What does a trade deficit mean for GDP? Not much.

Net exports fell in three of the last four phases of economic expansion

Statistics Canada’s latest release for the international merchandise trade balance shows that the trade deficit widened in July, and this is being interpreted as a sign that GDP growth will come in lower than previously thought. This might seem to be an obvious implication of a widening trade deficit when you decompose GDP into its spending components:

GDP = Consumption spending + Investment + Government spending + Net exports

Everything else being constant, a fall in net exports reduces GDP. But one of the dangers of reasoning from national accounts identities is that everything else isn’t always held constant. Here’s another national accounts identity:

Investment = Saving + Government surplus – Net exports

(I should be using the current account instead of net exports here, but this is close enough for my purposes.) Everything else being constant, a fall in net exports increases investment—and, as you can see in the first accounting identity, investment shows up as a positive contribution to GDP. Saying that Canada’s trade deficit widened is the same thing as saying that foreigners increased their flow of savings into Canada—and investment spending is financed out of savings.

So there’s no obvious reason to think that strong growth in net exports is positively correlated with strong growth in GDP: net exports fell in the expansions of 1982-1990, 2001-2008—and again in the most recent expansion:

That said, what could be considered worrisome is the drop in the levels of both exports and imports: this is indeed a sign of a slowdown in overall economic activity. But that would have been bad news even if net exports had gone up.

People should stop worrying about the trade balance; the fact that the word “deficit” is used shouldn’t alarm you.

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