There is no question the composition of a country's balance of payments is more important than its balance of trade. This does not make the balance of trade unsubstantial; after all, it comprises a large part of the balance of payments. But the balance of trade is only one side of the ledger, and it ignores much of what is really going on in an economy. Think of it like accounting; looking at the net balance of trade is like looking at debits but ignoring credits.

Understanding the Difference Between the Balance of Payments and Balance of Trade

It is unfortunate that the balance of trade, which is commonly known as the trade deficit or trade surplus, receives far more attention from the financial media and press than the balance of payments.

The balance of payments is divided into three parts: the current account, the capital account and the financial account. The current account includes trade-in merchandise and services between domestic and foreign producers and consumers, income receipts and unilateral transfers. The current account is roughly equal to the balance of trade.

Trade deficits and trade surpluses ignore the capital and financial accounts, though. These accounts include foreign ownership of domestic assets, domestic ownership of foreign assets, capital transfers, and the sales and purchases of intangible assets.

Problems With the Balance of Trade

Suppose the U.S. runs a balance of trade deficit with Japan. This means that, for any one period of time, consumers in the U.S. purchase more Japanese goods and services than the Japanese buy from Americans. This sounds like Japan is "winning" at international trade, but this is a silly notion; international trade always benefits both parties.

The Japanese are receiving an excess of U.S. dollars from American consumers and have to do something with those dollars. If they are not buying American products, those dollars have to come back home in the form of investments and assets or else stay with Japanese accounts and indirectly increase the value of American currency. This is the other side of the balance of payments.