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PAGE ONE Economics

®

International Trade: Making
Sense of the Trade Deficit
Scott A. Wolla, Ph.D., Senior Economic Education Specialist

GLOSSARY
Asset: A resource with economic value that an
individual, corporation, or country owns with
the expectation that it will provide future
income.
Balance of trade: The difference in value
between a country’s exports and imports.
Balance of payments: A summary of all the
transactions involving goods and services
and investment that all individuals, firms,
and the government of one nation makes
with all of those in all other nations in a
given time period.
Budget deficit: Government expenditures
exceed revenues.
Capital and financial account: The section of
a nation’s balance of payments that records
debt forgiveness by and to foreigners and
foreign purchases of assets in the United
States and U.S. purchases of assets abroad.

“I think there is a clear winner for the most misunderstood economics
statistic, and it’s the balance of trade.”
—Timothy Taylor, Managing editor of the Journal of Economic Perspectives

International trade is important to our economy, and its importance has
increased as countries have become more interconnected. But international
trade is not without controversy. Many people are alarmed when they hear
the United States has a trade deficit. In fact, the U.S. trade deficit for 2015
was $531.5 billion, which was a $23.2 billion increase over 2014.1 Why the
concern? Because people usually equate a deficit with failure and a surplus
with success. Specifically, they may think that a deficit means U.S. trade
policy is flawed and the Unite States is losing jobs to other nations. The
trade deficit, however, is more a function of national saving and invest­
ment decisions than of the fairness of international trade or the success of
U.S. firms.

Current account: The section of a nation’s
balance of payments that records its exports
and imports of goods and services, its net
investment income, and its net transfers.

Physical capital: Goods that have been produced and are used to produce other goods
and services. They are used over and over
again in the production process. Also called
capital goods and capital resources.
Real asset: A tangible item that has intrinsic
value due to its substance and properties.
Trade deficit: The difference that results when
the value of a country’s imports exceeds the
value of its exports.
Trade surplus: The difference that results when
the value of a country’s exports exceeds the
value of its imports.
Transfer: A one-way payment for which no
money, good, or service is given or

exchanged.

November 2016	

-10,000

-20,000
Millions	of	Dollars

Financial asset: A contract that states the conditions under which one party (a person or
institution) promises to pay another party
cash at some point in the future.

Trade	Balance:	Goods	and	Services,	Balance	of	Payments	Basis
0

-30,000

-40,000

-50,000

-60,000

-70,000
1995

2000

2005

2010

2015

Source:	US.	Bureau	of	Economic	Analysis,	US.	Bureau	of	the	Census

myf.red/g/7xSj

fred.stlouisfed.org

NOTE: The goods and services deficit in July 2016 was $39.5 billion.
SOURCE: FRED®, Federal Reserve Bank of St. Louis;
https://fred.stlouisfed.org/series/BOPGSTB; accessed October 3, 2016.

Tracking Trade
International trade includes all of the buying and selling of goods, ser­­
vices, and assets between persons, businesses, and governments in one
country with persons, businesses, and governments in other countries. All
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PAGE ONE Economics®
of the individual transactions are added together to cre­
ate national trade statistics.
To understand what causes a trade deficit, it is essential
to understand a bit about the accounting of interna­
tional trade. All of a country’s transactions with the
world are summarized in what is called its balance of
payments. If we simplify a bit, all of the transactions in
the balance of payments can be classified into one of
two subaccounts:
1)	The current account: The largest part of this
account is the country’s trade in goods and services
with all other countries. When net exports are posi­
tive (when exports exceed imports), the country has
a trade surplus. When net exports are negative
(when imports exceed exports), the country has a
trade deficit.
2)	The capital and financial account: This account
includes all of the country’s trade in assets with all
other countries. There are two types of assets: real
assets and financial assets. Invest­ment in real assets,
for example, might include foreign investment in a
factory in the United States or U.S. investment in a
foreign factory. Financial assets include stocks, cor­
porate bonds, and U.S. government bonds. People
invest in real and financial assets with the aim of
“making money”—they hope to earn interest, divi­
dends, profits, and/or capital gains in the future. When
foreign investors buy more U.S. assets than Americans
buy foreign assets, there is a surplus on the capital
and financial account. That is, there is a net inflow of
funds on the capital and financial account. When
Americans buy more foreign assets than foreigners
buy U.S. assets, there is a deficit on the capital and
financial account. That is, there is a net outflow of
funds on the capital and financial account.

