Tariffs have recently been the topic of both significant policy recommendations and casual conversations.

Goran Skosples is an associate professor of economics at Ohio Wesleyan University.

Tariffs have recently been the topic of both significant policy recommendations and casual conversations.

One of the main stated reasons for tariff increases has been that we are running persistent trade deficits with other countries who are taking advantage of our country. An increase in tariffs would, as it is claimed, improve our trade balance by decreasing our imports.

It is clear that the United States is running a trade deficit vis-à-vis the rest of the world. It currently sits at about $900 billion, or about 3% of GDP.

This means that we are consuming more goods and services (actually goods) than we produce. It is difficult to understand how other countries are taking advantage of the United States, as it has been claimed recently, if we can have higher consumption than we would be able to have if we did not have a trade deficit. In other words, a trade deficit allows us to live “beyond our means.”

Perhaps other countries are lending us the means and in the future, they will come to collect and then we will have to face the harsh truth of having lived beyond our means.

This line of reasoning misses the other side of the coin. In the language of economics, the flow of goods and services (trade) is referred to as the current account. The other side of the coin is the flow of funds or the capital account.

It is not that other countries are lending us the means which we then use to buy goods and services from these countries, but it is rather that we are selling them something on the other side of the coin.

What we are selling are different assets such as stocks, bonds, real estate, etc. When we purchase more goods and services from other countries and send our dollars to them, they use those same dollars to purchase our assets.

As it turns out, our deficit in good and services, or the current account, equals the sale of our assets, or the capital account. This is what is known as, albeit in a simplified version, the balance of payments. When we experience a larger trade deficit it is financed by a larger sale of assets.

A common misunderstanding is to draw a parallel between the entire economy and an individual.

If an individual enjoys larger consumption (equivalent to a trade deficit) and finances it by selling assets, that cannot be sustained as assets are limited and are eventually depleted. An individual cannot sensibly live “beyond her means” in perpetuity. But imagine that this individual is a skilled artisan creating world-renowned wicker baskets.

Every basket she weaves is technically her asset and she can sell it. In this situation, one would not consider her financing consumption by selling her baskets living “beyond her means.”

She would only face a problem if she stopped weaving baskets and then she would have to reduce her consumption of goods and services. She would not be able to finance her consumption if she stopped creating new assets.

Is a persistent trade deficit really bad?

If we zoom out to the entire economy, if our stock of assets is fixed and we do not create new assets, we would not be able to keep selling our assets forever to finance consuming more goods and services than we produce, or, in other words, we would not be able to run a trade deficit.

However, we do create new assets all the time. One thing the United States is good at is innovation and creating businesses. What we miss by focusing on the trade of goods and services, where we are running deficit, is the sale of something we are very skilled at producing and selling, and that is our innovation and business creation, where we are running an equivalent surplus.

In his "The Wealth of Nations," Adam Smith set out to find why some countries are wealthy and some countries are not. One of his main conclusions was that when a country specializes in something it is good at and trades with others, it does better than when it tries to do everything itself.

Since we are very good at innovation and business creation, specializing in this makes us better off than would be otherwise. The fact that we are able to run persistent trade deficits is not a sign of weakness, but rather a sign that we are good at creating assets that are attractive to other countries.

America Inc. is something that we specialize in and is highly desirable around the world.

Increasing tariffs may be an attempt to “solve” the problem of persistent trade deficits. That is, if you believe that our trade deficit is a problem that needs solving.