Trade balance in international economics

Trade Balance

The concept of trade balance dates back at least as far as Ricardo. Samuelson noted in 1964 that the theory of comparative advantage, in which international trade is explained, does not promise that there will be equilibrium of trade balance. Samuelson, however, was writing during the Bretton Woods period, when currencies were more or less fixed in value. Since the adoption of free float, the notion of trade balance equilibrium has become more a likelihood. It has been posited that there is equilibrium in trade balance. This paper will examine and discuss this theory. Some of the literature will be discussed, as will the impacts of long-run disequilibrium.

Trade Balance

The trade balance is the difference between the value of exports and the value of imports in an economy. If the value of exports is higher, the economy is said to have a trade surplus. If the value of imports is higher, the economy is said to have a trade deficit. Over the long-run, it is believed that equilibrium should emerge. In particular, it is believed that no nation can support a trade deficit on a permanent basis. Equilibrium is achieved when an economy faces currency devaluation as the result of long-term deficits. Under such a situation, the increase in the value of the currency would theoretically make exports less expensive, increasing exports; imports would be more expensive, increasing imports. This would bring the economy back to equilibrium under a very basic version of trade theory.

The trade balance is significant for an economy because it is a proxy for economic growth. Roughly, nations with a trade surplus are gaining wealth and nations with a trade deficit are losing wealth. Even under Ricardo's most basic example of comparative advantage, the nations need to trade equally in order to achieve equal mutual benefit. Long-run disequilibrium in trade may indicate that nations are trading on absolute advantage instead of comparative advantage. In such a scenario, the trade would be inefficient, to the detriment of both parties. This does not imply that the trade will trend towards long-run equilibrium, only that it should. If the parties are not rational, or if there are significant structural impediments to true free trade, equilibrium may be impossible to achieve.

Nations should seek equilibrium. A nation with a persistent trade surplus will be faced with inflation; nations with persistent deficits will face crippling debt payments. Wealth transfer in either direction can be sustained for years, possibly even decades, but eventually it will be critical for the health of the economy that the trade balance evens out. Krugman and Baldwin (1986) showed that long-term trade disequilibrium also causes feedback loops. They found that when the U.S. dollar traded at a persistently high level, this reduced U.S. exports. Those exports, however, were not to be recovered if the dollar dropped (which equilibrium would predict). Instead, the market position surrendered would have been taken by foreign firms and the American firms would not re-enter the foreign market. This means that the price elasticity for U.S. firms to export would have permanent implications that would impact on the ability of the economy to return to equilibrium based on a reversal of exchange rates. This brings into question the ability of the economy to ever find equilibrium.

Disequilibrium

Disequilibrium is common in world trade today. Nations such as China, Germany and Canada have run persistent trade long-run trade surpluses. The United States is among many nations that has faced a long-run trade deficit. The United States in particular makes for a good example. The U.S. is typically in a trade deficit position with both Canada and China. However, trade with Canada has traditionally fluctuated in relation to the prevailing currency exchange rates. When the C$ is high, the trade trends back towards equilibrium. The Chinese yuan, however, is on tightly controlled float, almost wholly pegged to the dollar. As a result, there is no natural control to the trade deficit and it has consistently expanded in recent years as China enjoys an absolute advantage in the production of most goods.

This shows that the exchange rate and the balance of trade bear a strong relationship. Thus, it has been theorized that a decline in the exchange rate of the party with the deficit will bring the trade back towards equilibrium. The Marshall-Lerner condition argues that this does not occur, at least not immediately. This is because the price of goods is not perfectly elastic, and because there is often a time delay on the impact of currency exchange rate changes. As the price of imports increases, the amount of imports will fall; as the cost of exports decreases, the amount of exports will increase. This condition implies that the trade balance will not improve in the short run as the result of a change in the exchange rates and may in fact worsen (Bhamani-Oskooee & Niroomand, 1998). Over time, however, consumers will adjust to the new price levels and the expected shifts in consumption will materialize. This is what is known as the J-curve (Backus & Kehoe, 1994).

It has been shown that Marshall-Lerner often does not hold -- in Turkey (Akbostanci, 2002) and in China (Ahmad & Yang, 2004). That there is little evidence to support Marshall-Lerner and the presence of a J-curve despite the predictions of the model, then the prospect of externalities must be considered. In Turkey and China -- two economies with heavy central government involvement -- the J-Curve does not exist. This indicates that with sufficient externalities, disequilibrium can be sustained. In China's case, the lack of free float on the yuan is widely speculated as one factor behind that country's persistent trade surplus.

