Trade deficits aren't deficits of trade

Please someone get Donald Trump to read this

Donald Trump cares a lot about the trade deficit. Lots of other people do, too. The media reports on the trade deficit reliably as though it is an important thing, and having a low number is bad. This is so silly I don’t know where to begin. But begin I must, because this is apparently becoming an incredibly important issue and everyone has the wrong idea about this.

When people hear the term “trade deficit,” it sounds bad. Like we’re deficient in some way, we have a deficit in trade. Who do we have a trade deficit with? Oh god, those countries must be ripping us off! They’re taking our trade! We have to get our trade back!

This isn’t even approximately accurate. (Although this is clearly what Donald Trump thinks. Sigh.)

Ok, let’s build this up from first principles. In economics, there are plenty of accounting identities. One value must equal the other as a matter of definition and mathematics. If I give you a dollar for no reason, then I am -1 dollar and you are +1 dollar. My loss is your gain. If, on the other hand, I trade you one dollar for one widget, that widget is worth $1 (because that’s what I paid for it). My dollar went to you, your widget went to me. $1 dollar of widgets in one direction, $1 dollar of money in the other direction. We’re even. We’re guaranteed to be even, in fact, because the price of the widget is the amount that I paid. Perhaps in some larger sense that trade might not have been even. If the market price of widgets is either greater or less than $1, you could argue that someone ripped someone off. But for the purposes of this transaction, we’re defining the value of the widget as $1, because that’s what I paid. This is known as the “balance of payments.”

We can do this same thing with any transaction. In a free and equal exchange, the value going one way is equal to the value going the other way. Again, you might quibble with that assumption, but that assumption is what this whole concept of a “trade deficit” is based on, so you have to roll with it.

In addition to coming up with accounting identities like the one I just mentioned, economists like to divide things that might be traded into two categories: goods and services on the one hand, and financial assets on the other. Goods and services are things like cars, widgets, meals at restaurants, a massage, and the time and effort of someone explaining economics to you. (This explainer has no value because you’re getting it for free.) Financial assets are things like dollars euros and yen, but also stocks, bonds, bitcoin, short-dated out of the money call options, and anything else that someone might work themselves into a tizzy over on Jim Cramer’s show.

Now as the example of 1 dollar for 1 widget shows, financial assets can be exchanged for goods and services. Don’t take my word for it! Just ask Homer’s brain.

What this means is that we can look at two individuals or organizations or countries or whatever, and look at the net flows of financial assets from one country to the other and the net flow of goods from one country to the other. If I paid you 1 dollar for 1 widget, I’m sending more financial assets to you then you’re sending to me, and you’re sending more goods and services to me then I’m sending to you. Because of the accounting identity mentioned above, those values are guaranteed to exactly offset. The value of the financial assets I’m sending to you is, by definition, the value of the goods you’re sending to me.

We can imagine this being more complicated, of course. If we both have lots of goods and lots of services, and lots of different kinds of financial assets, we can imagine trading all of these different goods and services back and forth. But we can still sum up the total flows to see what the net flow of goods/services and the net flow of financial assets is. But even in this more complicated case, the basic logic of the above exchange holds. If, after all of our trading back and forth, I’ve sent you, on net 1 dollar of financial assets, then we don’t need to count up all the goods and services that have been traded back and forth between us to know that you’ve sent me on net 1 dollar of goods/services. Those numbers balance by definition.

Economists, in their infinite wisdom, have chosen some technical terminology to describe these flows of assets as opposed to goods and services. If I am, on net, sending you more financial assets than I am sending goods and services, then I have a “trade deficit” with you. And if you are, on net, sending me more goods and services than you are sending me financial assets, then you have a “trade surplus” with me. Trade deficit equals trade surplus, by definition. Balance of payments.

That’s all the terms “trade surplus” and “trade deficit” mean. They are a measure of the net flows of financial assets and goods/services across borders. People who (correctly) say that the trade deficit isn’t bad often say “you have a trade deficit with the grocery store.” What they mean by that is that, unless you work at the grocery store, on net you send the grocery store money, and the grocery store gives you goods/services. That’s true even if you sometimes get a couple bucks for turning in your recycling at the grocery store, because we’re talking about net flows here.

The next important economics concept to take into account is the concept of comparative advantage. When there is trade between two entities, each entity will specialize in what they have the largest size of advantage in, even if they don’t have an absolute advantage in anything. A textbook example that I love: Bill Gates types more words per minute than his administrative assistant, because he’s a computer whiz. But he leaves all of his correspondence to his administrative assistant. That’s because he is a bit better at typing than his assistant, but he’s vastly better at running Microsoft, so he does that rather than type. (Ok, outdated example. But you know.) So, too, in international trade. A country doesn’t specialize in and export what they’re best at in absolute terms. They specialize in and export what they’re best at in relative terms. A country that is an inefficient mess and is terrible at creating will still be a net exporter of whatever they are least bad at making. And by the same token, a country that is awesome and kicking ass at everything will only specialize in and export the things that they have the largest proportional advantage in.

Now combine those two ideas, balance of payments and comparative advantage. In trade between two countries, which country will have a trade surplus and which a trade deficit? That depends on the relative quality of the financial assets produced by that country vs the goods/services produced by that country. The country that has relatively stronger financial assets will have a trade deficit, and the country that has relatively stronger goods/services will have a trade surplus.

The quality of the goods and services produced by the US is very, very high. But the quality of financial assets produced by the US in insane.

Say you want to save for retirement. You want some stocks. What stock market do you want to buy those stocks on? Are you in the market for US stocks or Argentinian stocks? US, right? And not just because you’re a US citizen. That’s obviously the smart investment. Now bonds. Whose government debt do you want to be invested in, US treasuries or Argentinian treasuries? (And before you start snarking about the exploding US debt, recall that the US has never defaulted on its debt, while Argentina does so every couple years as a little holiday event.) Now let’s say you want cash in the bank. You’re looking for a stable currency that has strong purchasing power at home and abroad. So of course you want the US dollar.

And that’s not just you. Everyone in the god damn world has the same preferences, because it’s irrational not to.

And what that all means is that the US has a very strong comparative advantage in financial assets. So we are a net exporter of financial assets. So we are a net importer of goods and services. That’s a trade deficit.

That’s it. That’s the whole thing.

Our businesses are so good, and our rule of law so well-established, that people all around the world are desperate to trade us cheap TVs for the opportunity to invest in our businesses.

That’s the trade deficit.

IT IS SO GOOD TO HAVE THIS KIND OF TRADE DEFICIT.

Someone please tell Trump.

Edit: In an earlier version of this post, I said “balance of accounts” rather than “balance of payments” because I am an idiot.