Are trade deficits bad for the economy?

The short answer is "no", unless the trade deficits are greater than about 3 percent of GDP for several years. Let's see why but, first, let's recall the terminology: an economy runs a trade deficit if the volume of its exports of goods and services is less than the volume of its imports. The United States has run trade deficits since the 1970’s while China has been running mostly trade surpluses.

When is the trade deficit too big?

Running a trade deficit means that the U.S. is purchasing more goods and services from the rest of the world than the world is purchasing from the U.S. The U.S. receives foreign money when it sells products and needs foreign money when it buys products. If it sells less than it wants to buy, the U.S. needs additional amounts of foreign currencies. Part of the needed foreign money is obtained by borrowing from the rest of the world. For example, the U.S. borrows Chinese yuan from China and uses the borrowed funds to buy Chinese products.

Therefore, running a trade deficit means that the country takes on more international debt. If the trade deficit is, for example, 500 billion dollars in 2010, then foreign debt will increase by about 500 billion dollars in 2010. If the trade deficit is again 500 billion dollars in 2011, the debt will increase by another 500 billion dollars. None of the debt will be repaid, it only increases. The debt can be repaid if the country runs a trade surplus.

So, the debt keeps increasing. The question is whether it increases relative to the size of the economy. If the GDP also increases by 500 billion dollars every year, then the debt-to-income ratio remains the same. If the economy grows more slowly, then it becomes more indebted relative to its income and it may have difficulty servicing its debts in the future.

Therefore, we have the following rule of thumb: the trade deficit (which is equal to the increase of foreign debt) should not exceed the rate of economic growth for many years. Otherwise, the debt-to-GDP ratio may become too big. Since economies typically grow at about 2-3 percent per year, the rule is that a trade deficit is sustainable if it doesn’t exceed 3 percent of GDP for many years.

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