Government involvement can also be another externality -- taxes and trade policy in particular can impact on the amount of trade that occurs between a nation and the rest of the world. Marshall Lerner also hints at elasticity being another externality. If a country does not have a J-curve, that could indicate that consumers are perfectly elastic to a price, refuting both Marshall Lerner and the J-curve. If consumers are perfectly inelastic, that could refute the J-curve as well. A major factor in the trade deficit of the United States is oil, and U.S. consumers have very low price elasticity of demand for oil. Currency fluctuations or changes in the price of crude oil have only marginal impact on the demand for oil, meaning that a currency decline will not bring the trade deficit back to equilibrium.

Impacts of Disequilibrium

Disequilibrium represents a transfer of wealth from one country to the next. Taking the United States and China as an example, because the trade balance between the two is large and is heavily impacted by China's currency policy, there are many outcomes. The Chinese economy grows, causing inflation. Under normal circumstances, it would be expected that this inflation would cause the value of the yuan to decline relative to the U.S. dollar. Instead in China inflation is high but the yuan moves slowly. Without active currency controls, the value of the yuan would be expected to increase sharply against the dollar. The U.S. dollar itself should be predicted to be on a long-term decrease against most other world currencies. There are externalities that prevent this from occurring sometimes. The U.S. dollar in particular sees strong demand as the world's safety currency, which is a source of demand only loosely related to economic fundamentals. As such, the U.S. dollar does not decline as much or as fast as it should.

Marshall Lerner predicts that the balance of trade will decrease if a currency decreases, until eventually consumers adjust, resulting in a J-curve. While externalities prevent a J-curve in government-controlled economies, it should hold in developed economies. Yet Rose (1991) showed that the J-Curve does not hold. Krugman & Baldwin (1998) argue that there is only a minor J-Curve effect and that other factors such as the decline in U.S. technological and productivity advantage may also be key drivers of trade levels. From a Ricardian standpoint, there is merit to that theory in that the U.S. may lose comparative advantage in high value goods and services, reducing its high value exports. If this cannot be matched by an increase in exports or a decrease in imports, then the U.S. trade deficit would indeed increase.

Mahmud, Ullah and Yucel (2004) found evidence that Marshall Lerner is only satisfied during fixed exchange rate regimes. Indeed, following on the findings of Krugman & Baldwin (1986), Marshall Lerner does not apply because once spending or trading patterns have changed as the result of a currency exchange rate fluctuation, those changes are difficult to reverse, even when the currency has revalued and the economics support such a reversal. The decisions undertaken by business in such a scenario may not be rational, but they are the decisions that are made in real world examples.

With the evidence running against long-run equilibrium, Himarios (2007) shows that long-run equilibrium is possible. His study incorporates more data over a longer time frame than the previous studies in the 1980s and 90s that refuted Marshall Lerner and the broader notion of trade balance equilibrium. Earlier studies based on Bretton Woods data were only refuted because the data sets of the later studies were insufficiently long. It may be, therefore, that Himarios is one of many that will now be able to demonstrate that long-term equilibrium is possible. It may that it requires nearly at least three decades' worth of data and a multi-country study in order to see the equilibrium emerge, meaning that previous theories were simply not taking into consideration the time frames that would be required for production, wage and policy shifts to be implemented and have their impact on a nation's balance of trade.

Himarios' findings do suggest that externalities cannot be maintained. While a single government can maintain consistent economic policy for decades seemingly regardless of the consequences (Cuba or North Korea, for example) a free economy cannot. Eventually a trade deficit will result in a workforce demanding jobs, for example, leading government to reduce trade barriers or lower the value of its currency. A persistent surplus will result in an overheated economy. China is not yet priced into the stratosphere, but it is becoming priced out of reach of many Chinese. Such a situation can be predicted to eventually lead to civic unrest, which would again spur the removal of externalities. The argument to be made, then, is not whether externalities can be maintained forever -- they cannot -- but for how long they can be maintained. The answer to this question, given the examples post-World War Two, appears to be in the decades. The longer the externalities are sustained against the forces of basic economies, the bigger will be the collapse.