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Are trade deficits bad for an economy?
Helping you understand trade deficits, it's importance to the economy and what it could mean for your business.
A trade deficit must be offset by a surplus elsewhere
In typical economist fashion, the answer to whether trade deficits are bad for an economy is: it depends. Globally, while some countries have been able to sustain a trade deficit without cause for concern, others have not. Meanwhile, a trade surplus is not a cause of, or prerequisite to, economic growth and can even suggest a lack of growth opportunities. Therefore it is useful to assess a trade deficit alongside the broader economic environment – what are its drivers and is it sustainable?
A trade deficit means a country is borrowing from overseas to consume. In its simplest form the trade balance should approximately equal the difference between national savings and investment.
Therefore a trade deficit implies savings are insufficient relative to the level of desired investment. Capital inflows meet that shortfall and fills the gap between savings and investment for a given level of real interest. That means a country can borrow externally to fund investment and consumption, and keep interest rates lower than would otherwise be needed to balance savings and investment.
But should we worry about a trade deficit?
If a trade deficit can be sustainably financed by borrowing from abroad, it shouldn’t be problematic. Indeed, the ability to finance investment via capital flows from abroad may signal a country’s growth prospects and attractiveness as a place to invest. Moreover, it also enables a government to respond to shocks, such as a global pandemic, without adverse consequences such as higher interest rates.
The point at which a trade deficit raises concern is if the domestic environment becomes uncompetitive or unstable such that capital flows are not forthcoming. Moreover, the trade deficit helps to enable government borrowing so its relationship to the fiscal deficit is important; often referred to the twin deficit phenomenon whereby the government is either directly or indirectly financing its borrowing from abroad. If the fiscal deficit is persistent due to a lack of savings, such that debt is increasing as a share of GDP, it can signal fiscal irresponsibility. It can be argued that for as long as a country is able to attract capital flows, i.e. run a trade deficit, then a persistent, stable fiscal deficit is manageable. However, if the private sector is being crowded out and growth is low, it risks a loss of confidence that sees the withdrawal of capital.
Therefore, trade deficits aren’t inherently bad. Some economies e.g. the US and UK have benefitted from an ability to save little and consume a lot, and manage a trade deficits, others such as Argentina have not. Generally, the ability to sustain a trade deficit is aided by various factors including: a flexible exchange rate regime, diverse exports, strong financial sector, coherent fiscal and monetary policy, and economic growth and stability. Some trade deficits (or trade surpluses) are temporary while some are persistent, but ultimately it depends on the broader economic trends to determines whether it’s a cause for concern.
The UK has run a trade deficit persistently that has been offset by a surplus in financial flows
1In this simple example, we consider the trade component of the current account, which also includes ‘primary income’ such as investment income and ‘secondary income’ such as remittances, foreign aid and contributions to international organisations
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