The Economics of Trade Balances

Last month, I explained why trade deficits don’t matter.

I make the same point in this short video from Freedom Partners.

Near the end of the video, I pointed out that unfettered trade is good, whether with your neighbors or with people in other nations.

And I also mentioned trade with people in other states, which gives us a great opportunity to look at how free trade between American states developed and what it has meant for U.S. prosperity.

Writing for the Wall Street Journal, John Steele Gordon gives us a valuable history lesson on free trade inside America’s borders.

The Constitution requires free trade, the U.S. Supreme Court held in 1824. …The court ruled unanimously…that the power to regulate interstate commerce lay exclusively with the federal government and that states couldn’t impose impediments to that commerce in their parochial self-interest. The economic effect of the ruling was immediate. …Charles Warren, the great historian of the Supreme Court, called Gibbons v. Ogden “the emancipation proclamation of the American economy.” The case made the U.S. the world’s largest free market by flattening state-imposed barriers to “commerce,” a word the court had defined broadly to include trade and navigation. Within a half-century, the American economy rose to become the mightiest in the world, due in no small part to the precedent created by that decision. Free trade allows maximal use of “comparative advantage” to minimize the price of goods for everyone. The lower the prices, the higher the demand and thus the larger the economy.

Sadly, we have not always applied the lessons we learned to trade across our borders.

The Great Depression was a very painful example of what happens when protectionists are in charge.

With its own example of the power of free trade to produce wealth for everyone, one would think that the U.S. would have promoted it world-wide. But for most of the country’s history, Americans have been anything but free traders beyond their own borders. …In 1930, hoping to safeguard the American domestic market for U.S. producers in the looming Depression, Congress passed the Smoot-Hawley tariff, the highest in American history. Despite the pleas of more than 1,000 economists, President Herbert Hoover signed it into law. The results were catastrophic. With the U.S. erecting higher tariff walls to protect its internal market, other countries naturally did the same in a game of beggar-thy-neighbor. American exports fell from $5.241 billion in 1929 to $1.161 billion in 1932, a 78% decline. World trade in that period declined from $36 billion to $12 billion—less, adjusted for inflation, than it had been in 1896.

Fortunately, policy has moved in the right direction ever since World War II, with spectacularly positive results.

After World War II, …The U.S., having learned its lesson, moved to lower tariffs world-wide. In 1947, 23 nations signed the General Agreement on Tariffs and Trade and began negotiations to lower tariffs, which then averaged 22%, as well as other barriers to trade. In a series of seven negotiations, …the average tariff had been lowered to only 5% by 1999. …The results of this long and often arduous process have been spectacular. World trade has increased exponentially. Merchandise trade amounted to about $58 billion in 1950. By the end of the century it was $5.4 trillion. Only 17 years later, merchandise trade had increased to $17 trillion. Trade in agricultural products and services has increased similarly. Even taking inflation into account, world trade since World War II has increased by a factor of about 30, making the whole world vastly more prosperous.

Last but not least, Gordon closes by pointing out that trade deficits are not a bad thing.

…there is the persistent though discredited belief that countries should strive to maintain a positive balance of trade, with more exports than imports. It is, of course, no more possible for all countries to have a positive balance of trade than it is for all people to be above average in height. Rapidly growing and maturing economies usually run foreign trade deficits, as the U.S. did throughout the 19th century while it grew into an economic superpower. The U.S. is again running large trade deficits, but those deficits are balanced by large capital inflows from foreign investors.

Amen. That’s the point of my video.

Especially the point about a trade deficit simply being the flip side of a capital surplus (now technically known as a financial surplus, but I’m sticking for now with the old terminology).

Let’s close by looking at the historical data on U.S. trade. Notice we had a trade deficit during much of the 1800s when we enjoyed very strong growth.

And also notice the miserable results during the 1930s.

P.S. While I generally don’t worry about the trade deficit/capital surplus, it can be a negative sign if foreigners are using the dollars they earn to buy government debt and prop up D.C.’s fiscal profligacy. But that’s the fault of Washington spending, not trade.

Addendum: The original one-minute video no longer exists and has been replaced by a longer video that covers the same material in greater detail.