There is a common perception in the media and in the general public that trade deficits are bad news. The conventional wisdom is that these deficits are a drag on gross domestic product. Surely, it must bad for a country's economy to import more than it exports, right?

In reality, the trade deficit may be more pro-cyclical, moving in the same direction as local GDP. In this article we will examine the correlation between trade deficits and GDP to show that sometimes it doesn't pay to follow conventional wisdom.

What Are Trade Deficits?
Trade has evolved over the years and is now defined as the annual amount spent by individuals, companies and government agencies on foreign-made products, minus the amount spent by foreign entities on domestically made products. Countries rarely import exactly as much as they export so there is usually a trade imbalance. A deficit is created when there are more imports than exports. (To learn more, see What Is International Trade?)

The difference between a country's imports and exports (called the balance of trade) differs across business cycles and types of economies. For countries where growth is led by exports like oil, industrial goods and other natural resources, the balance of trade will move positively toward a surplus during an economic expansion. The reason for this is that the host country exports products that are in demand during growth periods at a greater rate than it imports goods.

In contrast, in countries where growth is led by demand, like the United States, the trade balance tends to worsen during growth stages of the business cycle. This is because these economies need to import even more goods than usual in order to grow. Combine this with a negative national annual personal savings rate and you've got an ever-increasing trade deficit.

Now that we know a bit about trade deficits, let's look at the correlation with GDP.

Trade Deficit Effects
There are two competing theories that have surfaced regarding the effects of a trade deficit on GDP:

  • Theory 1: Trade deficits drag down GDP and add to the threat of an economic crisis if foreigners dump the local currency in world currency markets.
  • Theory 2: Increasing trade deficits can be a sign of strong GDP. They will not create a drag on GDP, and any potential downward pressure on the local currency is actually a benefit to that country.

Who Wins?
Theory 1 suggests there will be a general underlying weakness in the economy of the local country during periods of substantial trade deficit. Intuitively, the theory makes sense. If you are buying more than you are selling, it seems logical that this would be bad for the economy - especially in countries where the products to be exported do not create enough jobs to offset the jobs lost by importing goods.

Theory 1 may seem to make logical sense, but unfortunately the numbers do not support it. Throughout the 1990s and beyond, import heavy countries have run consecutive deficits frequently. For example, the United States has a massive and growing trade deficit, and so if Theory 1 held true, we should see the its GDP growth hindered. The opposite is the case however (Figure 1).

Figure 1: U.S. Trade Deficit Vs. GDP (1980-2007)
Year Trade Deficit GDP Year Trade Deficit GDP
1980 -19,407 5,161.7 1994 -98,493 7,835.5
1981 -16,172 5,291.7 1995 -96,384 8,031.7
1982 -24,156 5,189.3 1996 -104,065 8,328.9
1983 -57,767 5,423.8 1997 -108,273 8,703.5
1984 -109,072 5,813.6 1998 -166,140 9,066.9
1985 -121,880 6,053.7 1999 -265,090 9,470.3
1986 -138,538 6,263.6 2000 -379,835 9,817.0
1987 -151,684 6,475.1 2001 -365,126 9,890.7
1988 -114,566 6,742.7 2002 -423,725 10,048.8
1989 -93,141 6,981.4 2003 -496,915 10,301.0
1990 -80,864 7,112.5 2004 -607,730 10,675.8
1991 -31,135 7,100.5 2005 -711,567 11,003.4
1992 -39,212 7,336.6 2006 -753,283 11,319.4
1993 -70,311 7,532.7 2007 -700,258 11,566.8
Source: U.S. Census Bureau. Trade deficit figure in millions of dollars. GDP given in billions of chained (2000) dollars.

According to the U.S. Census Bureau, from the early 1990s to 2007, the U.S. continues on a general trend of increasing GDP year over year; the trade deficit is also increasing. If Theory 1 was true, there would be an inverse relationship between GDP and a trade deficit, but this does not seem to be the case. There are short periods of time in U.S. history where we see reduced GDP in conjunction with an increasing trade deficit, but most of those time periods can be excused as anomalies and the short-term weakness can be attributed as a symptom of other ailments and the trade deficit is just the nature of the host. As for the situation of dumping dollars in the world currency markets, this can happen in any environment but the probability of coordinating such an effort is low.

Theory 2 may hold much more weight as evidenced by the positive correlation between the U.S. GDP and the trade deficit. This can be easily explained by the fact that the U.S. is a demand-based consumer society with a negative savings rate. In addition, as the U.S. evolves into more of a service society, the products that individuals demand will no longer be made in the country. As more manufacturing and labor intensive products are created outside of the U.S., a trade imbalance may be inevitable.

In fact, the economic growth from 1980-2000 tended to grow in years in where the trade deficit grew compared to those years in which it declined. This provides even more evidence that an imbalance of trade in the form of a deficit did not drag the economy.

Fed Actions
Once you get past the idea that a trade deficit is a bad thing, it's easy to understand why the pattern we've seen in the U.S. makes sense. As the host economy expands, demand for imports and oil grows at a faster rate than the demand in other countries for the host's products grows.

Taking that point further we find that economic expansions in the U.S. tend to emerge during or at the tail end of the Federal Reserve's efforts to lower interest rates, which can affect currency exchange rates. (To learn more about the Federal Reserve, see The Whens and Whys of Fed Intervention and The Federal Reserve's Fight Against Inflation.)

The dollar trended lower over from 1997 to 2007. A weaker U.S. dollar can shrink the trade imbalance and increase GDP growth as local companies find more success in exporting their products and local customers tend to pass on foreign goods as their prices rise.

Conclusion
For the most part, the media and the general public have a perception that trade deficits as we know them are bad and can drag on GDP. In reality, the trade deficit may be more pro-cyclical, moving in the same direction as local GDP. In fact, the other factors contributing to the expanding GDP can accelerate its growth.

To continue reading on this subject, check out And The Importance Of Inflation And GDP.

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