Trade Deficit: Definition, Causes, and Economic Effects

A trade deficit occurs when a country imports more than it exports. Also known as a negative balance of trade, a country with a trade deficit has spent more money than it has made in international trade with the rest of the world. The balance of payments (BOP) records all free trade made between countries and will show when a country has a trade deficit or a trade surplus. The balance of trade can be measured using goods and/or services and can be calculated in three ways—current account deficit, capital account deficit, and financial account deficit. A trade surplus is the opposite of a trade deficit: If a country’s exports of goods or exports of services exceed its goods imports or service imports, it has a goods surplus or services surplus.

It can be hard to pinpoint the exact cause of a trade deficit. Typically, multiple factors are at play. Here are some of the leading causes of an increase in a country's trade deficit.

• Economic growth: A large trade deficit can actually indicate economic growth. When the economy of a country grows and strengthens, consumers have more wealth to purchase goods from overseas, which will increase the trade deficit. A strong economy also attracts foreign investors, further enlarging the trade deficit.
• Increased government spending: An increase in government spending can mean a country's savings diminish, increasing the trade deficit.
• Changes in exchange rate: A change in the strength of a country's currency can impact the trade deficit. When a country's currency weakens relative to other nations, trade between other countries becomes more costly. If a country’s currency is strong, it may want to import more goods or services.
• Limits of production: Certain goods simply cannot be produced domestically, or are much cheaper to produce abroad due to climate, natural resources, or other reasons. For example, a small island nation may rely on imports of agricultural products from the mainland.
• Removal of barriers to trade, such as tariffs: Trade policy can have an effect on the trade deficit, but unless the country was previously closed to trade, trade policy mostly serves to shift the trade deficit toward another trading partner, rather than creating or increasing the overall trade deficit.

Here are some of the ways a trade deficit can affect a country’s economy.

1. 1. Lower prices: A country may have a trade deficit because it is cheaper to purchase goods internationally than to produce them at home. This means that prices of consumer goods and services may decrease.
2. 2. Weakening currency: A trade deficit has the potential to weaken a country’s currency. Here’s how this works in theory: If the United States buys European goods with U.S. dollars, the European exporters will then need to exchange their dollars for euros. Euros will be in higher demand than dollars, and the dollar will weaken. In reality, many countries keep their U.S. dollars rather than exchange them, because they use U.S. dollars as their reserve currency.
3. 3. Deflation: A country that has a trade deficit is sending a portion of its currency overseas. This can cause deflation, a state in which reduced demand leads to lower prices.
4. 4. Changes in employment: If a country imports more than it exports, unemployment may increase. For example, if a country shifts from manufacturing cars to importing cars from international car manufacturers, the job market for car manufacturing will be negatively impacted. Some economists argue that the reduced prices caused by a trade deficit can make up for these losses, by allowing resources to be allocated to new jobs, while others suggest that workers displaced by shifts in trade are unlikely to benefit from jobs created in other fields.
5. 5. Decrease in GDP: Trade deficit is one factor used to calculate a country’s Gross Domestic Product (GDP), a measure of the size of the economy. If the trade deficit increases, the GDP decreases.

While the word deficit implies something negative, some economists believe that a trade deficit can be a good thing.

1. 1. Benefits for consumers: By definition, countries with a trade deficit consume more than they produce. Being able to import products for low prices can be a benefit for citizens and a sign that the economy is thriving.
2. 2. Increased local spending: If a trade deficit weakens a country’s currency, the deficit can actually balance itself out, making international goods more expensive to buy. This can encourage people to buy goods from within the country, placing downward pressure on the country’s currency.
3. 3. Increased foreign investment: A trade deficit doesn’t have to be a bad thing if the country with a deficit is seen as desirable or foreign direct investment. The U.S. dollar, for example, is much of the world’s reserve currency, creating a strong demand for U.S. dollars globally. Investors who sell to the U.S. in order to obtain U.S. dollars increase the trade deficit while increasing the asset wealth of the U.S. economy.

Depending on the overall economic context, a growing trade deficit can be a cause for concern.

1. 1. Foreign buyout: If a country has a trade deficit over the long term, this can have a negative impact on the ownership of businesses, property, raw materials, and other assets. A country with a trade deficit will attract foreign investors who can buy assets from the country. The more this happens, the less the country retains ownership of its own assets.
2. 2. Currency problems: If a country has a fixed exchange rate, a trade deficit may make devaluation of the currency impossible, which will negatively impact wages and employment in the country.
3. 3. Increased budget deficits: Some economists believe there are strong correlations between trade deficits and budget deficits. A country with a trade deficit may keep their national budget tight for fear of increasing the trade deficit further. Budget deficits can impact all parts of civic life, including education, infrastructure, and business.
4. 4. Reliance on foreign countries: If a trade deficit is caused by a large amount of importing from another country, that can leave the importing country at the mercy of the exporting country’s foreign trade policy or supply chain issues. Some see this power as a potential security threat.

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