What is 'Trade Deficit'?

Trade deficit is an economic measure of a negative balance of trade in which a country's imports exceeds its exports. A trade deficit represents an outflow of domestic currency to foreign markets.

Explanation: Economic theory dictates that a trade deficit is not necessarily a bad situation because it often corrects itself over time. However, a deficit has been reported and growing in the United States for the past few decades, which has some economists worried. This means that large amounts of the U.S. dollar are being held by foreign nations, which may decide to sell at any time. A large increase in dollar sales can drive the value of the currency down, making it more costly to purchase imports.

What is a 'Liability'?

A liability is a company's legal debt or obligation that arises during the course of business operations. Liabilities are settled over time through the transfer of economic benefits including money, goods or services.

Explanation: Recorded on the balance sheet (right side), liabilities include loans, accounts payable, mortgages, deferred revenues and accrued expenses. Liabilities are a vital aspect of a company's operations because they are used to finance operations and pay for large expansions. They can also make transactions between businesses more efficient. For example, the outstanding money that a company owes to its suppliers would be considered a liability.

Outside of accounting and finance this term simply refers to any money or service that is currently owed to another party. One form of liability, for example, would be the property taxes that a homeowner owes to the municipal government.

Current liabilities are debts payable within one year, while long-term liabilities are debts payable over a longer period.

What is a 'Deficit'?

A deficit is the amount by which a resource falls short of a mark, most often used to describe a difference between cash inflows and outflows. Deficit is the opposite of surplus and is synonymous with shortfall or loss.

Explanation: The term deficit is generally prefixed by another term to refer to a specific situation, a trade deficit or budget deficit, for example.

A trade deficit exists when a nation has exports of $2 billion and imports of $3 billion in a given year. The country’s deficit is at $1 billion for that year.

A budget deficit occurs when a government has revenues lower than its expenditures. Lets say a small country has $10 billion worth of revenue for a year and its expenditures were at $12 billion for that same year, it would be running a deficit of $2 billion.

An income deficit isn’t quite the same as a budget or trade deficit. A measurement used by the U.S. Census, an income deficit is the dollar amount by which a family’s income falls short of being at or above the poverty line. If the poverty line is $17,000 a year for a family of three, and the family income is at $15,000, then the family’s income deficit is $2,000.

Primary and Total Deficits:

While there are different types of deficits depending on context, even within a specific context there are different ways to measure deficit. When measuring a government deficit, there are two different ways to measure.

Primary deficit refers to the deficit without including interest payments on loans taken out to finance the operation of the government.

Total deficit measures the deficit while including interest payments on loans taken out to finance the operation of the government as well as the interest on the loans.

The size of these deficits can vary depending on the economic and political climate. If a country economy is expanding, increased tax receipts and other inflows of government income will reduce or eliminate government deficits and may lead to government surpluses. Specific goods can be taxed at higher rates, like in OPEC nations or Norway and Russia where oil and gas play important roles in the funding of public spending.

Intentionally Running a Deficit:

It’s not uncommon that in a recession, a government will intentionally run a deficit. The theory behind running a deficit is that by reducing taxes and increasing spending on infrastructure while maintaining government programs and expenditures, the public’s purchasing power will be increased and can then stimulate the economy. While running a deficit, a government can finance its expenditures with bonds, or from loans from foreign countries.

This tactic is by no means universally agreed upon. The Ricardian equivalence hypothesis, originally brought up by member of Parliament and economist David Ricardo, argues that households, anticipating a rise in taxes in the future necessary to pay current government deficits will keep money saved instead of spending it. However, for Ricardian equivalence to apply, the deficit spending would have to be permanent as opposed to a one time stimulus through deficit spending.

Another hypothesis, called crowding out says that when a government borrows to offset the deficit they’re running, interest rates rise as a response to increased demand, decreasing the incentive for private investment.

The experience of governments that have run persistent deficits in the 20th and 21st centuries have complicated the Ricardian and neo-classical analyses of the effect of government debt on economic activity. The Great Recession, which drove up government deficits across the world from 2008 to 2013, led many neo-classical economists to speculate that government budgets would collapse under the weight of persistent spending deficits. In a particularly famous case, the Harvard economists Carmen Reinhart and Kenneth Rogoff predicted in 2010 that government debt above 90% of GDP would actively retard economic growth. Researchers at the University of Massachusetts discovered a coding error in the Excel spreadsheet Reinhart and Rogoff used that invalidated their original conclusion.

Deficit and Risk:

It used to be that government budget deficits were financed exclusively by loans from private investors and foreign countries. These loans were often seen as holding a lot of risk for the lender seeing that they were often both large and long-term. When governments began to issue bonds, which could be payable to bearer, it enabled the original lender could sell the debt - reducing risk and interest rates.

If a deficit is large enough, it can over a number of years can wipe out equity for an individual or a company's shareholders, eventually leaving bankruptcy as the only option. Although sovereign governments have a much greater capacity to sustain deficits, negative effects in such cases include lower economic growth rates (in case of budget deficits) or a devaluation of the domestic currency (in case of trade deficits).

What is 'Sterilization'?

Sterilization is a form of monetary action in which a central bank seeks to limit the effect of inflows and outflows of capital on the money supply. Sterilization most frequently involves the purchase or sale of financial assets by a central bank, and is designed to offset the effect of foreign exchange intervention. The sterilization process is used to manipulate the value of one domestic currency relative to another, and is initiated in the foreign exchange market.

Explanation: Sterilization requires a central bank to look beyond its borders by getting involved in foreign exchange. For example, the Federal Reserve purchases a foreign currency, in this case the yen, and the purchase is made with dollars that the Fed had in its reserves. This action results in there being less yen in the overall market - it has been placed in reserves by the Fed - and more dollars, since the dollars that were in the Fed’s reserve are now in the open market. To sterilize the effect of this transaction the Fed can sell government bonds, which removes dollars from the open market and replaces them with a government obligation.

Emerging markets can be exposed to capital inflows when investors buy up domestic currencies in order to purchase domestic assets. For example, a U.S. investor looking to invest in India must use dollars to purchase rupees. If lots of U.S. investors start buying up rupees, the rupee exchange rate will increase. At this point the Indian central bank can either let the fluctuation continue, which can drive up the price of Indian exports, or it can buy foreign currency with its reserves in order to drive down the exchange rate. If the central bank decides to buy foreign currency it can attempt to offset the increase of rupees in the market buy selling rupee-denominated government bonds.