The Trade Deficit Myth

In 1998, I was a wide-eyed intern at the Cato Institute, and I thought that the "trade deficit" was a really bad thing - right up there with acid rain and sweet-n-low (it was the late 90s, afterall). For years I had heard on the news and read in the newspapers that the trade deficit was a "blot on an otherwise strong economic report" (again, late 90s).

Then I met Dan Griswold. Dan explained pretty quickly how everything I thought I knew about the trade deficit was wrong. He did so pretty easily too, just by using one graph - one so simple that even a political science major from a public university could understand. In the graph, Dan showed that, over the previous 20 years, the trade deficit typically expanded when US GDP growth increased, and it contracted when GDP growth fell. In layman's terms: good economy = expanding deficit; bad economy = contracting deficit. Now, Dan was clear not to foolishly claim that the trade deficit caused GDP to grow, but the correlation was strong, and his handy chart certainly undermined all the doom-n-gloom regarding the trade deficit and the US economy.

And yet that easy 2-minute lessson still hasn't sunk in to the Department of Commerce or the American journalists covering the domestic economy. Case in point: today's GDP stats which showed a 1% contraction in GDP and a shrinking trade deficit. Here's Dan on the unsurprising reporting of those figures:

This morning’s Commerce Department report on second-quarter GDP contained what passes for good news these days: the U.S. economy shrank at an annual rate of only 1.0 percent in the April-to-June quarter. And in the twisted logic of conventional thinking, a drastic fall in international trade was supposedly part of the good news.

An Associated Press report beautifully captures the conventional wisdom. Buried deep in the story was this gem: “An improved trade picture also added to economic activity in the spring. Although exports fell, imports fell more, narrowing the trade gap. That added 1.38 percentage points to second-quarter GDP.”

Behind that statement is the Keynesian assumption that exporting goods adds to GDP, while importing subtracts because every car, shirt, or DVD player we import is supposedly one less that we make ourselves. So never mind that exports have fallen sharply in the past year; imports have fallen even faster, leaving us supposedly better off.

The mistake is seeing imports as a subtraction from GDP. The fact that we import $1 million worth of t-shirts does not mean our GDP is therefore $1 million less than it would be if we did not import the shirts. In fact, the $1 million we sent abroad to buy the shirts quickly comes back to buy something valuable in our own economy.

The money foreigners earn selling in our market can be used to buy U.S.-made goods, but it can also be used to buy U.S. assets, such as stocks, real estate, or Treasury bonds. This investment also creates economic activity, and if the investment inflow is used wisely, it will actually raise our productivity and GDP. A rising level of trade allows us to deploy our economic resources more efficiently, boosting output and economic growth.

As I explain in a previous Free Trade Bulletin, rising imports are not a drag on growth but in fact usually signal rising demand in the domestic economy, just as falling imports are a reliable sign of slumping demand. That is why an “improved” (i.e., shrinking) trade deficit has accompanied every recent recession, including the one we’re still mired in.

If we want our economy to recover and grow, we should be rooting for more trade, not less.

Preach on, Dan. Preach on.