1. How international trade works-balance of trade-equality of exports and imports

Balance of trade is an often talked about subject by countries. The United States whines about a negative balance of trade with China, China whines about a negative balance of trade with South Korea, etc. etc. This was covered by Adam Smith in his Wealth of Nations [1]-but needs a new look in the present context. Towards the end of this article I will present some real data on world trade to back up the conclusions of this article.

Rule: Value of Annual Exports=Value of Annual Imports (E=I). The net balance of trade of a country with the rest of the world, i.e. all other countries taken together, is always zero.

Money and currencies (dollars, euros, yuans, etc.) are just a way to facilitate the exchange of goods (and services) between countries. The existence of currencies simplifies barter; but in the end, all trade is ultimately barter. What Chile imports annually from the world, is necessarily equal in value to what it exports annually (the major exports of Chile are copper, wines, fruits, and salmon. The major imports are construction materials, cars, electronic goods, machinery). Everything which Chile sends out in the form of exports, comes back in the form of imports. The reason to consider this over a year (annual) is because there may be a delay in the accounting of exports and imports and there may be a month to month variation where a surplus or deficit might run in a month because of not receiving the money in the same month, but over a longer period of time, say of one year (assuming payments in 30 to 90 days), the net exports should be equal to net imports. Chile is not sending its good anywhere for free; and neither is any country giving away their stuff to it for free (ignoring the small amounts of goods countries send out as charity/aid). The equality of exports and imports is a necessary condition for trade.

In practice, Chile first exports its goods to the outside world (more precisely, it is the companies in the Chilean exports sector who do this), gets US dollars (or yuans or euros) for it, and uses those dollars to buy goods to be imported to Chile (the companies who import goods into Chile do this part). Currencies serve as intermediaries to facilitate this underlying exchange.

The only reason to export goods (or services) outside your country is to buy objects or services produced by other countries, i.e. to import stuff (exceptions to this are covered later below). It may help to think of the stream of exports of a country coming back to it in the form of a stream of imports, with the streams having equal values.

If you restrict all imports, then exports automatically go to zero.

It follows that if you export more, you import more. Similarly, if you export less, you have to import less. The value of what you export is the upper limit to how much you can import into a country.

Note that this is for a country with all the rest of the world taken together. However, Chile may run surpluses or deficits with any one country for a long period of time or forever, without this rule being violated. That's because countries are trading with each other, and surpluses with country A cancel out a deficit with country B.

Let us imagine a world with only three countries-Chile, USA and China. The numbers are just for example purposes, and are not real.

Chile exports 10 million dollars worth of wine to USA.
Chile exports 5 million dollars worth of Salmon to China.
Chile receives 15 million dollars worth of machinery and automobiles from China.

Therefore, against USA, Chile is always running a surplus in trade balance, because it is only exporting, but importing nothing from it.

But the surplus against USA must be exactly equal to the deficit against China, as you can see, to make sure that the net exports are the same in value as net imports for Chile.

There must be some form of trade between USA and China, where USA must be exporting something to China and running a surplus with China for exactly 10 million dollars.

An example might be

USA exports 500 million dollars of airplanes to China
USA imports 490 million dollars worth of computers from China

Taken all the data together, as shown in the figure above, makes every country's exports exactly equal to its imports.

Even if Chile is forever running a surplus against USA and a deficit against China, it all needs to add-up perfectly for it, where all exports come back as imports, directly or indirectly.

Note that in this example, USA always runs a surplus against China.

This example can be extended to 4, 5 and hundreds of countries, with similar results.

Hopefully you can see with this explanation that there's no fuss to be made about a country running a deficit with a particular country. It is just the nature of trade. For every surplus, there must be a deficit with a different country somewhere.

You can extend this concept to smaller divisions within a country (to States), to counties and ultimately to even to the individual level.

Therefore, Texas has a net trade balance of zero with the rest of the USA+other countries. What goes out of Texas, must come back into it, either from other States in the US or from other countries directly to Texas.

For an individual-what you produce, you must eventually exchange for what others produce. You eventually exchange what you produce with the what others produce.

My trade balance with Walmart is always negative-I only buy stuff from Walmart, but don't sell anything to it. Does that make me worse off? Not at all. If I was to profess equality of trade surplus and deficit with Walmart and each company separately, I would have to sell something to Apple, Walmart, Home Depot, and thousands of other companies I buy stuff from, individually making sure that I don't buy anything from these companies if I don't sell anything to them. What I do normally is sell my labor to some company, get dollars for it, and with these dollars, buy a load of stuff from Walmart, Apple, Home Depot, etc. More on this here.

Corrections and adjustments to the rule

Import-export data is typically reported by customs or commerce departments of a country. There are several ways that trade and tranfer of consumption rights across countries occurs without showing up in what's reported at customs.

