A 2-country, 2-transaction example to understand trade, trade deficits, capital flows, and the balance of payments

From Mark Perry.

"To help understand international trade, suppose that there are only two international transaction that take place in a given period, but let’s assume that those two transactions are representative of the thousands or millions of other transactions that might have taken place. In that case, for the sake of simplicity and for illustrative purposes, we’ll assume that we can focus on just two transactions to help us understand the far more complex reality of “international trade.”

A similar approach is used in basic international trade theory — economists typically assume that there are only two countries trading two goods in a simple two-country, two-good “world economy” to keep the trade analysis manageable. The economic conclusions from a two-country, two-good world economy about absolute advantage, comparative advantage and the gains from trade don’t change when we more realistically assume that the world economy includes hundreds of countries trading thousands of goods.

So let me propose the following two-country, two-transaction example of international trade to illustrate some important economic conclusions about trade, trade deficits and surpluses, capital inflows and outflows, foreign investment deficits and surpluses, and the overall balance of payments.
In a given period, let’s assume that there are only these two international transactions:

Transaction 1 for Merchandise: An American consumer purchases a $1,000 55-inch Sony 4K Ultra HD TV that was made in Japan, and let’s assume for simplicity that as a result of the purchase the Sony Corporation in Japan has acquired the $1,000 in US currency.

Transaction 2 for a Financial Asset: The Sony Corporation uses the $1,000 in US currency to purchase a $1,000 certificate of deposit (CD) from a U.S. bank. Alternatively, and without changing the conclusions that follow, Sony might have used the $1,000 to purchase shares of Apple stock, a Ford Motor Company bond, a mortgage-back security (MBS) and a Treasury security.
Assuming that those two transactions are realistically representative of the thousands and millions of transactions that take place every year, we can make the following conclusions:

1. International trade involving merchandise or financial assets is always win-win, and every transaction involves a satisfied buyer and satisfied seller (or lender and borrower) who are both made better off following a voluntary, mutually beneficial international exchange of merchandise or financial assets. In this case, the American consumer with the new 55-inch TV is better off and Sony is better off with a sale that generates  1,000 US dollars. Neither the American consumer nor Sony has been “absolutely crushed” or “killed” or “ripped off,” as Trump would have us believe, and neither party (the US consumer or Sony) is “laughing” at their trading partner. The financial transaction is also win-win, and makes both Sony and the US bank better off. Neither Sony nor the bank has been “crushed” or “killed” or “ripped off.”

This example also illustrates the important point that even though we hear about America’s trade balances with other countries, it’s not the case that countries trade with each other; rather it’s only individual consumers, individual investors, and individual companies that trade with each other. International trade for both merchandise and financial assets is not “win-lose” as Trump suggests, it’s win-win, with a satisfied buyer (or investor, lender saver) and satisfied seller (or company, bank, borrower) for every transaction.

2. Merchandise Trade. As a result of the single merchandise transaction for the TV that represents thousands or millions of other transactions for goods, the US has a $1,000 “trade deficit” for merchandise, and Japan has a $1,000 “trade surplus” for merchandise. In economic terms, the US has a $1,000 “current account deficit” and Japan has a $1,000 “current account surplus.”

3. Financial Assets. As a result of the single financial transaction for the bank CD that is representing thousands or millions of other transactions for financial assets, the US has a $1,000 “foreign investment surplus” while Japan has a $1,000 “foreign investment deficit.” In economic terms, the US has a $1,000 “capital account surplus” and Japan has a $1,000 “capital account deficit.”

4. Balance of Payments. For the US, there’s been an outflow of $1,000 for merchandise that has been offset by a $1,000 inflow for financial assets. For Japan, there’s been an inflow of $1,000 for merchandise offset by a $1,000 outflow for financial assets. In terms of the balance of payments that considers all cash outflows and inflows over a certain period, the US has a $1,000 current account deficit that is exactly offset by a $1,000 capital account surplus. Japan has a $1,000 current account surplus that is exactly offset by a $1,000 capital account deficit. Under the accounting identity that a country’s Balance of Payments (BP) = +/- Current Account +/- Capital Account = 0, both the US and Japan have a Balance of Payments (BP) = 0.

