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Yes, the trade deficit matters

There are (at least) four ways in which the deficit might matter.

First, our deficit means that the world is running a trade surplus with us. The euro area, and much of Asia, are supplying more goods and services than they are demanding. This warns us that the UK is operating in a deflationary global environment. This might hold down inflation – but it’s also holding back growth.

There might, though, be a domestic reason to worry about the deficit too. It could be a sign of a mismatch between the goods we are capable of producing and those we want to buy. This is especially true because the deficit coincides with high unemployment. This in turn suggests market forces aren’t working as well as they might be; resources aren’t shifting to industries which are seeing growing domestic demand.

Now, this is in part a legacy of history; the UK’s comparative advantage in many manufactured goods declined decades ago. But it could also be a warning that – perhaps because of a lack of credit or of “animal spirits” – supply isn’t responding as well as it might to the pattern of demand.

There are other reasons why the deficit might matter. A trade deficit, if not offset by a surplus on services trade or investment income from overseas, means that we are borrowing from overseas. This could matter in two different ways.

One is that if anything were to happen to cause global investors to become more reluctant to part with their cash their reluctance to lend to the UK would cause sterling would fall. It’s no accident that the pound fell sharply in late 2008 when international liquidity dried up.

The other is that a current account deficit is a sign that domestic debt is rising. Much of this, of course, is government debt which probably isn’t a problem (yet). But household debt is also rising. This would not be a problem if it were evenly distributed; total households debt, at £1.43 trillion, is only 1.3 times disposable income. But it’s not. The Bank of England estimates that almost a fifth of mortgage debt is owed by households whose debt is more than five times their income. This means there’s a big minority of households which would be very vulnerable to any rise in interest rates or fall in incomes. In this sense, our external deficit warns us of internal imbalances.

None of this is to say that the trade deficit is an immediate, pressing problem. But it does alert us to some risks to the health of the UK economy.