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<\/figure>\nSource: US Census Bureau<\/p>\n
At face value, calculating a nation\u2019s balance of trade is a simple exercise. But the concept remains perhaps the single most misunderstood concept in all of economics. This Explainer seeks to develop a better, deeper understanding of the balance of trade, its origins, and its significance for Americans and non-Americans alike. In doing so, it clarifies the source of the common confusion surrounding what is ultimately an accounting identity, not an economic identity. To better understand the balance of trade, it is necessary to understand its source: gross domestic product (GDP).<\/p>\n
Part 2: Gross Domestic Product<\/h2>\n
GDP is a widely cited figure, used by economists and policymakers alike to measure economic output, income, and even economic well-being, despite the famed and Nobel-Prize winning economist, Simon Kuznets, warning against using GDP in this latter fashion.[1]<\/sup><\/a><\/p>\n GDP is a measure of the total dollar value of all the final goods and services produced in an economy in one year. This sentence deserves explication.<\/p>\n First, \u201cdollar values\u201d are used to provide a common unit for adding different and disparate items together in a meaningful way. \u00a0Adding, for example, the number of apples grown each year to the number of cars produced each year would give a number.\u00a0 But this number would be missing the important insight that producing a single car provides much more value than producing a single apple.<\/p>\n Second, GDP only measures final goods and services. A final good is one that is purchased by an end-consumer for use, in contrast to raw materials and intermediate goods. Raw materials are found in nature. The trees in the forest constitute a \u201craw material.\u201d For productive activities, say, building a house, trees must be harvested. The logs from the trees are milled into various dimensions of lumber, classified as an \u201cintermediate good,\u201d standing somewhere between the natural resource (the tree) and the final good (the house). The lumber is combined with other intermediate goods (nails, screws, wire, drywall, insulation) to arrive at the final good, the house, which the consumer ultimately purchases. The purchase price of the house, but not the price of the trees, lumber, nails, nor labor, is included in GDP.\u00a0 In other words, only the sale of the newly-constructed house counts toward GDP. Nothing else does.<\/p>\n Why are raw materials or intermediate goods not counted toward GDP? Because these are already accounted for in the price of the final good. If GDP figures were to count, for example, the purchase of the house and the purchase of the lumber that went into building the house, then the lumber would be double counted: once as lumber and again as a portion of the value of the house. By counting only<\/em> the sale of the house, GDP figures implicitly also count the economic activity that went into harvesting and milling the lumber, and all the other intermediate goods that go into building a house.<\/p>\n Third, GDP only counts economic production that takes place within a country\u2019s borders.\u00a0 What happens in the United States, for example, is of primary concern to US citizens and policymakers.<\/p>\n In a world of international and complex supply chains, considering only \u201cwhat is produced in the US\u201d is difficult. What if, for example, cotton is grown in the US, shipped over to Cambodia to be sewn into garments, which are then shipped back to the US for purchase by American consumers? How does GDP account for this, and which country gets to count the sale of the final good?<\/p>\n Cotton represents a raw material, and garments represent a final good. Since the final good was assembled in Cambodia, some measures of GDP would credit Cambodia with creating the final good, and credit its economy with the full production of the garment even though the cotton was imported. Other, more nuanced measures of GDP would count the cotton toward US production and the garments, less the value of the cotton, toward Cambodia\u2019s GDP. Many countries, the US included, not only export raw materials and intermediate goods to other countries, but also import raw materials and intermediate goods to make into final goods here, further complicating tabulation.<\/p>\n GDP is divided into four components: consumption, investment, government spending, and net exports.[2]<\/sup><\/a><\/p>\n Consumption (C) is spending on goods and services that people use and do not expect to resell or otherwise use later to generate revenue. Purchases of clothing, cars, food, entertainment, and travel count as \u201cconsumption.\u201d<\/p>\n Investment (I) is any spending that will either be resold later or used to generate revenue in the future. A company buying new computers or building a new factory would be classified as \u201cinvestment spending.\u201d Firms stockpiling inventories is also a form of investment.