A Trade Deficit is Not a Debt (Nor is it Bad)

After you finish this post, I have an updated post on the same topic here.

Well, the US trade deficit is up again, and you can be sure the news was accompanied by a lot of moaning and groaning and soul-searching.  The main reason that all the media and the majority of Americans freak out over large trade deficit numbers is that they look at the American economy as a large bank vault with a fixed supply of money on the shelves.  They reason that if more money is going out of the vault to buy things than is going back in from sales, then eventually the vault will go empty and we will be bankrupt.  Either implicitly or explicitly, those who fear trade deficits perceive the trade imbalance to be red ink, something bleeding out of a fixed supply.

This view of the trade deficit as a being a growing and unsustainable debt is wrong.  I will try to explain in a couple of ways.

The micro view

Lets first look at it from the perspective on one individual.  Lets say Fred made $50,000 this year, and lives in a US where, before he makes his spending decisions, trade is exactly in balance with China.  Fred spends some of his income on rent, and invests some in some nice US equities.  And he takes $1000 of what he just made that he might have saved and buys himself a nice Chinese-made plasma TV so he can really enjoy the Superbowl next year.

So, where's the debt?  One can argue that net savings is lower (perhaps - we haven't gotten yet to where the Chinese are spending their extra US dollars), but Fred seems to have increased the trade deficit without incurring any debt.  In fact, Fred is actually better off, since in a free society no one engages in a transaction that doesn't return more value than one spends.  In this case, the plasma TV provides more than $1000 of value back to Fred, or else he would not have engaged in the transaction. 

Yes, many people are buying Chinese TV's with consumer debt, but these same people are buying much more American stuff with consumer debt as well.  To the extent that there is or is not a "problem" with people taking on too much consumer debt, this problem is absolutely unrelated to the country of origin of the goods they are buying.  You can max out your Visa card on American stuff just as easily as on Chinese stuff.

But wait, you say.  The reason the debt is not obvious is from the way I structured the problem.  I assumed the rest of the economy was static while Fred was making his decision.  But if Fred had bought American, somewhere in the US economy there must have been less debt.  So we will tackle this next.

The Economy is Not Zero Sum

Repeat please:  The economy is not zero-sum.  Never has it been so hard to convince people of a concept that should be so obvious.  I used up bushels of electrons explaining why the economy is not zero sum here, but the short proof is easy:  Look at the world in 1900.  Look at it today.  The world as a whole and most every individual is far richer.  The fact is that economies create wealth every day, and free economies create a LOT of wealth.

At the heart of every argument that the trade deficit is bad is the mercantilist notion that the US economy is a bank vault leaking funds.  But this analogy that seems to be in everyone's head is flawed.  The supply of money or wealth in the US, in the vault, is constantly growing.  If you really have to think of it as a vault, then think of what's inside as rabbits rather than gold bars.  Does anyone doubt that if you start with a hundred rabbits and every year sent a few to China that you might still have more rabbits than you started with in the vault?  A free economy is like a group of rabbits on Viagra.  Even if the Chinese took billions of dollars they got from selling goods to the US each year and burned the money in a big bonfire, the US still would be growing in wealth.

Of course, the vault analogy sucks for a larger reason, that the US economy is deeply integrated with that of the rest of the world.  In fact, much of the wealth creation comes from this very integration, providing a more robust division of labor and a deeper well of creativity and entrepreneurship than any one country could achieve on its own.  And the dollars we send overseas don't stay there, they come back.  But we will address this next.

So What do the Chinese do with Those Dollars?

OK, so we are all short-sitedly (at least according the the "progressive" intelligentsia) sending dollars to China to satisfy our consumerism.  So what do those Chinese do with those dollars?  They can't spend them domestically, because stores and vendors in China don't accept dollars any more than the Wal-mart down the street from me accepts Yuan.

Most all the dollars have to come back to the US, or the person in China holding them gets no value.  You could say, well that person can take them to the bank and exchange them for Yuan, and that is true.  But that bank would not accept the dollars for exchange unless it knew it could get them back to the US, or had another client that needed them to make a purchase in the US.  So, the dollars will have to come back to the US to purchase something.

Some of the dollars come back to purchase US goods and raw materials, but of course this is less than the total dollars the Chinese have to spend, or else there would be no trade deficit.  In fact, this all that the words "trade deficit" really means.  It means that of the dollars the Chinese receive from sales to the US, only a portion is used to buy American goods that are shipped back to China.  The rest goes to buy American .. something else.

What?

