Why Trade Deficits Matter, by Lyn Alden

Editor’s Introductory Note: This article is a guest post that I selected from a contrarian economist and investment advisor. It first appeared at the Lyn Alden Investment Strategy web site.

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Due to the ongoing trade dispute between the United States and China, as well as between certain other nations, the concept of a trade deficit is now front and center in financial media.

This article takes a look at why trade deficits (eventually) matter, and how they can factor into an investment strategy.

• Key Terms Defined
• Trade Deficit Simple Example
• Modern Trade Deficit Explanation
• Why I’m Cautious About the Dollar
• Cut to the Chase: Portfolio Applications

The short version is that trade deficits, along with a few other factors, tell us whether a country’s

currency is more likely to strengthen or weaken going forward.

However, it often takes several years for trade deficits to matter for a currency, which means that for the vast majority of investors and traders, trade deficits aren’t really factored into their analysis. Trade balances are not usually a short-term piece of trade-able data, in other words.

Instead, understanding trade deficits is more actionable in regards to long-term portfolio positioning.

Terms Defined

Trade Balance- A country’s trade balance measures the value of goods and services it exports compared to the value of goods and services that it imports. A country that exports more than it imports (i.e. produces more than it consumes) has a trade surplus. A country that imports more than it exports (i.e. consumes more than it produces) has a trade deficit.

For example, if the United States buys $500 billion worth of goods and services from China each year, and China buys $200 billion worth of goods and services from the United States each year, then the United States has a $300 billion trade deficit and China has a $300 billion trade surplus. A country’s overall trade balance is measured by adding up all the various trade surplus and trade deficits it has with all of its trading partners.

Current Account Balance- A more “complete” picture of a country’s inflows and outflows. The current account balance includes the trade balance, plus investment income between nations, plus cash transfers. A country with a current account surplus has more value flowing into it. A country with a current account deficit has more value flowing out of it.

For example, if the United States has a $300 billion trade deficit with China, but owns enough companies in China that they receive $100 billion worth of dividends each year, then the United States only has a $200 billion current account deficit with China, and China has a $200 billion current account surplus with the United States.

Net International Investment Position (NIIP)- Private citizens and government organizations of a country may own assets of other countries, like real estate, shares of corporations, bonds, and so forth. A country’s net international investment position is determined from the total amount of foreign assets its citizens and government own minus the total amount of domestic assets that foreign citizens and governments own.

For example, suppose United States citizens own $1 trillion worth of Japanese real estate, Japanese citizens own $2 trillion of U.S. real estate, and Swiss citizens own $1 trillion worth of U.S. real estate and $1 trillion of Japanese real estate. In this example, the United States has a -$1 trillion negative international investment position, Japan has a $0 net international investment position, and Switzerland has a +$2 trillion positive net international investment position.

A Trade Deficit Example

To examine first principles of why a trade deficit or current account deficit matters, let’s rewind a few hundred years and imagine two countries that use gold as money. Prior to about 50 years ago, precious metals (gold, silver, etc) were the dominant forms of money worldwide. (We’ll get back to paper money in a second example, but this is important.)

There are two countries, called the Land of Silk and the Land of Iron. The Land of Silk is known for producing beautiful silk textiles, rich spices, tasty teas, and other luxuries. The Land of Iron is known for its rich mineral deposits and engineering prowess, and makes weapons and tools. Each country starts this example with a thousand tons of gold.

The people in the Land of Iron want some luxuries, and the people in the Land of Silk want some tools and weapons. So, various merchants from each country begin traveling by ship to the other nation to do business. Some merchants barter with each other, directly trading silk for weapons, tools for teas, and so forth. Other merchants prefer the convenience of gold coins for transactions. Either way, trade is performed.

A problem arises. Each year, the Land of Iron buys 300 tons of gold worth of luxuries, while the Land of Silk only buys 200 tons of gold worth of weapons and tools. So, the Land of Iron has a 100 gold-ton trade deficit, and the Land of Silk has a 100 gold-ton trade surplus. Each year, 100 tons of gold is physically shipped to the Land of Silk from the Land of Iron via thousands of individual transactions. The people in the Land of Silk are producing more than they consume and are getting richer, while people in the Land of Iron are consuming more than they produce, and are living above their means.

