Trade Deficits and Current Accounts. Is Mercantilism Inevitable?

In the past few days, a substantial amount of articles has been aiming at either defending (or better semi-defending since most arguments do not really prove or disprove anything) or attacking mercantilism. Thus, I decided I'd give my (rather lengthy) view of the subject.

To begin with, mercantilism is "the economic doctrine that government control of foreign trade is of paramount importance for ensuring the military security of the country. In particular, it demands a positive balance of trade." The system flourished in the 16th-18th century in Europe, although lighter forms of it appeared after World War II in several countries, where tariffs and taxes were imposed. Mercantilism is obviously not a system which can be sustained if every country in the world assumes it since in order for one country to have a positive balance of trade other countries need to have a negative one (on aggregate, this is a zero-sum game). The system favours domestic corporations and puts barriers on foreign ones, although in lighter forms of mercantilism many foreign companies have managed to successfully establish their presence in a country. The economic rationale behind these policies is that trade deficits matter; not only do they matter but they are of great importance to a country's well-being. So, do they?

As usual, economists are divided on the subject. Monetarists, echoing the words of Milton Friedman and following the rationale of David Hume state that a country could not permanently gain from exports because the income from exports would make prices rise in the country, thus making exports less attractive and imports more attractive. On the aggregate and in the long-run, countries' trade balances would balance out. On the most extreme form, Frédéric Bastiat asked the following question: "If I send $50 of wine abroad, sell it for $70, buy coal from the foreign country at that price and import and sell it in mine for $90 imports would be higher than exports (Imports=$70, Exports=$50) yet the trader would be richer." Using reductio ad absurdum Bastiat pointed out that a trade deficit is an indicator of a successful economy not a deteriorating one. A similar thesis is held by most mainstream economists today, with Gregory Mankiw stating that "Trade Can Make Everyone Better Off" in his "10 Principles of Economics".

On the other end of the spectrum, Keynesians state that the balance of trade matters. This is why Keynes had proposed the International Clearing Union and the Bancor at the Bretton Woods Conference; in cases of severe crises occurring governments could control the flow of capital and trade to their best interest. Similar proposals have arisen ever since the 2008 crisis, notably by Zhou Xiaochuan the Governor of the People's Republic of China which prompted an IMF analysis on the subject. (For details on Keynes's proposal George Monbiot has an excellent article on the subject). The prevalent opinion amongst those who believe that deficits matter is that one country is indebted to another (or several others) when it continuously runs a trade deficit. 

Nevertheless, if trade deficits matter and nations have to do all in their power to keep them at a minimum, then they will in fact be forced to act under a mercantilistic system. The simple reason is that if a country has to make sure that its exports match its imports at the end of the day, then it has to either control for the one or the other. Since it cannot obviously control for exports (other countries drive demand even if production is increased) then all it can control for is imports. Thus, the only solution is to limit imports to the amount of exports. In addition, if deficits matter this will not just be a country's private knowledge. Every other nation in the planet would also like to balance its trade every year and thus they would begin to pay attention to how much they import. And what better way to do that than by providing incentives for growth to domestic companies and by imposing tariffs and taxes on imports?

What proves to be rather against the Keynesian treatise is explaining why a nation becomes a debtor when it continuously has trade balances: the only way a nation could be a debtor is if it is buying directly from another, i.e. if the public sector of the economy is buying products or services from abroad. This does not hold if the country is not using its currency reserves to buy these goods; in essence it does not hold when the private sector is causing the deficit. The private sector's imports can in fact raise output in the country; this dates back to Bastiat's explanation of the subject and can be shown in a simple model:

GDP=G+C+I-X+M

where X is exports, M is imports, C is consumption, G is government spending and I is investment. Assume that G, I,C and M are constant. Now suppose that in a given country increases its imports by amount V; this would mean that GDP would be decreased by V. However, why are goods imported if not to be consumed? Thus, the import of goods would mean that C would also rise. Even under the very reasonable assumption that not all imported goods are consumed during the same calendar year, they are added to I, which means that no matter how much imports they cannot have any negative effect on GDP. In fact, deriving from Bastiat again, since merchants want to gain some profit from the transactions, the final price (i.e. the one measured as C in GDP) would be higher than V, meaning that an increase in imports would essentially raise GDP by more.

So are trade deficits totally innocent? Not really: if you remember, an increase in consumption means that demand is higher, thus prices will rise; an increase in prices means an increase in inflation (the way conventionally measured). Although the relationship is not very clear due to the lack of a longer data series, it can be seen in the following graphs: when the balance of trade is negative, inflation is higher in the US.

Even if the data series is relatively short, it is rather obvious that the inflation rate was lower during the times where the trade deficit was lower than other times. Yet this is not all there is to trade deficits. Enter the Current Account: "the sum of the balance of trade (i.e., net revenue on exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign investors) and cash transfers." Using Bastiat's example in a simpler form, we assume that country A exports $50 worth of goods to country B and country B exports $70 worth of goods to country A. Then this would mean that the Current Account of country A CA(A) would be -$20 and CA(B) would be +$20 than it would have otherwise been. However, consumption in country A would be raised by $20+ε (ε designating the increase in price when the good would be sold) and in country B it would be  decreased by $20. 

