International Finance Theory and Policy
by Steven M. Suranovic

Finance 6-1

The National Welfare Effects of Trade Imbalances

In this section a series of simple scenarios (or stories) are presented to demonstrate how the well-being of a country may be affected when it runs trade imbalances. The scenarios compare national output with domestic spending over two periods of time under alternative assumptions about the country's trade imbalance and its economic growth rate between the two periods. After each aggregate scenario is presented, we also provide an analogous situation from the point of view of an individual. Finally we present an evaluation of each scenario and indicate countries that may be displaying similar trade patterns.

Two periods are used as a simple way to introduce the dynamic characteristics of trade imbalances. The amount of time between the two periods can be varied to provide alternative interpretations. Thus, the two periods could be labeled; today and tomorrow, this year and next year, or this generation and next generation.

We assume that all trade imbalances correspond to debt obligations or IOUs. In other words, the financial account imbalances which offset the trade imbalances will be interpreted as international borrowing and lending rather than, say, foreign direct investment flows or real estate purchases.

Afterwards we will comment on how the interpretations of these scenarios may change with the alternative type of asset flow.

National welfare is best measured by the amount of goods and services which are "consumed" by households. What we care about, ultimately, is the standard of living obtainable by the average citizen, and this standard is affected not by how much the nation produces but by how much it consumes. Although GDP is often used as a proxy for national welfare, albeit an inadequate one for many reasons, it is even less adequate when a country runs trade imbalances. To quickly see why, consider the extreme situation in which a country runs the largest trade surplus possible. This would arise if a country exports all of its GDP, and imports nothing. The country's trade surplus would then equal its GDP, but, the citizens in the country would have no food, clothing or anything else to consume. The standard of living would be non-existent.

To avoid this problem we use domestic spending (DS), or the sum of domestic consumption, investment and government spending, as a proxy for national welfare. More formally let,

DS = C + I + G

where C, I and G are defined as in the national income accounts. Recall from chapter 5 that C, I and G each can be segmented into spending on domestically produced goods and services and spending on imported goods and services. Thus, domestic spending includes imported goods in the measure of national welfare. This is appropriate since imported goods are consumed by domestic citizens and adds to their well-being and standard of living.

One problem with using domestic spending as a proxy for average living standards is the inclusion of investment. [Note that this problem would also arise using GDP as a proxy] Investment spending measures the value of goods and services used as inputs into the productive process. As such, these items do not directly raise the well-being of citizens, at least not in the present period. To clarify this point, consider an isolated, self-sufficient corn farmer. Each year the farmer harvests corn using part of it to sustain the family during the year, while allocating some of the kernels to use as seed corn for the following year. Clearly the more kernels the farmer saves for next year's crop, the less corn the family will have to consume this year. As with the farmer, so goes the nation; the more is invested today, the lower will be today's standard of living, all eals equal. Thus we must use domestic spending cautiously as a measure of national welfare and take note of changes in investment spending if it occurs.

The analysis below will focus on the interpretation of differences between national income (GDP) and domestic spending under different scenarios concerning the trade imbalance. The relationship between them can be shown be rewriting the national income identity.

The national income identity is written as,

GDP = C + I + G + EX - IM

Substituting the term for domestic spending yields,

GDP = DS + EX - IM

Rearranging gives,

EX - IM = GDP - DS

The last expression implies that when a country has a current account (or trade) surplus, GDP must exceed domestic spending by the equivalent amount. Similarly when a country has a trade deficit then domestic spending exceeds GDP.

Note: To be completely accurate, we should use GNP rather than GDP in the analysis. This is so because we are interpreting EX - IM as the current account balance which includes income payments and receipts. With income flows included on the trade side, the measure of national output we get is GNP not GDP. Conceptually, treating GDP simply as a measure of national output, there is no difference in the interpretation of the results.

