To hear some people tell it, America’s trade deficit shows that our economy is failing. By this logic, America is a chump because our market is open while we let other countries limit our access to their markets.

Luckily for America, this way of looking at our trade balance is almost entirely wrong.

capital account surplus

capital account surplus

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Trade is about people, not countries

To understand why, it is important to recall that trade is about people, not countries. If an American goes car shopping and chooses a Kia instead of a Ford because she believes that her money is better spent that way, who are we to tell her she has made a mistake? If Ford buys a wiring assembly in Mexico that enables it to sell its car at a price that gets that sale, is that a good thing for America or a bad thing?

Dollars that flow out, flow back in

But doesn’t a trade deficit mean that money is flowing out of our economy, making us poorer and enriching our trading partners?

This is a tempting logic, but it’s misleading.

To understand why, it’s important to understand that a country’s balance of payments, which summarizes all transactions between its citizens and the rest of the world, is like a corporate balance sheet, where assets and liabilities are equal and add to zero.

However, in the case of the balance of payments, we don’t talk about assets and liabilities. Rather, we talk about short-term transactions (aka the “current account”) and long-term transactions (aka the “capital account”).

This means that a current account deficit is the flip side of a capital account surplus. Dollars that flow out to buy goods and services turn around and flow back in as foreigners buy goods and services and invest in the United States — either way, employing Americans.

From this perspective, a trade deficit is not an indicator of national economic failure. On the contrary, it is more like an indicator of success: It means the United States has a thriving economy that is an attractive place to do business and produces abundant wealth.

When people buy our dollars, it’s like getting a loan

However, this doesn’t mean a trade deficit is not important. For one thing, some people want dollars because it is the global standard for value. As a result, dollars circulate outside the U.S. economy for reasons unrelated to American goods and services.

This can reduce employment in the United States as foreigners keep the dollars they earn in trade rather than spending or investing them in the United States. This is harmful to American workers, of course, but the benefit to the United States is significant.

Think about it: It costs us about 14.3 cents to print a $100 bill, but foreigners will happily give us $100 worth of stuff in exchange for it. It’s a type of free loan. We should think long and hard before we give up this position.

Currency manipulation is ultimately self-defeating

A related factor is currency manipulation by governments. Sometimes, governments will try to promote exports by using their own currency to buy dollars, bidding the dollar’s value up and depressing the value of their own currency.

A policy like this can boost employment for some time, but it is ultimately self-defeating. Driving down the value of your currency eventually causes inflation. In turn, that leads to financial instability, interest rate increases, recession — and unemployment.

Trade deficits can encourage workers to get retrained

More important, the international trade and payments cycle is not instantaneous. Jobs are cut here and created there, affecting communities and workers differently.
As a result, a trade deficit may well require a policy response. The appropriate policy response would encourage investment to spread itself around, and encourage workers to move and/or seek retraining.

Trade deficits highlight domestic problems that need addressing

Most important of all, a trade deficit can point to imbalances elsewhere in the economy. A capital account surplus suggests that the economy is producing profitable investment opportunities that exceed what the available pool of domestic savings can finance.

In our case, domestic savings are inadequate mainly because of government budget deficits. Less government borrowing would leave more savings in the domestic pool, which would reduce the capital account surplus, which would in turn reduce the trade deficit.

A trade deficit that is driven by a budget deficit, as ours is, is in fact a serious problem. The solution lies not in policies designed to limit imports, but rather in a focused effort to reduce government borrowing.

Beware of the wrong cure.

We can think about a trade deficit like a fever. It is generally better not to medicate the fever, but rather to seek the underlying cause. You might reduce the discomfort of a viral fever with some aspirin, but an infection requires antibiotics. But using the wrong medicine for the fever can make things worse.