International Imbalances

An open economy is an economy that trades goods and services with other countries.

The United States is an open economy: an economy that trades goods and services with other countries. There have been times when that trade was more or less balanced—when the United States sold about as much to the rest of the world as it bought. But this isn’t one of those times.

A country runs a trade deficit when the value of goods and services bought from foreigners is more than the value of goods and services it sells to them. It runs a trade surplus when the value of goods and services bought from foreigners is less than the value of the goods and services it sells to them.

In 2013, the United States ran a big trade deficit—that is, the value of the goods and services U.S. residents bought from the rest of the world was a lot larger than the value of the goods and services American producers sold to customers abroad. Meanwhile, some other countries were in the opposite position, selling much more to foreigners than they bought.

Figure 21-9 shows the exports and imports of goods for several important economies in 2013. As you can see, the United States imported much more than it exported, but Germany, China, and Saudi Arabia did the reverse: they each ran a trade surplus. A country runs a trade surplus when the value of the goods and services it buys from the rest of the world is smaller than the value of the goods and services it sells abroad. Was America’s trade deficit a sign that something was wrong with our economy—that we weren’t able to make things that people in other countries wanted to buy?

Unbalanced Trade In 2013, the goods and services the United States bought from other countries were worth considerably more than the goods and services we sold abroad. Germany, China, and Saudi Arabia were in the reverse position. Trade deficits and trade surpluses reflect macroeconomic forces, especially differences in savings and investment spending.Source: CIA World Factbook.

No, not really. Trade deficits and their opposite, trade surpluses, are macroeconomic phenomena. They’re the result of situations in which the whole is very different from the sum of its parts. You might think that countries with highly productive workers or widely desired products and services to sell run trade surpluses but countries with unproductive workers or poor-quality products and services run deficits. But the reality is that there’s no simple relationship between the success of an economy and whether it runs trade surpluses or deficits.

Microeconomic analysis tells us why countries trade but not why they run trade surpluses or deficits. In Chapter 2 we learned that international trade is the result of comparative advantage: countries export goods they’re relatively good at producing and import goods they’re not as good at producing. That’s why the United States exports wheat and imports coffee. One important thing the concept of comparative advantage doesn’t explain, however, is why the value of a country’s imports is sometimes much larger than the value of its exports, or vice versa.

So what does determine whether a country runs a trade surplus or a trade deficit? In Chapter 34 we’ll learn the surprising answer: the determinants of the overall balance between exports and imports lie in decisions about savings and investment spending—spending on goods like machinery and factories that are in turn used to produce goods and services for consumers. Countries with high investment spending relative to savings run trade deficits; countries with low investment spending relative to savings run trade surpluses.

!worldview! ECONOMICS in Action: Spain’s Costly Surplus

Spain’s Costly Surplus

In 1999 Spain took a momentous step: it gave up its national currency, the peseta, in order to adopt the euro, a shared currency intended to promote closer economic and political union among the nations of Europe. How did this affect Spain’s international trade?

Spain’s Current Account Balance, 1999–2013Source: International Monetary Fund.

Figure 21-10 shows Spain’s current account balance—a broad definition of its trade balance—from 1999 to 2013, measured as a share of gross domestic product, the country’s total production of goods and services. A negative current account balance, as shown here, means the country is running a trade deficit. As you can see, after Spain switched to the euro it began running large trade deficits, which at their peak were more than 10% of gross domestic product. After 2008, however, the trade deficit began shrinking rapidly, and by 2013 Spain was running a small surplus.

Did this mean that Spain’s economy was doing badly in the mid-2000s, and better thereafter? Just the opposite. When Spain adopted the euro, foreign investors became highly optimistic about its prospects, and money poured into the country, fueling rapid economic expansion. At the heart of this expansion was a huge housing boom, led in particular by the construction of holiday homes along Spain’s famed Mediterranean coast.

Unfortunately, this epic boom eventually turned into an epic bust, and the inflows of foreign capital into Spain dried up. One consequence was that Spain could no longer run large trade deficits, and by 2013 was forced into running a surplus. Another consequence was a severe recession, leading to very high unemployment—including the unemployment of Javier Diaz, the jobless graduate we described at the start of this chapter.

Quick Review

  • Comparative advantage can explain why an open economy exports some goods and services and imports others, but it can’t explain why a country imports more than it exports, or vice versa.

  • Trade deficits and trade surpluses are macroeconomic phenomena, determined by decisions about investment spending and savings.