Case 1: The Base Case
(No Trade Imbalances; No GDP Growth between periods)

The base case is used to demonstrate how GDP compares with domestic spending in the simplest scenario. Here we assume that the country does not run a trade deficit or surplus in either of the two periods and that no GDP growth occurs between periods. No trade imbalance implies no net international borrowing or lending occurs on the financial account. The case mimics how things would look if the country were in autarky and did not trade with the rest of the world.

Note from the adjoining figure that domestic spending, shown as the aqua bar graph, is exactly equal to GDP in both periods. Since domestic spending is used to measure national welfare, we see that the average standard of living remains unchanged between the two periods. All in all, nothing very interesting happens in this case, but, it will be useful for comparison purposes.

Case 1: The individual analogy

Consider an individual named Amine. For an individual, GDP is analogous to a Amine's annual income since his income represents the value of goods and services produced with his labor services. Domestic spending is analogous to the value of the goods and services purchased by Amine during the year. It corresponds to the Amine's consumption of goods and services which serves as a proxy for his welfare level. Trade for an individual occurs whenever a transaction occurs with someone outside his household.

Let's assume for simplicity that Amine earns $30,000 per year. The assumption of no GDP growth in case 1 implies that he continues to earn $30,000 in period 2, and thus experiences no income growth. The assumption of no trade imbalances implies that Amine engages in no borrowing or lending outside of his household. That implies that he spends all of his income on consumption goods and thus purchases $30,000 worth of goods and services. This level of consumption remains the same in both periods implying that his standard of living is unchanged.

Another way of interpreting balanced trade for an individual is to imagine that he exports $30,000 worth of labor services and afterwards imports $30,000 worth of consumption goods and services. Since exports equals imports, trade is balanced.

Case 2:
(Current Account deficit period 1; No GDP Growth between periods)

In case 2 we assume that the country runs a current account, or trade, deficit in the first period. We'll also assume that the resultant financial account surplus corresponds to borrowing from the rest of the world, rather than asset purchases. These borrowed funds are assumed to be repaid in their entirety in the second period. In other words, we'll assume that loans are taken out in the first period and that the principal and interest are repaid completely in the second period. We also assume that there is no GDP growth between periods.

As shown in the adjoining diagram, the trade deficit in the first period implies that domestic spending, DS1, exceeds GDP1. The difference between DS1 and GDP1 represents the current account deficit as well as the value of the outstanding principal on the foreign loans. The extra consumption the country can enjoy is possible because it borrows funds from abroad and uses them to purchase extra imports. The result is the potential for a higher standard of living in the country in the period in which it runs a current account deficit if the extra funds are not directed into domestic investment.

In the second period the borrowed funds must be repaid with interest. The repayment reduces domestic spending below the level of GDP by the amount of the principal and interest repayment as shown by the light colored areas in the diagram.(1) Since GDP does not change between the two periods, DS2 will lie below GDP1. What this means is that the average standard of living can fall during the period in which the loan repayment is being made.

This outcome highlights perhaps the most important concern about trade deficits. The fear is that large and persistent trade deficits may require a significant fall in living standards when the loans finally come due. If the periods are stretched between two generations, then there is an intergenerational concern. A country running large trade deficits may raise living standards for the current generation, only to reduce them for the next generation. It is then as if the parents' consumption binge is being subsidized by their children.

Case 2: The individual analogy

In case two our individual, Amine, would again have a $30,000 income in two successive periods. In the first period suppose Amine borrows money, perhaps by running up charges on his credit card. Suppose these charges amount to $5000 and that the interest rate is a generous 10%. Assuming Amine does not save money in the first period, his consumption level in period 1 would be the sum of his income and his borrowed funds. Thus he would enjoy $35,000 worth of goods and services reflecting a standard of living higher than his actual income.

In the second period Amine must pay back the $5000 in loans plus the interest charges, which, at a 10% interest rate, would amount to $500. Thus $5,500 of Amine's $30,000 income would go towards debt repayment leaving him with only $24,500 to spend on consumption.

