No Reason to Worry About the U.S.' Trade Deficit with Germany (Or Any Other Trade Deficit)

As the cliché goes, "there is always too much of a good thing." Germany might be experiencing that with its current trade surplus, something that has caught the ire of U.S. President Donald Trump. The trade surplus has not only caught the attention of Trump. It has been covered by such media outlets as Bloomberg and the New Yorker as bad news. In its Article IV Consultation of Germany, the International Monetary Fund (IMF) also expressed concern over the trade surplus, and I can see why. When we hear a phrase such as "trade deficit," our minds are lead to believe that a deficit is bad. A deficit is an excess of spending, and in this case, is one in which the amount of imports exceeds exports. "Surplus = good. Deficit = bad." But can trade balance be that simple? I think we should answer an even more important question: Is there any reason we should even care about running a trade deficit with Germany? Should we care about trade deficits at all?

When people say that the United States has a trade deficit with Germany, it means that the United States has purchased more German goods than the Germans have purchased American goods. It is not a value judgement, but rather an accounting measure illustrating a macroeconomic trend. Trade deficit as an accounting measure is a part of the greater GDP. The GDP, which I covered three years ago in detail, can be summarized as consumption (C), investment (I), government spending (G), and the trade balance (exports minus imports: X-M), or as expressed as an equation:

GDP = C + I + G + (X-M)

As World Bank data show, trade only accounted for 28 percent of the U.S.' GDP in 2015, which means there are other larger factors that drive the economy aside from the trade balance. Let's contextualize it a bit further. In 2016, our trade deficit with Germany was $64 billion. Our overall trade balance in 2016 was $504 billion. Contrast that to the size of the entire United States GDP for 2016, which was $18.68 trillion. And this is keeping in mind that the trade balance is factored into the  GDP. 

Going back to the GDP formula, trade deficits don't matter. As Tim Worstall as Forbes illustrates, "I have a terrible bilateral deficit with the supermarket, they never buy anything at all from me. This still seems to be a useful and stable arrangement though." No one would expect the supermarket to buy an equal amount back from the customer to "even out the balance." What matters with trade is what Americans get to consume. And what did Americans consume when the United States imported $114 billion worth of German goods in 2016? Automobiles, industrial machinery, pharmaceuticals, chemical goods, food products. It's not as if the U.S. threw away $114 billion for nothing. The American people enhanced their quality of life by purchasing these German goods. Another point is that imports lower prices for domestic consumers and provide greater competition in markets, which increases purchasing power. As Cato Institute scholar Daniel Ikenson puts it:

Exports are not the reason we trade; they are the means by which we acquire imports. It is imports, not exports, that allow Americans to enjoy a higher standard of living. Exports without imports are like jobs without a paycheck.

Even better, it doesn't look like reducing the trade deficit or aiming for a trade surplus does any favors. Per the survey results from expert economists with the University of Chicago's IGM Forum, decreasing trade deficits would not improve quality of life. If we took Trump's misguided notion that imports are bad, we should simply ban imports. But doing that would undoubtedly worsen economic welfare and quality of life in the United States.

I have some other news for Trump. The United States has run a trade deficit every year since 1975. Did the United States' economy fall flat on its face over the past 42 years? Not at all! What happened was that the size of the economy tripled, the value of the manufacturing sector quadrupled, and the number of jobs doubled, the latter of which killing the notion that the trade deficit costs jobs. These facts remind us that trade deficits do not indicate much when it comes to the health of the overall economy.

Basic accounting dictates that a deficit in one place implies that there is a credit in another place. Germany is not just going to sit on the money. What does Germany do with the dollars they earn in their trade surplus? Germans can buy goods and services from the United States, buy dollar-denominated assets, or exchange the dollar for other currencies. If we go back to the GDP equation, we see what happens with savings (S) and investment:

GDP = C + I + G + (X-M)

(GDP - Tax - C) + (Tax - G) - I = (X-M)

S - I = X - M 

What the macroeconomic formulas above show is that if there is a trade deficit, the money will come back to the United States in the form of investment in the United States, which is illustrated by the $2.9 trillion in foreign direct investment in the United States and the multiple German companies operating in the U.S., including T-Mobile, Volkswagen, and Trader Joe's. As a matter of fact, U.S. affiliates of foreign companies (also known as "insourcing" companies) outperform U.S.-based companies (Ikenson, 2013). It's the sort of investment inflow that allows for the U.S. economy to grow the way it has. Another way of framing the "issue" is that the trade deficit is financed by inflows of foreign capital used to purchase U.S. assets. Since the flows are determined by national rates of savings and investment, trade policy would not do much to mitigate trade deficit. 

The formulas above also show that the trade balance reflects a low level of savings, a high level of investment, or both. Countries that are growing faster than its trading partners attract foreign investment, which is another way to cause a trade deficit. Alternative reasons as to the trade imbalance could be reckless fiscal policy, low level of competitiveness, or a consumption binge. In the case of Germany, its high savings rate boosts its trade surplus, which means that excess capital flows to other countries. Since many Germans are saving for retirement, investment from both the public and private sectors are its best chance of ameliorating the situation. 

Another facet to consider is the balance of payments. Balance of payments is the macroeconomic accounting mechanism that reminds us that the goods and services (CA), as well as assets (KA) of the United States (or whichever domestic country) is approximately identical equal to the amount of goods, services, and assets that foreigners (ORT) buy from the United States (or whichever domestic country). In the event that there is a difference, the change in foreign reserves accounts for the remainder of the difference. So in theory, the formula should look like this:

Balance of Payments = CA + KA + ORT = 0

This brings us to another point, which is the issue with Germany is not trade flows, but capital flows (Jacoby, 2017). The ECB needs to raise interest rates, stop quantitative easing, and remove Euro Zone budget restrictions that would allow for more expansionary fiscal policy. Instead of heavily relying on trade, Germany could reduce taxes on labor and consumption or reduce national savings [by increasing investment]. Other countries should work on debt sustainability. The United States could focus on its own affairs by dealing with the zero bound issue, the problem when central banks are close enough to 0 percent interest rates where it stymies their capabilities and creates a liquidity trap.

The head of the Germany Council of Economic Experts is not worried because he views the surplus as being caused by short-term factors that should fade over time, such as the European Central Bank's quantitative easing and low oil prices, which is why it should be no surprise that the German trade surplus is expected to have already hit its peak.

Since there was a lot of information covered, here is a summary of the findings:

1. There is more to an economy than just the trade balance. 
2. A country running a trade deficit is not just throwing away money. It acquires goods and services that improves consumers' lives, creating a mutually beneficial relationship between the two countries. 
3. The United States has run a trade deficit for the past 41 years, and yet, its economy has grown just fine. 
4. The trade deficit is not a good metric of economic health. 
5. Even if the trade deficit were an issue, the focus would need to be on savings, investment, and capital flows, not trade flows. 

Trump wants to blame the trade deficit in hopes of passing an "American First" trade policy. While Trump could use this as a pretense to increase tariffs or other measures on Germany, Trump would be pursuing a solution without a problem. Even better, Germany ranked fifth for most foreign direct investment (FDI) in the United States in 2014, and is also the fifth largest importer of U.S. goods. If Trump wants to make America great again, it would be wise for him to lay off the protectionist banter and focus on ways to better the American economy.