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In the chapter on Gross National Product, we learned the identity \(Y = C + I + G + NX\) to describe the output of an economy. The last term, \(NX\), represents net exports, or exports minus imports. \(NX\) is positive if a country exports more goods and services than it imports; this is called a trade surplus. \(NX\) is negative if a country imports more products than it exports; this is called a trade deficit. Since a trade surplus adds to GDP and a trade deficit subtracts from it, and since GDP is a measure of an economy’s productivity (and GDP per capita a measure of living standards), trade surpluses have historically been viewed favorably, and trade deficits have been considered undesirable.
One obvious cause of trade deficits is protectionism. Suppose that Cornucopia were to impose tariffs on lumber imported from Treedonia, while Treedonia continued to freely accept crops coming from Cornucopia. This would reduce Treedonia’s lumber exports while leaving the inflow of Cornucopian crops untouched. Other things being equal, the result would be a trade deficit for Treedonia (and a trade surplus for Cornucopia).
However, trade deficits have other causes besides foreign protectionism. We will look at two notable ones: a strong currency and net foreign investment.
Strong Currency
When two nations have different currencies, one currency can be exchanged for another at the current exchange rate. For example, in early 2025 the U.S. dollar could be exchanged for Mexican pesos at a rate of 20.5 pesos per dollar. In the abstract, the dollar should neither gain nor lose purchasing power through conversion into pesos. So, for example, if in early 2025 a bag of frozen French fries cost $4 in the United States, then it should cost about \(4\times20.5 = 82\) pesos in Mexico. This is the principle of purchasing power parity (PPP).
However, the PPP principle doesn’t always hold in practice. The exchange rate does not always track perfectly with price level changes in each country, and the result can be that one currency grows strong relative to another. If the dollar were strong against the peso in 2025, this would be reflected in a price of, say, just 75 pesos for a bag of frozen fries. Then the $4 that would buy a bag of fries in the U.S. could, after conversion into pesos, be used to buy a bag of fries in Mexico with money left over. If you’re the traveling type, you may be aware that times when the dollar is strong against other currencies are good times for a trip abroad, since your dollar goes further when you pay for local food and accommodations.
The connection with trade and trade deficits is this: when the dollar is strong against other currencies, American-made goods become more expensive not just for foreign tourists visiting the United States, but also for foreign purchasers of American exports. Conversely, foreign-made goods become more affordable for American buyers. When foreign buyers respond to these developments by demanding fewer American exports, while American buyers start demanding more foreign imports, the result is a trade deficit for the United States. A strong dollar, which sounds like a good thing, has led to something widely considered a bad thing.
In trade with the rest of the world, for a long time the United States ran a surplus. When the dollar and other national currencies became fiat currencies in 1971, however, the United States quickly began running a trade deficit. Why? One reason is that since 1971, the dollar has generally been strong against other currencies. Many other currencies experience more inflation than the dollar does. It therefore often makes sense for someone holding money in another currency to convert it to dollars, in order to preserve the money’s value. The tendency for holders of foreign currencies to demand dollars drives the price of a dollar—the exchange rate—up past what would be expected based on purchasing power parity.
Foreign Investment
By foreign investment, we mean the purchase by foreign entities (firms, households or governments) either of domestic capital (commercial properties, for example) or of debt issued either by the government or by domestic firms. Trade deficits and foreign investment are actually in something of a chicken-and-egg relationship. For reasons that should become clear in a moment, each causes the other.
To see how foreign investment is a cause of trade deficits, we note a few things. First, strong domestic growth requires a lot of capital investment. Second, government borrowing requires buyers for the Treasury notes being issued. And third, the funds for capital investment and government borrowing must come from savers. If, now, there is strong domestic growth and/or a lot of government borrowing, and domestic households are spending money on consumption—including consumption of imported goods—instead of saving it, then the remaining money to finance capital investment and government borrowing must come from outside the country. That foreign money is then not being spent on consumption of goods produced domestically and exported.
The bottom line, in very simple terms, is that money being spent on consumption of imports is coming back into the country to secure ownership of domestic assets, in the form of capital and government- or privately-issued debt. The relationship between net exports, \(NX\), and net foreign investment, \(NFI\), is in fact a circular one that makes the two quantities theoretically equal: \(NX=NFI\). (This is the chicken-and-egg relationship.)
Are Trade Deficits Bad?
Whether trade deficits are actually bad for a country is a matter of debate. Economists tend to be much less worried about trade deficits than politicians and the general public. Probably the biggest concern is the implications of foreign ownership of domestic properties. In theory, foreign actors that own American properties might do things with those properties that are contrary to American interests. But historically, so far, this has not been a problem. The United States has never had cause to regret allowing (for example) Chinese companies to own real estate in Manhattan’s business district.
Anyway, if trade deficits are bad, there are few good solutions for them. Retaliatory tariffs? As already explained, you help certain domestic industries but hurt all domestic consumers. Weaken your currency? That would require fueling inflation—not a good idea. Discourage investment? Now you’re throttling back on infrastructure development. That leaves reduced government borrowing and increased household saving. Those would both be good ideas, but neither borrow-and-spend politicians nor free-spending households like to be told what to do.