In this case, extra consumption, or a higher living standard in period one, is achieved by sacrificing a lower living standard in the future.

Note that in the first period Amine imports more goods and services in consumption than he exports in terms of labor services. Hence this corresponds to a trade deficit. In the second period, Amine imports fewer goods and services in consumption than the labor services he exports, hence this corresponds to a trade surplus.

Case 2 Evaluation

Case 2 reflects legitimate concerns about countries that run large or persistent trade deficits. The case highlights the fact that trade deficits which arise from international borrowing may require a reduced average standard of living for the country in the future when the loans must be repaid.

An example of this situation would be Mexico during the 1970s and 80s. Mexico ran sizeable current account deficits in the 1970s as it borrowed liberally in international markets.

In the early 1980s, higher interest rates reduced its ability to fulfill its obligations to repay principal and interest on its outstanding loans. Their effective default, precipitated the third world debt crisis of the 1980s. During the 80s, as arrangements were made for an orderly, though incomplete, repayment of Mexico's loans, the country ran sizeable current account surpluses. As in case two here, Mexico's current account deficits in the 70s allowed it to raise its average living standards, above what would have been possible otherwise, while its current account surpluses in the 80s forced a substantial reduction in living standards.

It is worth emphasizing that current account deficits are not detrimental in the periods in which the deficits are occurring. In fact, current account deficits correspond to higher consumption, investment and government spending levels than would be possible under balanced trade. Instead, current account deficits pose a problem only when the debt repayment occurs which is when the country is running current account surpluses. Trade deficits raise national welfare in the periods in which they occur, while trade surpluses reduce welfare in the periods in which they occur.

In other words, in terms of the national welfare effects, the problem here isn't large or persistent trade deficits, but rather, the large and persistent trade surpluses that might arise in the future as a result.

It is also worth noting that trade deficits in this case need not be a problem in the long run if they are not too large. Just as an individual may make a choice to substitute future consumption for present consumption, so might a nation. For example, an individual might reasonably decide while young, to take exotic vacations, engage in daredevilish activities, or maybe purchase a fast car, even if it means taking out sizeable loans. Better to enjoy life while healthy, he might reason, even if it means that he will have to forego similar vacations or activities when he is older. Similarly, a nation, through a aggregation of similar individual decisions, might "choose" to consume above its income today even though it requires reduced consumption tomorrow. As long as the future reduced consumption "costs" are borne by the individuals who choose to over-consume today, deficits for a nation need not be a problem. However, if the decision to over-consume is made through excessive government spending, then the burden of reduced consumption could fall on the future generation of taxpayers in which case there would be an intergenerational welfare transfer..

Case 3:
(Current Account deficit period 1; Positive GDP Growth between periods)

In case 3 we assume, as in case 2, that the country runs a trade deficit in the first period, that the trade deficit corresponds to borrowing from the rest of the world and that in period 2 all of the loans are repaid with interest. What differs here is that we will assume GDP growth occurs between periods 1 and 2. As we'll see growth can significantly affect the long term effects of trade deficits.

In the adjoining diagram note that period 1 domestic spending, DS1, lies above GDP in period 1, GDP1. This arises because a trade deficit implies that the country is borrowing from the rest of the world which, in turn, allows it to spend (and consume) more than it produces.

In period 2 we assume that GDP has grown to GDP2 as shown in the graph. The principal and interest from first period loans are repaid which lowers domestic spending to DS2. Note that since domestic spending is less than GDP2, the country must be running a trade surplus. Also note that the trade surplus implies that consumption, and the average standard of living, is reduced below the level obtainable with balanced trade in that period. In a sense, then, the trade deficit has a similar long-term detrimental effect as in case two.