A couple of corrections need to be done to the rule, 1) when a country is loaned a large amount of money by foreign countries e.g Greece or Puerto Rico, whose governments were loaned large sums of money by foreign entities and 2) when a country has a good fraction of earnings coming from tourism e.g. Costa Rica. For these countries the annual exports will not be equal to the annual imports (exports will be smaller than imports), because a loan from a foreign entity or a tourist bringing in money are effectively an assignment to bring in additional imports. When an American tourist goes to Costa Rica and spends a few thousand dollars there, those dollars are in reality used by Costa Rica to buy imported goods. Same with loans to Greece by the German banks-the loans are in Euros, and Greeks will buy stuff using their Euros for their country, without having to export any goods. When the rule is skewed by foreign loans, as in the case of Greece and Puerto Rico, it is temporary, until the loan is paid off or the country defaults, as has happened with Greece and Puerto Rico. When it is by tourism, as for Costa Rica, Bahamas, Thailand, etc. the deviation from the rule, or the imbalance of exports and imports, is stable and can continue on forever.

For example, for Costa Rica, we will find that the net imports of Costa Rica will be considerably more than the exports for Costa Rica. The tourists who come to Costa Rica will sort of bring in their own consumption rights to the country-in the form of foreign currency bills, normally US dollars. It as as if these tourists saved up loads of things to be consumed in their home countries, but instead of consuming them there, they came to consume them in Costa Rica. This increases the imports of goods for Costa Rica, because these foreign tourists in Costa Rica have the right to bring goods from foreign countries, which they normally express by carrying US dollar bills.

Some adjustments must be made for credit and foreign currency accumulation-for Chile might export stuff and instead of exchanging them for other goods right away, maybe hold US dollar reserves, to buy something later in the US or in other countries. This is a small correction to the rule E=I, because dollar or foreign currency reserves are a small part of the net value of goods exported or imported-they are  like the liquid cash any businessman holds to facilitate transactions.

If you see recent data it seems that the US is running a constant trade deficit with the rest of the world for many years. On the other hand, China seems to be running a constant trade surplus with the rest of the world. This is a problem with incomplete or bad data- not everything which goes out of  or comes into a country shows in the exports and imports numbers at customs. For example, Chinese have bought a lot of real estate in Canada, and that purchase must have been financed by something exported out of China (the goods exported from China have been exchanged with a house in Vancouver, BC, Canada). Chinese tourists are the biggest tourist group to Thailand-and are known to purchase massive quantities of goods in that country. That purchasing power also comes from what China has exported from its shores in some way. As explained above, these activities of Chinese citizens will not show up in the customs declarations or the standard export and import numbers-the real exports of China are greater than the published amounts by Chinese customs, and they need to be corrected by the amount of real estate holdings of Chinese citizens in Canada, or what Chinese citizens spend in Thailand (all normalized to time, per year).

The US stock market attracts capital from all over the world, and that will also not show up in the raw export and import numbers reported by US customs. This can continue on for many decades, as long as the US stock market keeps attracting foreign capital to it. This accumulation of US stocks by foreigners and foreign entities will not show up in the export-import numbers of the US (or of the respective countries where their foreigners reside). Instead of getting raw exports-foreign entities are happy owning US stocks, which will depress the US exports numbers temporarily (as seems to be the case in 2018). If foreign holdings of US stocks change by +$100 billion in one year, that number needs to be added to the exports of the US as declared by US customs to come up with the real value of exports (it is as if US exported $100 billion worth of US stocks in that year).

Similarly, exports and imports of intangible goods like software (software exports are a large part of exports for some countries like the US and India), and digital games, digital movies, Facebook, Netflix payments and earnings, etc. do not show up in the customs and import-export declarations. Corrections need to be made to our rule for this.

Some countries have a large amount of money coming into them from remittances by their expats abroad (e.g. Mexicans in the US). These will also not show up in customs import or export declarations, warranting another  correction to our rule.

Trying to encourage domestic industries by restricting imports has the opposite effect, it actually discourages domestic industry overall

If you agree that this basic equality of exports and imports holds, we can show that if you restrict imports in industry A to improve domestic industry in A, you must at some other place restrict the domestic industry B, which was producing B domestically, which was being exchanged for the imported product in industry A.

Before the restriction, imported industry A products must have been exchanged for something which went out of the country, products of industry B, for the trade equality to hold at that time. The moment you restrict imported industry A products, ostensibly to increase the production of industry A in the country, because you have restricted the total amount of industry A products now coming into the country from foreign sources, you must be exporting less of some domestic products of industry B.

A reduction in importation, by encouraging a domestic producer, automatically results in a reduction in exportation, and the industries which were exporting will be hurt indirectly.

A government must never restrict importation of industry A, and let the market take care of itself, because the skilled part of the country is the industry B, who by their great products and skillful exports were getting the imported products of industry A into the country.  The country has built a comparative advantage in B, that's why it is able to sell those products outside the country, and you don't want to handicap your strongest player to support your weaker players, which is what happens when you restrict imports in a particular industry.

