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The Negative Effects of Unbalanced Trade – 1/8

Charles St. Pierre

The Negative Effects of Unbalanced Trade

The United States trade imbalance in goods and services has long been an unresolved
issue. Some claim that this imbalance is harmful to the economy, and that barriers to free
trade are necessary. Others claim that the imbalance is beneficial to the economy, since it
provides goods and services that otherwise we would have to work for, that is provide
and equal value of goods and services in return. Some claim that such barriers are not
only unnecessary, but harmful in themselves, and even immoral, since they would force
higher prices on otherwise uninvolved consumers, that is force them to work harder for
what they got.

Those who claim that current trade policies are harming the US have, to our knowledge,
proposed no clear mechanism. We propose one here.

We show that, while balanced free trade may be beneficial to all, or at least not harmful,
when trade is not balanced, when one country is a net exporter, and the other country is a
net importer, the net exporting country grows at the expense of the importing country.
That is, the net importing country’s economy undergoes deflation, and erodes. The
demand of the importing country’s economy is driven down, and its industry is
increasingly idled. Since this affects labor, even many of those consumers enjoying the
immediate benefits of lower prices, may pay a greater price, in lower wages and higher
unemployment. Consumers are involved, whether they want to be or not.

The basic idea is that the price level in the importing country goes down, decreasing the
revenue available to its industries. Of course, this happens in the transition from autarky
to free trade anyway. What is different, however, is the further reduction in revenue due
to the net competition in quantity with imported goods. That is, the net importing country
must compete in both price and quantity with the exporting country. Now the net
importing country’s demand is ultimately equal to the revenue of its industries. That is
the key relationship. The country's demand declines with the decline of the revenue of its
industries. With continued imports, the price level continues to go down, as does revenue
and demand, along the Aggregate Supply curve. With the continued erosion of revenue,
industries are increasingly idled, and unemployment increases. The importing country is
forced into a deflationary spiral.

In the exporting country, on the other hand, the price level goes up, and including the
revenue from its exports, so does the revenue of its industries, and ultimately the
country’s demand. Its industries, with increased revenue, grow, as does the country’s
demand, along its Aggregate Supply curve. With continued exports and continuing
increases of revenue, industries continue to grow. So does demand, and employment.
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Charles St. Pierre
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We first look at a country with a trade deficit. See the first diagram. The country
initially produces at eB, the intersection of Aggregate Demand and Aggregate supply.
Revenue collected equals revenue spent equals domestic price times domestic quantity
produced equalts PB x QB. Now suppose the country becomes a net importer. Then
Aggregate Supply ASB increases, the curve moving right to ASB+I. The demand curve
does not change, so the equilibrium point moves down the Aggregate Demand AD curve
to eB+I at new price level PB+I and total quantity QB+I. But there is a problem here. The
Quantity from QB’ to QB+I is the quantity imported. This quantity times PB+I is the
revenue which goes overseas. But total domestic demand can only equal total domestic
revenue, and domestic supply has gone down along the ASB curve, with the decline in
price, to eB’, so domestic revenue has shrunk to PB+I x QB’. This means that aggregate
demand has also decreased to eB’, the demand curve shifting to AD’. The entire
economy has contracted along the domestic Aggregate Supply curve ASB. But otherwise
the situation has not changed. Total supply is still along the ASB+I curve, so the price is
driven down further, to eB+I’. And so is total domestic revenue, now driven down to
PB+I’ x QSB’’ at eB’’. The process repeats itself, and the economy continues to contract.
Note it also undergoes deflation.

A couple things should be mentioned about this diagram. Since a trade imbalance is only
about 5% of GDP, we only need to represent a limited section of the Aggregate Demand
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curve, so we can approximate it by a straight line. Second, the AS lines are not
completely vertical. This is a more general situation than an economy operating at its
frontiers. In that particular case, the price level still declines, while the quantity produced
by domestic industry, QS, does not. The decline in revenue captured by domestic
producers, and the decline in their demand, is then just (PB – PB+I) x QB. However, we
would expect the general case to be more applicable, and decline to be at the greater rate
PB x QB – PB+I x QB’, since an economy in decline would not generally be operating at
its frontier.

