Balance of trade

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Cumulative current account balance 1980–2008 based on International Monetary Fund data.
Cumulative current account balance per capita 1980–2008 based on International Monetary Fund data.

The commercial balance or net exports (sometimes symbolized as NX), is the difference between the monetary value of exports and imports of output in an economy over a certain period, measured in the currency of that economy. It is the relationship between a nation's imports and exports.[1] A positive balance is known as a trade surplus if it consists of exporting more than is imported; a negative balance is referred to as a trade deficit or, informally, a trade gap. The balance of trade is sometimes divided into a goods and a services balance.

Understanding Balance of Trade

Trade, in general connotation, means the purchase and sales of commodities. In International Trade, purchase and sale are replaced by imports and exports. Balance of Trade is simply the difference between the value of exports and value of imports. Thus, the Balance of Trade denotes the differences of imports and exports of a merchandise of a country during the course of year. It indicates the value of exports and imports of the country in question. If the value of its exports over a period exceeds its value of imports, it is called favourable balance of trade and, conversely, if the value of total imports exceeds the total value of exports over a period, it is unfavourable balance of trade. The favorable balance of trade indicates good economic condition of the country.

Policies of early modern Europe are grouped under the heading mercantilism. Early understanding of the imbalances of trade emerged from the practices and abuses of mercantilism in which colonial America's natural resources and cash crops were exported in exchange for finished goods from England, a factor leading to the American Revolution. An early statement appeared in Discourse of the Common Wealth of this Realm of England, 1549: "We must always take heed that we buy no more from strangers than we sell them, for so should we impoverish ourselves and enrich them."[2] Similarly a systematic and coherent explanation of balance of trade was made public through Thomas Mun's 1630 "England's treasure by foreign trade, or, The balance of our foreign trade is the rule of our treasure"[3]

Definition

The balance of trade forms part of the current account, which includes other transactions such as income from the net international investment position as well as international aid. If the current account is in surplus, the country's net international asset position increases correspondingly. Equally, a deficit decreases the net international asset position.

The trade balance is identical to the difference between a country's output and its domestic demand (the difference between what goods a country produces and how many goods it buys from abroad; this does not include money re-spent on foreign stock, nor does it factor in the concept of importing goods to produce for the domestic market).

Measuring the balance of trade can be problematic because of problems with recording and collecting data. As an illustration of this problem, when official data for all the world's countries are added up, exports exceed imports by almost 1%; it appears the world is running a positive balance of trade with itself. This cannot be true, because all transactions involve an equal credit or debit in the account of each nation. The discrepancy is widely believed to be explained by transactions intended to launder money or evade taxes, smuggling and other visibility problems. However, especially for developed countries, it is likely the transaction statistics are accurate.

Factors that can affect the balance of trade include:

  • The cost of production (land, labor, capital, taxes, incentives, etc.) in the exporting economy vis-à-vis those in the importing economy;
  • The cost and availability of raw materials, intermediate goods and other inputs;
  • Exchange rate movements;
  • Multilateral, bilateral and unilateral taxes or restrictions on trade;
  • Non-tariff barriers such as environmental, health or safety standards;
  • The availability of adequate foreign exchange with which to pay for imports; and
  • Prices of goods manufactured at home (influenced by the responsiveness of supply)

In addition, the trade balance is likely to differ across the business cycle. In export-led growth (such as oil and early industrial goods), the balance of trade will improve during an economic expansion. However, with domestic demand led growth (as in the United States and Australia) the trade balance will worsen at the same stage in the business cycle.

Monetary balance of trade is different from physical balance of trade[4] (which is expressed in amount of raw materials, known also as Total Material Consumption). Developed countries usually import a lot of raw materials from developing countries. Typically, these imported materials are transformed into finished products, and might be exported after adding value. Financial trade balance statistics conceal material flow. Most developed countries have a large physical trade deficit, because they have a large ecological footprint. Civil society organisations point out the predatory nature of this imbalance, and campaign for ecological debt repayment.

