What Is a Trade Deficit?

A trade deficit occurs when a country's imports exceed its exports during a given time period. A trade deficit represents an outflow of domestic currency to foreign markets. It is also referred to as a negative balance of trade (BOT).

Trade Deficit = Total Value of Imports – Total Value of Exports

KEY TAKEAWAYS

  • A trade deficit occurs when a country's imports exceed its exports during a given time period.
  • The merchandise trade deficit equals the value of goods imported minus the value of goods exported.
  • The current account deficit uses a broader definition that also includes services and some types of income.
  • Trade deficits are not always harmful because they can result from beneficial foreign investment and alleviate temporary shortages.
  • In the long run, persistent trade deficits can create unemployment and lead to the loss of a nation's wealth to other countries.

Understanding Trade Deficits

Nations of the world record trading activity in their balance of payment (BOP) ledgers. One of the primary data silos in this item is the current account, which tracks goods and services leaving (exports) and those entering (imports). The current account shows direct transfers like foreign aid, asset income from foreign direct investment (FDI), as well as the BOT.

Developed countries often attract substantial foreign investment, which implies large trade deficits.

Trade deficits can occur when a country fails to produce enough goods for its residents. However, in some cases, a deficit can signal that a country’s consumers are wealthy enough to purchase more goods than their country produces.

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Trade Deficit

Types of Trade Deficits

There are two significant types of trade deficits. The merchandise trade deficit equals the value of goods imported minus the value of goods exported. The merchandise trade deficit is based on a narrow definition of trade that involves only physical goods. The current account deficit uses a broader definition that also includes services and some types of income. The merchandise trade deficit tends to be higher for countries that import a lot of manufactured goods, such as the United States.

Advantages of Trade Deficits

The most obvious benefit of a trade deficit is that it allows a country to consume more than it produces. In the short run, trade deficits can help nations to avoid shortages of goods and other economic problems.

Many trade deficits correct themselves over time. A trade deficit creates downward pressure on a country's currency under a floating exchange rate regime. With a cheaper domestic currency, imports become more expensive in the country with the trade deficit. Consumers react by reducing their consumption of imports and shifting toward domestically produced alternatives. Domestic currency depreciation also makes the country's exports less expensive and more competitive in foreign markets.

Trade deficits can also occur because a country is a highly desirable destination for foreign investment. For example, the U.S. dollar's status as the world's reserve currency creates a strong demand for U.S. dollars. Foreigners must sell goods to Americans to obtain dollars. According to the U.S. Treasury Department, foreign investors held over four trillion dollars in Treasuries as of October 2019. Other nations had to run cumulative trade surpluses with the U.S. totaling over four trillion dollars to buy those Treasuries. The stability of developed countries generally attracts capital, while less developed countries must worry about capital flight.

Disadvantages of Trade Deficits

Trade deficits can create substantial problems in the long run. The worst and most obvious problem is that trade deficits can facilitate a sort of economic colonization. If a country continually runs trade deficits, citizens of other countries acquire funds to buy up capital in that nation. That can mean making new investments that increase productivity and create jobs. However, it may also involve merely buying up existing businesses, natural resources, and other assets. If this buying continues, foreign investors will eventually own nearly everything in the country.

Trade deficits are generally much more dangerous with fixed exchange rates. Under a fixed exchange rate regime, devaluation of the currency is impossible, trade deficits are more likely to continue, and unemployment may increase significantly. According to the twin deficits hypothesis, there is also a link between trade deficits and budget deficits. Some economists believe that the European debt crisis was caused in part by other EU members running persistent trade deficits with Germany. Exchange rates can no longer adjust between countries in the eurozone, making trade deficits a more serious problem.

Real World Example

The U.S. holds the distinction of owning the world's largest trade deficit since 1975. For the year before Sept. 30, 2019, the U.S. current account deficit in goods and services was more than $517 billion. The U.S. imported and consumed significantly more electronics, raw materials, oil, and other items than it sold to foreign countries.