Well, some of it goes to purchase American goods that stay in the US.  Lets shamelessly steal an analogy from Don Beadreaux and Jack Wenders.  If Chinese companies buy American steel and lumber and ship it to China, it shows up in the trade balance.  If they buy the same products and build a factory in the US, it does not.  The Chinese use a lot of their dollars to invest in buildings, real estate, capital assets, factories, production facilities, etc. in the US.  And this is bad, how?  I know that since the Japanese investment boom of the eighties, there are lots of folks who call themselves "liberal" who suddenly got very upset about foreigners owning US-based assets.  It is impossible for me to see this concern as anything but xenophobia and racism, since hundreds of years of Dutch, Canadian, and British investment never worried a soul but Japanese and Chinese investment has everyone in a lather

By the way, if you worry about China as a security threat, wouldn't you rather see them invested in the US economy, and therefore have a strong interest in our continued prosperity?  One could easily wonder why Saudi Arabia does not use their power over oil reserves to screw with the US like they tried to do in the early 70's.  The reason is that all of their wealth is invested in dollar and euro-denomitated assets.   People worry about the power the Saudis may have to mess with our economy, but their reinvestment of dollars back in our economy has made this a game of mutual assured destruction.  The same thing is occuring with China.

The other thing the Chinese do with the money is invest in dollar-denominated financial assets, which in many ways is just an indirect way of investing in the same capital assets listed above.  They will invest dollars in equities and, yes, debt securities.  But the fact that the Chinese choose to spend their dollars on debt securities does not mean that the trade deficit is causing the debt.  If the Chinese had a predilection for debt securities, more so than say an American holder of dollars, one might argue that this predilection drives down interest rates a bit and therefore might increase total debt, but this is a fairly tenuous chain of causation and not, I think, what seems to be bothering folks who panic over the trade deficit.  In fact, one can argue that the causation runs more strongly the other direction, that the large US budget deficit keeps the dollar higher than it might otherwise be, increasing the trade deficit.

So when people lament that "we now consume much more than we produce", they are making a meaningless statement because the we in the first part are not the same as the we in the second part.  The US and the Chinese are sending equal amounts of money back and forth - its has to be, over the medium to long term, or exchange rates would crash.  All the trade deficit means is that there is a difference in WHERE Chinese and Americans consume the goods.  Americans consume Chinese goods in the US.  The Chinese consume some of the US goods it buys in China, and then consumes the rest in the US.  The trade deficit represents the net amount of American goods and services the Chinese buy in the US and choose not to haul back to China.  Instead, they take ownership of the American goods here, in the form of capital assets or financial securities that represent ownership or calls on the cash flow of these capital assets. 

Anyway, you can find more here at Cafe Hayek.

Postscript:  By the way, the US has run a trade deficit of a magnitude that panics people for over two decades.  If this is bad, surely we would be able to find the damage somewhere.  But the US over the last two decades has had the strongest economy in the world.  I suspect that a lot of people would answer "we have run up a huge debt".  But any increase in total debt in the US is not relevant to the trade deficit, or only tangentially related as discussed above.  The Federal debt is run up because the politicians are all spending whores who support their reelection with "good works" paid for with our money.  Consumer debt, which may or may not be "too high", is based on individual spending and saving choices, and is unaffected by whether a person buys an American or Chinese TV.

  • earl

    You know, you should really try sticking to things you understand. Say, not international economics.

    The first counterpoint to your argument is change in the US NFW position over the last 20 years -- say, 1985 on.

    The second is that the argument that a global savings glut / lack of strong investment opportunities has helped depress global interest rates and in particular, depressed domestic saving is anything but a "tenuous" argument. Viz Bernanke.

    Third, the problem w/ large amounts of foreign investment is we're selling lots of our future earnings to foreigners, and repayment may well depress future growth.

    Fourth, it *may* be rational to use cheap foreign capital to invest in America... were that what we're doing. I'm dying to see your argument that wasting several hundred billion dollars on a voluntary war and a massive drive up of housing prices / real estate is, in any way, going to increase future productivity in America. In other words, it's not investment spending, it's consumption spending.

    Five, we are consuming more than we produce -- that's why we are borrowing.

    Six, exchange rates are being propped by the Chinese government, most likely to prevent social unrest in China if their export market were to diminish. This is fine... as long as it continues. Were it to stop suddenly, ie were the Chinese central bank to stop taking large sums from domestic taxation and converting to dollars at a negative real interest rate, US interest rates would be forced to jump very rapidly in a short period of time in order to cover required spending. Hence the fear of a hard landing, not a soft one.

    I could go on, but your post essentially demonstrates a lack of knowledge.

  • This article (http://www.slate.com/id/2040/) also makes a good argument by analogy against trade deficit freakout.

  • Your essay sheds some light on the matter, but I still have trepidation about basing an economy on consumption. America produces much fewer durable goods than it used to and many people consider foreign re-investment to be a type of faux-wealth that could dry up rapidly if another currency becomes more attractive than the dollar.