However, it is possible that the first period trade deficit, in this case may actually be generating a long-term benefit. Suppose for a moment that this country's balanced trade outcome over two periods would look like the base case, case 1. In that case, balanced trade prevails but no GDP growth occurs, leaving the country with the same standard of living in both periods. Such a country may be able to achieve an outcome like case 3, if, it borrows money from the rest of the world in period one, - thus running a current account deficit - and uses those funds to purchase investment goods, which may in turn stimulate GDP growth. If GDP rises sufficiently, the country will achieve a level of domestic spending that exceeds the level that would have been obtained in the base case.

Indeed, it is even possible for a country's standard of living to be increased in the long term entirely because it runs a trade deficit. In case three, imagine that all of the borrowed funds in period one are used for investment. This means that even though domestic spending rises, the average standard of living would remain unchanged, relative to the base case, because investment goods generate no immediate consumption pleasures. In period two, the higher level of domestic spending may be used for increased consumption which would cause an increase in the country's average living standards. Thus, the country is better-off in both the short term and long term with the unbalanced trade scenario compared to the balanced trade case.

Case 3: The individual analogy

Case 3 is analogous to our individual Amine with, say, a $30,000 income in period one. The trade deficit in the first period means that he borrows money using his credit card to purchase an additional, say, $5000 worth of "imported" consumption goods. Thus, in period one the person's consumption, and standard of living is higher than reflected by his income.

In the second period, GDP rises which corresponds to an increase in the Amine's income. Let say that his income rises to $40,000 in the second period. We'll also assume that all credit card loans must be repaid along with 10% interest charges in the second period. Consumption spending for Amine is now below his income. Subtracting the $5000 principal repayment and the $500 interest payment from his $40,000 income yields consumption of $34,500.

The investment story above is similar to the case where an individual takes out $5000 in student loans in period one, earns an advanced degree, which allows him to acquire a better paying job. Assuming the educational investment does not add to his consumption pleasures, (a seemingly reasonable assumption for many students), his welfare is unaffected by the additional spending that occurs in period one. However, his welfare is increased in period two since he is able to consume an additional $4500 worth of goods an services even after paying back the student loans with interest.

Case 3 Evaluation

The lesson of case 3 is that trade deficits, even if large or persistent, will not cause long term harm to a nation's average standard of living, if the country grows rapidly enough. Rapid economic growth is often a cure-all for problems associated with trade deficits.

In some cases it is possible for growth to be induced by investment spending made possible by borrowing money in international markets. A trade deficit that arises in this circumstance could represent economic salvation for a country rather than a sign of economic weakness.

Consider a less-developed country. Countries are classified less developed because their average incomes are very low. Indeed, although many LDCs have a small, wealthy upper class, most of the population lives in relative poverty. Individuals that are poor rarely save very much of their incomes, therefore, LDCs generally have relatively small pools of funds at home that can be used to finance domestic investment. If investment is necessary to fuel industrialization and economic growth, as is often the case especially in early stages of development, an LDC might be forced to a slow or non-existent growth path if it restricts itself to balanced trade and limits its international borrowing.

On the other hand, if an LDC borrows money in international financial markets, it will by default run a trade deficit. If these borrowed funds are used for productive investment which, in turn, stimulates sufficient GDP growth, then the country may be able to raise average living standards even after repaying the principal and interest on international loans. Thus, trade deficits can be a good thing for less developed countries.

The same lesson can be applied to the economies in transition in the former Soviet bloc. These countries suffered from a lack of infrastructure and a dilapidated industrial base after the collapse of the Soviet Union. One obvious way to spur economic growth in the transition is to replace the capital stock with new investment. Build new factories, install modern equipment, improve the roads and telecommunications, etc. However, with income falling rapidly after the collapse there were few internal sources to fund this replacement investment. It was also not obvious which sectors were the best to invest. Nevertheless, one potential option was for these countries to borrow funds on international financial markets. Trade deficits, that would occur under this scenario, could be justified as an appropriate way to stimulate rapid economic growth.