Since the mid-1980s, the United States has had a growing deficit in tradeable goods, especially with Asian nations (China and Japan) which now hold large sums of U.S debt that has funded the consumption.[5][6] The U.S. has a trade surplus with nations such as Australia. The issue of trade deficits can be complex. Trade deficits generated in tradeable goods such as manufactured goods or software may impact domestic employment to different degrees than trade deficits in raw materials.

Economies such as Japan and Germany which have savings surpluses, typically run trade surpluses. China, a high-growth economy, has tended to run trade surpluses. A higher savings rate generally corresponds to a trade surplus. Correspondingly, the U.S. with its lower savings rate has tended to run high trade deficits, especially with Asian nations.

Views on economic impact

Classical theory

From Classical economic theory, those who ignore the effects of long run trade deficits may be confusing David Ricardo's principle of comparative advantage with Adam Smith's principle of absolute advantage, specifically ignoring the latter. The economist Paul Craig Roberts notes that the comparative advantage principles developed by David Ricardo do not hold where the factors of production are internationally mobile.[7][8] Global labor arbitrage, a phenomenon described by economist Stephen S. Roach, where one country exploits the cheap labor of another, would be a case of absolute advantage that is not mutually beneficial.[9][10][11] In 2010, economist Ian Fletcher authored a significant work entitled, Free Trade Doesn't Work: What Should Replace It and Why, where he has supported a strategic approach to trade rather than an unconditional or unilateral approach.[12]

Small trade deficits are generally not considered to be harmful to either the importing or exporting economy. However, when a national trade imbalance expands beyond prudence (generally thought to be several[clarification needed] percent of GDP, for several years), adjustments tend to occur. While unsustainable imbalances[13] may persist for long periods (cf, Singapore and New Zealand’s surpluses and deficits, respectively), the distortions likely to be caused by large flows of wealth out of one economy and into another tend to become intolerable.[citation needed]

In simple terms, trade deficits are paid for out of foreign exchange reserves, and may continue until such reserves are empty, at which point, the importer can no longer purchase abroad. This is likely to have exchange rate implications: a loss of value in the deficit economy’s currency relative to the surplus economy’s currency will change the relative price of tradable goods, and facilitate a return to balance or (quite commonly in historical data) an over-shooting into surplus, the other direction.

When an economy is unable to export enough physical goods to pay for its physical imports, it may be able to find funds elsewhere: Service exports, for example, are more than sufficient to pay for Hong Kong's domestic goods import. In poor countries, foreign aid may compensate, while in developed economies a capital account surplus caused by sales of assets often offsets a current-account deficit. There are some economies where transfers from nationals working abroad contribute significantly to paying for imports. The Philippines, Bangladesh and Mexico are examples of transfer-rich economies.

A country may rebalance the trade deficit by use of quantitative easing at home. This involves a central bank printing money and making it available to other domestic financial institutions at small interest rates, which increases the money supply in the home economy. Inflation usually results, which devalues in real terms the debt owed to foreign creditors if that debt was instantiated in the home currency.

Adam Smith on the balance of trade

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See also: Friedrich List

"In the foregoing part of this chapter I have endeavoured to show, even upon the principles of the commercial system, how unnecessary it is to lay extraordinary restraints upon the importation of goods from those countries with which the balance of trade is supposed to be disadvantageous. Nothing, however, can be more absurd than this whole doctrine of the balance of trade, upon which, not only these restraints, but almost all the other regulations of commerce are founded. When two places trade with one another, this [absurd] doctrine supposes that, if the balance be even, neither of them either loses or gains; but if it leans in any degree to one side, that one of them loses and the other gains in proportion to its declension from the exact equilibrium." (Smith, 1776, book IV, ch. iii, part ii) [14]

Keynesian theory

In the last few years of his life, John Maynard Keynes was much preoccupied with the question of balance in international trade. He was the leader of the British delegation to the United Nations Monetary and Financial Conference in 1944 that established the Bretton Woods system of international currency management.

