What is a Trade Deficit? What causes a Trade Deficit?

trade deficit, also known as a trade gap, is a negative commercial trade balance. It occurs when a nation imports more products and services than it exports, more specifically, when the value of its imports exceeds those of its exports. If a country exports $100 billion and imports $110 billion, it has a trade deficit of $10 billion. The opposite – when the value of its exports exceeds those of its imports – is a trade surplus.

Imports are the goods and services people buy from abroad, while exports are those that are sold to foreigners.  They are both the major components of international trade.

This means that a country with a trade deficit has an outflow of domestic currency to foreign markets that is greater than the inflow.

Even though most of us think that being in a situation where a country is importing more than it exports is not good, economists insist this is not necessarily so.

Any imbalance in trade should eventually correct itself over time, so several experts believe.

Do trade balances self-correct?

Are they right? Recently this belief that a trade balance corrects itself has been subject to a lot of scrutiny and controversy. An example is the United States, which has experienced decades-long and growing deficits.

Economists express concern at the growing quantity of US dollars being held abroad by nations that can sell them at any time, which would cause the value of the US currency to plummet, thus making imported goods much more expensive, to say nothing of the effect it could have on inflation.

A country can function properly if it runs a trade deficit when other nations provide funds in the form of loans to purchase the excess imports.

The causes of a trade deficit:

  • Domestic companies have located most of their production facilities abroad. This means their goods are imported when sold to the home market.
  • A country cannot produce enough to meet the needs of its population – the shortfall has to be met by bringing goods in from abroad.

The initial effects of a trade deficit:

  • Initially raises the standard of living as people have more access to a wider variety of goods.
  • It reduces the threat of inflation – as products are priced competitively.
  • It is also an indication of a wealthy population, whose purchasing power exceeds domestic production.

The lasting effects of a trade deficit:

  • Companies begin to progressively seek outsourcing opportunities.
  • Local companies start going bust as domestic demand shifts to foreign-made products.
  • The country with the trade deficit creates fewer jobs, while more are created in the nations where the imported products come from.

How governments try to tackle a trade deficit

Governments are at the forefront of tackling a serious trade deficit problem. This is typically approached by increasing import traffics and enacting laws that encourage trade protectionism.

Free-market economists say governments tend to cause more problems in the long run when they implement protectionist policies.

In many cases, making it easier for companies to expand at home, and for foreign companies to open up in the country running a trade deficit – by offering tax-breaks and other incentives – is more effective in securing long-term economic stability than putting up trade barriers.

One of the major problems with raising import tariffs is the quality of products – without free competition there is not guarantee that the best product wins, and no incentive for domestic producers to improve.

For example, if Factory A in America makes inferior TVs to Factory B in Korea, but imported Factory B televisions have a 100% import tariff, Factory A has no incentive to improve its product, because it knows the government has priced Factory B out of the US home market. The government would be encouraging the survival of inferior products, which is bad for consumers and undermines Factory A’s long-term ability to compete in world markets.