    Should we be concerned that we manufacture very little? I tend to think so, but as long as other nations do the manufacturing at a fraction of our cost I don't see any way to change the course.

  • JohnDewey

    Do we manufacture very little in this country? or do we manufacture quite a lot? I tried to answer this by enumerating my purchases, after taxes and savings.

    U.S. goods:

    house (mortgage principal)
    house (maintenance and improvements)
    Ford pickup truck
    Honda Accord (assembled by American workers)
    gasoline
    groceries
    utilities
    books
    furniture
    appliances(Whirlpool)
    toll roads

    U.S. services:

    mortgage interest
    health insurance/medical expenses
    vacations
    auto insurance
    homeowner's insurance
    life insurance

    Foreign-made goods:

    electronics
    clothes
    household goods
    appliances(GE)

    One important thing about foreign-made goods: only a portion of my purchase price actually goes out of the country.

    Most of the foreign-built items were shifted overseas a decade or two ago, with little impact to my income and positive impact to my standard of living.

    Why should I be concerned if 6% or 7% of our GDP is spent on net U.S. imports?

  • RP

    The Feds tax individual income, capital gains, dividends, and interest, on US citizens.
    The Feds tax US corporations, and US corporations arrange the books such that they have no/little taxable income.
    But the Feds cannot tax foreigners, nor Foreign Central Banks, on their investments, right?
    And if foreigners don't *consume* what they earn (i.e. they save and invest in other consumers), there is no/little
    income flowing back via US export sales.

    Therefore, I would suggest that the major problem will be that the Feds will eventually need to tax consumption
    (AARP...uh oh), or eventually inflate away it's debt (dollar value...uh oh), or Uncle Seymour will starve. Of
    course, we could always hope that foreigners suddenly match US consumption practices...but I wouldn't hold my
    breath on that.

  • RP

    Oh, and if you think this will end well (independant of national borders), you should google "telecom vendor financing in the late 1990s". It didn't end well for the financee nor financer. One day, we will talk about "FCB supplier financing in the 2000s".

  • Something you may be overlooking: China is willing to accept dollars because (1) the dollar is historically stable, and (2) the dollar can be exchanged for what China wants. What does China want? Petroleum. Because the major petroleum markets are dollar-denominated, the demand for dollars is strong. What will happen when those markets diversify, and petroleum purchases are increasingly denominated in Euros?

    In order to keep the value of the dollar stable in the face of declining international demand, it will be necessary to reduce the money supply. An increase in import costs is guaranteed, but also a contraction in the economy. This makes domestic investment unattractive. An inflationary policy is likely, because devaluation is the only way to mitigate the vast debt which pervades the system. In combination, if the timing is poor, we have a perfect storm, insuring the flight of capital out of the U.S., in turn further devaluing the dollar, creating a forceful inflationary spiral. Increasingly, the bulk of investment is internationally mobile. When the interest of the investor is best served by a contraction of the U.S. economy, one may expect the U.S. economy to contract.

    Heroin is very pleasant while it is in good supply. It is when the supply is withdrawn that the painful consequences of the habit become evident. Venezuela is contracting in Euros today. Iran opens it's Euro-denominated bourse in March, at the same time that the Fed ceases to publish M3 numbers. I'm expecting a long, hot summer.

  • Anon

    You've discussed how well the US is doing without mentioning anything about the military grip it has on South America and the Middle East. I think accusations of ignorance are well founded.

    You claim the US is the strongest economy in the world but that is based on GDP. Do you think GDP is the best evaluation of an economy and if so, do you think it's a worthy measurement? Compare it to something like UN 'quality of life' measurements or unemployment rates, or anything.

  • grumpY!

    in the immediate term, a consumption based economy producing trade deficits need not cause concern.

    longer term, we are injecting a great deal of volatility into the global economic system by exporting our imbalances to what will soon be the world's largest economy. stephen roach has written ad nauseum on this, as has bill gross, etc.,. this isn't the largest system issue - one or two serious dollar crises can correct this imbalance as china's dollars drop in value. the largest issue us that our economy cannot continue to progress as a nation that exports manufacturing and high-margin services (the outsourcing trend in finance, software, semiconductor research and even biotech has gutted any argument that we are the only "thinkers"). this is a credit-card binge on a national scale. and like any credit binge, lenders will always keep the credit going, but only as long as it is to their advantage.

    one day china's domestic market will be larger than the US export market. when that happens, they will dump their dollars whenever they feel like making the US economy scream (to borrow a Nixon term about his designs on Chile).

  • Doctor

    Err, why is gasoline among US goods? Oil is THE reason for the trade deficit, and the cost of energy in production and transportation is hidden in more or less everything that's US-made.