The current account change indicates the flow of funds in the economy. Thus a negative current account balance would indicate that total money in the economy would be decreased (if nothing else changes) while a positive CA balance indicates a rise in the amount of money in the economy. Then, we are faced with the following the scenario: the net importer sees its money supply fall while its consumption increases and the net exporter sees its money supply increase and its consumption fall. What happens to inflation then the reader may inquire. If we assume that the change in money supply has equal effect to the level of prices as does the change in consumption, then on aggregate country A (the net importer) would have a positive change (20-20+ε=ε) thus a rise in inflation and the net exporter (country B) would have a zero aggregate change (20-20=0). Yet, since the change in the money stock is usually more powerful than the change in consumption (or at least it should be) then we would expect that in the real world, the net importer would witness an increase in the level of prices (i.e. a greater inflation rate than it would have otherwise been) while the net exporter would face a decrease in the inflation rate (disinflation).

The above can also be seen in a country which has a large export sector, Germany. When the balance of trade is positive, the inflation rate is lower than during other times; when the balance of trade is positive, yet less than what it used to be, inflation is again higher. (Note: private consumption is constantly rising in Germany over the the past 20 years. This does not mean that this case does not hold since consumption can rise for many reasons not just the balance of trade, e.g. population increase. For details on inflation read this)

Returning to our original question do trade deficits matter? It depends on whether one considers the inflation rate to matter. If an inflation rate of 2-3% does not matter then having a trade deficit when the rate is 1% will not mean anything. This changes when the inflation rate is increased to 10 or 15%. Thus, it depends both on the size of the deficit and its continuity. For example, even though the US has been experiencing trade deficits and current account deficits in the last 25 years it has not affected the economy's ability to grow and prosper.

An implicit subject in the whole above analysis is that every country has the ability to print its own money. This subject, which was taken for granted until the developments in the Eurozone nearly a decade ago, is anything but certain now. The Eurozone countries for example have to take much greater care with their finances than the US or the UK, since in the absence of new currency entering the market, the monetary outflows will decrease money in circulation if they experience large and prolonged current account deficits. This will lead to a situation where the amount of money in economy will become scarcer every year, leading to a deflationary state, with all the known consequences. After a country which does not issue currency reaches that level of deflation, imports would collapse since it cannot further sustain them and a period of lower consumption and lower GDP would take over.* The question posed is whether if the situation would remedy itself or if it will require an intervention of some sort; in addition what kind of monetary policy should the ECB pursue to avoid such issues.

The answer is that both are possible: the situation will eventually remedy itself but the period would be longer and the consequences direr than if the country could just print its own currency. In essence, the country would see its consumption fall, unemployment rise and witness a general slump in economic activity which would in time (although the length required to do depends on the economy's ability to adjust) decrease demand for foreign goods, decrease prices and force exports to rise. Nevertheless, this case means that the economy would have much larger variability than it would otherwise have; in order to avoid such a case, Eurozone countries should be extra careful with their finances, leading again to some sort of protectionism. While the ECB will lower the probability of this happening in the near future and possibly reducing the consequences by continuing its money mandate, I would not dare suggest that any proprietary measures would (or could) be taken for any nation which will face a current account problem. Given the current situation in the Eurozone it is very doubtful whether any ECB intervention (or increase in money supply for that matter) could be done to avoid or counter the occurrence of the problem. 

A summation of the above analysis would be this:
1. Trade deficits matter with regards to inflation with net importers having greater inflation than if they were balanced and net exports lower than balanced.
2. They also matter with regards to money supply with net importers seeing a decrease in money supply and net exporters a rise.
3. Trade deficits and Current Account deficits do not matter much if they are not extremely large and if the country can produce its own currency. Yet, they matter a lot if they cannot.
4. If trade deficits (and subsequently current accounts) matter then countries should consequently either start paying attention to their imports and exports (which would lead to mercantilism/protectionism) or just let free trade be (and witness large ups and downs in the economy).

Free trade can and has worked in the world economy, being a stimulant over the past 30 years. Yet, what was once considered a burden, i.e. the existence of too many currencies, was what actually assisted to the development of trade. In an inflationary world, economies work much better than in a deflationary one, making the economic future of the Eurozone countries depend on their course of action regarding trade balances.

*Readers may (rightly) ask: "then why is this not happening to the US?" The US face a very similar situation with the Eurozone as their states are (economically speaking) tied the same way to the greater country. Nevertheless, after examining some of the existing data what makes the US different from the Eurozone lies in a sentence in page 11 of the .pdf file (or page 313 if you prefer) "Put another way, each state indirectly subsidizes or is being subsidized by the other states". This means that specific states would never run out of money as long as the whole nation is prospering (that is, its citizens will not witness deflationary pressure) since states are assisting one another. With this in mind, the Eurozone is inherently different: the ECB can never "print" new euros to support nations with current account problems thus the probability of EZ Member-States facing problems is (much) larger than the one for US states.

P.S. Given the recent publicity Keynes's plan with Bancor and the ICU has taken I would like to note that at the time when Keynes was proposing the plan was one where the world was leaving the gold standard behind and the process had just began. It was a time of managed currencies, tariffs and barriers to trade, with the world divided between communist and capitalist countries, with dire memories of the Great Depression and a World War, entering an era which lasted for almost 50 years. The circumstances at the moment are much different than the ones when Keynes proposed his plan. Although I am not against the IMF changing its agenda, it would be somehow pointless to promote a currency just for trade given that we do not wish to impose trade barriers or mercantilistic tactics and that fund transfers and done in fractions of a second. If a large crisis occurs, controlling capital and trade would be indeed beneficial to the country's economy; nevertheless, if all countries did that we would again end up in mercantilism. If Keynes was alive today I doubt whether his plan would have been the same as the one in the 1944. In his own words: "In my facts change, I change my conclusions. What do you do Sir?"