The trade deficit is the value of a country’s imports minus its exports. A country has a trade surplus when the value of its exports exceeds the value of its imports. The United States has a large trade deficit (roughly half a trillion dollars in 2019), while countries like Germany and China have large trade surpluses.
The trade deficit is a frequently misunderstood economic statistic due to currency effects. Suppose a country becomes more productive and thus able to export more. As a result, the demand for that country’s currency rises, raising the value of the currency. Since the value of the currency rises, that means imports become cheaper for the country. As a result, even while the positive productivity shock increases exports, it will increase imports correspondingly and the “current account” (the balance of trade) will remain balanced.
It’s worth understanding these points in detail. Suppose the United States discovers a new way of efficiently extracting oil and starts exporting it en masse. As a result, lots of foreigners need to acquire dollars to buy that oil. So whereas before there might be 20 pesos to the dollar, now it becomes 22 pesos to the dollar. How does this affect imports? Well suppose an American company wishes to import avocados from Mexico for 10 pesos per avocado. Before that would cost them 50 cents. Now, because the dollar got more valuable, it costs them 45 cents. As a result, the increase in exports causes a corresponding increase in imports and the trade deficit or surplus remains unchanged.
The same logic explains why tariffs cannot reduce the trade deficit. Suppose the United States imposes a 25% tariff on goods from China. As a result, demand for the Chinese yuan declines as fewer people in the US want to buy goods from China since the price has risen 25%. Whereas before it may have cost 7 yuan to the dollar, now it may be 7.70 yuan to the dollar. Now suppose a company in China wants to buy soybeans from an American farm and it usually costs them 100 yuan/bushel to do so at the old exchange rate. Now because the value of the yuan has fallen vis a vis the dollar, it costs them 110 yuan. As a result, they import less and the trade deficit remains unchanged.
If tariffs and other policies do not increase or decrease the trade deficit, how then is it possible for the United States to sustain a massive trade deficit?
It’s worth noting that it is generally misleading to look only at bilateral trade deficits. Suppose Country A sells $100 of goods to Country B, who sells $100 of goods to Country C who sells $100 of goods to Country A (and that is the only financial transaction between the two of them). While Country A has a $100 bilateral trade deficit with Country B, their overall current account (trade balance) is balanced. Thus policies and technological developments can affect bilateral trade deficits, but currency effects mean that the overall trade balance should remain unchanged. But nevertheless, countries like the United States do have a large trade deficit. How is this possible?
Some countries can sustain trade surpluses and deficits if they are part of a currency union (such as the Euro area). While an increase in German export technology will increase demand for the Euro, since Germany is but a fraction of the total Euro area, it will not create a fully offsetting amount of imports in Germany. That is how Germany can run persistent trade surpluses while Greece can run persistent trade deficits.
Countries can also sustain trade deficits if they engage in large amounts of external borrowing. External borrowing occurs when a country consumes more than it produces–this can only possibly work if the excess consumption comes from abroad. As a result, the cause of the U.S. trade deficit is entirely its large external deficits.