Trade Imbalances: A Parable for Teachers

Last week I posted about "Current Account Deficits," and the reasons for which they may be cause for concern. In explaining these issues to students, it's often hard to get across that there's nothing intrinsically wrong with trade surpluses or trade deficits. It's also delicate to explain that a U.S. trade deficit is the mirror image of an inflow of foreign investment capital, and that a country with a trade surplus is by definition experiencing an outflow of capital. I've had good luck teaching these topics with a parable about trade between Robinson Crusoe and Friday. Here's the parable as it appear in my Principles of Economics textbook, published by Textbook Media (pp. 466-467).

(Of course, if you are teaching a college-level intro econ class, I'd encourage you to give the book a look. It's mainstream in its content and approach; it has worked well in a lot of classrooms; students can get both e-versions and paper versions; it's available in micro and macro splits; and it's very competitively priced at $40 for the entire book and electronic access combined. For information on the book, click here.) 

"To understand how economists view trade deficits and surpluses, consider a parable based on the story of Robinson Crusoe. Robinson, as you may remember from the classic novel by Daniel Defoe first published in 1719, was shipwrecked on a desert island. After living alone for some time, Robinson is joined by a second person, whom he names Friday. Think about the balance of trade in a two-person economy like that of Robinson and Friday.

Robinson and Friday trade goods and services with each other. Perhaps Robinson catches fish and trades them to Friday for coconuts. Or Friday weaves a hat out of tree fronds and trades it to Robinson for help in carrying water. For a period of time, each individual trade is self-contained and complete. Because each trade is voluntary, both Robinson and Friday must feel that they are receiving fair value for what they are giving. As a result, each person’s exports are always equal to his imports, and trade is always in balance between the two men. Neither person experiences either a trade deficit or a trade surplus.

However, one day Robinson approaches Friday with a proposition. Robinson wants to dig ditches for an irrigation system for his garden, but he knows that if he starts this project, he won’t have much time left to fish and gather coconuts to feed himself each day. He proposes that Friday supply him with a certain number of fish and coconuts for several months, and then after that time, he promises to repay Friday out of the extra produce that he will be able to grow in his irrigated garden. If Friday accepts this offer, then a trade imbalance comes into being. For several months, Friday will have a trade surplus: that is, he is exporting to Robinson more than he is importing. More precisely, he is giving Robinson fish and coconuts, and at least for the moment, he is receiving nothing in return. Conversely, Robinson will have a trade deficit, because he is importing more from Friday than he is exporting.

This parable raises several useful issues in thinking about what a trade deficit and
a trade surplus really mean in economic terms.

The first issue raised by this story of Robinson and Friday is: Is it better to have a trade surplus or a trade deficit? The answer, as in any voluntary market interaction, is that if both parties agree to the transaction, then they may both be better off. Over time, if Robinson’s irrigated garden is a success, it is certainly possible that both Robinson and Friday can benefit from this agreement.

A second issue raised by the parable is: What can go wrong? Robinson’s proposal to Friday introduces an element of uncertainty. Friday is in effect making a loan of fish and coconuts to Robinson, and Friday’s happiness with this arrangement will depend on whether that loan is repaid as planned, in full and on time. Perhaps Robinson spends several months loafing, and never builds the irrigation system. Or perhaps Robinson has been too optimistic about how much he will be able to grow with the new irrigation system, which instead turns out not to be very productive. Perhaps after building the irrigation system, Robinson decides that he doesn’t want to repay Friday as much as
previously agreed. Any of these developments will prompt a new round of negotiations between Friday and Robinson. Friday’s attitude toward these renegotiations is likely to be shaped by why the repayment failed. If Robinson worked very hard and the irrigation system just didn’t increase production as intended, Friday may have some sympathy. But if Robinson loafed, or if he just refuses to pay, Friday may become peeved. Whenever money is borrowed for an investment project and the project goes bad, a negotiation takes place between the borrower and the lender as to how much of the original loan will be repaid. Such negotiations are often full of accusations and anger.

A third issue raised by the parable of Robinson and Friday is that an intimate relationship exists between a trade deficit and international borrowing, and between a trade surplus and international lending. The size of Friday’s trade surplus is exactly how much he is lending to Robinson. The size of Robinson’s trade deficit is exactly how much he is borrowing from Friday. Indeed, to economists, a trade surplus literally means the same thing as an outflow of financial capital, and a trade deficit literally means the same thing as an inflow of financial capital."