Abstract
A profits based interpretation of how persistent trade deficits lead to high levels of leverage and financial instability.
Orthodox trade theory focuses on the reallocation of real resources through trade and ignores the monetary/financial and balance sheet aspects of trade. Once in a while, the Twin Deficits bogey is raised to warn about the perils of fiscal deficits, but current account deficits themselves are generally viewed benignly. In reality, growing current account deficits not only lead to an unsustainable buildup in external debt but also lead to a buildup in domestic debt, especially private sector debt. The resolution of these unsustainable trends does not generally occur smoothly through changes in prices and exchange rates but through painful adjustments in output and income. Persistent trade imbalances pose a threat to the global economy. They exacerbate financial imbalances, contribute to financial instability and economic crises, and thereby stoke political resentment to free trade