He was the principal author of a proposal – the so-called Keynes Plan — for an International Clearing Union. The two governing principles of the plan were that the problem of settling outstanding balances should be solved by 'creating' additional 'international money', and that debtor and creditor should be treated almost alike as disturbers of equilibrium. In the event, though, the plans were rejected, in part because "American opinion was naturally reluctant to accept the principle of equality of treatment so novel in debtor-creditor relationships".[15]

His view, supported by many economists and commentators at the time, was that creditor nations may be just as responsible as debtor nations for disequilibrium in exchanges and that both should be under an obligation to bring trade back into a state of balance. Failure for them to do so could have serious consequences. In the words of Geoffrey Crowther, then editor of The Economist, "If the economic relationships between nations are not, by one means or another, brought fairly close to balance, then there is no set of financial arrangements that can rescue the world from the impoverishing results of chaos."[16]

These ideas were informed by events prior to the Great Depression when – in the opinion of Keynes and others – international lending, primarily by the U.S., exceeded the capacity of sound investment and so got diverted into non-productive and speculative uses, which in turn invited default and a sudden stop to the process of lending.[17]

Influenced by Keynes, economics texts in the immediate post-war period put a significant emphasis on balance in trade. For example, the second edition of the popular introductory textbook, An Outline of Money,[18] devoted the last three of its ten chapters to questions of foreign exchange management and in particular the 'problem of balance'. However, in more recent years, since the end of the Bretton Woods system in 1971, with the increasing influence of Monetarist schools of thought in the 1980s, and particularly in the face of large sustained trade imbalances, these concerns – and particularly concerns about the destabilising effects of large trade surpluses – have largely disappeared from mainstream economics discourse[19] and Keynes' insights have slipped from view.[20] They are receiving some attention again in the wake of the financial crisis of 2007–08.[21]

Monetarist theory

Prior to 20th century Monetarist theory, the 19th century economist and philosopher Frédéric Bastiat expressed the idea that trade deficits actually were a manifestation of profit, rather than a loss. He proposed as an example to suppose that he, a Frenchman, exported French wine and imported British coal, turning a profit. He supposed he was in France, and sent a cask of wine which was worth 50 francs to England. The customhouse would record an export of 50 francs. If, in England, the wine sold for 70 francs (or the pound equivalent), which he then used to buy coal, which he imported into France, and was found to be worth 90 francs in France, he would have made a profit of 40 francs. But the customhouse would say that the value of imports exceeded that of exports and was trade deficit against the ledger of France.[22]

By reductio ad absurdum, Bastiat argued that the national trade deficit was an indicator of a successful economy, rather than a failing one. Bastiat predicted that a successful, growing economy would result in greater trade deficits, and an unsuccessful, shrinking economy would result in lower trade deficits. This was later, in the 20th century, echoed by economist Milton Friedman.

In the 1980s, Milton Friedman, a Nobel Prize-winning economist and a proponent of Monetarism, contended that some of the concerns of trade deficits are unfair criticisms in an attempt to push macroeconomic policies favorable to exporting industries.

Friedman argued that trade deficits are not necessarily as important as high exports raise the value of the currency, reducing aforementioned exports, and vice versa for imports, thus naturally removing trade deficits not due to investment. Since 1971, when the Nixon administration decided to abolish fixed exchange rates, America's Current Account accumulated trade deficits have totaled $7.75 Trillion as of 2010. This deficit exists as it is matched by investment coming into the United States- purely by the definition of the balance of payments, any current account deficit that exists is matched by an inflow of foreign investment.