Fast forward after ten years of this, and the Land of Iron has run out of gold, while the Land of Silk has all two thousand tons of gold.

Now, people in the Land of Iron are broke and can no longer buy luxuries from the Land of Silk. However, people in the Land of Silk can still buy weapons and tools. So, for the next few years, people in the Land of Iron go without luxuries (or with a lot less), working hard to keep producing their iron wares to rebuild some of their gold supplies from the Land of Silk. By necessity, the Land of Iron develops a small gold/trade surplus.

This example illustrates why trade deficits tend to be self-correcting after a while. A country becomes broke and can’t buy as much, and they get more desperate to sell things, so their exported goods and services become more competitive.

However, people in the Land of Iron start to grow restless and depressed from this new reality, working so hard and going without luxuries. The process of rebuilding their wealth is taking too long and is no fun at all. There is talk of rebellion in the air. Some of the Iron leaders get together and debate what to do about this growing discontent.

“Let’s go to war and take back our gold!” says the venerable General Vladimir Von Ironborn IV. “Bunch of dress-weaving weaklings, they are.”

“The problem,” says Lady Gemsworth, Mistress of Merchants, “is that we’ve already sold those weaklings quite a large number of weapons, and rumor has it, they also procured some defense services from the Land of Warriors with some of their huge gold stockpiles. I don’t think we could win. However, I have a better idea.”

“Hmph! Out with your plan then,” says the general, disappointed. He was hoping for a good fight; hadn’t had one in decades.

“I traveled last month to the Land of Silk,” says Lady Gemsworth. “Several of their merchants have agreed to open up some lines of credit. We can start buying luxuries again, but instead of paying with gold, since we don’t have much, we’ll continue to give them tools and weapons in addition to small percentages of our businesses and properties each year. That will keep our people happy for now until we figure out a better solution.”

So, for the next few years, the Land of Iron keeps sending weapons and tools to the Land of Silk, and the Land of Silk resumes sending luxuries to the Land of Iron. Since once again there are more luxuries being sent than weapons and tools, however, the difference is made up with some business equity and property value flowing to the merchants of the Land of Silk.

If this continues, Lady Gemsworth has put the Land of Iron in an even worse situation, because now not only do they not have much (or any) gold, but in addition, the Land of Silk owns an increasing percentage of the Land of Iron’s properties, and are entitled to various dividends, rents, and other income from those assets. Now it goes beyond just trade deficit problems and extends to other layers of the current account deficit and net international investment position.

Eventually it would get bad enough that merchants in the Land of Silk would no longer extend credit to the Land of Iron, or would demand ridiculous terms, because they worry that the Land of Iron will default on its debts.

So, with less generous lines of credit from the land of Silk, the Land of Iron will eventually be forced into buying less luxuries and to continue focusing on rebuilding its gold reserves by producing more than it consumes. Spending so many years consuming more than they produced might have made them look and feel rich on the surface, but their real wealth has diminished and eventually they run out of ways to keep it going.

The Modern Case – Paper Money

These days, we don’t pay with gold. Countries create paper (or increasingly digital) money that has fluctuating purchasing power compared to other currencies. Unlike gold that is relatively fixed in amount (other than through a very slow and labor-intensive mining process), central banks can easily issue more paper money, which may dilute the value of each unit of money depending on various global supply/demand characteristics of that currency.

A country with a consistent trade surplus and current account surplus builds up larger amounts of wealth in the form of bonds of other currencies, gold, luxuries, equity stakes in various companies and properties around the world, and so forth. People in other countries may of course own some business stakes and properties in the wealthy country as well, but the net international investment position is that the wealthy country owns a lot more assets in other countries than those countries own of its assets.

A country with a consistent trade deficit and current account deficit builds up debts to other countries, finds its reserves depleted, and sells off some of its assets to foreigners. It’s often very gradual and often not visible; even a seemingly booming economy can be financed under the surface via foreign investment and ownership.

Countries with trade surplus and current account surplus generally find that their currencies go up in value. More money flows into the country than flows out of the country, year after year, and some of this wealth essentially gets “stored” in the strength of its currency. Due to its stability and sustainable wealth, more people from all over the world want to own its currency. In addition, more people want to buy properties and business stakes in that country, which means they have to convert their currency into units of that rich country’s currency. Hence, there is substantial demand for that currency. This increased demand pushes up the value of that currency, all else being equal.

