The balance of payments myth

In March, the US trade account balance stood at a deficit of $50 billion against a deficit of $49.28 billion in February and a deficit of $47.4 billion in March last year.


Most commentators consider the trade account balance as the single most important piece of information regarding the health of the economy.


According to the widely accepted view, a surplus on the trade account is considered as a positive development while a deficit is perceived in a negative light. What is the reason for this?


By popular thinking, the key to economic growth is demand for goods and services.  Increases and decreases in demand are behind the rises and declines in the economy’s production of goods. Hence, in order to keep the economy going economic policies must pay close attention to the overall demand.


Now, part of the demand for domestic products emanates from overseas. The accommodation of this type of demand is labelled exports. Likewise, local residents exercise demand for goods and services produced overseas, which is labelled import.


It is held that while an increase in export strengthens the demand for domestic output, an increase in import weakens the demand. Exports, according to this way of thinking, are a factor that contributes to economic growth whilst imports detract from the growth of the economy. Hence whenever imports exceed exports a trade deficit emerges and this is bad news for economic activity as depicted by the gross domestic product – GDP.


The deficit is viewed as a symptom of bad economic health. Subsequently, by the popular way of thinking what is required is a boost in exports and a curtailing of imports in order to reduce the deficit.


This, it is held, will lead to improved economic health. The popular view maintains that it is the role of the government and the central bank to introduce a suitable mix of policies, which will guide the economy along the path towards a “favorable” trade account balance.


As a result of the so-called unfavorable trade account balance, the US has recently lifted its tariffs on imports from various countries, in particular China, in order to make the trade balance “more favorable” (see chart). However, does it all make sense?




Trade account balance in market economy

In a market economy, each individual sells goods and services for money and uses money to buy desired goods and services. The goods and services sold by an individual could be termed export, while the goods and services bought could be termed import. The record of such monetary exchanges for any period could be labelled as the trade account balance.


In a free market economy individuals’ decisions regarding the selling and the buying of goods and services i.e. export and import is made voluntarily, otherwise it would not be undertaken. The emergence of an exchange between individuals implies that they expect to benefit.


Whenever an individual plans to import more than he exports the shortfall will be balanced either by running down existing savings or by borrowing. The creditor who supplies the required funds does so because he expects to profit from that.


The current practice of lumping individual’s trade account balances into a national trade account balance is of little relevance to businesses.


What possible interest can a business have with the national trade account balance? Will it assist him, in his business conduct? Since there is no such thing as the US PTY Ltd that can be bought or sold in the market the national trade account balance, will be of no use to businesses.


While the national trade account balance is of little economic significance and is a sterile concept, individual or company trade account balances are real things that carry economic significance.


For instance, the trade account statement of a particular company could be of assistance to various present and potential investors in that company. Again, this is not the case with the national trade account balance.


While the national trade account balance is a harmless definition, the government reaction to it produces harmful effects. Government policies that are aimed at attaining a more “favorable” trade account balance by means of monetary and fiscal policies disrupt the harmony in the market place. This disruption leads to a shift of scarce resources away from the production of most desired (by consumers) goods and services, towards the production of less desirable goods and services.


Furthermore it is not the US that export wheat, but a particular farmer or a group of farmers who export wheat. They are engaged in the export of wheat because they expect to profit from that.


Similarly, it is not the US that imports Japanese electrical appliances, but an individual from the US or a group of Americans. They import these appliances because they believe that a profit can be made.


If the national trade account balance is an important indicator of the economic health, as various commentators imply, one is then tempted to suggest that it would be a sensible idea to have trade account balances of cities or regions. After all, if we could detect the economic malaise in a particular city or a region, the treatment of the national malaise could be made much easier.


Imagine then that the economists in New York have discovered that their city has a massive trade account deficit with Chicago. Does this mean that the city of New York authority should step in to enforce the reduction of the deficit by banning imports from Chicago?


Luckily, we do not have inter-city trade account balances and it seems that no one is concerned with this issue. Yet the principle of the inter-city trade account balances is also valid for the national trade account balance.


The concern expressed by many commentators that an “unfavorable” trade account balance is bad for the economy is questionable. No individual or group of individuals can suffer as a result of “unfavorable” trade account balance. An important reason for suffering can emerge from a drop in incomes of individuals because of government tampering with the economy.


Again, the enthusiasm and excitement revealed by the financial markets towards the trade account data is not because of its importance, but because of the expected response of the government and the central bank to the data.


Economists and analysts spend much of their time guessing the likely response of the government or the central bank to a particular trade account balance. Various methods are employed to forecast the trade gap and its implications on the government’s reaction. Sophisticated econometric models are used to produce various possible outcomes. However, all of that is barely related to true economic fundamentals that from time to time awaken analysts by means of sudden shocks.


The fallacy of the national trade account balance concept is also relevant to the national foreign debt. There is no such thing as the national foreign debt since nations as such do not borrow or lend only individuals can do that.


Consequently, if an American lends money to an Australian the entire transaction is their own private affair and is not of concern to any other. Both the American and the Australian are expecting to benefit from this transaction.


Lumping individuals’ foreign debt into the total national foreign debt is thus also another questionable practice. What is this total supposed to mean? Who owns this debt? What about all those individuals who do not have foreign debt? Should they also be responsible for the national foreign debt?


The only situation in which individual Australians should be concerned with foreign debt is when the government incurs the debt. The government is not wealth generating unit and as such derives its livelihood from the private sector.


Consequently, any foreign government debt incurred means that the private sector will have to foot the bill sometime in the future.


Summary and Conclusions

According to popular thinking, a widening in the trade account deficit is seen as negative for economic prosperity since it undermines the growth rate of Gross Domestic Product (GDP).  On this way of thinking, the government and the central bank are expected to intervene with policies that will result in the decline in the trade account deficit. We suggest that government and central bank policies designed to trim the deficit can only lead to the misallocation of scarce resources and the lowering of individual’s living standards.



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