Long-run trade balance equilibrium and persistent disequilibrium effects

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.

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.

Conclusion

For many years, economists had found that trade balance equilibrium was not achieved through exchange rate fluctuations alone. This hinted that if such equilibrium were probable, it would come about only as the result of a confluence of multiple factors. The externalities that cause the disequilibrium in the trade balance will eventually need to be unwound. While for years, evidence of long-term equilibrium under free currency floats could not be validated, in recent years evidence has begun to emerge supporting the idea of trade balance equilibrium. This is not unreasonable, considering the types of externalities that need to be adjusted in order to bring about a state of equilibrium. Exchanges rates are just one -- consumer spending patterns, wages, trade policy and other factors all impact the balance of trade. The process of adjusting all of these requires a much longer frame of time than had perhaps been originally believed. More evidence should arrive in the coming years in support of long-term trade equilibrium -- it will be interesting to see if this materializes because it appears that only know are we able to gather sufficient information since the advent of free floating currencies regarding trade equilibrium.

Works Cited:

Ahmad, J. & Yang, J. (2004). Estimation of the J-curve in China. East-West Center Working Paper. No. 67, 2004. Retrieved March 31, 2010 from https://scholarspace.manoa.hawaii.edu/bitstream/10125/3706/1/ECONwp067.pdf

Akbostanci, E. (2002). Dynamics of trade balance: The Turkish J-Curve. Economic Research Center. Retrieved March 31, 2010 from http://www.erc.metu.edu.tr/menu/series02/0205.pdf

Backus, D., Kehoe, P., Kydland, F. (1994). Dynamics of trade balance and the terms of trade: The J-curve? The American Economic Review. Vol. 84 (1) 84-103.

Bahmani-Oskooee, M. & Niroomand, F. (1998). Long-run price elasticities and the Marshall-Lerner condition revisited. Economics Letters. Vol. 61 (1) 101-109

Baldwin, R. & Krugman, P. (1986). Persistent trade effects of large exchange rate shocks. NBER Working Paper No. 2017. Retrieved March 31, 2010 from http://www.graduateinstitute.ch/webdav/site/ctei/shared/CTEI/Baldwin/Publications/Chapters/Trade%20Theory/w2017.v5.pdf

Himiaros, D. (2007). Do devaluations improve the trade balance? The evidence revisited. Economic Inquiry. Vol. 27 (1) 143-168.

Krugman, P. & Baldwin, R. (1987). The persistence of the U.S. trade deficit. Brookings Papers on Economic Activity. 1: 1987.

Mahmud, S., Ullah, a. & Yucel, E. (2004). Testing Marshall-Lerner condition: A non-parametrical approach. Applied Economics Letters. Vol. 11 (4) 231-236.

Rose, a. (1991). The role of exchange rates in a popular model of international trade: Does the Marshall-Lerner condition hold? Journal of International Economics. Vol. 30 (3-4). 301-316

Samuelson, P. (1964). Theoretical notes on trade problems. The Review of Economics and Statistics. Vol. 46 (2) 145-154