Third, this diagram should be ‘superposed’ on the balanced trade effect of lowering price
levels, due to the increase in supply of goods and services brought about by specialization
and comparative advantage. We will discuss this at the end.

We now look at a country with a trade surplus. See Diagram 2. The country initially
produces at eB, the intersection of Aggregate Demand AD and Aggregate Supply. ASB
Revenue collected equals revenue spent equals domestic price times domestic quantity
produced equals PB x QB. Now suppose the country becomes a net exporter. Then
domestic Aggregate Supply ASS decreases, the curve moving left to ASB-E. The demand
curve does not change, so the equilibrium point moves up the AD curve to eB-E at new
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Charles St. Pierre
price level PB-E and total quantity QB-E. But there is an inconsistency here. The domestic
demand equals total revenue, and total revenue now equals total domestic revenue plus
revenue from exports, (now QB-E to QB’ times PB-E) and domestic supply has gone up
along the ASBcurve, with the increase in price, to eB’, so total revenue has increased to
PB-E x QB’. This means that aggregate demand has also increased to eB’, the demand
curve shifting to AD’. The entire economy has expanded along the domestic Aggregate
Supply curve ASB. But otherwise the situation has not changed. Net supply is still along
the ASB-E curve, so the price is driven up further, to e2’. And so is total domestic
revenue, now driven up to PB-E’ x QSB’’ at eB’’. The process repeats itself, and the
economy continues to expand. Note it also undergoes inflation.

Note that when trade is balanced, there is, here, no effect. Only when there is an
imbalance in trade, where one country is a net exporter, and the other country a net
importer, does the importer’s economy erode, and the exporter’s economy grow. There is
a certain symmetry: The exporter benefits at the importer’s expense, despite the apparent
benefits to the importing country, and the apparent costs to the exporting country.

Notice, finally, that the flow of capital, which is equal and opposite to the net flow of
goods and services, and the overall balance of payments, which of course adds to zero,
are largely irrelevant here. The IOU’s (that is what the US owes) deposited in US banks
do nothing to stimulate the producing economy of the United States. Indeed, so far as
they represent demand on resources, demand available to the banks, they are detrimental
to the rest of the economy. The banks prosper, while the rest of the economy languishes.
Unless it is loaned to the buyers of goods and services, it does nothing to stimulate
demand. Indeed, it is pointless to lend it to industry, because their market has contracted,
and there is no point for them to increase, or indeed, even maintain production. However
stimulating demand, either by increase of loans or fiscal expenditure, of itself, does
nothing to rescue domestic industries, as we will show below.

Mercantilist policies work, promoting economic expansion in the country running the
export surplus, to the enormous detriment of the industry of the country running the trade
deficit. This involves the exporting nation acquiring a surplus of the importing country’s
money. The rosy idea that the system of free trade cannot be exploited to one country’s
advantage is, on the face of it, absurd. No economic system has ever been developed
which has not been abused. History has shown, those countries which adopt an export
oriented posture prosper, those that do not decline. One may ask, why did the European
powers prosper, while their colonies remained stagnant or declined? (They still practice
it, in the form of foreign aid.) How did the Asian Tigers arise? Why does China prosper,
while the US declines? Why is Germany tasked with ‘rescuing’ Greece? The answer is
always the same. One country runs a trade surplus, while the other runs a deficit. The so
called mercantilist fallacy is no fallacy. There is indeed benefit to running a surplus, and
accumulating your partner’s money.

Some suggest, now, that we counter China’s policies of hoarding our money, simply by
giving money to consumers sufficient to overcome its effects, and create sufficient
demand .to sustain domestic industry, as well as the excess in imports. They propose a
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tax holiday, distribution of Federal money to the states, national service employment, and
other policies designed to get money into the consumer’s pocket.

