The one thing that everybody can agree on when it comes to the field of economics is that economists rarely agree. One point of contention has been whether or not a trade deficit, also known as a current account deficit, is beneficial or detrimental to a country's economy. If a deficit is a net positive, how long can a nation thrive with such an imbalance is another sticking point. The answer is that a trade deficit can confer both positives and negatives for a country, but it all depends on the circumstances of the country involved, the policy decisions that have been made and the duration and size of the deficit. Often times the observed data and the underlying economic theory don't line up.
A trade deficit exists when a country spends more money annually on imports than it receives from its exports. Currently, the United States owns the largest trade deficit by far, with a trade imbalance of over $7.3 trillion accumulated over the past few decades. But many other countries, including Spain, the United Kingdom, Australia, Mexico, Turkey, and Brazil, also are experiencing deficits. Meanwhile, other countries export more than they import and enjoy trade surpluses. China, Russia and Japan all have large surpluses. (For more, see: The Sustainability of the Falling U.S Trade Deficit.)
The Pros & Cons of Trade Deficits
For the past several years, the United States has been running trade deficits. Some people have reacted to this fact with doom and gloom, while others chalk it up to certain foreign governments not playing fair in U.S. markets and international trade. Still others argue that trade deficits imply that we are living beyond our means and accumulating too much debt.
Employment: When a country persistently experiences a trade deficit there are predictable negative consequences that can affect economic growth and stability. If imports are more in demand than exports, domestic jobs may be lost to those abroad. While theoretically, this makes sense, the data suggests that unemployment levels can actually persist at very low levels even with a trade deficit, and high unemployment may occur in countries with surpluses.
Currency Value: The demand for a country's exports impacts the value of its currency. American companies selling goods abroad must convert those foreign currencies back into dollars in order to pay their workers and suppliers, bidding up the price of their home currency. As the demand for exports falls compared to imports, the value of a currency should decline. In fact, in a floating exchange rate system, trade deficits should theoretically be corrected automatically through exchange rate adjustments in the foreign exchange markets. Put another way, a trade deficit is an indication that a nation's currency is desired in the world market.
The United States, however, is in a unique position of being the world's largest economy and its dollar the world reserve currency. As a result, the demand for U.S. dollars has remained quite strong despite persistent deficits. Surplus countries like China who do not utilize a floating currency regime, but rather keep a fixed pegged exchange rate versus the dollar, benefit by keeping their currency artificially high. (See also: Currency Exchange: Floating Rate Vs. Fixed Rate.)
Interest Rates: Similarly, a persistent trade deficit can often have adverse effects on the interest rates in that country. A downward pressure on a country's currency devalues it, making the prices of goods denominated in that currency more expensive; in other words it can lead to inflation. In order to combat inflation, the central bank may be motivated to enact restrictive monetary policy tools that include raising interest rates and reducing the money supply. Both inflation and high interest rates can put a damper on economic growth. Again, the United States as well as Europe have resisted this outcome with historically low interest rates and low levels of deflation over the past decade. However, smaller countries would not fare so well.
Foreign Direct Investment: By definition, the balance of payments must always net out to zero. As a result, a trade deficit must be offset by a surplus in the country's capital account and financial account. This means that deficit nations experience a greater degree of foreign direct investment and foreign ownership of government debt. For a small country this could be detrimental, as a large proportion of the country's assets and resources become owned by foreigners who can then control and influence how those assets and resources are used. According to Nobel laureate Milton Friedman, trade deficits are not ever harmful in the long run because the currency will always come back to the country in some form or another, such as via foreign investment.
The Bottom Line
Economic theory suggests that persistent trade deficits will be detrimental to a nation's economic outlook by negatively impacting employment, growth, and devaluing its currency. The United States, as the world's largest deficit nation, has consistently proven these theories wrong. This may be due to the special status of the United States as the world's largest economy and the dollar as the world reserve currency.
Smaller countries certainly have experienced the negative effects that trade deficits can bring over time. Proponents of free markets, however, insist that any negative effects of trade deficits will correct themselves over time through exchange rate adjustments and through competition leading to a change in what a country produces. Large trade deficits may simply reflect consumer preferences and may not really matter much at all in the long run. Time will tell.