In 1971, US President Richard Nixon terminated the dollar’s convertibility to gold, ending the Gold Standard and making trade deficits feckless. This topic might seem tedious, but it is a debate that must be resolved because many think a trade deficit is problematic.
Before 1971, other nations’ dollar reserves had the potential to cause harm to the US Treasury, as foreign governments could hypothetically cash their US Treasury holdings in at any time (a false fear today) for an equivalent value in gold. Rightfully so, in the mid-1960s, US government officials realized this could be a problem because some foreign dollar reserves had grown more significantly than the US gold stockpile.
Before Nixon ended the guaranteed dollar convertibility, a country could have theoretically run up a large trade surplus with the US, forcing the Treasury to redeem the deficit for gold on demand. So when the US ran its first goods trade deficit with the rest of the world, it was understandably a cause for concern, particularly with declining gold reserves. The end of the guaranteed gold redemption at a fixed rate altered how trade deficits would be calculated moving forward. Yes, foreign banks could still convert their dollars to gold, but they had to do it on the open market. This change removed a significant liability from the Treasury. In turn, balancing the trade deficit became pointless and no longer had any urgency.
When net trade lost its possible influence over the Treasury’s gold reserves, the trade deficit lost the ability to cause severe financial harm to the nation. Instead, international trade became similar to interstate commerce—just an accounting identity, offset perfectly by inbound foreign investment.
Contrary to popular belief, the trade deficit does not signify economic weakness. Understandably, by its very name, a trade deficit implies the US lacks some functional capacity or manufacturing prowess, which ignores the fact that investment inflows match trade outflows. That is, dollars earned through trade by foreigners abroad are automatically invested back in the US. When looked at as a whole, everything balances. Economies thrive, and consumers win with more trade; the US and Canada are no exception.
While financial media often misconstrues the deficit as evidence that the US is “spending more than they earn,” we know this interpretation is flawed. Trade “imbalances” for goods and services reflect a choice among trading partners about whether to hold more cash or consume more goods and services from abroad.
Remember that the trade deficit might be headline-grabbing, but it is meaningless.
P.S. No, imports do not subtract from GDP—it is an accounting gimmick.
