Balance of Trade and Currency Exchange Rates

(This is a current page, from the Patterns of Power Edition 3 book contents.  An archived copy of this page is held at https://www.patternsofpower.org/edition03/3384.htm)

If a country imports more than it exports, it is said to be running a trade deficit.  The deficit has to be financed either by debt or by an inflow of foreign investment.[1]  America has run a trade deficit for many years but has received substantial foreign investment (which has increased its prosperity) but rising debt has been a problem in some countries – as the resulting interest payments consume an increasing proportion of their national budgets.

There are several ways to correct a trade deficit, each with some disadvantages:

  • Applying tariffs, in an attempt to stem the level of imports, increases inflation because it increases prices and reduces the standard living for consumers; this is problematic, as described in the previous sub-section ( There is also a high risk of retaliatory tariffs and adverse effects on trade, as described later (
  • Purchasing power in international transactions depends on the relative strength of the currencies used, so a country can increase the competitiveness of its exports by allowing the value of its currency to drift downwards. A depreciating currency, though, increases the price of a country’s imports so it also causes inflation – as the higher costs of supplies result in higher prices of finished goods in the shops.
  • Cutting wages and/or benefits increases competitiveness, but it is painful and unpopular.
  • Some countries have had to apply to the International Monetary Fund (IMF) for a loan to stabilise their finances. This only provides a temporary respite and, as will be seen at the end of this chapter, there are other governance problems with these international transfers of funds (3.5.5).

In practice, the technique of allowing the value of the currency to ‘float’ seems to be the least politically difficult of the above options, but they all ultimately lead to the same outcome: real wages (and standards of living) have to shrink, or productivity has to increase, until stability is restored.

Some governments try to control exchange rates, to boost exports, but most now accept that currency exchange rates have to ‘float’ according to economic circumstances and are beyond direct political control.  China’s policy of pegging the renminbi against the American dollar in the early 21st century was an egregious exception, but the resulting huge foreign currency inflows were described as “An embarrassment of riches in an article of that name in The Economist – noting that the excess money supply might eventually cause inflation.

The Eurozone operates as if it were a single country within the framework of international trade, but the individual countries within it cannot unilaterally manage currency exchange rates or external tariffs – so several have got into difficulties.  An Economist article entitled So hard to bend described Spain’s problems in April 2010: noting that “As a member of the euro, it cannot address that problem by devaluing the currency”.



[1] Samuelson and Nordhaus explain the accounting for international trade in chapter 34 of Economics.