  • John Dewey

    "Err, why is gasoline among US goods? Oil is THE reason for the trade deficit"

    Crude oil is a raw material, most of which is imported. Gasoline, diesel fuel, jet fuel, synthetic rubber, plastics, and hundreds of other products are manufactured goods produced from that raw material. Most of those manufactured goods used in the U.S. are manufactured at U.S. plants.

    I'm not sure that most economists would agree that "oil is the reason for the trade deficit".

  • Andre Kooy

    Dear sir,
    I can show you where's the debt. Take your Fred example. If he's the average American, he then makes 50,000 USD a year, but spends 53,500 USD.
    Hence the trade deficit, which is just the difference between what you make (GDP, or Fred's 53.500) and what you spend. The difference is currently 7% of GDP (or 3,500 USD for Fred).
    Hence, Fred has 3,500 USD new debt this year, on top off all the debt he already has. Fred also needs to pay interest over his debt. If you spend more every year than you make, that is your personal trade deficit, and you accumulate debt, that needs servicing (= pay interest, or dividend when the Chinese invest in an US company; and the Chinese and other foreigners only do that to get more USD out than they invest now!)

    So, the current account deficit(currently almost identical to trade deficit) means that the US are accumulating more and more debt (or, in macro economic terminology: the Net International Investment Position is negative and growing).

    This means that the US needs to pay more and more interest. High consumption in the current years needs to paid off, with interest, by future generations.

  • W. Raymond Mills

    The trade deficit harms U. S. busineses.

    If we had equal trade between the U. S. and the rest of the world, we would still have plenty of competition for U. S. businesses. The only firms that would survive are those that could sell on the international market - BUT with equal trade the U. S. would not be financing the improvements of competitor businesses.

    Japan firms stay ahead of U. S. auto producers because they have annual profits from selling in the U. S. to fund their research.

    At the moment, U. S. auto firms cannot compete.

    The temporary solution is to reduce imports from the 5 countries that are responsible for 60% of the U. S. trade deficit. Tariffs should be applied to ALL imports from those 5 countries, in a gradually increasing rate, until our imports shrink to the level more nearly equal to our exports.

    This is not protectionism, as traditionally defined, because it does not discriminate among products. It discriminates among countries. For a valid reason - to get closer to balanced trade.

  • Ames Tiedeman

    The trade deficit is a debt. We cannot get the dollars back we have spendt unless we export to get them back. It is called an external debt for a reason. It is called a current account debto for a reason.

  • Andre Kooy

    In response to W. Raymond Mills:

    Please note that this will help some US businesses, however hurts all US consumers: they have to pay more money for the same products. Tariffs generate in total a loss to the economy imposing them: the big advantages for some businesses never outweigh the total of small losses to all consumers.

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  • Fast Eddy

    What nonsense. "But the fact that the Chinese choose to spend their dollars on debt securities does not mean that the trade deficit is causing the debt."

    We buy perishable goods from China, they buy our debt. In 20 years the Chinese made TV is worthless, in 20 years they still have US dollars. The dollars are inflated by the printing of new dollars but if we print too many they can buy US businesses and other hard assets and dump Tbills.

