Understanding Trade Deficits: How They Affect Economic Growth and Why Some Are Questioning Free Trade

Summary: Learn about trade deficits and their impact on the economy. Contact Tim to understand the benefits and drawbacks of free trade and liberalized immigration.

A consensus converged in the 1980s around three economic principles:

  1. reduced regulation of banks
  2. free trade
  3. liberalizing immigration

Today, many people in Europe, Great Britain, and the U.S. are questioning numbers 2 and 3. In particular, President Trump, his principal trade adviser Robert Lighthizer, and his top economic adviser Peter Navarro are questioning the benefits of trade, especially when that trade causes the U.S. to have a trade deficit with another country.

Trade deficits reduce economic growth, according to a theory posited by the great 18th-century Scottish economist and philosopher David Hume. The outflow of gold to pay the shortfall (trade deficit) would contract the money supply and automatically lead to the reduction of domestic prices as if by an ‘invisible hand.’[i]

What Is a Trade Deficit?

A trade deficit occurs when we buy more goods and services from a country than we sell to it. Hume worried that such a shortfall could deplete a country of its reservoir of gold since the nation that sold those goods could request payment in gold.[ii] Moreover, in theory, since the amount of gold determined how much banks could lend, any depletion of that supply would have an enormous financial effect on a country that expended more than it received.

Today, however, no country is on the gold standard, and almost all banking systems are closed. This means that their money must remain in their banking systems. Therefore, China, like any other country that sells goods here in the U.S., must use its proceeds to buy U.S. financial assets or goods and services. To ‘bring money home,’ Chinese companies must first go to the currency market and sell its dollars for yuan.

Who Buys Currencies?

Commercial and central banks, speculators, hedge and other funds, and companies that want to hedge their currency risk participate in an enormous foreign exchange market. On average, daily trading volumes approach $6.6 trillion.[iii] In contrast, the average trading volume in 2013 for stocks on the NYSE was $169 billion.

What Happens When U.S. Companies Sell Overseas?

Foreign sales by U.S. companies trap money in other countries’ banking systems. For example, German consumers buy Apple computers or iPhones with euros and Japanese consumers pay with yen. This means that if Apple or another American company wants to ‘bring that money home,’ it must also go to the currency market and sell its yen or euros.

Moreover, ‘bringing money home’ does not change the number of dollars available to our economy; it gives us no additional purchasing power. All that changes is who owns the dollars, which makes us suspect all of these claims that we need to lower the tax rate to incentivize companies and repatriate the $2.4 trillion they have trapped in banks overseas.

These companies knew the rules when they sold products overseas. So, why should we reconfigure the tax code again when most of the returning money will go to executives and shareholders, simply increasing our income inequality?

Are We Addressing the Wrong Problem?

Capitalism has a propensity for credit bubbles because, as the great English economist John Maynard Keynes pointed out in his classic, Treatise on Money, ‘It is evident that there is no limit to the amount of bank money which banks can safely create provided that they move forward in step.’ [iv]

However, what capitalism does better than any other economic system is what the great economist Joseph Schumpeter called ‘creative destruction,’ or innovation fueled by competition.[v] Thus, anything that reduces competition, such as trade barriers, has the potential to extinguish the fire that fuels capitalism and relaxing any bank-lending regulations has the potential to burn the system down.


[i] Ingham, Geoffrey. The Nature of Money. Cambridge, U.K., and Malden, Mass.: Polity Press, 2004.

[ii] Hume, David. Essays Moral, Political, and Literary. Indianapolis: Liberty Classics, 1987

[iii] Debnath, Anooja and Susanne Barton. “Global Currency Trading Surges to $6.6 Trillion-A-Day Market.” DailyFx, September 16, 2019 https://www.bloomberg.com/news/articles/2019-09-16/global-currency-trading-surges-to-6-6-trillion-a-day-market

[iv] Ingham, op. cit.

[v] Schumpeter, Joseph. Capitalism, Socialism and Democracy (New York: Harper & Row, 1942), p. 83.

These are the opinions of Financial Advisor Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only and should not be construed or acted upon as individualized investment advice. Content provided via links to third party sites should not be considered an endorsement of content, which we cannot verify completeness or accuracy of.

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Financial Advisor Tim Hayes

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