What is a trade deficit and how does it affect the economy?

Trade between nations is a mainstay of the global economy. It provides consumers and industry with a wide range of goods and services that may not otherwise be available in the country where they live.

Forecasts for 2023 from the World Trade Organization (WTO) paint a bleak picture that may affect the balance of trade between countries in an already difficult economic climate. The WTO has downgraded its trade growth forecast from 3.4% to just 1.0% for next year. Rising inflation, energy prices and the instability caused by Russia’s invasion of Ukraine are all putting pressure on global trade.

Most countries are both importers and exporters. They sell goods that they have in abundance to other countries, while using international markets to buy any products that are in short supply domestically. When the balance between imports and exports becomes skewed, a country can find itself in a trade surplus or trade deficit.

A trade deficit occurs when a country imports more than it exports. In other words, when a country buys more than it sells, it has a trade deficit.

The word “deficit” can have negative connotations; we use it to mean lacking or to describe shortages. When used in the context of global trade, this often leads to an assumption – that trade deficits are unequivocally negative for economies. Let’s address two of the biggest misconceptions.

They can be – but not exclusively. Notably, trade deficits allow countries to consume more than they produce. This can help increase economic activity and boost living standards.

The World Economic Forum’s Global Future Council on Trade (GFCT) takes the view that; “trade deficits are not necessarily bad and are not a measure of whether trade policies or agreements are fair or unfair”. The GFCT concludes “there is no straightforward relationship between the state of a nation’s trade balance and the state of its economy”.

The United States, one of the world’s most powerful economies, has run a trade deficit since the 1970s as the chart below illustrates.

The Congressional Research Service (CRS), a US government policy research organization, notes that “most economists conclude the trade deficit stems largely from U.S. macroeconomic policies and an imbalance between saving and investment in the economy”. It adds that “trade creates both economic benefits and costs, but that the long-run net effect on the economy as a whole is positive”.

When a large trade deficit exists between nations, it is frequently accompanied by assertions that excess imports are destroying jobs in the local manufacturing sector. This claim, however, is often unsupported, according to experts.

The United States, for instance, has a significant trade deficit with China, and attempts to reduce the deficit have largely failed to increase US manufacturing jobs.

“Most economists argue that equating a trade deficit, whether on a bilateral basis or overall, with unemployment or job losses is questionable given the macroeconomic origin of the trade deficit and the relatively limited role that trade plays in the overall U.S. economy,” the CRS report added.

Analysis from the Center for Strategic International Studies (CSIS) in 2021 also paints a nuanced picture of the relationship between US trade and jobs. “The net effect of trade saw a loss of 3.5 million workers,” the CSIS report notes, before adding: “This number is not large when compared to the size of the labor force (over 150 million) or the growth in employment by 40 million jobs from 1991 to 2019”.

The study concludes that efficiencies in the US manufacturing sector had a much greater impact than trade on the decline of manufacturing jobs as a percentage of the wider US workforce. “The bottom line is that almost the entire decline from 32 percent of the labor force in 1955 to 8 percent in 2019 was not caused by imports but by higher productivity,” CSIS states.

Today, with economic indicators flashing red, the WTO is urging nations to avoid protectionist trade policies.

“While trade restrictions may be a tempting response to the supply vulnerabilities that have been exposed by the shocks of the past two years, a retrenchment of global supply chains would only deepen inflationary pressures, leading to slower economic growth and reduced living standards over time,” WTO Director-General Ngozi Okonjo-Iweala warned in a recent statement. “What we need is a deeper, more diversified and less concentrated base for producing goods and services.”