  • May Xu

    How Bastiat Toppled the “Balance of Trade” Bugaboo

    Protectionists of all stripes often rail about trade deficits. An unfavorable balance of trade. One of the catch phrases of these people, because at some level they realize the value of trade, is that they want "fair trade." That's just protectionism under the guise of being pro-free trade.
    One of Donald Trump's bugaboos is trade with China. On the Trump website it says "for free trade to bring prosperity to America, it must also be fair trade. Our goal is not protectionism but accountability."
    And Hillary Clinton, in her nomination speech at the DNC, said “we should say ‘no’ to unfair trade deals... we should stand up to China.”
    Those dastardly Chinese just don't play fair!
    Alleged currency manipulation is part of his objection to the Chinese. The Chinese renminbi was pegged to the dollar until 2005. There was considerable hue and cry in the States that the Chinese currency was overvalued. It was alleged that this created a trade imbalance.
    The idea that trade has to be balanced, that the amount of imports and the amount of exports should match is, on the face of it, a load of malarkey.
    The Trump website goes further. "In a system of truly free trade and floating exchange rates like a Trump administration would support, America's massive trade deficit with China would not persist."
    Balance of trade! That old bugaboo.
    What specifically does Trump propose with respect to trade? During the primary debates he argued for a 45% tariff on imported goods and scuttling NAFTA. Those dastardly Mexicans are as unfair as the Chinese with their cheap car production.
    Ironically, proponents of free trade often make the same mistaken argument. They support free trade because they believe that their country will be a winner. They will win the "trade wars" and have a favorable balance of trade. The country's exports will exceed its imports which will be good for everyone.
    But the idea that trade has to be balanced, that the amount of imports and the amount of exports should match is, on the face of it, a load of malarkey.
    "He believes and loudly proclaims that if France gives ten in order to receive fifteen, it loses five."
    Frederic Bastiat vs. the Protectionists
    Nobody has explained this fallacy better than Frederic Bastiat, the brilliant 19th century French economist and polemicist. Bastiat's forte is the reductio ad absurdum. He takes the position of the protectionists and draws it out to its logical conclusion. His petition of the "Manufacturers of Candles, Tapers, Lanterns, Candlesticks, Street lams, Snuffers and Extinguishers, and the Producers of Tallow, Oil, Resin, Alcohol, and Generally of Everything Connected with Lighting" against the competition of the sun is a classic. His proposal of a "negative railroad" skewers his opponents mercilessly.
    His attack on the notion of a balance of trade is equally devastating and equally hilarious. It made me laugh out loud when I read it. Speaking of one of the protectionists, a Monsieur Lestiboudois, he says, "he believes and loudly proclaims that if France gives ten in order to receive fifteen, it loses five." In other words, if France exports say, ten million francs of goods and imports fifteen million, France is out five million francs.
    He quotes this trade critic at length with the conclusion that when trade is not balanced, the deficit is money that is given away. "Every year we give away 200 million francs to foreigners.
    The Trade Balance and the Businessman
    The theories of the free traders are attacked as valid only in theory by the protectionists, but, asks Bastiat, "do you think the account books of businessmen are valid in practice?"
    If there's anyone who understands profit and loss, surely it is the businessman. So, says Bastiat, consider the case of one of his businessman friends who he refers to by his initials, M.T.. Let's compare M.T.'s accounting to that of the customhouse.
    "M.T. despatched a ship from Le Havre to the United States with a cargo of French goods, chiefly those known as specialties of French fashion, totalling 200,000 francs. This was the amount declared at the custom house."
    Now after arriving at New Orleans, paying the shipping charge and an American tariff, M.T. still manages to sell the French fashions for a profit of twenty per cent or 40,000 francs. The return of his original investment, the shipping costs, the tariff and his profit nets him 320,000 francs which he uses to buy cotton.
    In addition, M.T. had to pay for shipping the cotton back to France, commissions, insurance and so forth bringing the cost of the cotton to 352,000 francs. And that is what the customhouse entered into its books as the value of the imported cotton.
    M.T. sells the cotton and nets another 70,400 francs in profit. M.T. is up 40,000 francs on the sale of French fashions to the Americans and 70,400 francs on the sale of American cotton to domestic French consumers. He has profited to the tune of 110,400 francs! Not a bad business trip!
    But in the accounts of the French customhouse, France has exported 200,000 francs and imported 352,000 francs. Oh my god! It's a trade deficit! France just got snookered out of 152,000 francs! Or as Bastiat puts it, the esteemed trade critic must conclude that France "has consumed and dissipated the proceeds of previous savings, that it has impoverished and is on the way to ruining itself, that it has given away 152,000 francs of its capital to foreigners!" (italics in the original).
    Throw it into the sea!
    But Bastiat is not done yet! It seems M.T. despatched another ship shortly thereafter with another 200,000 francs of goods. Sadly, the ship sank and M.T. had no choice but to enter into his accounts a loss of 200,000 francs.
    The good gentleman at the customhouse, however, entered the shipment as 200,000 francs in the export ledger before the ship sailed. But because it sank, there will never be anything entered in the import ledger to counter it. "It follows," says Bastiat, "that M. Lestidoubois and the Chamber will view this shipwreck as a clear net profit of 200,000 francs for France!"
    Trade exists because the parties to the trade see an advantage to doing so, not because it is "good for the country.
    But wait! Bastiat is still not done! "There is still a further conclusion to be drawn from all this, namely, that, according to the theory of the balance of trade, France has a quite simple means of doubling her capital at any moment. It suffices merely to pass its products through the customhouse, and then throw them into the sea. In that case the exports will equal the amount of her capital; imports will be non-existent and even impossible, and we shall gain all that the ocean has swallowed up."
    Indeed, when someone sells something, whether to a domestic or foreign consumer, he does so to make a profit or he wouldn't make the trade. Conversely, when someone buys something, whether from a domestic or foreign consumer, he does so because he sees it as advantageous. Trade exists because the parties to the trade see an advantage to doing so, not because it is "good for the country.
    Indeed, we could go further and argue that if we need a balance of trade between countries, why not between the states? Why shouldn't New York insist that the value of movies it imports from Hollywood be balanced out by an equal value of manufactured goods exported to California? To ask the question is to see its absurdity.