Free trade (a trade without restrictions on imports, or exports for that matter) therefore automatically allocates capital in what the country does best.

You should not get worried at all of you see imported goods in your country, in fact, you should celebrate it, as I show here. You can be sure that a fellow countryman of yours must have exported some goods outside of your country for these goods to be imported in the first place.

To explain this important idea better, let me give you an example. The Indian government has a very misplaced "Make in India" drive to encourage domestic manufacturing. Apple is being encouraged to buy mobile phone components from domestic Indian companies, or if they want to import them, they shall be taxed heavily. What they do not realize is that the imported mobile phone components can be brought into India only by India exporting something out of the country. By forcing Apple to buy domestic components, they are hurting another (unknown) domestic industry whose products must have been exported to bring in the imported components. The US also has a "Make in USA" rhetoric, which is equally hurtful to the US because of the same reason.

What is true for capital is also true for jobs. By restrictions on imports, you push extra capital, and together with it, extra jobs into the hands of your weakest industries. The job gains in the domestic sector where imports are restricted is compensated by job losses in industries which are exporting.

Physics fans will realize that the Rule E=I is like the conservation of energy principle-energy can never be created or destroyed (except the modifications due to Einstein).

What does the actual trade data for countries look like?

With the disclaimer that trade data is very difficult to capture and what is declared sometimes in importing or exporting is not exactly the value of goods, let's see if what I have proposed above agrees with the data.

Import Export Data by country, top 20 countries by nominal GDP
All values are in billions of US Dollars, year 2016
Data source: World Bank trade data-see this link for details

Country Imports Exports  Ratio (Imports/Exports)
USA 2248 1450 1.55
China 1588 2098 0.76
Japan 607 645 0.94
Germany 1061 1341 0.79
UK 636 411 1.55
France 560 489 1.15
India 357 260 1.37
Italy 405 462 0.88
Brazil 137 185 0.74
Canada 403 389 1.04
South Korea 406 495 0.82
Russia 182 285 0.64
Australia 189 190 0.99
Spain 303 282 1.07
Mexico 387 374 1.03
Indonesia 136 145 0.94
Turkey 199 143 1.39
Netherlands 398 445 0.89
Switzerland 269 305 0.88
Saudi Arabia 164 201 0.82
Mean 1.01
Std. Dev.

The mean value of  the Import/Export ratio is (surprisingly) close to 1. However, the data has a large standard deviation of 0.26, with the range being between 0.64 to 1.55.

I found another data set for imports & exports, and here is the table for imports and exports in 1970. It is adjusted for today's US Dollars (inflation corrections etc. stuff I don't agree with, but still, I will present the data as is, from this independent source, and way back in time, 1970. I chose that year to be several decades behind today to make it two independent snapshots in time).

Import Export Data by country, top 20 countries (in the available dataset) by value of imports, 1970
All values are in billions of US Dollars (year 1970, adjusted, see link for details of adjustments)
Data source: Barbieri, Katherine and Omar M. G. Omar Keshk. published in 2016. Correlates of War Project Trade Data Set Codebook, Version 4.0. Online: http://correlatesofwar.org

Country Imports  Exports  Ratio (Imports/Exports)
United States of America 42.70 43.22 0.99
Germany* 29.96 34.23 0.88
United Kingdom 21.73 19.35 1.12
France 19.09 18.01 1.06
Japan 18.78 18.96 0.99
Canada 15.18 16.75 0.91
Italy 14.92 13.18 1.13
Netherlands 13.39 11.76 1.14
Russia 11.74 12.80 0.92
Belgium 10.85 11.03 0.98
Luxembourg 10.85 11.03 0.98
Sweden 7.01 6.78 1.03
Switzerland 6.49 5.16 1.26
Australia 4.99 4.78 1.04
German Democratic Republic 4.85 4.58 1.06
Spain 4.75 2.39 1.99
Denmark 4.40 3.35 1.31
Poland 3.97 3.55 1.12
Norway 3.70 2.38 1.55
Czechoslovakia 3.70 3.79 0.97
Mean 1.12
Std. Dev. 0.26
* Germany: Data is probably for West Germany, but I am not sure.

The mean value of  the Import/Export ratio is 1.12, close enough to 1. The data has a large standard deviation of 0.26, with the range being between 0.88 to 1.99.

I believe that the data sets of these two widely different years, 2016 and 1970, confirm reasonably well what I tried to show in the article, that the value of imports is approximately equal to the value of exports for all countries. The ratio of exports to imports tends to be close to the stable value of 1, and while it may deviate for short periods of time due to capital inflows/outflows and for the reasons mentioned above, but I am quite certain that these deviations are temporary, and for most countries for most of the time, the ratio is quite close to 1.

This article is very closely related to the article here about anti-dumping duties, restriction on imports because of bad trade balance numbers with a country, supporting domestic producers, etc.