How International Trade Affects the Economy

But research has found that, for example, in 2004 the United States’ bilateral trade deficit with China based on the value added by Chinese companies to its exports to the United States was 40% smaller than the reported bilateral trade deficit that was based on the gross value of goods. 

The mirror image of this is that the bilateral trade deficit with Japan based on value added was about 40% larger than the recorded trade deficit. These differences reflect that China was a net importer of inputs to production of goods that saw their way to the United States, while Japan was a net exporter of these inputs. 

This type of problem with bilateral trade statistics does not follow through to overall aggregate trade statistics, since everything must come from somewhere, so overestimates and underestimates cancel out. 

An aggregate trade deficit is not by itself evidence of economic weakness. National income, as measured by Gross Domestic Product (GDP), measures the sum of what households consume, investment by firms, government spending, and net exports (exports minus imports). Although imports figure negatively in this relationship, this does not literally mean that imports subtract from GDP. 

The components of GDP are all interrelated and are driven by other, underlying factors. There are episodes when stronger GDP growth is associated with increasing trade deficits. For example, during the Reagan boom of 1981–1985, tax cuts and increased defense spending stimulated GDP growth. Stronger growth in national income led to higher consumption and greater investment, including consumption and investment of imports. 

At the same time, these policies led to higher interest rates in the United States, which attracted foreign capital inflows that strengthened the dollar, making imports cheaper and exports more expensive. The dollar appreciation further contributed to the increasing trade deficit. 

Alternatively, there are scenarios in which stronger GDP growth could be accompanied by a shrinking trade deficit. For instance, faster growth abroad draws in exports from the United States, which shrinks the American trade deficit while driving a higher rate of U.S. GDP growth. 

These two examples illustrate that there is no consistent theoretical relationship between the trade deficit and GDP growth. In fact, the correlation between net exports relative to GDP and GDP growth over the last half century is essentially zero (-0.6%).

Over the long term, trade deficits that are persistent reflect underlying economic conditions that contribute to higher levels of imports over exports. A nation that has a persistent trade deficit is one that is consistently spending more than it earns. Much like a household that buys more than it earns, a nation will need to borrow from abroad to fund its higher spending. Persistent trade deficits can lead to a larger or more productive economy over the long-term, if spending is for productive investment.

Manufacturing employment has decreased in advanced economies over the past two decades regardless of whether they have had trade deficits or trade surpluses. The Trump administration has argued that trade deficits are the source of manufacturing employment decline. Manufacturing employment as a fraction of total employment has been declining in the United States, a country that has run persistent trade deficits. But manufacturing employment as a fraction of total employment has been declining across all advanced economies.