Understanding this is a key to International Trade Policy
Balance of Trade vs. Balance of Payments:
The balance of trade is the difference between the value of a country's exports and imports of goods and services. The balance of payments is the difference between the inflow of foreign exchange and the outflow of foreign exchange from both trade and investment.
Balance of trade is a very important, but misunderstood, statistic. And this leads many people to think that we have a problem that doesn't exist. Let me explain.
The US is a very rich country, with by far the largest GDP in the world, and among the highest GDPs per capita. We consume a lot. It’s a good thing that our past policies have gotten us to be a wealthy economy.
International trade is a good thing for world economies and a key reason that the world has grown richer. It is optimal when there is free trade and we can buy what we want at the best prices from those countries that can produce goods more efficiently. Both parties benefit from this free exchange; we get the goods/services we want from the most efficient producers, and they get to sell to us at a profit .
It works both ways - we also sell to other countries the things that we produce that they can’t or don’t produce as efficiently (or don’t produce enough to meet their needs). But because of our wealth, we buy much more from foreign countries than we sell to them, which creates a large trade deficit. For example, in February, 2023, the US had a trade deficit of 70.5 billion dollars. This results from a trade deficit for goods of 93 billion dollars, offset by a trade surplus for services of 22.5 billion dollars (the total imports were 321.7 billion dollars, and exports were 251.2 billion dollars).
So, for any given year we may have a trillion dollar trade deficit split between many different countries. The foreign countries that export to us end up with dollars we pay them to buy their products which exceeds the amount they pay to us for our products.. Since our currency has no intrinsic value; it is only valuable insofar as it can be used to purchase goods and services or to invest. That is where the balance of payments (which includes both trade and investment) comes into play, as the investment component are those dollars flowing back into the US.
What happens to the trillion dollars foreign countries accumulated by exporting to the US? Most of it comes back in one of three forms: (1) foreign purchases of American bonds, mainly government bonds, (2) foreign purchases of other assets such as stocks, land, and property, and (3) so-called direct investment whereby foreigners build plants and equipment in the United States. Overall, the Balance of Payments tends to zero out as the flows back to us for these investments equal the flows out to them as a result of the Trade Deficit.
A trade deficit is not a problem. For more information on this please see these two short articles, one from Foundation for Economic Education, or this article from Dan Mitchell.
What becomes a problem is politicians trying to interfere with free trade in an effort to get rid of a non-existent problem, because they don’t understand it, or because they are trying to protect some favored industry, or because it just ‘sounds bad’ to have a large negative trade deficit. The interference comes in the form of tariffs and quotas trying to protect some businesses and reduce the deficit (purchases from foreigners will slow as tariffs make prices of imported goods higher). That translates into higher prices for you and me, and that, my friends, is called inflation, which hurts everyone, especially those with lower incomes. The government collects these tariffs from sellers to this country, but we are the ones paying the tariff via higher prices. It is indirectly a tax on us going to the government. This interference with the market is often to benefit politically-connected companies, cronyism at its worst. We pay, they benefit.
And radical impositions of tariffs can do great damage to world economies. This is what happened when President Hoover passed, against economists’ objections, the Smoot-Hawley Tariffs in 1930, leading to a worldwide collapse of trade and contributed greatly to the Depression.
BOTTOM LINE
Quit worrying about the negative trade balance. It means we have more wealth than others. What we should be concerned about is the crony protectionism of select industries, via tariffs and quotas, which is harmful to our economy and our pocketbooks. Free trade is the best policy unless there are overriding considerations for a few key industries.
Buy American? That’s fine - if it is the best value for your buck! But forcing the government, companies, or its citizens to Buy American, when it is not in our best interest, is just plain stupid.
LEARN ECONOMICS, THEN VOTE SMART