People from that rich country now have more global purchasing power. They can easily travel the world and buy expensive things from other countries. It also extends their military power if they want to use it like that, because their strong currency makes it easier to build and maintain foreign bases and buy advanced military equipment from nations that specialize in making it.

This has a self-correcting effect, however, because a more expensive currency means that the products and services of that country are more expensive for people in other countries to buy, and they might therefore buy fewer goods from that country. Their trade surplus and current account surplus may slowly diminish or level out. Sometimes wealthy nations intentionally try to devalue their currencies to present their exports from becoming noncompetitive.

The same self-correcting force happens for countries on the other side of the balance. Countries that run chronic current account deficits eventually have a crisis that results in a weakened paper currency. This means they can’t buy as much foreign goods, and their exports become more competitive and attractive to other countries. In other words, it forces them to consume less and helps them produce more, which brings the balance back towards a sustainable level.

Argentina Example

When a country has a growing trade deficit (and in particular, a current account deficit), it has a currency crisis in the making, although it can take years to happen. The deficit will eventually force the currency to weaken, and the weakening of the currency will help self-correct the deficit.

Take a look at the following charts for Argentina. The first one shows Argentina’s current account and the second one shows the U.S. dollar to Argentine peso conversion rate. I marked a red dot for the beginning of 2018 on both charts, because that’s the pivot:

Chart Sources: Trading Economics & XE

For years, Argentina was running a big current account deficit, which peaked in the beginning of 2018.

Their currency had been gradually weakening for a while, but at a reasonably stable pace. However, early 2018 was the breaking point for the currency, and it suddenly went from about 20 pesos to the dollar to 45 pesos to the dollar. It stabilized briefly a couple times, but had another big spike up in 2019 to a 60-to-1 ratio, meaning the peso lost roughly 2/3rds of its purchasing power in about a year and a half.

This major currency weakening sharply forced Argentina’s current account closer to a balanced level by reducing their ability to import things, and boosting their export competitiveness a bit.

(And I’m not trying to pick on Argentina here. I visited the country in 2014 and loved the place. But it’s an example of a specific problem to be aware of for countries in general, and in Argentina the reasons for it were complicated.)

Reserve Currency: A Unique Situation

The United States has had the world’s reserve currency for the better part of the past century, which makes its trade balance a bit unique compared to other countries.

Most oil around the world has been priced in dollars for decades. Even when the United States is not involved in the transaction, they still usually price it in dollars. The same is generally true for many other commodities.

And when countries or companies make loans into emerging or frontier markets, they often do so in dollars rather than that country’s local currency.

In addition, central banks of various countries buy U.S. dollars and treasuries and hold them as foreign-exchange reserves so that they can defend the value of their currency if needed. The dollar is by far the most-used currency for global transactions and reserves.

This gives the United States a big privilege because it creates almost endless demand for dollars, and gives the United States the rare ability to print money to pay for hard commodities. Other countries have to earn dollars (which they cannot print) in exchange for oil and commodities. It generally makes the dollar stronger than it otherwise would be, which strengthens our military projection capabilities around the world with hundreds of military bases.

However, it also trigger’s Triffin’s dilemma. Economist Robert Triffin noted back in the 1950’s that having (and maintaining) the reserve currency means you have to supply enough dollars to the world to use the currency. The world can’t use Swiss Francs for the reserve currency, for example, because there simply aren’t enough of them. It has to be a big country, and that country generally needs to run a persistent current account deficit, so that it supplies the rest of the world with its currency and they supply it with goods and services. This works for a time but eventually undermines the economy of the country that has the reserve currency.

So, a reserve currency gives the country tremendous power but also essentially places a curse on it and guarantees that such a position cannot last forever.

When Triffin pointed out his dilemma, the U.S. was on a gold standard and he said that this wouldn’t be sustainable. For the next decade, gold indeed kept leaving the country, and in 1971 President Nixon ended the gold standard, ending the convertibility of U.S. dollars into gold.

And for decades since then, the United States has had a current account deficit. It reached 3% of GDP in the mid-1980’s until the Plaza Accord purposely reduced the dollar’s strength, which helped fix the deficit briefly. Then it spiked to 6% of GDP but the self-correcting force of the subprime mortgage crisis reduced that back down a bit.

