The United States, much like its global counterparts, employs a system of double-entry accounting to keep tabs on certain aggregate metrics collectively referred to as National Income Accounting. Among these metrics is the balance of trade, which highlights the difference between a country’s imports and exports. If imports surpass exports, we find ourselves facing a trade deficit; conversely, when exports exceed imports, we enjoy a trade surplus. A state of equilibrium, where imports equal exports, is termed a balanced trade. While the balance of trade technically encompasses both goods and services, much of the public discourse tends to focus on the trade of goods, commonly referred to as the “Merchandise Balance of Trade.”
However, the concept of the balance of trade is often misunderstood. Historical figures like David Hume and Adam Smith have critiqued its utility, suggesting that it can do more harm than good. Hume, in his essay “On the Balance of Trade,” discusses how those “ignorant of the nature of commerce” misinterpret this balance. Smith, in his seminal work Wealth of Nations, goes even further, labeling the entire concept as “absurd” on multiple occasions (see pages 377 and 488 in the Liberty Fund edition). Much of his argument against protectionism and mercantilism in Book IV is fundamentally a critique of the balance of trade itself.
Despite its inclusion in National Income Accounting, confusion surrounding the balance of trade continues to thrive. The terminology of “surplus” and “deficit,” along with the accounting conventions of pluses and minuses, can mislead those unfamiliar with the concept into believing that deficits are inherently negative while surpluses are positive. Yet, a deeper examination reveals that 1) both “deficits” and “surpluses” are value-neutral, and 2) labeling these as “trade deficits/surpluses” is somewhat misleading.
It is crucial to understand that the balance of trade is not predominantly about merchandise trade but is actually a reflection of the broader relationship between national Savings and national Investment. We can illustrate this with the accounting identity:
GDP = Consumption + Investment + Government Savings + Net Exports,
From this, we can derive that
Net Exports = Savings – Investment.
In simpler terms, if the demand for Investment funds exceeds the supply of saved funds, the nation will inevitably need to import savings from abroad. This situation often leads to foreign investors purchasing fewer tangible goods, opting instead to acquire assets.
Both Saving and Investment are influenced by a variety of factors that are largely independent of the volume of goods traveling across borders. Elements such as real interest rates, growth expectations, market confidence, institutional quality, and other macroeconomic indicators play a far more substantial role. Robert Carbaugh, in his textbook International Economics, notes that approximately 98% of transactions in the foreign exchange markets involve currency exchanges for investment purposes rather than for purchasing goods or services. Given that the foreign exchange market processes around $6 trillion in trades daily, that’s a staggering amount of currency—dollars, pounds, yen, euros, and more—exchanged to match savers with investment opportunities.
Thus, the balance of trade emerges as a byproduct of macroeconomic realities. It serves, at best, as a symptom of broader economic phenomena rather than a root cause. Furthermore, since it is individuals—not nations—that engage in trade, understanding any trade deficit requires an exploration of the underlying dynamics between Savings and Investment. Investment typically stems from firms and individuals engaging in significant capital expenditures, such as buying a home. If these investments are directed toward enhancing long-term productivity, a trade deficit can signal positive economic activity. Conversely, if borrowing occurs without such productivity gains, the trade deficit may indicate underlying economic distress. Ultimately, it’s essential to recognize that the balance of trade is largely disconnected from the act of trade itself; it is shaped by much grander macroeconomic factors.
This brings us to the essence of my argument. Perhaps a more accurate term for the balance of trade would be the “balance of savings,” though even this might lead to further misunderstanding. No nation, government, or entity is legally held accountable for the balance of trade. A trade surplus is not synonymous with profit, nor does a deficit equate to a loss. Additionally, a trade balance does not necessitate “financing” in the conventional sense, nor does a deficit imply an increase in national indebtedness. Such terminology arises solely from accounting conventions, a historical quirk of integrating trade into a system of accounting—nothing more.
