Trade Imbalances Overview

There is a popular and pervasive myth about international trade. The myth, simply stated, is that trade deficits are bad and trade surpluses are good. Good or bad for whom one might ask? Well, for the entire country.

The presence of a trade deficit or an increase in the trade deficit in a previous month or quarter is commonly reported as a sign of economic weakness. Similarly, a decrease in a trade deficit, or the presence or increase in a trade surplus is commonly viewed as a sign of strength in an economy.

Unfortunately, these perceptions and beliefs are somewhat misguided. It is simply not true, in general, that a trade deficit is a sign of a weak economy and a trade surplus is a sign of a strong economy. Merely knowing that a country has a trade deficit, or that a trade deficit is rising, is not enough information to say anything about the current or future prospects for a country. And yet, that is precisely how the statistics are often reported.

The truth about trade deficits is that sometimes they are good, sometimes they are bad, but, most times they are immaterial (i.e., they don't matter). There are situations in which trade deficits should be interpreted as a sign of a strong thriving economy. There are other situations in which trade deficits should be interpreted as a signal of economic problems. In most situations, however, trade deficits are not large enough to warrant a positive or negative interpretation. In this case they should be viewed without interest. These same points hold for trade surpluses as well.

The purpose of this section is to explain, clearly and intuitively, the circumstances in which trade imbalances should be interpreted as good and the circumstances in which they are bad. The section will show situations in which trade deficits can indeed lead to long-term harm for an economy. However, it will also show cases in which trade deficits significantly improve a country's long-term economic prospects. We will highlight cases in which trade surpluses are appropriate and a sign of strength for a country, and we will show other cases in which trade surpluses may correspond to current demise or even an eventual collapse of an economy.

Most importantly, one should realize after reading this section, that merely knowing that a country has a trade deficit or surplus is not enough information to say anything substantive about the strength of a country or its economic prospects.

International Finance Theory and Policy - Chapter 6-0: Last Updated on 8/20/03