In the late 1970s and early 1980s, the U.S. had experienced high inflation and Friedman's policy positions tended to defend the stronger dollar at that time. He stated his belief that these trade deficits were not necessarily harmful to the economy at the time since the currency comes back to the country (country A sells to country B, country B sells to country C who buys from country A, but the trade deficit only includes A and B). However, it may be in one form or another including the possible tradeoff of foreign control of assets. In his view, the "worst-case scenario" of the currency never returning to the country of origin was actually the best possible outcome: the country actually purchased its goods by exchanging them for pieces of cheaply made paper. As Friedman put it, this would be the same result as if the exporting country burned the dollars it earned, never returning it to market circulation.[23]

This position is a more refined version of the theorem first discovered by David Hume.[24] Hume argued that England could not permanently gain from exports, because hoarding gold (i.e., currency) would make gold more plentiful in England; therefore, the prices of English goods would rise, making them less attractive exports and making foreign goods more attractive imports. In this way, countries' trade balances would balance out.[25]

Friedman believed that deficits would be corrected by free markets as floating currency rates rise or fall with time to encourage or discourage imports in favor of the exports, reversing again in favor of imports as the currency gains strength. In the real world, a potential difficulty is that currency markets are far from a free market, with government and central banks being major players, and this is unlikely to change within the foreseeable future. Nevertheless, recent developments have shown that the global economy is undergoing a fundamental shift. For many years, the U.S. has borrowed and bought while in general, the rest of the world has lent and sold.

As of October 2007, the U.S. dollar weakened against the euro, British pound, and many other currencies. For instance, the euro hit $1.42 in October 2007,[26] the strongest it has been since its birth in 1999. Against this backdrop, American exporters are finding quite favorable overseas markets for their products and U.S. consumers are responding to their general housing slowdown by slowing their spending. Furthermore, China, the Middle East, central Europe and Africa are absorbing more of the world's imports which in the end may result in a world economy that is more evenly balanced. All of this could well add up to a major readjustment of the U.S. trade deficit, which as a percentage of GDP, began in 1991.[27]

Friedman contended that the structure of the balance of payments was misleading. In an interview with Charlie Rose, he stated that "on the books" the US is a net borrower of funds, using those funds to pay for goods and services. He essentially claimed that the foreign assets were not carried on the books at their higher, truer value.[citation needed]

Friedman presented his analysis of the balance of trade in Free to Choose, widely considered his most significant popular work.

Trade Balances' effects upon their nation’s GDP

Annual trade surpluses are immediate and direct additions to their nations’ GDPs. To some extent exports induce additional increases to GDP that are not reflected within the export products’ prices; thus contributions to GDP from trade surpluses are generally understated.

Products’ prices generally reflect their producers’ production supporting expenditures. Producers often benefit from some production supporting goods and services at lesser or no cost to the producers.

For example, governments may deliberately locate or increase the capacity of their infrastructure, or provide other additional considerations to retain or attract producers within their own jurisdictions. The curriculum of a nation's schools and colleges may provide job applicants specifically suited to the producer’s needs, or provide specialized research and development. All national factors of production, including education, contribute to GDP, and unless globally traded products fully reflect those goods and services, these other export supporting contributions are not entirely identified and attributed to their nations’ global trade.

Annual trade deficits are immediate and indirect reducers of their nations’ GDPs.

Trade deficits make no net contribution to their nations’ GDPs but the importing nations indirectly deny themselves of the benefits earned by producing nations; (refer to “Annual trade surpluses are immediate and direct additions to their nations’ GDPs”). Among what’s being denied is familiarity with methods, practices, the manipulation of tools, materials and fabrication processes.

The economic differences between domestic and imported goods occur prior to the goods entry within the final purchasers' nations. After domestic goods have reached their producers shipping dock or imported goods have been unloaded on to the importing nation’s cargo vessel or entry port’s dock, similar goods have similar economic attributes.

Although supporting products not reflected within the prices of specific items are all captured within the producing nation’s GDP, those supporting but not reflected within prices of globally traded goods are not attributed to nations' global trade. Trade surpluses' contributions and trade deficits' detriments to their nation's GDPs are understated. The entire benefits of production are earned by the exporting nations and denied to the importing nation.