Currently it is about 2.5% of GDP each year:

Chart Source: St. Louis Fed

Due to decades of these deficits, the United States has indeed developed a large negative net international investment position, equal to about -50% of U.S. GDP:

Chart Source: St. Louis Fed

So, foreigners own a lot more American assets than Americans own of foreign assets.

This world reserve status has been both a blessing and a curse for the United States, as previously described.

Blessings: Americans have been able to live above their means for a long time (especially the middle and upper classes), the U.S. military has had strong purchasing power, and various countries have invested heavily into the United States to build businesses and technologies.

Curses: The reserve status of the currency prevents the current account deficit of the United States from ever fully self-correcting, which keeps perpetuating it. The strong dollar has made many of our exports noncompetitive for decades, which has hollowed out a lot of our manufacturing capability and hurts the working class the most.

Due to Triffin’s dilemma, a currency can’t be the world’s reserve currency forever. Eventually the accumulated current account deficits in the form of a vastly negative net international investment position will have their reckoning and weaken the U.S. dollar. This also will be a blessing and a curse, because the U.S. may regain some export competitiveness, but will have less global purchasing power and military projection capability.

China vs U.S. Trade Deficit

China has various practices that the U.S. should try to address, such as theft of intellectual property and certain other unfair business practices.

However, the trade deficit itself is a symptom of a much greater issue- the dollar’s considerable strength and reserve status. Many developed countries don’t have a trade deficit with China. We do. The problem is more on the U.S. side due to our strong currency. The U.S. has a trade deficit with Europe, too.

We can manage it around the margins, but as long as we have a very strong dollar, it’s going to be difficult or impossible to not have a trade deficit.

Portfolio Applications

Okay, all of this is a great story, but it’s getting boring. How can we apply this to a portfolio, already!?

As stated before, the issue with current accounts is that they don’t matter… until they matter.

Seeing a country with a persistent and growing current account deficit is like watching a train wreck in slow motion, or watching a guy drink and drive while also texting. You know it’s going to end badly, but when?

For two years now, I’ve released an annual report that collects various metrics for about 30 investable countries, and ranks those countries in terms of how attractive they are based on five major categories: valuation, growth, debt, currency, and stability. The second one, from earlier in 2019, is available here if you’re interested, although the data is not quite as fresh as when it came out. It’s also available for free as part of my premium research subscription.

I write that report mainly for myself, because it helps me find good investments and build my portfolios. And for example, I’ve given Argentina the worst score for two years in a row, and Russia the best score for two years in a row. Here’s how the single-country ETFs for those countries performed since the first report in June 2018:

Both countries have various pros and cons, but Russia scored the top rank for currency strength and Argentina scored the worst rank for currency strength. For a while it didn’t matter too much, and then suddenly it mattered all at once, and there currently is a 35% total return performance differential between the stock markets of these nations in U.S. dollar terms.

Emerging markets are not all the same. They are different markets with different problems, and need to be analyzed and understood separately.

I’ve had similar results for the rest of the report so far. Not every top-ranked country does great, and not every bottom-ranked country falls apart, but so far, the top-ranked countries have outperformed the bottom-ranked countries on average.

Paying attention to trade deficits, current account deficits, net international investment positions, and those sorts of metrics are not applicable for most traders, but they play an important part of risk management when investing globally for the long term and deciding how much exposure you want to a given market and a given currency.

Try to reduce or avoid exposure to countries with persistent and growing current account deficits. They’ll have an unpleasant self-correcting event at some point (and that may be a good time to look around for investments there). Or try to hedge them in some way, or be very selective, or understand the major reasons why they have such a deficit and work around it.

The United States is kind of a special case due to the dollar status as the world reserve currency, but it’s part of my thesis on why the U.S. stock market is likely not going to be one of the better-performing markets during the 2020’s decade like it was during the 2010’s decade.

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Editor’s Closing Note: Lyn Alden has studied well and has wisdom that does not match her age. Despite her youthful appearance, she has a bachelor’s degree in electrical engineering and a master’s degree in engineering management, with a focus on engineering economics and financial modeling. She now has 15 years of experience in market analysis. In addition to the Lyn Alden Investment Strategy web site, Alden also produces a Strategic Investment e-newsletter with issues released at roughly six week intervals. It is free to subscribe, and highly recommended.