Of course, just because trade deficits can induce economic growth and generate long term benefits for a country, doesn't mean that a trade deficit will spur long term economic growth. Sometimes investments are made in inappropriate industries. Sometimes external shocks cause once profitable industries to collapse. Sometimes borrowed international funds are squandered by government officials and used to purchase large estates, and big cars. For many reasons good intentions, and good theory, do not always produce good results. Thus, a country that runs large and persistent trade deficits, hoping to produce the favorable outcome shown in case three, might find itself with the unfavorable outcome shown in case two.

Finally a country running trade deficits could find itself with the favorable outcome even if it doesn't use borrowed international funds to raise domestic investment. The US, for example, has had rather large trade deficits since 1982. By the late 1980s the US achieved the status of the largest debtor nation in the world. During this same period domestic investment remained relatively low especially in comparison to other developed nations in the world. One might quickly conclude that since investment was not noticeably increased during the period, the US may be heading for the detrimental outcome. However, the US maintained steady GDP growth during the 80s and 90s with the exception of the recession year in 1992. As long as growth proceeds rapidly enough, for whatever reason, a country with persistent deficits can wind up with the beneficial outcome.

Case 4:
(Current Account surplus period 1; No GDP Growth between periods)

In this case we assume that the country runs a trade surplus in the first period and that no GDP growth occurs between periods. A surplus implies that exports exceed imports of goods and services and that the country has a financial account deficit. We will assume that the financial account deficit corresponds entirely to loans made to the rest of the world. We can also refer to these loans as saving, since the loans imply that someone in the country is forgoing current consumption. In the future, these savings will be redeemed along with the interest collected in the interim. We shall assume that all of these loans are repaid to the country, with interest, in the second period.

In the adjoining diagram we see that in the first period, when the trade surplus is run, domestic spending, DS1, is less than national income or GDP. This occurs because the country is lending, rather than consuming, some of the money available from production. The excess of exports over imports represents goods which could have been used for domestic consumption, investment, and government, but are instead being consumed by foreigners. This means that a current account surplus reduces a country's potential for consumption and investment below that achievable with balanced trade. If the trade surplus substitutes for domestic consumption and government spending, then the trade surplus will reduce the country's average standard of living. If the trade surplus substitutes for domestic investment, then average living standards would not be affected, but the potential for future growth can be reduced. In this sense trade surpluses can be viewed as a sign of weakness for an economy, especially in the short-run during the periods the surpluses are run. Surpluses can reduce living standards and the potential for future growth.

Nevertheless this does not mean that countries should not run trade surpluses or that trade surpluses are necessarily detrimental over a longer period of time. As shown in the diagram, when period two arrives the country redeems its past loans with interest. This will force the country to run a trade deficit and domestic spending, DS2, will exceed GDP. The trade deficit implies imports exceed exports and these additional imports can be used to raise domestic consumption, investment and government spending. If the deficit leads to greater consumption and government spending, then the country's average standard of living will rise above that achievable with balanced trade. If the deficit leads to greater investment, then the country's potential for GDP growth in the third period (not shown) is enhanced.

In brief, this case describes the situation in which a country forgoes first period consumption and investment so that in period two it can enjoy even greater consumption and investment.

Case 4: The individual analogy

Consider our individual, Amine, who has an annual income of $30,000 over two periods. This corresponds to the constant GDP in the above example. Amine would run a trade surplus in period one if he lends money to others. One way to achieve this is simply to put money into a savings account in the local bank. Suppose Amine deposits $5000 into a savings account. This money is then used by the bank to make loans to other individuals and businesses, thus, in essence Amine is making loans to them with the bank acting as an intermediary. The $5000 also represent money that Amine does not use to buy goods and services. Thus, in period one Amine exports $30,000 of labor services, but imports only $25,000 of consumption goods. The excess is loaned to others so that they might consume instead in the first period. It is clear that Amine's standard of living, at $25,000, is lower in the first period than the $30,000 he could have achieved had he not deposited money into savings.