<\/p>\n Government spending, (G) in this context, is not all<\/em> government spending but only some<\/em> government spending. For example, money the government spends to build a new highway system or to maintain existing highway systems will count toward GDP as government spending. The same is true for spending on defense (the purchasing of new fighter jets, missiles, tanks), education, and public transportation, etc.<\/p>\n Programs such as Social Security and entitlement programs, however, do not count as \u201cgovernment spending\u201d in this context, so we cannot simply use the federal government\u2019s total outlays as a measure of total government spending for GDP purposes. These types of payments are referred to as \u201ctransfer payments\u201d because it is literally transferring money from one group of people to another.\u00a0 In the case of Social Security payments, it is a transfer from the currently-working people to the current Social Security recipients. In the case of entitlement programs, it is a transfer from taxpayers to the tax recipients.\u00a0 Because the issuance of these funds do not constitute the direct purchase of final goods and services, they do not count toward GDP. The recipients of these funds, however, use them to purchase goods and services, which does count toward GDP. For example, in July of 2024, the average social security check was $1,781.07. The check sent out by government, in and of itself, would not count toward GDP, but the purchasing of groceries, gas, and other final goods by the recipient would.<\/p>\n Net exports (E \u2013 M) is the final component of GDP and are defined as the total dollar value of a country\u2019s exports (E) minus the total dollar value of a country\u2019s imports (M).<\/p>\n All of this, taken together, gives us our equation for GDP:<\/p>\n GDP = C + I + G + E \u2013 M<\/p>\n Importantly, these are the only categories into which all spending must fall. Replacing these with actual figures from the Bureau of Economic Analysis<\/a> for 2023, gives us (in billions of dollars):<\/p>\n $27,360.9 = $18,570.6 + $4,843.9 + $3,027.2 \u2013 $3,825.9<\/p>\n Net exports, as a concept, is the source of discussions of the \u201cbalance of trade\u201d or \u201ctrade balance\u201d and of much confusion. At first blush, it seems that if a country could reduce its imports, GDP would increase by the amount of the reduction. Elected officials and Washington bureaucrats have used this mercantilist logic for decades, and it pervades popular culture and news commentary. Unfortunately, this assumption is flawed, both theoretically and empirically.<\/p>\n To see why, recall the definition of GDP: the total dollar value of the final goods and services produced in a country in one year. Counting exports (goods and services produced domestically and sold abroad) as a positive makes clear sense. Because they were produced in the US, this production should (and does) count toward a country\u2019s domestic production<\/em>.<\/p>\n Subtracting imports seems strange. Given the definition of GDP, it would seem that the US should completely ignore goods and services produced abroad and purchased here in the US.[3]<\/sup><\/a><\/p>\n In an increasingly global society, consumers do not exclusively depend on the businesses in their individual communities anymore but instead acquire increasingly more goods and services from afar. American households and businesses are purchasing more goods and services from foreign producers than ever before. If a US household purchases a shirt made in Cambodia, the spending on that shirt counts toward total US consumption spending, even though it is on a foreign-produced shirt. Likewise, when a US firm buys a new computer assembled in Japan, that spending counts toward total US investment spending. And if the federal government purchases oil from the United Arab Emirates, that spending would show up under total US government spending.<\/p>\n So US consumption, US investment, and US government spending each have both domestic and foreign components. Expanding the above equation for GDP by splitting these into their foreign and domestic components captures this:<\/p>\n GDP = Cd<\/sub> + Cf<\/sub> + Id<\/sub> + If<\/sub> + Gd<\/sub> +Gf<\/sub> + E \u2013 M<\/p>\n Given that GDP is only supposed to measure domestic output, why are there foreign components in the equation? In an ideal world, they would not be in there at all. Simply put, GDP should be:<\/p>\n GDP = Cd<\/sub> + Id<\/sub> + Gd<\/sub> + E<\/p>\n There are two items to note about this equation. First, it has gotten rid of all the foreign components from C, I, and G. Second, it has also gotten rid of imports, M. From the definition of GDP, this equation seems like it should be the most appropriate. But both equations are algebraically identical. Consider this rearrangement:<\/p>\n GDP = Cd<\/sub> + Id<\/sub> + Gd<\/sub> + E + Cf<\/sub> + If<\/sub> + Gf<\/sub> \u2013 M<\/p>\n All that has been done here is grouping the components of GDP by whether they represent domestic or foreign spending. Recall that Consumption, Investment, and Government Spending are the only<\/em> categories into which all <\/em>spending must be catalogued. There are no other options.