    https://fee.org/articles/how-bastiat-toppled-the-balance-of-trade-bugaboo/

  • May Xu

    Is There an Unfavorable Balance of Trade?
    Economists who believe in the market economy seldom have kind words for the ideas of the late John Maynard Keynes, and understandably so. Keynes, who did so much to make inflation a popular policy worldwide, was no friend of the free market. Scattered here and there in his voluminous writings, however, are passages with which free mar­ket advocates can wholeheartedly agree. This one in particular deserves to be carved in stone and enshrined forever:
    The ideas of the economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly under­stood. Indeed the world is ruled by little else. Practical men, who believe them­selves to be quite exempt from any in­tellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.¹
    Today it seems that defunct economists and academic scribblers are making a dramatic comeback. Economics has become burdened with foolish notions that were once thought to be discredited. Some of these notions are put forward as if they are imaginative, new discoveries; too many are designed to turn the clock back to the days before free trade unleashed the creative energies which have built the prosperity of Western civilization.
    Twin Obstructions
    A leading illustration of this point involves the twin concepts of "balance of trade" and "balance of payments." These two concepts, which sound innocuous in name, often form the basis for erecting barriers to foreign goods. With the demand for "protectionist" legislation on the rise throughout the world, we can expect to hear more about them in coming months.
    How are these terms defined? The "balance of trade" is considered to be the difference between the money value of a country’s merchandise imports and the money value of its merchandise exports. The "balance of payments" is regarded as a broader measure of economic activities between nations because it includes merchandise and such "invisible" imports and exports as credit transactions and government payments abroad (for foreign aid or to support military forces, for example).
    The definitions are not as important, though, as the actual purpose behind them. Both "balance of trade" and "balance of payments" concepts attempt to fracture the process we know as "trade" so that the resulting fragments can be designated either "good" or "bad." In this way, "trade" is deemed to be "good" if it meets certain statistical criteria and "bad" if it does not. Such value judgments, moreover, are reached independently of the individuals who are doing the actual trading.
    The Mercantilists
    The first economists to develop this analysis of trade were the mercantilists, so it is certainly not new with today’s theoreticians. Thomas Mun, a leading mercantilist scholar of the seventeenth century, argued that England would prosper in foreign trade if only she would strive for a "favorable" balance:
    The ordinary means, therefore, to in­crease our wealth and treasure is by Foreign Trade wherein we must ever observe this rule; to sell more to strangers yearly than we consume of theirs in value. For suppose that when this Kingdom is plentifully served with Cloth, Lead, Tin, Iron, Fish and other native commodities, we doe yearly export the over-surplus to forraign Countreys to the value of twenty two hundred thousand pounds, by which means we are enabled beyond the Seas to buy and bring in forraign wares for our use and Consumptions, to the value of twenty hundred thousand pounds; By this order duly kept in our trading, we may rest assured that the Kingdom shall be enriched yearly two hundred thousand pounds, which must be brought to us in so much Treasure, because that part of stock which is not returned to us in wares must necessarily be brought home in treasure…2
    Mun and the mercantilists be­lieved that a nation must never buy from foreigners more than it sells to them. If such an "unfavorable" balance occurred, the nation had to pay the difference in gold, the internationally-accepted medium of payment. To prevent that, the gov­ernment was supposed to actively promote an excess of exports over imports. Mercantilists were so con­vinced that specie itself constituted the wealth of the nation that they closed their borders to trade and often waged war in order to protect and accumulate vast supplies of gold. That a nation should strive for a "favorable" balance of trade (more exports than imports) is the economic heritage of the sixteenth, seventeenth, and eighteenth cen­turies.
    Mercantilist reasoning did not die with the mercantilists, however. According to the U.S. Department of Commerce, imports surpassed exports for eight consecutive months through January 1977. This situation, disparagingly labeled a trade "deficit," is provoking concern among many orthodox econo­mists. Already, demands are increasing for restricting imports to redress the "imbalance." Japan is singled out for particular scorn, because she sold $5 billion more in goods to the U.S. than the U.S. sold to her in 1976. Each month that government statistics indicate an "unfavorable" balance seems to push America closer to a neo-mer­cantilist policy of protectionism and trade wars.
    Adam Smith and Bastiat
    It was Adam Smith who first at­tacked the notion that exports are good and imports are bad. He pos­tulated a "harmony of interests" in trade, by which both parties to an exchange benefit. With the excep­tion of obvious fraudulent prac­tices, which are minimal in number and a responsibility of the courts, there can be nothing "unfavorable" about voluntary trade from the point of view of the individuals do­ing the trading, otherwise those in­dividuals would not have engaged in it.
    This principle is readily visible when trade involves two parties within a country; it somehow becomes confused if an invisible political barrier separates the two. Introduce more than one currency and the principle becomes all but totally obscured in the welter of economic fallacy. Mercantilists of yesteryear and like-minded economists of today face an impossible dilemma posed by this question: Since each and every trade is "fa­vorable" to the individual traders, how is it possible that these trans­actions can be totalled up to pro­duce something "unfavorable"?
    Frederic Bastiat, the nineteenth-century French economist and phil­osopher who exploded myths with stunning clarity, once addressed himself to this very point. His anal­ysis remains to this day one of the best critiques of the "unfavorable balance" concept:
    M.T. despatched a ship from Le Havre to the United States, with a cargo of French goods, chiefly those known as specialties of Parisian fashion, totalling 200,000 francs. This was the amount declared at the customhouse. When the cargo arrived in New Orleans, it had to pay a shipping charge of ten per cent and a tariff of thirty per cent, which brought the total to 280,000 francs. It was sold at a profit of twenty per cent, or 40,000 francs, for a total price of 320,000 francs, which the consignee converted into cotton. This cotton had to pay ten per cent more, for transporta­tion, insurance, commissions, etc.; so that, when the cargo arrived at Le Havre, its cost amounted to 352,000 francs, and that was the figure entered into the accounts of the customhouse. Finally, M.T. again realized, on this return trip, twenty per cent profit, or 70,400 francs; in other words, the cotton sold for 422,400 francs.
    If M. Lestiboudois requires it, I shall send him some figures taken from the books of M.T. There he will see, in the credit column of the profit-and-loss account—that is to say, as profit—two entries, one for 40,000 francs and the other for 70,400 francs; and M.T. is fully satisfied that in this respect his ac­counting is not in error.
    And yet, what do the figures in the ac­count books of the customhouse tell M. Lestiboudois regarding this transac­tion? They tell him that France has ex­ported 200,000 francs, and that it has imported 352,000 francs; whence the honorable deputy concludes "that it has consumed and dissipated the proceeds of previous savings, that it has im­poverished and is on the way to ruining itself, that it has given away 152,000 francs of its capital to foreigners."
    Some time afterward, M.T. dis­patched another ship with a similar cargo, worth 200,000 francs, of products of our domestic industry. But the un­fortunate vessel sank while leaving the harbor, and there was nothing else for M.T. to do but to inscribe in his books two brief entries phrased thus:
    Sundry goods due to X: 200,000 francs for the purchase of various commodities carried by ship N.
    Profits and losses due to sundry goods: 200,000 francs for ultimate total loss of the cargo.
    Meanwhile, the customhouse on its part was entering 200,000 francs into its export ledger; and as it will never have anything to enter into the opposite im­port ledger on this account, it follows that M. Lestiboudois and the Chamber will view this shipwreck as a clear net profit of 200,000 francs for France.
    There is still a further conclusion to be drawn from all this, namely, that, ac­cording to the theory of the balance of trade, France has a quite simple means of doubling her capital at any moment. It suffices merely to pass its products through the customhouse, and then throw them into the sea. In that case the exports will equal the amount of her capital; imports will be nonexistent and even impossible, and we shall gain all that the ocean has swallowed up.3
    In a parting shot, Bastiat again applies reductio ad absurdum logic to the argument. He declares:
    Assume, if it amuses you, that for­eigners flood our shores with all kinds of useful goods, without asking anything from us; even if our imports are infinite and our exports nothing, I defy you to prove to me that we should be the poorer for it.4
    A Two-Way Street
    It ought to be obvious that trade is a two-way street. In a free mar­ket, where trade is a voluntary, de­sired, and spontaneous feature of human action, there is a "perfect balance." Professor W.M. Curtiss demonstrates that trade between people of different nations is no dif­ferent in this respect from trade between people of the same nation:
    Suppose you sell a bushel of apples for two dollars. You get two dollars, which you would rather have than the apples; the buyer gets the apples, which he would rather have than the two dollars. A perfect balance!
    True enough, our exporters may sell goods to English buyers and get ster­ling exchange. They may spend this money in France or Germany rather than in England, so that the flow of goods is not directly between England and America. But the same might be true in the trade of apples for dollars. With your two dollars, you probably will buy something from a third party rather than from the man who bought your apples.5
    The mercantilists, we have noted, viewed the export of money and bul­lion as inherently evil. Exports were to be encouraged and imports dis­couraged by means of tariffs and quotas in order for money to be "kept in" the country. Similar cries are heard today. Many economists and government officials view with alarm any net outflow of money to foreigners.
    In the context of individuals engaged in free trade, such alarm is misplaced if directed at the market. Often a net outflow of funds is a symptom of the government’s own policy of inflation which erodes public confidence in the dollar. Professor Ludwig von Mises believed that in any case, this occurrence
    … is not the product of an unhappy concatenation of circumstances that be­falls a nation like an act of God. It is the result of the fact that the residents of the country concerned are intent upon reducing the amount of money held and upon buying goods instead.6
    Furthermore, Mises contended, it is not correct to assume that gov­ernment must take measures to prevent a total loss of the nation’s money by such an "unfavorable balance." Quoting from Professor Mises again:
    No government interference is needed to prevent the residents of New York from spending all their money in deal­ings with the other forty-nine states of the Union. As long as any American at­taches any weight to the keeping of cash, he will spontaneously take charge of the matter… But if no American were interested in keeping any cash holding, no government measure con­cerning foreign trade and the settlement of international payments could prevent an outflow of America’s total monetary stock.?
    Keynes was correct when he said that ideas, right or wrong, rule the world. The undue concern over the "balance of trade" and the "balance of payments" will quite probably produce wider restrictions on inter­national trade. If that occurs, our government’s policy-makers will be treading blindly in the footsteps of the defunct economists and aca­demic scribblers of mercantilist times.
    1John Maynard Keynes, The General Theory of Employment, Interest and Money (New York: Harcourt, Brace and World, 1964), p. 383.
    2"England‘s Treasure by Forraign Trade," 1664 by Thomas Mun in John R. McCulloch (ed.), Early English Tracts on Commerce (Nor­wich: Jarrold and Sons, Ltd., 1952), pp. 125-26.
    3Frederic Bastiat, Economic Sophisms (Irv­ington, New York: Foundation for Economic Education, 1968), pp. 53-54.
    4/bid., p. 55.
    5W.M. Curtiss, The Tariff Idea (Irvington, New York: Foundation for Economic Educa­tion, 1962), p. 36.
    6Ludwig von Mises, Human Action (Chicago: Henry Regnery Co., 1966), p. 452.
    7Ibid.