In the second period, we imagine that Amine again earns $30,000 and withdraws all of the money plus interest from the savings account. Suppose he had earned 10% interest between the periods. In this case his withdrawal would amount to $5,500. This means that in period two Amine can consume $35,500 worth of goods and services. This outcome also implies that Amine's domestic spending capability exceeds his income and so he must be running a trade deficit. In this case Amine's imports of goods and services at $35,500, exceeds his exports of $30,000 worth of labor services, thus he has a trade deficit.

Is this outcome good or bad for Amine? Most would consider this a good outcome. One might argue that Amine has prudently saved some of his income for a later time when he may have a greater need. The story may seem even more prudent if Amine suffered a significant drop in income in the second period to, say, $20,000. In this case the savings would allow Amine to maintain his consumption at nearly the same level in both periods despite the shock to his income stream. This corresponds to the words of wisdom that one should save for a rainy day. Savings can certainly allow an individual to smooth his consumption stream over time.

Alternatively, one might consider the two periods of the story to be middle age and retirement. In this case it would make sense to save money out of one's income in middle age so that one can draw upon those savings and their accumulated earnings during retirement when one's income has fallen to zero.

On the other hand, excessive saving in the first period might make Amine seem miserly. Few people would advise that one save so much as to put oneself into poverty or to reduce one's living standard below some reasonable norm. Excessive prudence can seem inappropriate as well.

Case 4 Evaluation

The prime example of a country that mimics the first period of case four is Japan during the 1980s and 1990s. Japan ran sizeable trade surpluses during those two decades. As this story suggests, the flip side of the trade surplus is a financial account deficit which implied a considerable increase in the amount of loans that Japan made to the rest of the world. Although Japan's trade surplus has often been touted as a sign of strength, an important thing to keep in mind is that Japan's trade surpluses implied lower consumption and government purchases, and thus a lower standard of living than would have been possible with balanced trade. Although trade surpluses can also result in lower investment, this effect was not apparent for Japan. During those two decades investment spending as a percentage of GDP always exceeded 25%, higher than most other developed countries.

These surpluses may turn out to be especially advantageous for Japan as it enters the 21st century. First of all, it is clear that Japan's surpluses did not usher in an era of continual and rapid GDP growth. By the early 1990s Japan's economy had become stagnant and finally began to contract by 1998. However, rather than allowing a decline in GDP to cause a reduction in living standards, Japan can use its sizeable external savings surplus to maintain consumption at the level achieved previously. Of course this would require that Japan increase its domestic consumption and begin to run a trade deficit; two things which in 1998 do not seem to be occurring.

In another respect Japan's trade surpluses may be advantageous over the longer run. Japan, along with most other developed nations, will experience a dramatic demographic shift over the next three decades. Its retired population will continue to grow as a percentage of the total population as the post-world war II baby-boom generation reaches retirement and because people continue to live longer. The size of the Japan's working population will consequently decline as a percentage of the population. This implies an increasing burden on Japan's pay-as-you-go social retirement system as a smaller number of workers will be available per retiree to fund retiree benefits. If at that time Japan draws down its accumulated foreign savings and runs trade deficits, it will be able to boost the average consumption level of its population while reducing the need to raise tax burdens to fund its social programs. Of course this outcome may never be realized if Japan's economy does not rebound strongly from its recent stagnant condition.

All in all, regardless of the outcome, Japan's economy, today faced with a potentially severe recession, is certainly in a stronger position by virtue of its accumulated foreign savings than it would be if it had run trade deficits during the past two decades.

1. In actuality, the interest repayment component may be included as part of domestic spending since interest represents a payment for services received - those services being the privilege of consuming earlier. However, since this service is unlikely to raise one's standard of living in period two we have excluded it from domestic spending.

International Finance Theory and Policy - Chapter 6-1: Last Updated on 6/3/04