Trade Deficits: Accounting Masquerading as Economics

For 2023, the year for which we have the most current data, the total US trade deficit fell from $951.2 billion to $773.4 billion. What does this mean, and should we actively pursue reducing it further?

Trade deficits are one of, if not the, most misunderstood concepts in all of economics. The Build America Buy America Act, which this month celebrates its second anniversary of taking effect, seeks to reduce trade deficits by restricting the use of imported goods for certain infrastructure projects. Last month, President Biden suggested reducing our trade deficit with China by "tripling the tariff rates for both steel and aluminum imports from China." Former President Donald Trump has stated that he also seeks to reduce trade through aggressive tariffs, floating a "10 percent tariff on all imports, and a more than 60 percent tariff on Chinese imports" to create a "ring around the country." The former President and his advisors have even gone so far as to suggest devaluing the US dollar as a means of reducing trade deficits. The misunderstanding of the effects of trade deficits on economies pervades Washington, DC. It is time to correct this misunderstanding.

A trade deficit is merely an accounting identity, not an economic identity.

Despite this truth, policymakers of all stripes fundamentally treat trade deficits as if they were a source of economic harm to the nation. To understand what a trade deficit is, we must first take a slight detour to understand a related concept: gross domestic product (GDP).

At its core, GDP is a measure of the total value of all the economic output produced in a country in one year. Conceptually, it is broken down into four components: consumption (C), investment (I), government spending (G), and net exports (NX). Because of this, we can say:

GDP = C + I + G + NX

Net exports is the source of the concept of "trade deficits" and the source of much confusion. We define net exports as "the total value of exports (E) minus the total value of imports (M)." If imports exceed exports, then net exports will be negative, and we experience a trade deficit. If exports exceed imports, then we will be experiencing a trade surplus. We can rewrite the above equation as:

GDP = C + I + G + E - M

The "minus M" term would imply, to the untrained, that imports reduce GDP within a country. The logic goes that if we could somehow reduce imports, we would increase GDP by the same amount of the reduction. This logic has been used by elected officials and Washington bureaucrats of both stripes for decades. It has even pervaded popular culture and news commentary.

Unfortunately, this logic has a flaw.

Remember: GDP seeks to measure the total value of all the economic output produced in one year within a country's borders. Counting exports as a positive makes clear sense: Exports are economic goods produced domestically and sold internationally. Because they were produced in the US, they count toward the US's domestic product.

Subtracting imports, though, seems strange - why not just ignore them entirely and not include them in our definition of GDP at all?

Consider the following truism: US consumers purchase many items each year, some of which were made in the US and some produced abroad for import. But consumption spending (C) includes all consumption spending that US consumers engage in, and therefore includes spending on both domestically produced goods and services and foreign-produced goods and services. We can use similar logic to break Investment and Government Spending down into their domestic and foreign components.

Since GDP is supposed to be a measure of only domestic production, the domestic spending on consumption, investment, and government spending on foreign goods and services should not be included. Since it already is, we must subtract it from our total. To do this, we must realize something very clever. If we were to add together all the foreign consumption spending, the foreign investment spending, and the foreign spending by the US government, that would account for all the import spending, since those are the only categories into which any spending must fall.

So why do we subtract imports from GDP? Because they have been added elsewhere in our calculation for GDP, and need to be subtracted. By the very definition of GDP, we must subtract imports from whatever figures to arrive at an accurate number. To not subtract imports would be tantamount to counting other countries' production as our own, which is clearly not true.

What would happen if, for example, Biden or Trump were successful in reducing imports of, say, legwarmers? All told, the US imported about $4.2 million worth of legwarmers in 2023. Because consumers purchase legwarmers, there would be $4.2 million worth of consumer spending (C). Because the legwarmers were produced abroad and purchased here, there would also be $4.2 million worth of imports (M). If we were to successfully prevent the importation of legwarmers, we would add $4.2 million fewer dollars to consumption and we would subtract $4.2 million fewer dollars of imports. The total effect of this would be zero. While legwarmers might seem like an absurd example, the same logic works for all forms of spending in the US on imported goods. Reducing imports by any amount of dollars would reduce consumption, investment, or government spending by an equal amount, as well, for a net effect on GDP of zero.

From this, we can plainly see that reducing "imports" would not, in fact, increase GDP at all. At best, doing so would leave GDP unchanged since we would be adding less to consumption, investment, and government spending while subtracting equally less from imports. More likely, it would reduce GDP, since we would have to produce more goods and services ourselves instead of benefitting from international trade and increased specialization.

Policy makers and the would-be-intelligentsia of both the American Right and the American Left who carp on about the trade deficit and use it as a means of speaking authoritatively on the state of the US economy reveal one thing: a stunning lack of understanding about which they speak. Trade deficits are merely an accounting number, nothing more and equally, nothing less.