The World Economic Forum at Davos has released a working paper which tries to correct a number of misconceptions that President Trump, and many other people, have about trade. Reuters talks about it here. Trade doesn’t change the number of jobs in an economy, only which jobs are done, more trade doesn’t mean a slower growing economy, etc. — these are all standard things economists agree on regarding trade.
But there’s something much more important that we’ve all got to understand. A trade deficit doesn’t make an economy smaller than it would be without one, nor does a trade surplus make it larger. This is such a common mistake that we see it in newspaper reports about trade figures all the time. Things like “a larger trade deficit was a drag on GDP” and so on, something which is just flat out untrue.
The size of the trade deficit, or surplus, makes no difference to the size of the economy at all. Editors hate it when I put an equation into a piece but, sorry, here goes:
GDP=C+I+G+(X-M)
GDP is consumption plus investment plus government (and that’s purchases, not redistribution such as Social Security or food stamps) and the balance of exports minus imports. So, everyone looks at that and sees that if there’s a trade deficit, then X-M is negative, so GDP is smaller, right?
And yet that’s the part that’s wrong. But almost everyone believes it to be true, even those who write up the press reports on the GDP figures when they come out. We should all know it’s not true, because the next page of the economics textbooks tells us it’s wrong.
The size of the trade surplus or deficit makes no difference to GDP.
GDP is one and all of three different things. It’s all production, all incomes, and all consumption. The three are, by definition, equal to each other. This isn’t an arguable point, this is how we define GDP itself. Precisely because this is true, we’ve got to treat imports and exports as we do.
So, we make some stuff and send it off to foreigners. They’re consuming it, right? But we’ve got the income from it and we produced it — but all three, income, production, and consumption must be equal. So, we’ve got to add exports back into GDP to make them equal. Similarly, we’ve imported stuff which we’ve consumed. But we’ve not got the incomes from having produced it, so we’ve got to subtract it from GDP. This is just what we’ve got to do if we’re going to balance the three different measures of what GDP is.
Another way to say the same thing is that anything that has been imported is already included in things consumed, or invested, or that government has bought. So, when we work out what has been produced domestically (it’s “gross domestic product,” recall), then we’ve got to deduct it or we’ll be double-counting those imports. Just as we’ve got to add the exports.
The net effect of all of this is that when people say the trade deficit makes the economy smaller, they’re simply wrong. Confused, perhaps, but still wrong — confused by the technicalities of how the economists are doing the counting. A trade deficit simply does not make the American economy smaller, whatever Trump or anyone else says about it.
Economists really are right about this: Trade deficits just don’t really matter. And we’d have better economic and trade policy if people understood this simple point.
Tim Worstall (@worstall) is a contributor to the Washington Examiner's Beltway Confidential blog. He is a senior fellow at the Adam Smith Institute.
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