Trade Deficits In Relation To Budget Deficits & Trade Policy
This caused at least one reader to wonder whether this meant that I endorsed the theory that mercantilism can boost growth.
But that was not what was meant. First of all it needs to be remembered that a reduced trade deficit and a reduced net capital inflow are flip sides of the same thing. While the "trade deficit reducing" aspect of it raises output, the "capital inflow reducing" part lowers it because it raises interest rates. From a demand point of view, nothing happens to aggregate demand, it is the compostition that changes.
It must also be remembered that the main way in which the reduced demand from fiscal austerity is compensated is by lowering interest rates. However, if a reduction in the budget deficit reduces the trade deficit then net capital inflow decreases too which in turn means that interest rates may not fall so much. What this means is simply that the reduced demand from a reduction in the budget deficit is counteracted by a lower trade deficit rather than lower interest rates.
This however, doesn't mean that you can boost growth by erecting barriers for imports because this will also reduce capital inflows something which in turn will raise interest rates.
To use an analogy: assume that a company sells for a billion dollars, this could increase their cash assets (not necessarily notes and coins)accounts receivables by a billion dollars . But if some customers pay later then perhaps cash assets will increase by only $500 million while will increase $500 million. In this analogy accounts receivable are like a lower trade deficit and cash are like the interest rates, they are two forms of economic improvements resulting from deficit reduction and sales respectively.
This however doesn't mean import barriers would improve the economy, any more than refusal to accept cash payments would improve corporate profits, because the trade deficit reduction and accounts receivable increases would be counteracted at least fully by higher interest rates and less cash assets respectively. The fact that one thing (a sale or a budget deficit reduction) can have positive effects doesn't mean that a change in the composition of improvements is necessarily better because the necessary flip side of this change in composition is negative, something that cancels out the apparent improvemebt from more of the positive flip side of this change in composition.