Samuelson and Nordhaus explain the accounting for international trade in chapter 34 of Economics: the deficit must be financed by a debt to the supplier or by an inflow of foreign currency. Currency inflows can be in the form of inward investments, such as purchases of shares or government bonds, which might help the country’s economy. Problems arise, though, if these inflows are temporary and are suddenly withdrawn
The price paid for imported goods and services directly reflects the values placed on the currencies of the two countries involved – as described previously (3.3.4.6). Oil is normally priced in dollars for example, so a country such as Britain pays a higher price in sterling for oil if the pound is weak against the dollar. Having a weak currency makes a country’s imports more expensive and makes its exports more competitive.
America has run a trade deficit for many years, but it has received substantial foreign investment which has increased its prosperity – as explained by Investopedia. Dollars are still seen as safe. In many countries with weaker economies, though, a trade deficit is more of a problem, and foreign investors might leave if they think there is a currency risk. When most countries need to import goods and services, they may need to increase their money supply to pay for them – which is inflationary, as described in the previous sub-section (3.3.8.3). And the value of their currency will drift downwards in relation to other currencies – so their imports become more expensive, further fuelling inflation.
If a country tries to correct a trade deficit by applying tariffs, in an attempt to stem the level of imports, that also increases inflation: it increases prices and reduces the standard of living for consumers. There is also a high risk of retaliatory tariffs and adverse effects on trade, as described later (3.5.4.2).
Some countries have had to apply to the International Monetary Fund (IMF) for a loan to stabilise their finances. This only provides a temporary respite and, as will be seen at the end of this chapter, there are other governance problems with these international transfers of funds (3.5.5).
Some governments try to control foreign currency exchange rates, to boost exports, but most now accept that currency values have to ‘float’ according to economic circumstances and are beyond direct political control. China’s policy of pegging the renminbi against the American dollar in the early 21st century was an egregious exception, but the resulting huge foreign currency inflows were described by The Economist as “An embarrassment of riches” – noting that the excess money supply might eventually cause inflation.
The Eurozone operates as if it were a single country within the framework of international trade, but the individual countries within it cannot unilaterally manage currency exchange rates or external tariffs – so several have got into difficulties when they experience a trade deficit. An Economist article, So hard to bend, described Spain's problems in April 2010: noting that “As a member of the euro, it cannot address that problem by devaluing the currency” .
(This is an archive of a page intended to form part of Edition 4 of the Patterns of Power series of books. The latest versions are at book contents).