For the US: -$1,000 Current Account Deficit + $1,000 Capital Account Surplus = 0 BP
For Japan: +$1,000 Current Account Surplus – $1,000 Capital Account Deficit = 0 BP
Bottom Line/Summary from the two-country, two-transaction example of trade above:

a. Individuals trade, not countries.
b. International trade is win-win so there are no losers, only winners.
c. Merchandise trade deficits (current account deficits) are offset by financial investments surpluses (capital account surpluses). Merchandise trade surpluses (current account surpluses) are offset by financial investments deficits (capital account deficits).
d. There is no “trade imbalance” or “trade deficit” when all cash inflows and outflows for both merchandise transactions and financial asset transactions are accounted for, i.e. the Balance of Payments = 0.

e. Trade deficits are not a sign of economic weakness as the media so frequently reports, and increasing trade deficits are not a “drag” on the economy. As Jon Murphy has pointed out, rising trade deficits and imports are only a drag on GDP, based on the way that GDP is calculated, but not necessarily a drag on the economy or economic growth. Further, even to the extent that merchandise trade deficits might “drag” on the US economy (which they really don’t), the media constantly fails to report the financial investment inflows/surpluses (“capital account surpluses”) that are always the flip-side of the trade deficits, and further fail to recognize some of the significant and positive economic benefits to the US economy from those foreign capital inflows (“vital capital-creating, job-generating foreign investments for a better America”).

Update: In response to the lively discussion in the comment section about whether an increase in the trade deficits and imports should correctly be considered as a “drag on economic growth,” I present this Cafe Hayek blog post from Don Boudreaux “The Trade-Deficit Zombie Continues Its Haunting Ways“:

You report that “the U.S. trade deficit widened sharply in October as exports weakened following a summer surge, and imports jumped, setting up a likely drag on overall economic growth in the final months of 2016” (“U.S. Trade Deficit Widened Sharply in October,” Dec. 6). This reporting is sub-par.

Because about half of American imports are raw materials or intermediate goods used by U.S.-based producers, why does a jump in imports necessarily portend slower economic growth? This jump in imports might well fuel faster economic growth or signify producer optimism about future sales. Also, because a rising trade deficit means more capital flowing into the American economy – and because more capital flowing into the American economy generally promotes economic growth – why is your reporter so quick to conclude that an increase in the trade deficit is “setting up a likely drag on overall economic growth”?

MP: Beyond the technical accounting issues of exactly how imports, net exports, and trade deficits impact the calculation of GDP, I think the most important point is that an increase in imports (and the trade deficit) is not necessarily, or even usually, a sign of economic weakness and should not be considered a “drag on the economy.” Whether or not an increase in imports and the trade deficit are a “drag” on “gross domestic production” according to national income accounting, it’s definitely the case that rising imports leading to larger trade deficits are not a drag on the economy, or a drag on economic vitality, or a drag on our standard of living (see Morganovich’s example in the comments), or a drag on economic activity more broadly measured.

Related: See Daniel Griswold’s 2011 Cato article “The Trade-Balance Creed Debunking the Belief that Imports and Trade Deficits Are a ‘Drag on Growth’“:

A nearly universal consensus prevails that the goal of U.S. trade policy should be to promote exports over imports, and that rising imports and trade deficits are bad for economic growth and employment. The consensus creed is based on a misunderstanding of how U.S. gross domestic product is calculated. Imports are not a “subtraction” from GDP. They are merely removed from the final calculation of GDP because they are not a part of domestic production.

Contrary to the prevailing view, imports are not a “leakage” of demand abroad. In the annual U.S. balance of payments, all transactions balance. The net outflow of dollars to purchase imports over exports are offset each year by a net inflow of foreign capital to purchase U.S. assets. This capital surplus stimulates the U.S. economy while boosting our productive capacity.

…………

In theory and in practice, rising imports, or a rising gap between imports and exports, does not hinder economic growth, stock market appreciation, manufacturing output, or job creation. In fact, all the evidence points in exactly the opposite direction. Misguided efforts to restrict imports to cure the trade deficit would cause far more harm than good to the U.S. economy."