The Trade Deficit Myth

I’ve just finished reading the excellent How To Win A Trade War by Soumaya Keynes and Chad Bown. I will be writing a full review of it at some point but I think one of the best chapters in the whole book is the one on trade deficits. Keynes and Bown are absolutely right to point out that while they sometimes can be problematic, they often aren’t. I’ve been planning on writing about this for a while so here is my take on it.

Advanced economies such as Britain and the US do tend to worry about the trade deficit. Especially in terms of goods. They see it as a sign of industrial or even national decline. And, in the case of Trump’s America, of being cheated by the rest of the world. In reality, the trade deficit is not a sign of decline. It’s closer to a side effect of being a country which the rest of the world most wants to invest in. Rather than something to panic about, it can actually be a sign of a relatively healthy economy.

I’ve written about this before but there is this idea in politics that trade is a zero-sum game with winners and losers where exports count as a positive point and imports a negative. In the UK’s negotiations with Australia and New Zealand, for example, much of the commentary was around how we had been ‘beaten’ because we opened up our markets (especially in agriculture) more than the other side and so we had lost. Leaving aside the fact that Australia and New Zealand were already very open in terms of agriculture, it reveals a fundamental (and very old-fashioned) understanding of trade.

Imports are a win. They lower prices for consumers and give them greater choice. They force domestic firms to up their game and become more productive. There will be some losers such as firms who refuse to adapt, but they make most of our lives better. When I worked for Truss I tried to set up an ‘Importing is GREAT Britain’ to make this case but sadly it never took off. Thankfully Adam Smith made the case more eloquently than I ever could 250 years ago.

Our politicians and much of the media treat the trade balance like a scoreboard between countries instead of what it actually is: an accounting identity that mechanically reflects how much a country saves versus how much it invests. If you actually run the numbers, and the ‘we’re losing’ narrative collapses almost immediately for both Britain and America.

Let’s start with the US. America. has run a trade deficit nearly every year since 1976. If the doom-mongers were right, that’s 50 years of continuous economic self-destruction. Instead, America spent that half-century becoming the largest, most dynamic, most innovative economy on the planet, home to the companies the rest of the world envies and the capital markets the rest of the world depends on.

I wrote about this year but the link between currencies and trade is vitally important here. The Dollar is the world’s reserve currency. Central banks, sovereign wealth funds, pension systems, and ordinary savers around the world want dollar-denominated assets (Treasury bonds, US equities, American real estate etc) because the US has the deepest, most liquid, most trusted capital markets in human history. To buy those assets, foreigners need dollars. The main way the world acquires dollars is by selling goods to the US. The trade deficit is, in large part, simply the flip side of the rest of the world’s appetite for American assets.

This confers an exorbitant privilege on the US. It has the ability to borrow cheaply in its own currency from a world eager to lend it money. Try running this experiment in reverse: imagine if America forcibly balanced its trade tomorrow. That would mean choking off the foreign capital inflows that fund American businesses, keep Treasury borrowing costs low, and finance the federal government far more cheaply than it could otherwise. President Trump and Peter Navarro should be careful what they wish for.

Let’s focus on Britain. The UK runs a goods trade deficit (it imports more cars, machinery, food, and oil than it exports. That’s the number that gets waved around as though it’s an issue which urgently needs to be fixed. You see this across the political spectrum, including from organisations I respect.

However, Britain consistently runs a substantial surplus in services trade such as financial services, insurance, legal services, consulting, and creative industries that the rest of the world buys from London at scale. The City remains one of the most important financial centres on Earth, and that status generates enormous invisible exports that never show up on the evening news but absolutely show up in the balance of payments. Britain effectively sells the world expertise and trust; the world sells Britain physical goods. Measured the way mercantilists measure things (bags of gold) that looks bad. Measured the way a modern, services-dominated economy should be measured, it’s a sign Britain still punches well above its weight in exactly the sectors of the future: finance, professional services, and intellectual capital.

Moreover, like America (and despite all its current problems), Britain attracts substantial foreign investment such as into the property market, firms, and our gilts. This is because investors still see Britain as a stable, rule-of-law jurisdiction with deep capital markets and a lot of potential. That capital has to come from somewhere, and the trade deficit is, again, part of how it gets there.

The Trumps of this world and the mercantilists among our own political and media class cry out that other countries are beating us. No they’re not! The countries most often cited as trade ‘winners’ such as China, Germany, and Japan run large persistent surpluses, and the case can be made this reflects a weakness, not a strength: chronically weak domestic demand, ageing populations reluctant to spend, and businesses that would rather export their savings than invest them at home in better wages or infrastructure. Germany has been quietly hammered by its own central bank, the EU, and by the IMF for exactly this as it is running a surplus so large it amounts to under-investment in its own economy.

If running a surplus made a country an economic winner, Germany and Japan would have been growing faster than America for decades. They haven’t. The US economy has outgrown both for most of the past thirty years, deficit and all.

We do need to discuss the loss of manufacturing jobs. While it is true that some communities really were hurt, and pretending otherwise insults the people who lived through it. Specific regions exposed to import competition (parts of the American Rust Belt and certain British manufacturing towns) experienced real, sustained job losses that didn’t simply get absorbed by new opportunities elsewhere.

However, the trade deficit barely deserves the blame it gets for this. The single biggest force hollowing out manufacturing employment in both countries over the past forty years has been automation and productivity growth, not imports. American factories produce vastly more output today with a fraction of the workforce they once needed and that’s true even adjusting for trade. In the case of Britain we should also be pointing the finger at the reckless and frantic push towards Net Zero which has raised energy prices and crippled industry.

The deficit didn’t cause the disruption; it’s one symptom of a much larger structural shift that was happening anyway. Tariffs aimed at ‘fixing’ the trade balance, in both countries, have a long track record of raising consumer prices and provoking retaliation against exporters while doing almost nothing to bring back the specific jobs people are nostalgic for.

However, we shouldn’t be complacent here. A serious in-balance in trade can cause issues, especially if the country is facing other issues. What is more, Britain is in danger of its services surplus being eroded in the coming years and decades. We have a tax system which punishes hard work, investment, and other productive activity. We have a planning system which makes it expensive to build enough of the stuff we need including homes, offices, labs, data centres, and energy and transport infrastructure. We have burdensome taxes and regulations targeting the Jewel in the Crown of our economy: the financial services sector. Finally, we have an unstable political environment with profligate politicians determined to borrow more while we’re in the midst of a global bond glut which risks spooking the markets.

All this is to say that rather than blaming the trade deficit, we should actually do something. Provide targeted support and opportunities for people in ‘left behind’ areas who have lost out from trade. We also need to liberalise the planning system, cut red tape, and slash public spending so that we can start lowering taxes. We should then double down on free trade by striking more deals with other countries and pursuing free trade in food.

Other stuff

I’ve written a few opinion pieces over the past two weeks. I wrote two for the Great British Think Tank: the first was on why an ‘exit tax’ would be a terrible idea and the second was on the parlous state of the public finances.

I also wrote a piece for CapX on why Burnham’s ‘Buy British’ plan is fraught with danger. I wrote an article for Conservative Home on why those on the centre-right should support the OBR. Finally, I wrote a short piece for UnHerd on why repealing the Vagrancy Act was a bad move. You can read it here.

Thanks as ever for reading. I might write something else this week. Stay cool.