Managing Foreign Trade: Does Trade Create Wealth for a Nation?

The following article is the first in a ten part series written by Emeritus Associate Professor W. Raymond Mills.

A vigorous restatement of economic realities must precede the proposed solution. Several generations of economists have perpetuated erroneous myths about the U.S. economy in their efforts to argue that free trade is the only reasonable stance from which to view international trade. Rather than argue with them, I will simply provide an accurate picture of economic reality as a basis for my proposed solution.

This restatement of economic assumptions and facts will require several days of discussion, beginning with the section below.

DOES TRADE CREATE WEALTH FOR A NATION?

Wealth of Nations author and economist Adam Smith answered the above question with a resounding “Yes” without any qualifications or conditions. My answer is more nuanced. Trade does create wealth for most nations participating. But the benefits from trade vary greatly between nations. Nations with a large trade deficit, like the U.S., may experience some addition to national wealth via trade, but their gains are tiny compared to the large gains made by nations that have a large trade surplus. Can this be changed by U.S. action? Should a nation like the U.S. manage its trade with the aim of changing conditions so that the U.S. gain from trade is larger? My answer is a resounding “Yes.”

Adam Smith was unable to take advantage of the additional knowledge of trade made possible by the invention of a means for measuring Gross Domestic Product in each nation. The National Accounts were invented in the U.S. in the decade of the 1930s. Of course he could not use this resource. Likely he would have used these numbers, had they been available. The National Accounts were created using one of Adam Smiths’ insights. He argued that the total wealth created by a country is a function of the value of the goods and services created and sold by the businesses domiciled in the nation. Smith preferred to say “created by labor.” Now we see labor as only one of the important inputs used by businesses to create goods and services. Gross Domestic Product measures the total value of the goods and services created by the economic activities in a nation during a given time period (One Quarter. One Year).

The following discussion is as clear and as simple as I can make it but some people find it impossible to tolerate formulae. To those I say, stick with it, the gain in insight is worth the trouble. By understanding how Gross Domestic Product is measured, we can see clearly how trade increases the wealth in a nation.

Gross Domestic Product = Consumption (both public and private) + Investment (both public and private) + Trade Balance (exports minus imports). The above version of this formula is different from the one most commonly used. The public component of both Consumption and Investment is usually separated out, added together and labeled “Government.” The version I use is simpler. It focuses attention on Consumption and Investment (congruent with my needs).

Consumption and Investment are not production, they are expenditures. They measure the value of goods and services when they are sold. How do we get from measurement of expenditures to estimates of the value of domestic production? Simple. If trade did not exist (no imports or exports), expenditures and production would be equal. We get the statistical equivalent of no trade when exports and imports are equal. When unbalanced (unequal) trade exists, we must add the value of the exports and subtract the value of the imports to get the value of the domestic expenditures that are equal to the value of domestic production. It is the size of domestic production that we seek.

This formula correctly estimates the value of domestic production, even when unbalanced trade exists. We need to know more about how the formula works.

When imports come into a country they are used – they go somewhere – and the only place they can go in this accounting system is Consumption or Investment. Consumption and investment are added together to get Gross Domestic Product. Thus, as the size of imports increase, the size of Gross Domestic Product, as measured, increases. The U.S. accepts a lot of imports. Our measurement of Consumption and Investment includes the imports sold in the U.S. If exports are as large as imports, the larger measured GDP, including imports, properly measures the actual production in the U.S. That is because the exports that match the imports require additional production in the U.S. to create the goods and services sold overseas. Imports create a larger measured GDP. Exports create a larger real GDP. Thus the real and measured are the same, when exports and imports are in balance. When imports are in excess of exports, the size of this excess is subtracted from Gross Domestic Product. This calculation prevents measured GDP from exceeding actual GDP.

When exports and imports are equal, a large increase in imports means a large increase in exports and both changes together result in a large increase in Gross Domestic Product. Adam Smith knew that it was not necessary to create a trade surplus in order to benefit from trade. He just did not have the tools to demonstrate that reality so clearly.

Our formula clearly shows that exports add to domestic production and imports subtract from domestic production. Domestic production is obviously less when goods are made overseas as compared to when goods are made in the U.S. Free traders assert that the production lost to imports is made up for by additional domestic production of some other product. If that were in fact the reality, there would be no trade deficit. The large trade deficit shows a net reduction in domestic production (and domestic employment) compared to what would happen if exports and imports were equal. This is the vital reality which provides the foundation on which this document is built. Adam Smith was 100 percent wrong when he argued that a trade deficit could be ignored.

The above discussion can be made concrete by examining the data shown in Table 1.

Table 1. Exports and Imports as a share of Gross Domestic Product for four nations, 2006. (Goods only)(In billions of Current U.S. dollars)

Source: IMF for GDP: WTO for all others, Statistics, Annual Reports 2008, Appendix tables A6 and A7

Note:
a) Exports and Imports for each nation are the total trade with the world.

b) % for equal trade is calculated, for China, by dividing 791 by 2664 = .297. For the U.S. the calculation is 1,037 divided by 13195 = .079.

The smaller number of the two (exports and imports) measures the amount of trade in each nation that can be said to be equal trade. Equal trade adds to GDP in each case, just as the above discussion indicated. But in the case of China and Germany, equal trade contributed 30 percent of the Gross Domestic Product created in the country. For the U.S., equal trade contributes only 8 percent to the Gross Domestic Product created in the country.

The trade balance shows further disparity. In the U.S. the trade deficit takes away most of the gain made from equal trade. For the other 3 nations, the trade surplus adds to the gains they get from trade.

This discussion leads to both a moral and practical question. Does the U.S. Congress and the president have a moral obligation to the citizens of the U.S. to manage trade so that the difference in gain from trade between the U.S. and its trading partners is reduced?

How about the U.S. obligations to other nations – do we have a moral obligation to move international trade closer to a balance so that international trade will become sustainable?

How could trade be managed so that the U.S. trade deficit is reduced? How the U.S. should manage trade will be thoroughly discussed later in this series.

W. Raymond Mills is an Emeritus Associate Professor of City and Regional Planning at The Ohio State University. Mills' Ph.D was in Sociology from the U. of Michigan (in 1958), his speciality was forecasting economic and population growth in metropolitian areas in the U.S. He can be contacted via email: wrmills@wideopenwest.com