21-5

  1. Question 6.8

    Which of the following reflect comparative advantage, and which reflect macroeconomic forces?

    1. Thanks to the development of huge oil sands in the province of Alberta, Canada has become an exporter of oil and an importer of manufactured goods.

    2. Like many consumer goods, the Apple iPod is assembled in China, although many of the components are made in other countries.

    3. Since 2002, Germany has been running huge trade surpluses, exporting much more than it imports.

    4. The United States, which had roughly balanced trade in the early 1990s, began running large trade deficits later in the decade, as the technology boom took off.

Solutions appear at back of book.

The Business Cycle and the Decline of Montgomery Ward

Before there was the internet, there was mail order, and for rural and small-town America, what that meant, above all, was the Montgomery Ward catalog. Starting in 1872, that catalog made it possible for families far from the big city to buy goods their local store wasn’t likely to stock—everything from bicycles to pianos. In 1896 Sears, Roebuck and Co. introduced a competing catalog, and the two firms struggled for dominance right up to World War II. After that, however, Montgomery Ward fell far behind (it finally closed all its stores in 2000).

Why did Montgomery Ward falter? One key factor was that its management misjudged postwar prospects. The 1930s were a difficult time for retailers in general because of the catastrophic economic impact wrought by the Great Depression. Figure 21-11 shows an index of department store sales, which plunged after 1930 and hadn’t fully recovered by 1940. Montgomery Ward coped with this tough environment by cutting back: it closed some of its stores, cut costs, and accumulated a large hoard of cash. This strategy served the company well, restoring profitability and putting it in a very strong financial position.

Department Store Sales Index, 1919–1946Source: National Bureau of Economic Research.

Unfortunately for the company, it made the mistake of returning to this strategy after World War II—and the postwar environment was nothing like the environment of the 1930s. Overall department store sales surged: by 1960 they were more than four times their level in 1940. Sears and other retailers expanded to meet this surge in demand, especially in the rapidly growing suburbs. But Montgomery Ward, expecting the 1930s to return, just sat on its cash; it didn’t open any new stores until 1959. By failing to expand with the market, Montgomery Ward suffered what turned out to be an irretrievable loss of market share, reputation, and name recognition.

Nothing in business is forever. Eventually Sears too entered a long, slow decline. First it was overtaken by newer retailers like Walmart, whose “big box” stores didn’t sell large appliances but generally sold other goods more cheaply than Sears, in part because Walmart used information technology to hold costs down. More recently, the rise of internet sales has hurt traditional retailers of all kinds. But Montgomery Ward’s self-inflicted defeat in the years after World War II nonetheless shows how important it is for businesses to understand what is happening in the broader economic environment—that is, to take macroeconomics into account.

QUESTIONS FOR THOUGHT

  1. Question 6.9

    t2KTnVYdgQvhbq9oWBVRVDUhqoyP4mASMDZYBcmVg89LL4xb+W1pYxUX41Yh2Fq1U2FgpvnbQwFm5aKxfm/SaBInvtN1aXe5f6zU8w==
    What caused the steep decline in department store sales in the 1930s?

  2. Question 6.10

    scM+Az1wa6C7CWWr6BdeLSu6YX26M3IblAqcWqAAdRBOZyNRabs+Z0i1iqiwr5a5TKRRKXET5Lx6wEWBphUnanSGVMhHiEfsZqjU+2ZBPYVDD4ZI1y6Awe8S6mvNz3VvbQb2wTf4w4K/UV1PQVi0Eiti9N0=
    In terms of macroeconomics, what was the management of Montgomery Ward betting would happen after World War II?

  3. Question 6.11

    zBzllDfY3DvaSP8hX4lrVHVlfuyhIOobhm9lXyi+9J/6/jrf9zLiF0LtOuUGcemMBxYvMuGHlHwML5Znxq/7m9ZQXMM7NFL4wfqyu5kYiRZWZMlPqHc56GDZzox1tJ2O8rCgHjOi7YoAbAmJpWX5ku3oA/nQO8XyufPlgVkXkFucR2LzEXESBrYdLj8ZQj1yAWPkI4YwGh8mIkRClDGIr/s84pwwKpx9pP8crM9A7/gzwudjV5Sx+LyW0VVY1Wj8j2tYrMPOxKP3GdKgrtDI7c1eQr1lpU9V0z/9zje0oWibS/TLfymo8g==
    Economists believe that improvements in our macroeconomic understanding over the course of the 1930s led to better policies thereafter. If this is true, how did better policies after World War II end up hurting Montgomery Ward?