On balance of trade-how international trade works-equality of exports and imports

Balance of trade is an often talked about subject by countries. US 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 Smith-but needs a new look in the present context.

Rule: The net balance of trade of a country with all other countries is always zero. i.e.Value of Annual Exports=Value of Annual Imports

Let us remember that money (dollars, yuans, Gold or Silver) is just a way to facilitate the exchange of goods (and services) between countries. It simplifies barter; but in the end, all trade is 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. There might be some delay obviously in the accounting and there may be a month to month variation where a surplus or deficit might run because of not receiving the money in the same month, but over a long period of time, say of 1 year (assuming payments in 30 to 90 days max.), the net exports should be equal to net imports. Chile is not sending it's 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). Therefore, the equality of exports to imports is a necessary condition for trade.

It follows that if you export more, you import more. Similarly, if you export less, you have to import less.

The only reason to export stuff outside your country is to buy other stuff from outside your country, i.e. import stuff. Dollars etc. are used to facilitate this transaction, but one must never lose sight of the whole purpose of trade-you sell to exchange your produce with what others produce. It holds as much at the country level as the individual level.

Some allowance 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 in the form of loans to the US Government, to buy something later on in the international markets. These are small corrections to the rule (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), but the general rule of Exports=Imports holds for all countries at an individual country level. What goes out (as exports), must come back in (as imports).

Note that this is for a country with all the rest of the world. However, Chile may run surpluses or deficits with any one country for a long period of time, 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 me explain this with an example.

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.

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.

So an example might be

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

and adding what we said before
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.

Makes every country's exports exactly equal to it's imports.

Even if Chile is forever running a surplus against USA and a deficit against China, it all needs to balance in the end for it, where all exports come back as imports, directly or indirectly.

Note that in this example, the US must always run a surplus against China.

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

I have heard of people talking about the net exports of a country to the world being less than it's imports, and that the country is running a deficit forever. This can't be true. It may manifest that way because of measuring the value of exports and imports incorrectly, delay in payments, etc. but in the end, if you are a country X, your total deficit or surplus with the rest of the world is exactly zero, in real terms.

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.

Note that you can extend this example 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 all what you produce with the productions of others.  You must discount for savings and the part of the savings you invest for further returns-but it still means that overall, what you produce will always be exchanged for the same real value of what others produce.

At an individual level, 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. Would be ridiculous, won't it? 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. Once again, what I buy can never exceed what I sell. However, it can happen that what I buy is below what I sell-because I can save some of my earnings or loan a part of my savings to others, and not buy anything from these stores.

Currency reserves by countries like China holding US dollars in foreign reserves are savings which gets some interest from the US Government, but the main purpose of all these savings in US dollars is eventually to buy something from somewhere-goods and services which Chinese citizens can use. The overall currency reserves of a country are a small part of what the country exports annually. They are the liquidity, just like the liquid cash which every business has, to run it's business smoothly. It is there to facilitate trade (US dollars are easily accepted when China wants to buy Oil from Saudi Arabia, weapons systems from Russia, or Soybeans from Brazil). Because the US dollar is the most liquid currency in the world, it is the preferred way to hold foreign reserves. However, developing countries do hold other important internationally accepted currencies like the Euro and the Yen in their coffers. No country is giving away it's stuff out to the world for free-and if there is some foreign currency accumulation, it is a minor part of the exports.

This rule that the net trade balance of a country with all other countries taken as a group is zero is one of the most important principles of international trade. Abba Lerner assumed this to propose his famous Lerner Symmetry Theorem. For some reason economists keep doubting this original assumption in Lerner's theory. I think it is because economists get lost in all the talk about currencies and dollars and foreign reserves, and forget that the main purpose of money is to facilitate the exchange of goods (and services). If we were to just do barter all over again between countries, the validity of the rule would be much easier to see.

A couple of minor corrections need to be done to the rule for small countries,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 may not balance 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, which will not appear in rule directly. When an American tourist goes to Costa Rica and spends a few thousand dollars there, those dollars are used by Costa Rica to buy more imported goods, and they do not show in the Export=Imports rule directly. Same with loans to Greece by Germans-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,  and it is likely that the loan holders will lose money. When it is by tourism, as for Costa Rica, Bahamas, etc. the deviation from the rule, or the imbalance of exports and imports, is stable and can continue on forever.

Let's examine the case of a tourist country like Costa Rica in detail. This will help in understanding the "tourism correction" to countries and places which depend highly on tourism-e.g. Thailand, Bahamas, etc. The net imports of Costa Rica will be considerably more than the exports for Costa Rica. We must only assume, and I hope you will realize that this is a very reasonable assumption, that the number of tourists coming to Costa Rica is much more than the number of Costa Rica citizens who are touring foreign countries.

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 dollar. 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 importation 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. They could just haul a ship's worth of consumable items to Costa Rica and live there for 15 days with those supplies-or what's more convenient, is  to bring US dollar bills, and use them to pay for goods which Costa Rican companies import for them on their behalf.

For countries which do not depend much on tourism, this is a minor factor in the overall imports. But for a country which as a lot or revenue from tourism, this can be a very large factor, and must be accounted for.

Apart from these corrections, there's not much there is not a whole lot of modifications to the original rule of Imports=Exports for all countries taken individually. When the US is worried about a negative balance of trade with Germany, it must always realize that every such deficit MUST be equaled by a corresponding surplus with some other country. Trade is done worldwide in several roundabout ways-but what goes out of a country in one form, must equal exactly to what it imports in another form. The whole point of exporting goods is to eventually import goods, or to provide for your citizens when they travel abroad (i.e. the Costa Rica example, but looked at from the point of view of a foreign country like the US which has lots of American tourists going to Costa Rica). Also, if you have send troops to foreign lands-major countries like Russia, USA and France have a large number of troops outside their borders, they are indirectly fed and supplied by exports to other countries. What the French troops consume in Algeria needs to be exported out of France in some way. Money and currencies are instruments to facilitate these real transactions of goods and services around the world; but we must never forget their underlying use, and we will always find the rule of Exports=Imports true for all countries individually. It is like the conservation of energy principle in Physics-energy can never be created or destroyed (except the small corrections due to Einstein), and in a similar way, the value of goods which you export out of your country, necessarily comes back to you in form or another, or is sometimes used by your citizens who are stationed abroad as troops, or your other citizens who are touring the world.  We could call it the conservation of value of goods principle in international trade, to make the analogy with conservation of energy principle clearer. Stated this way:

Value of exported goods=Value of imported goods for each and every country of the world, taken individually.


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