The Balancing Act
The balance of payments must balance—a deficit in one
of the accounts must be offset by a surplus in the other
account. So, when the current account is added to the
capital and financial account, it equals zero. You see,
dollars that leave the U.S. to buy foreign goods, services,
or assets find their way back to the U.S. economy to pur­
chase U.S. goods, services, and assets.

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Current Account + Capital and Financial Account = 0
For example, suppose a U.S. firm buys $10 million (in
U.S. dollars) of Chinese goods to sell to American con­
sumers. This transaction is recorded on the current
account as –$10 million (a negative number) because
the money is paid to the Chinese firm. If there were no
other transactions, the United States would have a $10
million deficit on the current account. But the Chinese
firm now has $10 million to spend. How they spend that
money will determine on which account the transaction
is recorded. If they purchase U.S. goods and services, the
transaction will be recorded on the current account; if
they invest in U.S. real or financial assets, the transaction
will be recorded on the capital account. So it could go
something like this:
Case 1: The Chinese firm spends the $10 million on
U.S. goods and services. In this case, it is counted as
a U.S. export and recorded on the current account
as $10 million (a positive number). This transaction
offsets the $10 million in imports on the current
account and results in balanced trade. (See the boxed
insert on page 3.)
Case 2: The Chinese firm invests $10 million in U.S.
assets. In this case, the firm has decided to save the
money (not spend on current consumption) by invest­
ing it in the United States. This $10 million investment
in assets is recorded as $10 million on the capital
and financial account and creates a surplus for the
United States on that account. (See the boxed insert
on page 3.) The surplus on the capital and financial
account exactly offsets the deficit on the current
account, but the trade deficit remains.2
Focusing on the trade deficit—and thus primarily on
goods and services—can be misleading because it ignores
the larger balance of payments. Investment in U.S. assets
should be considered as well. The U.S. economy benefits
from both types of transactions: The foreign purchase of
U.S. goods and services generates revenue for American
firms and employment for workers. Foreign investment
in real and financial assets allow firms to expand; and
foreign investment in U.S. government bonds helps to
finance the national debt. So, going back to our exam­
ple, whether the $10 million that was spent on imports
returns as current spending to purchase goods and ser­
vices or as investment in real or financial assets (which

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Case 1: Balance of Payments
Current Account

Capital and Financial Account

($10M exports – $10M imports)

+

0

=

0

=

0

Result = Balanced Trade
Case 2: Balance of Payments
Current Account
–$10M imports

Capital and Financial Account
+

$10M U.S. financial assets

Result = Trade Deficit
NOTE: M, million.

In both Case 1 and Case 2, the balance of payments is balanced because when the current account
is added to the capital and finance account, the sum is zero. For Case 2, however, in spite of balanced
payments, there is a trade deficit.

leaves a $10 million trade deficit), the transaction bene­
fits the U.S. economy.3

What Causes a Trade Deficit?
It is tempting to blame the trade deficit on factors that
might influence international trade. Some have suggested
the current trade deficit is a result of U.S. firms produc­
ing inferior goods that are not competitive in the global
economy. Others have suggested that trade policy is
flawed, implying that U.S. firms are the victims of unfair
foreign competition. Finally, some suggest currency
manipulation by foreign countries has put U.S. exporters
at a disadvantage. Economists, however, attribute the
trade deficit to national saving and investment decisions.
Trade and exchange rate policies can affect these deci­
sions but not as much as people might think. In practice,
they have a minor influence.

