Perhaps no other single topic in all of economics has been so widely misunderstood as the trade deficit. Strangely enough, the trade deficit is a remarkably simple subject. Suppose you and your neighbor Jim get to talking one Saturday morning, and the two of you decide that each has some things the other wants. So you decide to trade. Jim gives you his 15 horsepower, John Deere riding lawnmower that is still in mint condition. In exchange, you give him a rake. Jim agrees to grill steaks for your family every night for the next six months. You give him a bag of dogfood. Jim gives you his brand new Porsche. You give him a bottle cap opener. Using any reasonable accounting standard, you have just accumulated a tremendous "trade deficit:" the value of the items that you have received is greater than the value of the items you gave up. When a trade deficit occurs at the individual level, you thank your lucky stars that you were fortunate enough to live next door to a chump like Jim. ("It's just like the realtor said, honey, the three most important things in choosing a home are location, location, and location.") Why is it then, that when a trade deficit occurs at the national level, it is a source of great consternation and travail?

Let's consider trade between two countries, say America and Japan. Suppose Sony of Japan sells 10,000 camcorders to Sears, Roebuck and Company in the U.S. for $500 a piece. At this point in the transaction, this trade can be summarized as follows: The U.S. gets 10,000 camcorders, and Japan gets $5,000,000 (equals 10,000 times $500) in green pieces of paper. What can Japan do with its $5,000,000? There are THREE POSSIBILITIES.

First, JAPAN CAN SPEND ITS MONEY ON AMERICAN GOODS AND SERVICES. This was exactly the scenario described in Chapter 33 when we discussed "Who Gains From Trade?" Let's suppose the Japanese spend their money on American personal computers costing $2,000 a piece. Then America ends up trading 2,500 personal computers (2500 times $2,000 equals $5,000,000) in exchange for 10,000 Sony camcorders. If we follow the flow of goods and money in a diagram, it would like something like this.

There are two things to observe in the diagram above. The first is that money and goods flow in opposite directions. If money is flowing out of the country, goods and services must be flowing into the country. Since it is goods and services that provide happiness, not money, we need to be careful and keep our eye on the ball when considering the impact of trade on America's happiness. The second thing to note is that there is no trade deficit in this case: $5,000,000 flows out of the country, and $5,000,000 flows back into the country. The monetary value of the goods we import is exactly equal to the monetary value of the goods we export.

Note that even though the monetary value of imports and exports is the same, Americans are still benefitted from this trade. Because Sears is motivated by profits, we know the reason it was willing to buy the camcorders in the first place was because it figured its customers would pay a higher price to Sears than what Sears paid to the Japanese. As a result, we know that Americans should receive more than $5,000,000 in happiness from these camcorders. Thus, this trade allows American consumers to give up personal computers that would have produced only $5,000,000 of happiness, in order to get camcorders that produce more than $5,000,000 of happiness. Even though there is no deficit or surplus, Americans are clearly made better off by this trade. So far, so good.

Now let's consider the second possibility: JAPAN CAN SPEND ITS MONEY ON GOODS AND SERVICES FROM OTHER COUNTRIES. It just so happens that American greenbacks are widely accepted as payment in international commercial transactions. So if Japan wants to buy, say, oil from Saudi Arabia, it could do that without having to first exchange its dollars for riyals (the currency of Saudi Arabia). Of course, that just pushes back the question of what happens to those $5,000,000. To keep this saga short, let's suppose that after the Saudi's sell their oil to Japan, they take the $5,000,000 they earned from that sale to buy personal computers from America. Now if we follow the flow of goods and services, it will look like this.

You would certainly think that--from the perspective of America's happiness--it shouldn't make a difference whether the Japanese spend their $5,000,000 in the U.S. directly, or buy oil from the Saudi's who in turn spend the money in the U.S. After all, the bottom line is that we are still getting camcorders in return for giving up $5,000,000 of personal computers. But look now at the respective trade balances between America and her two trading partners. Because the U.S. received camcorders from Japan and sent nothing back in exchange, we are recorded as having a $5,000,000 trade deficit with Japan. What significance should we attach to this trade deficit?

Do we even have to say it? This trade deficit with Japan is of absolutely no consequence for the happiness of U.S. consumers. For at the same time that we are running a trade deficit with Japan, we are running a trade surplus with Saudi Arabia of exactly the same amount. This should make clear that looking at bilateral trade balances can be very misleading. Again, why should we care whether Japan uses its dollars to buy from us or to buy from other countries, who in turn will buy from us? So even though we are now running a trade deficit with Japan, the outcome of this case is precisely the same as in the previous case: the happiness of America's consumers is still increased by the trade.

Let's now look at the third possibility. JAPAN EITHER HOLDS THE MONEY IT EARNS IN TRADE WITH THE U.S. OR BUYS GOODS FROM OTHER COUNTRIES, WHO IN TURN HOLD THE MONEY. This is the last remaining possibility. To see the impact on the happiness of America's consumers, let's keep careful track of the flow of goods and dollars. The diagram represents the case where Japan decides to keep the $5,000,000 it earns from selling camcorders in the U.S.

Just like in the previous case, America is running a trade deficit with Japan. Only this time, the dollars don't come back. There are no trade surpluses from other trade partners to balance this trade deficit. And this fact changes everything from the perspective of (American) society's happiness. Because now in return for getting camcorders, the U.S. gives up....you guessed it--absolutely nothing (or just about absolutely nothing). We have traded $5,000,000 of green pieces of paper in return for 10,000 shiny new camcorders. This is a great trade! As long as we remember that we don't get any happiness from dollars, but from the goods and services that dollars can buy, we see that the U.S. has gotten something of great value (camcorders) by giving up something of very little value (little green pieces of paper). It kind of makes us wonder...has our friend Jim moved to Tokyo?

In summary, when Japan (or any country) sells goods to the U.S., there are three--and only three--things it can do with the dollars it earns. If it comes right back and buys American goods and services, then Americans have to give something up for its imports, but it's still a good trade. If Japan buys goods from other countries, and those countries buy American goods and services, then it's exactly the same as the first case. And if it holds onto the dollars it earns, or buys from other countries and they hold on to the dollars, it's nothing less than a generous gift from one of our trading partners. It's Christmas all over again! Only this time Santa Claus speaks Japanese. That's it. Three possibilities, no more. The first two are good for the happiness of U.S. consumers. The third is even better. So why all this hair-pulling and chest-thumping over the trade deficit?