Friday, June 6, 2008

Is a Trade Deficit Harmful?

There was a time in the 1950s and 1960s, when a current account (trade) deficit was a political disaster. People felt a deficit was a reflection of a weak economy and a sense of national shame. In the UK, there was even a 'buy British' campaigns, which amongst other things sought to help improve the UK's trade deficit.

Nowadays, in an era of globalisation, 'buy British' campaigns sound rather out of touch. In fact, some economists argue that with the free movement of capital, a current account deficit is no problem because the deficit can easily be easily financed. However, a current account deficit can give insights into the performance of an economy, and in some cases cause economic problems.

Effects of A Trade Deficit

Competitiveness. A deficit may imply a decline in competitiveness; e.g. higher labour costs. The UK's persistant deficit since the early 1980s, is arguably a reflection of the deterioration in the competitiveness of the manufacturing sector.

Depreciation. In the long term, a current account deficit can cause a depreciation of the exchange rate which reduces living standards (imports are more expensive). This is because a deficit means foreign exchange is flowing out of the country. If the deficit is small, it may be easy to finance it through capital flows; but, if the deficit is large like US (6.5% of GDP in 2007, it will almost certainly cause a depreciation in exchange rate.

High Growth. A deficit may simply be because the economy is growing quickly. When the economy is growing people will be buying more imports. Therefore, a current account deficit may be a reflection of high growth and falling unemployment, which is a good thing. Japan has had a current account surplus but very sluggish growth in the 1990s.
  • However, a deficit may also indicate the economy is growing too quickly causing domestic inflation and so people buy from abroad to avoid high domestic prices.
Low Savings Ratio. A deficit may also indicate that the savings ratio is too low. When savings ratio is low people are spending and investment levels are lower. Therefore, people are enjoying high consumption now at the expense of better living standards in the future.
  • E.g. China has economic growth of 10%, but, has a current account surplus. This reflects its high savings ratio. The US current account was partly due to a very low savings ratio and high level of personal debt, which suggests an unbalanced economy.
How Deficit is Financed. It depends how the current account deficit is financed. If the deficit is financed through long term capital investment, this can be beneficial for an economy. If it is financed through short term borrowing and hot money flows, this is likely to be more problematic. The problem with the US current account deficit was that they were relying on Asian investors buying dollar securities at relatively low interest rates. However, with a falling dollar these dollar securities suddenly started to look very unattractive hence the long depreciation in the currency.


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