The trade account balance and the state of economy

By Dr Frank Shostak

Some commentators consider the trade account balance as the single most important piece of information regarding the health of the economy. According to the popular 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 the demand are behind the fluctuations in the economy’s production of goods and services. 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 comes from overseas. The accommodation of this demand is labelled exports. Equally, local residents exercise demand for goods and services produced overseas, which are labelled imports.  

It is held that while an increase in exports strengthens the demand for domestic products, an increase in imports weakens the demand. Exports, according to this way of thinking, is a factor that contributes to economic growth whilst imports detract from the growth of the economy. Hence, 

whenever imports exceed exports, this is considered as bad news for economic activity as depicted by the gross domestic product – GDP.  (Note that in the GDP framework exports add to GDP while imports subtract).

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

This, it is held, will lead to an improved economic wellbeing. 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 “favourable” trade account balance.  But, does it all make sense? 

Individuals trade account balance versus total trade account balance 

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 individuals could be named their exports, while the goods and services bought could be labelled imports. The record of such monetary exchanges for any period could be categorized as the trade balance for that period. 

In a free market economy, individuals’ decisions regarding the selling and buying of goods and services i.e. their exports and imports is made voluntarily, otherwise it would not be undertaken. 

The emergence of an exchange between individuals implies that they expect to benefit from this.  

According to Rothbard,

There is therefore never a need for anyone to worry about anyone else’s balance of payments.

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

The current practice of lumping individual’s trade balances into a national trade balance is of little relevance to businesses. What possible interest can an entrepreneur have with the national trade account balance? Will it assist him, in his conduct of his business? 

According to Mises,

While an individual’s balance of payments conveys exhaustive information about his social position, a group’s balance discloses much less. It says nothing about the mutual relations between the members of the group. The greater the group is and the less homogeneous its members are, the more defective is the information vouchsafed by the balance of payments.

While the national trade account balance is of little economic significance to businesses, individual or company trade balances carry economic importance. For instance, the trade account balance statement of a particular company could be of help to various investors. 

Whereas the national trade account balance data is harmless, the government’s reaction to it can produce harmful effects. Government policies that aimed at attaining a more “favourable” 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 the most desired (by consumers) goods and services, towards the production of less desirable goods and services. 

Besides, it is not the US that exports goods and services but individuals. For example, it is not the US that exports wheat, but a particular farmer or a group of farmers. They are engaged in the exports of wheat because they expect to profit from that.  

Likewise, 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 are of the view that this will make them profit.

If the national trade account statement 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 ascertain the trade balance conditions 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.  

Consider that economists in the New York have discovered that their city has a massive trade 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?  

No individual or group of individuals can suffer as a result of “unfavourable” trade account balance. An important reason for suffering can emerge from a drop in incomes of individuals because of the government tampering with the economy.  

The fallacy of the national trade account balance is also relevant to the national foreign debt.  If an American lends money to an Australian, the entire transaction is their own private affair and is not of any concern to any one else. Both the American and the Australian are expecting to benefit from this transaction. 

Lumping individuals’ foreign debt into the total national foreign debt is a 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 individuals should be concerned with foreign debt is when the government incurs the debt. The government is not a 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 a popular thinking, a widening in the trade 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 trimming of the trade account deficit. We suggest that government and central bank policies designed to reduce the deficit can only lead to the misallocation of scarce resources and the lowering of individual’s living standards. 

More from Dr Frank Shostak
The IMF chief economist sees a threat to world economies from a liquidity trap
In the Financial Times from November 2 2020, the IMF chief economist...
Read More
0 replies on “The trade account balance and the state of economy”