These proposals may have other significant merits. However, these proposals will not
change the relationship between the Aggregate Supply curve provided by domestic
industries, and the augmented Aggregate Supply curve provided by the combination of
domestic industries and imports. The augmented Aggregate Supply curve will always be
to the right, and the equilibrium price level will always be less than the price level in the
absence of imports.

The revenue received by domestic industry will thus on average, always be less than the
cost of its production, despite any overlay of inflation caused by giving money to
consumers. Domestic industries will be under persistent competitive disadvantage. See
Diagram 3. We have simplified and altered the notation for this diagram somewhat, to
make the diagram more easily interpreted

Giving money to consumers shifts Aggregate Demand AD1 to the right to AD2. This
increases the base price level, the level without imports, from PB1 to PB2, and the base
Quantity from QB1 to QB2. But the Aggregate Supply with imports ASI does not change
in its relation to the base Aggregate Supply. ASB. So the equilibrium point of the
economy shifts down the AD2 curve, just as it shifted down the AD1 curve before the
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stimulus. But again, the revenue of domestic industries is still along ASB curve, not the
ASI curve at PI2 and QI2, but at PI2 and QI2’, so this is the new equilibrium. It is just the
same original process (Solid lines) but acting instead at a higher price and quantity
level.(dotted lines.) So an economy undergoing inflation does not escape the pattern,
(and neither does one undergoing deflation.) The process repeats itself, as in the first
diagram

We wish to know under which circumstances an importing country benefits from its trade
deficit. .

Lets start with Diagram 4:

We now consider a healthy economy, or at least one at or near its production frontier, so
the Aggregate Supply curve is vertical. Net imports still cause the rightward shift. We are
still considering just a small region of the Aggregate Demand curves, so we again
approximate them by straight lines. Now with net imports, the loss in producer surplus is
the rectangle (PB – PB+I) x Q, and (PB – PB+I) x Q is the most the gain in consumer
surplus can be. It is probably going to be less. This is in a healthy economy, where the
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Charles St. Pierre
domestic quantity produced does not change as a result of imports. That is, under the
circumstances of unbalanced trade, the loss in producer surplus is always going to be
equal to or greater than the gain in consumer surplus.
Now lets consider a less than healthy economy:

The red arrows are as above, so the new equilibrium point is established at eB’. The loss
in producer surplus is now equal to the trapezoid (PB - PB+I) x ½(Q + Q’). The gain in
consumer surplus, however, can at most only be the rectangle (PB - PB+I) x Q’. Note now
the loss of revenue to producers, (PB x Q ) – (PB+I x Q’), as above, is greater than just the
loss of surplus.

There is another peculiar result to this analysis. Consider balanced trade. So where are
the gains from trade? They must be there, or trade, exchange of any sort, wouldn’t occur.
Then we know, from the analysis of comparative advantage, that there is still a shift
rightward in the AS curve, because trade increases the total supply of goods. So there
should still be a change downward in price levels, along the AD curve.
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But now the quantity produced by domestic industry increases to QB+T, so there is still a
decrease in producer’s surplus, the rectangle (PB – PB+T) x QB, but the increase in
consumer surplus is greater, the trapezoid (PB – PB+T) x ½(QB + Q B+T). Note domestic
producers do not lose the revenue (Diagram 1) PB+I x (QB+I -QB’), as they do when there
are net imports, so the Aggregate Demand curve AD does not shift to the left.
We do note that even under conditions of balanced trade increased pressure is put on
producers.

The relative size of the effects is going to depend on the size of the unbalance compared
to total trade. Where the imbalance is small compared to the total volume of trade, and
the total economy, we would expect a negligible effect. Where it is large, say several
percent of GDP, we would expect the effects to be significant.

Now suppose instead we start with a change in price levels. If they decrease, we would
expect, for the vertical AS curve, any increase in consumer surplus to be accompanied by
at least an equal decline producer surplus. In an unhealthy economy undergoing price
deflation, the increase in consumer surplus is bought at a greater loss in producer surplus.
Conversely, an increase in price level, or inflation, will bring a greater gain to producer
surplus, than loss of consumer surplus.