New version page

Cal Poly Pomona PLS 458 - US Trade Deficits

Upgrade to remove ads
Upgrade to remove ads
Unformatted text preview:

10Trade Deficits:Causes andConsequencesDavid M. GouldSenior Economist and Policy AdvisorFederal Reserve Bank of DallasRoy J. RuffinResearch AssociateFederal Reserve Bank of DallasandM. D. Anderson Professor of EconomicsUniversity of HoustonFor the most part, trade deficitsor surpluses are merely a reflectionof a country’s internationalborrowing or lending profileover time.…Neither one, by itself,is a better indicator of long-runeconomic growth than the other.On September 19, 1996, the WashingtonPost, Wall Street Journal, and New York Timesreported trade figures released by the U.S. De-partment of Commerce showing that the monthlyU.S. trade deficit increased by $3.5 billion in July1996. Almost unanimously, analysts quoted inthe articles stated that the recent trade figuresshowed weakness in the U.S. economy. Thenews was not earth shattering, nor was theinterpretation of the increasing trade deficit con-troversial. The conventional wisdom is that thetrade balance reflects a country’s competitivestrength—the lower the trade deficit, the greatera country’s competitive strength and the higherits economic growth.But the conventional wisdom on trade bal-ances stands in stark contrast to that of theeconomics profession in general. Standard eco-nomic thought typically regards trade deficits asthe inevitable consequence of a country’s pref-erences regarding saving and the productivity ofits new capital investments. Trade deficits arenot necessarily seen as a cause for concern, norare they seen as good predictors of a country’sfuture economic growth. For example, large tradedeficits may signal higher rates of economicgrowth as countries import capital to expandproductive capacity. However, they also mayreflect a low level of savings and make countriesmore vulnerable to external economic shocks,such as dramatic reversals of capital inflows. Isthe conventional wisdom wrong, or has theeconomics profession just failed to keep itstheories well-grounded in fact?Certainly, anyone can create a theory abouttrade deficits and speculate about how theymay, or may not, be related to a nation’s eco-nomic performance. The paramount question isnot whether one can create a theory, but whetherit is logically consistent and stands up to em-pirical observation.The purpose of this article is to answer thequestion of whether trade deficits, bilateral aswell as overall, are related to a country’s eco-nomic performance. We begin by discussing theorigin of popular views on trade deficits andcompare these views with current economicthought on trade balances. Next, we discuss therelationship between international capital flowsand trade balances and relate them to economicgrowth. We then empirically examine the rela-tionship between trade deficits and long-runeconomic growth.The evolution of ideas about trade balancesThe mercantilists. Much of the currentpopular thinking on trade balances can trace itsFEDERAL RESERVE BANK OF DALLAS 11 ECONOMIC REVIEW FOURTH QUARTER 1996intellectual roots to a group of writers in theseventeenth and eighteenth centuries called themercantilists. The mercantilists advanced theview that a country’s gain from internationalcommerce depends on having a “favorable”trade balance (favorable balance meaning thatexports are greater than imports). The mercan-tilists were businessmen, and they looked at acountry’s trade balance as analogous to a firm’sprofit and loss statement. The greater are re-ceipts over outlays (exports over imports), themore profitable (competitive) is the business(country). Thus, they argued that a country couldbenefit from protectionist policies that encour-aged exports and discouraged imports. Becausemost international transactions during theseventeenth and eighteenth centuries were paidfor with gold and silver, mercantilists were ad-vocating a trade surplus so that the countrywould accumulate the precious metals and,according to their arguments, become rich.1In 1752, David Hume exposed a logicalinconsistency in the mercantilism doctrinethrough his explanation of the “specie-flowmechanism.”2 The specie-flow mechanism refersto the natural movement of money and goodsunder a gold standard or, indeed, any fixedexchange rate system in which the domesticmoney supply is inextricably linked to a reserveasset. The reserve asset need not be gold.3Hume argued that an accumulation of goldfrom persistent trade surpluses increases theoverall supply of circulating money within thecountry, and this would cause inflation. Theincrease in overall inflation also would be seenin an increase in input prices and wages. Hence,the country with the trade surplus soon wouldfind its competitive price advantage disappear-ing as prices rose but the exchange rate re-mained constant. Automatically, through thespecie-flow mechanism, the country with a tradesurplus would find that its surplus shrank asits prices rose relative to other countries’ prices.Any attempt to restore the trade surplus byraising tariffs or imposing other protectionistpolicies would simply result in another round ofcost inflation, leading ultimately to a balancebetween exports and imports once again.Several of the mercantilists—such as Gerardde Malynes (1601) and Sir Thomas Mun (1664) —understood the problems of maintaining a per-petual trade surplus as domestic prices rose butdiscounted this problem as a very long-runphenomenon and emphasized the benefits ofaccumulating gold as a means of exchange in ahostile and uncertain world.4A few decades after Hume’s original writ-ings, economists such as Adam Smith and DavidRicardo added further arguments against themercantilistic advocacy of trade surpluses. Theyargued that what really matters to a country isits terms of trade—that is, the price it pays forits imports relative to the price it receives forits exports. Smith and Ricardo stood the advo-cacy of trade surpluses on its head when theyshowed that a country is better off the moreimports it receives for a given number of exportsand not vice versa. They argued that the mer-cantilistic analogy between a country’s exportsand a firm’s sales was faulty.Adam Smith in 1776 argued that money toan economy is different from money to an indi-vidual or firm. A business firm’s objective isto maximize the difference between its importsof money and its exports of money. Money“imports” are the sale of goods and money“exports” are the purchases of labor and otherinputs to

View Full Document
Download US Trade Deficits
Our administrator received your request to download this document. We will send you the file to your email shortly.
Loading Unlocking...

Join to view US Trade Deficits and access 3M+ class-specific study document.

We will never post anything without your permission.
Don't have an account?
Sign Up

Join to view US Trade Deficits 2 2 and access 3M+ class-specific study document.


By creating an account you agree to our Privacy Policy and Terms Of Use

Already a member?