Balance of trade

The balance of trade (or net exports, NX) is the difference between the monetary value of exports and imports in an economy over a certain period of time. A positive balance of trade is known as a trade surplus and consists of exporting more than your imports; a negative balance of trade is known as a trade deficit or, informally, a trade gap. The balance of trade is sometimes divided into a goods and a services balance; especially in the United Kingdom the terms visible and invisible balance are used.
Contents
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    * 1 Definition
    * 2 Economic impact
    * 3 Milton Friedman on trade deficits
    * 4 United States trade deficit
    * 5 Physical trade balance
    * 6 See Also
    * 7 External links

 Definition

The balance of trade forms part of the current account, which also includes other transactions such as income from the international investment position as well as international aid. If the current account is in surplus, the country's net international asset position increases correspondingly. Equally, a deficit decreases the net international asset position.

The trade balance is identical to the difference between a country's output and domestic demand (the difference between what goods a country produces and how many goods it buys from abroad, this does not include money respent on foreign stocks, nor does it factor the concept of importing goods to produce for the domestic market).

Measuring the balance of payments can be problematic because of problems with recording and collecting data. As an illustration of this problem, when official data for all the world's countries are added up, exports exceed imports by a few percent; it appears the world is running a positive balance of trade with itself. This cannot be true, because all transactions involve an equal credit or debit in the account of each nation. The discrepancy is widely believed to be explained by transactions intended to launder money or evade taxes, and other visibility problems. However, especially for developed countries, accuracy is likely to be good.

Factors that can affect the balance of trade figures include:

    * Prices of goods manufactured at home (influenced by the responsiveness of supply)
    * Exchange rates
    * Trade agreements or barriers
    * Other tax, tariff and trade measures
    * Business cycle at home or abroad.

The balance of trade is likely to differ across the business cycle. In export led growth (such as oil and early industrial goods), the balance of trade will improve during an economic expansion. However, with domestic demand led growth (as in the United States and Australia) the trade balance will worsen at the same stage in the business cycle.

 Economic impact

Since the falling from favor of mercantilism, most economists do not believe that trade deficits are inherently good or bad, but must be judged based on the circumstances in which they arose. More radical voices ([1]) would claim that trade deficits are positive, noting the correlation between increasing trade deficits and increasing GDP and employment. Large imbalances may sometimes be a sign of underlying economic problems or rigidities. An example includes a situation where exchange rates have been fixed or pegged for political reasons at levels impeding a correction of a trade imbalance.

The trade deficit is "financed" by a capital account surplus. This includes foreign investment and capital purchases (stocks, bonds ect). An increase in net foreign liabilities tends to lead to an increase in the net outflow of income on international investments. Such payments to foreigners have intergenerational effects: by shifting consumption over time, some generations may gain at the expense of others ([2]). However, a trade deficit may lead to higher consumption in the future if, for example, it is used to finance profitable domestic investment, which generates returns in excess of that paid on the net foreign liabilities (a situation that might arise if a country experiences an unexpected gain in productivity). Similarly, a surplus on the current account implies an increase in the net international investment position and the shifting of consumption to future rather than current generations.

However, trade imbalances are not always indicative of the smooth operation of the market given differences in international productivity and intertemporal consumption preferences. Trade deficits have often been associated with a loss of international competitiveness, or unsustainable 'booms' in domestic demand. Similarly, trade surpluses have been associated with policies that inefficiently bias a country's economic activity towards external demand, resulting in lower living standards. An example of an economy in which a positive balance of payments was regarded as a bad thing by some was Japan in the 1990s. The positive balance was partly the result of protectionist measures that also caused the price of goods in Japan to be much higher than they would have been, had imports been freely allowed. The foreign currency Japanese companies earned overseas remained largely unconverted into yen in order to suppress the yen's value, further preventing Japanese consumers from benefiting from the trade surplus. In addition, the potential benefit from the trade surpluses were partly squandered by spending it on prestige real estate purchases in the United States that often proved unprofitable.

 Milton Friedman on trade deficits

Milton Friedman, the Nobel Prize-winning economist and father of Monetarism, argued that many of the fears of trade deficits are unfair criticisms in an attempt to push macroeconomic policies favorable to exporting[3] industries. He stated that these deficits are not harmful to the country as the currency always comes back to the country of origin in some form or another (country A sells to country B, country B sells to country C who buys from country A, but the trade deficit only includes A and B). In fact, in his view, the "worst case scenario" of the currency never returning to the country of origin was actually the best possible outcome: the country actually purchased its goods by exchanging for pieces of cheaply-made paper. As Friedman put it, this would be the same result as if the exporting country burned the dollars it earned, never returning it to market circulation.

From a mainstream perspective, Friedman's argument is believed to be correct but incomplete. In particular, it is seen by many as ignoring the intergenerational consequences of deficits. If country A has a trade deficit because of large imports of consumer goods, other countries accumulate cash from country A. That money can be used to purchase existing investment assets and government bonds within country A. As a result, the return from those assets will accrue not to citizens of country A but to foreigners. The consumption standard of future generations in country A may therefore potentially decline as a result of the deficit. In particular, Americans are increasingly paying taxes to finance the interest on federal bonds held by foreigners. However, a criticism of this argument notes that all transactions are win-win. In the case of foreign investment in American assets, it helps fuel American economic growth and keeps US interest rates low.

Friedman also believed that deficits would be corrected by free markets as floating currency rates rise or fall with time to encourage or discourage imports in favor of the exports, reversing again in favor of imports as the currency gains strength. A potential difficulty however is that currency markets in the real world are far from completely free, with government and central banks being major players, and this is unlikely to change within the foreseable future.

Friedman and other economists have also pointed out that a large trade deficit (importation of goods) signals that the country's currency is strong and desirable. To Friedman, a trade deficit simply meant that consumers had opportunity to purchase and enjoy more goods at lower prices; conversely, a trade surplus implied that a country was exporting goods its own citizens did not get to consume or enjoy, while paying high prices for the goods they actually received.

Perhaps most significantly, Friedman contended strongly that the current structure of the balance of payments is misleading. In an interview with Charlie Rose, he stated that "on the books" the US is a net borrower of funds, using those funds to pay for goods and services. He pointed to the income receipts and payments showing that the US pays almost the same amount as it receives: thus, U.S. citizens are paying lower prices than foreigners for capital assets to exchange roughly the same amount of income. The reasons why the U.S. (and UK) appear to earn a higher rate of return on their foreign assets than they pay on their foreign liabilities are not clearly understood.

Friedman presented his analysis of the balance of trade in Free to Choose, widely considered his most significant popular work.

 United States trade deficit

The United States has posted a trade deficit since the 1970s, and it has been rapidly increasing since 1997 (see chart below). The US trade deficit hit a record high of 763.6 billion dollars in 2006, up from 716.7 billion dollars in 2005.[4]

 Physical trade balance

Monetary trade balance is different from physical trade balance (which is expressed in amount of raw materials). Developed countries usually import a lot of primary raw materials from developing countries at low prices. Often, these materials are then converted into finished products, and a significant amount of value is added. Although for instance the EU (as well as many other developed countries) has a balanced monetary trade balance, its physical trade balance (especially with developing countries) is negative, meaning that in terms of materials a lot more is imported than exported. That means the ecological footprint of developed countries is larger than that of developing countries.