Difference between Balance of Trade and the Balance of Payments

Balance of Trade Balance of Payment
The Balance of Trade includes only visible imports and exports, i.e. imports and exports of merchandise, the difference of imports and exports is called Balance of Trade. If imports are more than exports, it is unfavourable balance of trade. If exports exceeds imports, it is favourable balance of trade. The Balance of Payments includes all those visible and invisible items exported from and imported into the country in addition to exports and imports of merchandise.
Balance of Trade includes revenues received or paid on account of imports and exports of merchandise. It shows only revenue items. Balance of Payments includes all revenue and capital items whether visible or non-visible. Balance of Trade thus form a part of Balance of Payments.
Balance of Trade can be favourable or unfavourable. If imports are more than exports, it is unfavourable balance of trade. If exports exceeds imports, it is favourable balance of trade. Balance of Payments is always balanced just like Trading and Profit and Loss A/c of a business.
In case of Balance of Trade, there is no deficit or surplus balance. The balance shows favourable or non-favourable. So, external assistance is not required. In case of Balance of Payments, any balance, deficit or surplus is to be financed by external source or assistance or be utilised.

Notes

  1. ↑ Lua error in package.lua at line 80: module 'strict' not found.
  2. ↑ Now attributed to Sir Thomas Smith; quoted in Jose rizal, The Wheels of Commerce, vol. II of Civilization and Capitalism 15th–18th Century, 1979:204.
  3. ↑ Thomas Mun, Oxford National Dictionary of Biography
  4. ↑ Physical Trade Balance, OECD Glossary of Statistical Terms
  5. ↑ Bivens, L. Josh (14 December 2004). Debt and the dollar Economic Policy Institute. Retrieved on 8 July 2007.
  6. ↑ MAjor foreign holders of treasury securities. U.S. Treasury.gov
  7. ↑ Roberts, Paul Craig (7 August 2003). Jobless in the USA Newsmax. Retrieved on 6 May 2007.
  8. ↑ Hira, Ron and Anil Hira with forward by Lou Dobbs, (May 2005). Outsourcing America: What's Behind Our National Crisis and How We Can Reclaim American Jobs. (AMACOM) American Management Association. Citing Paul Craig Roberts, Paul Samuelson, and Lou Dobbs, pp. 36–38.
  9. ↑ See Roberts, Loc. cit.
  10. ↑ Paul Craig Roberts (07/28/04)."Global Labor Arbitrage".VDARE. Retrieved on 7 July 2009.
  11. ↑ Whitney, Mike (June 2006).Labor arbitrage. Entrepreneur. Retrieved on 7 July 2009.
  12. ↑ Fletcher, Ian Free Trade Doesn't Work: What Should Replace It and Why (U.S. Business & Industry Council 2011 Edition ISBN 0578082616)
  13. ↑ Aristovnik, Aleksander, 2006. "Current Account Sustainability in Selected Transition Countries" William Davidson Institute Working Papers Series WP844.
  14. ↑ Smith, Adam. (1776). An Inquiry into the Nature and Causes of the Wealth of Nations, Indianapolis: Liberty Fund, 1981, 2 vols., (1776) (reprint of the Clarendon Press edition, Oxford 1976, with Edward Cannan's original index from 1922)
  15. ↑ Lua error in package.lua at line 80: module 'strict' not found.
  16. ↑ Lua error in package.lua at line 80: module 'strict' not found.
  17. ↑ Lua error in package.lua at line 80: module 'strict' not found.
  18. ↑ Lua error in package.lua at line 80: module 'strict' not found.
  19. ↑ See for example, Krugman, P and Wells, R (2006). "Economics", Worth Publishers
  20. ↑ although see Duncan, R (2005). "The Dollar Crisis: Causes, Consequences, Cures", Wiley
  21. ↑ See for example,Lua error in package.lua at line 80: module 'strict' not found.
  22. ↑ Bastiat: Selected Essays
  23. ↑ Free to Choose video series from PBS
  24. ↑ Lua error in package.lua at line 80: module 'strict' not found.
  25. ↑ Lua error in package.lua at line 80: module 'strict' not found.
  26. ↑ Lua error in package.lua at line 80: module 'strict' not found.
  27. ↑ Michael M. Phillips, World Economy in Flux As America Downshifts

External links

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