar from his mom’s kitchen. Kid USA prefers the box of chocolates to the sugar, and Kid China, even though he doesn’t eat sugar by itself, knows that he can use it to make all sorts of things that he or other people might like.
The immediate effect of the transaction is that Kid USA comes out pretty well– he gets to eat a box of chocolates, whereas Kid CHINA just gets to go back home and work on making more boxes of chocolates (or whatever) using the sugar he’s received as sort of a spur to industry.
If we think of the sugar as money, then Kid USA just ran-up a trade “deficit” with Kid China.
However, after Kid USA finishes his box of chocolates, he realizes he has no more sugar to use for “buying” more boxes of chocolate from Kid China. This sounds bad for Kid USA, but it’s equally bad for Kid China. This is because all of the other kids in the neighborhood have a history of not being able to “buy” nearly as many boxes of chocolates as Kid USA has proven capable of. Thus we see that Kid China’s “trade surplus” can be as bad as Kid USA’s “trade deficit.” [Just keep in mind that at this point, all this talk of “surplus” or “deficit” is bogus– these kids are totally even-stevens with each other and feel that way, too]
Now, if the little “economy” of the two kids is to continue, they each face a set of different options…
Kid USA has four main options: 1) borrow sugar from somewhere else (probably at interest), 2) convince his mom to hand-over more sugar, or 3) steal sugar from some place else. I will go into the fourth option a little later…
In this analogy — 1) borrowing sugar for buying boxes of chocolates– is equivalent to a nation borrowing money to support its trade deficit. And — 2) convincing mom to just hand-over more sugar — is similar to using political means to push the government to expand the Money Supply (by various means, such as reduced lending rates); increasing the Money Supply is basically synonymous with a “Credit Expansion.” Actually, borrowing sugar (money) is also a form of Credit Expansion.
The third option for Kid USA — that of stealing more sugar — I just threw in for fun, but it could represent a country’s exploitation of another country’s resources.
Meanwhile, what is Kid China supposed to do with his boxes of chocolates (which he doesn’t particularly like)? Well, one thing he may want to do is to loan some sugar (at, say, 5% interest) from his stock to Kid USA so that Kid USA can use them to “buy” Kid China’s boxed chocolates. This is good for Kid China because this way he not only gets to continue receiving sugar from Kid USA, but he’s now earning INTEREST on top of it– it’s like being able to increase his prices by 5% without triggering any reduction in demand. Good work when you can get it.
Loaning sugar at interest is like one nation loaning its trading partner money so that the borrowing nation can continue purchasing the lending-nation’s goods. The lender must make the evaluation that this is the best way to invest his stock of “sugar,” instead of, say, investing it in more products or in infrastructure improvements. It’s a tough call for Kid China, but only he can make it.
One problem with this solution is that purchasing power is being extended via loans to a country which, at least at the time, is fundamentally incapable of maintaining that level of buying. The borrowing works as a prop or crutch, enabling the borrower to continue spending beyond his means. If-and-when the borrower recovers, he has in the meanwhile, essentially, been paying 5% higher (the interest charged) for his imported goods than he needed to be.
And if the borrower never recovers or changes his market-behavior, than inevitably, BOTH trading partners will suffer through the combination of: 1) the eventual cessation of trade due to the borrower’s inability to keep borrowing in order to finance more purchases, and likely simultaneously, 2) the lender’s loss of its loaned-out funds when the borrower’s finances collapse and the debt-crutch at last snaps.
Going back to the analogy, Kid China also has a second option — that of loaning his reserves of sugar to OTHER kids, kids who have perhaps normally been too poor to make very good economic partners. Using this tactic, Kid China can continue trading and charging interest– however, loans to these other kids will be more risky as their ability to be good trading partners is questionable. Still, it may be a risk Kid China is willing to take.
Kid China may also need to consider Option #3– reducing the price of his chocolates so that he can at least receive SOMETHING for them, instead of just having them setting there. In the real world, one may not actually be able to reduce prices any farther via efficiency or productivity improvements. But there’s another way… One could make his products APPEAR cheaper even if the nominal price stayed the same. This would be done by depreciating the producer/seller’s currency-value, and increasing the value of the buyer’s currency.
In our analogy this would be like Kid China continuing to accept the same number of bags of sugar from Kid USA even though he knows that Kid USA has started filling some of the sugar bag-volume with air. Kid China is still charging the same “price” for his chocolates in term of sugar-bags, although in reality he is receiving less sugar for each box. He may have several reasons for doing this… for instance, making sure that Kid USA doesn’t lose the habit of buying from him during this rough financial patch, or he may want to discourage Kid USA from being forced to reconsidering his approach to economic life.
This brings us back to the perspective of Kid USA. There is that Option #4 I postponed talking about… Kid USA could MAKE something that Kid China wants to consume, such as cookies, and then trade those cookies for sugar, which he can then sometime later use to buy more chocolates.
[For reasons that need not concern us, Kid USA can only make big batches of cookies. He doesn’t want to trade this large amount of cookies DIRECTLY for boxes of chocolates because the chocolates will go stale before he can eat them all. So he insists that Kid China give him sugar for the cookies… like all good monies, sugar is portable, divisible, and keeps most of its value over time].
Kid China gladly “buys” the cookies with sugar– not only because he loves cookies, but because he knows that Kid USA needs the sugar so that he (Kid USA) can later import more of Kid China’s boxes of chocolates. Everybody wins.
So what’s the net take-away from the above, long (perhaps overly extended) analogy (besides the fact that at least one of us is now craving chocolate)?…
In the above analogy, I have collapsed time… Instead of a trade deficit only slowing eating away at a trading partner’s ability to continue making purchases of foreign goods, I have assumed that the “trade deficit” partner has immediately ran out of “sugar” due to the fact that his expenses have outpaced his disposable wealth. But sooner or later, the same basic circumstance occurs in a real-world economy. And when it does, the same options will be on the table for the trading partners if they wish to continue doing business: Either: 1) somehow maintain the spending ability of the deficit-partner in spite of fundamentals, or 2) change economic behaviors.
In the real world, a nation has more than one trading partner, of course, so a large trade deficit with one country could be compensated-for by numerous trade surpluses with other countries. Maybe a luckier Kid USA would be selling cookies-for-sugar all over town before handing over all his income to Kid China for chocolates.
Also, in the real world, a nation can lend money to its “trade deficit” partner via investments in private business (such as buying corporate shares or bonds) as well as via buying government bonds. Both ways work as a credit expansion in the borrowing country– both allow either corporations or the government to finance employee/buyer incomes directly (thru hiring) or indirectly (increasing demands for goods, such as military supplies or education, thus leading to more jobs). Both ways succeed in pumping (borrowed) money into the debtor’s economy via paychecks– paychecks which the lending country hopes to get a piece of.