The latest issue of BusinessWeek included an article on the ballooning trade deficit which currently stands at over $400 billion. The article concludes by stating that this trade gap could lead to a "potential problem" in our financial markets. But what does that mean? While in recent times news agencies have gone out of their way to warn Americans of our ever-growing trade deficit, few if any of these reports ever bother to mention why the trade deficit is a problem. They just leave Americans to assume (incorrectly) that because we have a large trade 'deficit' that it must somehow be bad.

The word deficit is very intimidating, especially when it's over $400 billion dollars. But what exactly is a trade deficit? Well, the answer is quite simple. When the US trades with other countries, the value of the goods traded is compared. If the US imports more goods then it exports (as it has for decades), the US has a net trade deficit. How big of a difference exports are compared to imports determines how large the trade deficit is. But unlike other types of deficits, the US doesn't owe money on this deficit because the companies that are doing the importing have already paid for the goods in dollars.

So what happens to all these dollars that other countries now own? US dollars are only good in one country, the US. When other countries receive dollars for their goods, those dollars must stay in the US economy. When other countries sell their goods to the US, they are investing in the US economy by, in effect, buying dollars with their exports; thus, another name for the trade deficit is Net Foreign Investment (or NFI). If the countries do not want to spend their money in the US right away, then these countries end up holding on to their dollars and put them in our financial institutions (such as banks) to garner interest.

In order to facilitate business growth and economic expansion, companies must be able to borrow funds, and the only way businesses can borrow this money is if there is actually money being saved in our financial institutions to borrow. Currently, the average American spends more money than s/he makes, and while this spending has proven vital in upholding the US economy, it has left little to no money in savings for businesses to borrow from for investments in new factories and technology. Since businesses can borrow little money from US citizens, companies must borrow from foreign investors...i.e. the US needs to have a strong NFI to promote long-term stable economic growth. Or in other words, our trade deficit allows US businesses to grow new jobs and increase the standard of living in America.

But at some point these countries must spend their money, so what happens then? There are two possible outcomes. One outcome is that a major holder of dollars (such as China) would spend a vast amount of their holdings at once. Adding hundreds of billions of dollars into the economy would disrupt the supply and demand for the US currency, which could lead to high levels of inflation and devastate the US economy. The higher the trade deficit with a given country, the more dollars they could flood into the economy and the higher they can push our inflation.

While this sounds like a problem at first glance, it is important to realize this will not occur. The only way a country could have enough dollars to devastate the US economy is if they are one of the countries we have a major trade deficit with. Any country that the US has a large trade deficit with is, by definition, dependent on the health of the US economy for its economic survival (we are their export industry). So a country that could hurt the US in this way would, if they did, be devastated too. The same is true if the country tried to exchange away their dollars in the currency market. If they trade away too many dollars, both economies would be devastated. Thus, no problem.

The other possible outcome is that since these countries know they cannot spend all their dollars at once, they will spend their dollars in the US economy gradually over time. This leads to a steady and stable growth rate of consumption in the US. This would, in turn, have a very positive effect on the US economy, leading to new businesses and jobs being created in the US, higher wages for existing employees, bigger profits for businesses, and a strong growth in GDP.

Opponents of our trade deficit will have you believe that to prevent possible inflation in the future the US must dramatically reduce its imports. However, dropping our imports would yield less goods for Americans to buy, causing import industries to close, jobs to be lost, business investment to decline, and prices to rise... Some economists, by the way, would call that inflation. I, for one, welcome foreign investors into this country, and we should all be supportive of the over $400 billion dollars of Net Foreign Investment that come to this country each year, providing jobs and economic stability in an otherwise economically unstable time.