The Role of National Saving and Investment
A growing economy requires investment in (i) physical
capital (real assets) to increase worker productivity and
(ii) stocks and bonds (financial assets) to finance business
expansion. In addition, governments often borrow to
finance budget deficits by issuing government bonds.
In a closed economy (an economy that doesn’t interact
with any other economies), investment can occur only
to the extent that the firms and citizens in that economy
save. Imagine an economy that needs $100 million of
investment to maintain its current level of economic

growth. In a closed economy, citizens and firms would
have to save $100 million, which would be invested in
capital to produce more in the future. That is, after pay­
ing taxes and spending on their current consumption,
the country would need $100 million to invest in real and
financial assets. If less saving occurred, however, the
amount available to invest would shrink by that amount.
Thus, in a closed economy, domestic saving is equal to
domestic investment.
Of course, the U.S. economy is an open economy, which
means it trades with other countries. That trading includes
goods and services and assets. In this way, the total
level of U.S. investment can exceed the savings of U.S.
citizens—the difference is made up by foreigners invest­
ing in the United States. So, for example, $100 million of
U.S. investment might include $50 million of domestic
investment and $50 million of foreign investment. In
the United States, the current account deficit (the trade
deficit) is offset by the financial and capital account sur­
plus, which is made possible by a net inflow of foreign
investment. This is what allows total domestic investment
to be greater than domestic saving. Of course, when the
U.S. borrows money (by selling corporate or government
bonds), or sells claims on future output (by selling assets),
it is trading off more consumption today for less con­
sumption in the future.
Because international trade includes more than goods
and services, when economists are asked about the trade

PAGE ONE Economics®
deficit, they often discuss national saving and investment
rather than only imports of goods and services. By defi­
nition, if Americans saved more (by spending less), the
trade deficit would be smaller. While Americans save little
(relatively speaking), foreign savers have found the United
States an attractive place to invest. Former Federal
Reserve Chair Ben Bernanke attributed the trade deficit
to a “global savings glut” in which foreigners with excess
savings are drawn to invest in U.S. assets because the
U.S. economy offers appealing investment opportuni­
ties.4 As such, the low American saving rate, and the inflow
of foreign investment seeking opportunity, has pushed
up the trade deficit.

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Notes
1

U.S. Census Bureau. “Annual Trade Highlights.” Accessed September 28, 2016;
https://www.census.gov/foreign-trade/statistics/highlights/annual.html.
2

It is common to equate the current account balance and the balance of trade,
although they are not exactly synonyms.
3

Economists debate the potential effects of running trade deficits over long
periods, but in the short-run the transactions provide benefits.
4

Bernanke, Ben S. “The Global Saving Glut and the U.S. Current Account Deficit.”
Presented at the Virginia Association of Economists, Richmond, VA, April 14,
2005; http://www.federalreserve.gov/boarddocs/speeches/2005/200503102/.

Conclusion
In general, the United States imports more goods and
services than it exports, resulting in a trade deficit, which
is the biggest part of the current account. People often
assume that a surplus is good and a deficit is bad, but it
is not that simple. The net outflow of funds on the goods
and services side of the ledger (the current account) is
offset by the net inflow of funds on the assets side of
the ledger (the financial and capital account). Because
the two accounts must offset each other (as a matter of
accounting), if Americans saved more, the trade deficit
would be smaller. As such, the U.S. trade deficit says
more about U.S. national and global saving than trade
policy. n

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Name___________________________________ Period_______
Federal Reserve Bank of St. Louis Page One Economics ®:

“International Trade: Making Sense of the Trade Deficit”
After reading the article, answer the following questions:
1.	 Explain the difference between the current account and the capital and financial account in the balance of payments.

2.	 What is a trade deficit?

3.	 Assume a U.S. firm buys (imports) $5 million (in U.S. dollars) of foreign goods. That transaction by itself increases 		
	 the trade deficit by $5 million. But, the $5 million will flow back to the United States to purchase either (i) U.S. goods 		
	 and services or (ii) U.S. assets.
	 •	
		

How does the way the $5 million comes back to the United States determine whether there will be balanced 		
trade or a trade deficit?

	 •	
		

How does the U.S. economy benefit from either transaction (the foreign purchase of U.S. goods and services 		
[exports] or the purchase of U.S. assets)?

4.	 How does the “global savings glut” help explain the trade deficit?


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