Wednesday, January 13, 2010

Trade Deficit Bad?

As always, please explain to me where I’m getting it wrong.

The common argument, repeatedly endlessly by reporters and politicians, is that if we import more than we export then that’s bad. It’s bad for American workers because they’re going to lose their jobs if we don’t buy what they make. It’s bad for our long term prosperity because we’re sending all of our money to foreign countries. And it’s bad because it means we’re losing! We’re being outcompeted by our economic and military rivals, e.g. China.

It’s a pretty compelling argument, on the face of it. But there’s something confusing about the whole thing, something that doesn’t quite add up.

When I buy a shiny new Japanese-built car my dollars go to the manufacturer in Japan, and I get the car. But the manufacturer can’t use my dollars to buy things in Japan; the law says you can only use yen to buy things in Japan. So the manufacturer who built my new car has to either spend those dollars in the US, or trade them to someone else who wants to spend them in the US. Those dollars are claims against goods and services in the US – they have to come back to the US in order to be spent.

So every time I spend a dollar buying some imported good, that dollar goes to the foreign company that sold me their product. But eventually that same dollar comes back to the US to be spent on something here. It HAS to, there’s no other place for it to go. So how can we even have a trade deficit? Every dollar spent by Americans on imports eventually comes back as spending on domestic goods, services … or investment.

Investment is the thing that balances the trade deficit. Investment doesn’t show up in imports and exports (when I buy stock in a business, the business stays where it is), so it isn’t counted when computing the trade deficit. So, the reason that America has had a trade deficit with the rest of the world for decades is because Americans have been buying imports while the rest of the world has been buying ownership in America.

What does it mean that the rest of the world is buying ownership in America? Primarily it means two things: 1) Foreign investment in American companies, and 2) Foreign investment in US Federal debt. The rest of the world wants to invest in America because America is a good bet. American companies are enormously productive, and the American government doesn’t default on its loans.

Is it a bad thing that foreigners have been buying ownership in American business? No! American businesses use that investment to innovate and grow. Is it a bad thing that foreigners own US Federal debt? No! The US Treasury sells bonds according to policies that it believes are in the best interests of the US financial system and economy.

The primary effects of the trade deficit have been that Americans have enjoyed low prices for goods and services of all kinds, and have benefited from high levels of direct foreign investment. The real risk is that one day the trade deficit will go away as investment shifts from the increasingly regulation-bound US, to freer markets.


  1. The Japanese can also exchange the money in the bank and spend it at Japan. Since Golden Standard has been abandoned, most countries decided to store US dollars instead. So, no, they do not have to spend every dollar at the States.

  2. Anonymous,

    Right, I understand. So what does the Japanese bank that gives you Yen for your dollars do with those dollars?

  3. The US imports about 75% of what the whole world produces. Now in this case it would be very hard for 1 country to produce that much stuff back!! It's almost impossible for only one country to "re-produce" 75% of the total world's goods. Because we can't, we have our trade deficit.

  4. Anonymous,

    That's an interesting point...though I would like to see the source for your 75% number.

    In any case, the US does produce enough (of something) to purchase all of that 'stuff' from other nations. As I have argued, a significant part of what the US produces is high quality investment - as opposed to physical goods.

  5. Suppose China sold a TV to America and got a USD 100 bill in year 2000.
    America enjoyed the TV and did NOT have to give anything back. All China got back was a piece of paper. So, a trade deficit of USD 100 was created.

    Suppose after 10 years in 2010, China gives this USD 100 bill back to America and asks for, say, wheat. This is what America should have given back 10 years ago to china, but China did not want any thing back at the time. So America had enjoyed the TV for 10 years giving back nothing in return.
    In practise due to inflation, after 10 years, value of USD 100 has gone down. If China had wanted to get wheat 10 years ago, America would have given more wheat than what America has to give back now. Kudos to trade deficit.

    The longer China holds on the USD 100 bill, the more the benefit to America.