[4]<\/sup><\/a> Given this, the sum of the foreign spending components would be equal to the total amount of money spent on imports. In other words:<\/p>\n Cf<\/sub> + If<\/sub> + Gf <\/sub>= M<\/p>\n With a simple substitution:<\/p>\n GDP = Cd<\/sub> + Id<\/sub> + Gd<\/sub> + E + M \u2013 M<\/p>\n Imports cancel one another, and all that remains is a sum for GDP that only counts domestic production without a trace of foreign production.<\/p>\n In short, imports are subtracted from GDP because they have been added elsewhere. For a national GDP figure to be meaningful, imports must be subtracted in order to avoid counting other countries\u2019 production as our own, not because imports are somehow \u201cbad\u201d or a \u201cdrain\u201d on the domestic economy.<\/p>\n Reducing imports would not increase our GDP at all. In the best-case scenario, reducing imports would not affect GDP, since it would be tantamount to adding a smaller number and subtracting that equal, smaller number.<\/p>\n More likely, though, reducing imports would reduce GDP. Consider the calls from both the American Left and American Right to raise tariffs, which are taxes on imports. These are being proposed under the auspices of \u201cprotecting American jobs\u201d and \u201cpromoting economic wellbeing.\u201d[5]<\/sup><\/a>, [6]<\/a><\/sup> If these measures protect jobs, they do so by raising the cost of imports to US households and, importantly, US firms, which use now-more-costly foreign-produced intermediate goods in their production processes. The tariff is passed on to consumers in the form of higher prices.<\/p>\n If businesses can get the inputs necessary to produce their products more cheaply (and pass at least some of those savings on to consumers in the form of lower prices) abroad, they absolutely will. By making it more expensive for US firms to acquire raw materials and intermediate goods, tariffs raise prices for American consumers. Higher prices mean less can be purchased, reducing GDP.<\/p>\n If higher consumer prices were not sufficient reason to concern ourselves with the misrepresentation of trade deficits, there is a second reason. A trade deficit is offset by a capital account surplus.<\/p>\n As Don Boudreaux writes<\/a>, \u201cthe truth is that US trade deficits are neither evidence of a faltering economy, nor a source of such faltering. Quite the opposite. US trade deficits exist because investors across the globe find America to be an attractive place to invest.\u201d<\/p>\n Discussions of the trade deficit by politicians and media capture only the aggregated total of goods and services<\/em> traded across borders, which we refer to as the goods account. The alleged deficit does not account for flows of currency<\/em> across borders, referred to as the capital account. \u00a0Virtually all people are now free from the tribulations of a barter economy, and money is one side<\/a> of virtually all commercial transactions. In other words, the US does not so much \u201csend exports out\u201d as barter for imports. American consumers purchase imported goods and sell our exports using money, but the money is not counted in the trade deficit.<\/p>\n Consider the simple case of a family purchasing a loaf of bread from the grocery store for $2.50. When this happens, the family\u2019s goods account rises by $2.50, and its capital account (money) falls by $2.50. For the grocers, the exact opposite occurs: the store\u2019s goods account falls by $2.50 and its capital account rises by $2.50.<\/p>\n Looking just at the goods account, the household would see a trade deficit and the grocery grocer would see a trade surplus. But the household would also see a capital account surplus, and the grocer would see a capital account deficit. Including both accounts for both trading partners reveals that everything is in balance. This simple insight remains true whether the grocery store is just down the street, in Canada, or in China.<\/p>\n When it comes to international exchange, one complication is not present with trade between domestic partners: currency exchange. While volumes of text have been written on the complexities and intricacies of foreign currency exchange and exchange rates,[7]<\/a> these complications are not necessary here.<\/p>\n Simply put, American households have dollars and Chinese factories, for example, have yuan. Americans need yuan to purchase Chinese goods, and Chinese citizens need dollars to purchase American goods. To facilitate this, American consumers sell dollars and purchase yuan. As of this writing, one US dollar buys a little over seven yuan.<\/p>\n Consider a slightly more complicated example of trade between the US and China. Most recent figures suggest that the US exported around $45 million worth of cherries<\/a> to China, Hong Kong, Taiwan, and South Korea. Meanwhile, the US imported around $52 billion worth of computers<\/a> from this same region.<\/p>\n Breaking this down into our goods and capital accounts, we see the following:<\/p>\n US:<\/p>\nComponents of GDP<\/h3>\n
The Source of Confusion<\/h3>\n
Part 3: What Should Be Done About Trade Deficits?<\/h2>\n
Foreign Currency Exchange<\/h3>\n