  6. Would someone please explain why people say that a trade deficit is bad because it creates "debt" for the country in deficit? Who is lending the money?

  7. Anonymous,
    There isn't a literal debt created. That's just a bad metaphor that people use to make it sound like a trade deficit is a bad thing. Why would they want to make a trade deficit sound like a bad thing? Lots of possible reasons, but the most obvious one is because they want to drum up popular support for tariffs on imported goods. For example, if I manufacture cars in the US, and am unhappy having to compete with cheaper cars coming out of South Korea (Hyundai, Kia) then I might want the Federal Govt. to raise tariffs on imported cars so that those Korean cars aren't as cheap. But it's not in the interest of voters to pay more for cars, and so voters need to be persuaded to support policies (tariffs on imported cars) that are bad for them. So we see articles in the paper, and here reporters in the news talking about how a trade deficit is putting us "in debt" to foreign countries.
    That's my quick and dirty response. I gave a more thorough response in my post -- that stuff about foreigners using the dollars they earn from exporting stuff to the US to buy US federal debt (treasury bonds). When foreigners buy US treasury bonds they are literally lending money to the Federal Govt. Is this a bad thing? The quick answer (the one I gave in my post) is NO! After all, the Federal Govt. isn't under any obligation to sell US treasury bonds. It sells bonds when it sees an advantage in doing so.
    The real question is why would foreigners want to work hard at making cars and selling them to Americans, and then lend those hard-earned dollars to the US govt? Really, why does ANYone buy bonds? To save money. The developing world (including, for example, China) has a MUCH higher savings rate than does the US. And those people who are doing all of this saving want to put their money where it will be very secure. So, they might not choose to save Yuan in a Chinese bank if they fear that Chinese banks are a bad risk, or if they fear that the Yuan will have high inflation. US treasury bonds, on the other hand, are widely believed to be among the very most safe and secure of all types of investment.
    So: we get cars and consumer electronics from the rest of the world, and the rest of the world gets secure investment options from us. That's what has made it possible for the US to enjoy a trade deficit that has lasted literally for decades.

  8. I have enjoyed reading that response, as well as your original. Economists can be tricky for me (although I do understand all of your points above and they make sense), which is why I still don't understand why they use 'debt' as a metaphor for trade deficits being bad. It seems more than the 'debt' of us selling treasury bonds. For example, if all the foreign exporters took those dollars and decided to FX them back into their local currency, would economists still use 'debt' as a metaphor? I hope I am clear in my explanation.

  9. "...if all the foreign exporters took those dollars and decided to FX them back into their local currency..."

    You have to think that through in all of its ugly detail. Someone has to buy those dollars with yuan, or whatever the local currency is. It actually gets really crazy when you start thinking about things like, for example, the fact that the Chinese govt. uses yuan to buy dollars, and then stuffs those dollars into a big closet -- thereby decreasing the world supply of dollars (and increasing the world supply of yuan), which makes the dollar strengthen relative to the yuan, which means it's cheaper for Americans to buy Chinese goods. The Chinese govt. does this explicitly to manipulate the exchange rate and to increase Chinese exports to the US. So maybe this is what people mean when they talk about a trade deficit resulting in a debt: The Chinese govt. has a bunch of dollars that ONE DAY they could start spending on US goods, services, and investment (e.g. buying ownership in US companies). But that still isn't a very good metaphor, because the Chinese govt. is not FREE to start spending those dollars, because doing so would weaken the dollar, strengthen the yuan, and dramatically decrease the total amount of export from China to the US, because Chinese goods would become relatively more expensive than they are now for Americans to buy. And the Chinese govt. doesn't want that to happen.
    Really there are only two possible options, once a dollar has been spent on foreign goods: 1) the dollar comes back to the US in the form of a purchase of goods, services, or investment, or 2) the dollar stays locked up in the vault of a foreign government where it slowly loses values due to inflation.

    BTW, you're not my friend Karen, by any chance?

  10. Ha, nope, not Karen. But thank you for the responses.

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