    https://fee.org/articles/is-there-an-unfavorable-balance-of-trade/

  • May Xu

    The Fallacy of Trade Balance by Frederic Bastiat

    The Balance of Trade

    13.1
    The balance of trade is an article of faith.
    13.2
    We know what it consists in: if a country imports more than it exports, it loses the difference. Conversely, if its exports exceed its imports, the excess is to its profit. This is held to be an axiom, and laws are passed in accordance with it.
    13.3
    On this hypothesis, M. Mauguin warned us the day before yesterday, citing statistics, that France carries on a foreign trade in which it has managed to lose, out of good will, without being required to do so, two hundred million francs a year.
    13.4
    "You have lost by your trade, in eleven years, two billion francs. Do you understand what that means?"
    13.5
    Then, applying his infallible rule to the facts, he told us: "In 1847 you sold 605 million francs' worth of manufactured products, and you bought only 152 millions' worth. Hence, you gained 450 million.
    13.6
    "You bought 804 millions' worth of raw materials, and you sold only 114 million; hence, you lost 690 million."
    13.7
    This is an example of the dauntless naïveté of following an absurd premise to its logical conclusion. M. Mauguin has discovered the secret of making even Messrs. Drably and Lebeuf laugh at the expense of the balance of trade. It is a great achievement, of which I cannot help being jealous.
    13.8
    Allow me to assess the validity of the rule according to which M. Mauguin and all the protectionists calculate profits and losses. I shall do so by recounting two business transactions which I have had the occasion to engage in.
    13.9
    I was at Bordeaux. I had a cask of wine which was worth 50 francs; I sent it to Liverpool, and the customhouse noted on its records an export of 50 francs.
    13.10
    At Liverpool the wine was sold for 70 francs. My representative converted the 70 francs into coal, which was found to be worth 90 francs on the market at Bordeaux. The customhouse hastened to record an import of 90 francs.
    13.11
    Balance of trade, or the excess of imports over exports: 40 francs.
    13.12
    These 40 francs, I have always believed, putting my trust in my books, I had gained. But M. Mauguin tells me that I have lost them, and that France has lost them in my person.
    13.13
    And why does M. Mauguin see a loss here? Because he supposes that any excess of imports over exports necessarily implies a balance that must be paid in cash. But where is there in the transaction that I speak of, which follows the pattern of all profitable commercial transactions, any balance to pay? Is it, then, so difficult to understand that a merchant compares the prices current in different markets and decides to trade only when he has the certainty, or at least the probability, of seeing the exported value return to him increased? Hence, what M. Mauguin calls loss should be called profit.
    13.14
    A few days after my transaction I had the simplicity to experience regret; I was sorry I had not waited. In fact, the price of wine fell at Bordeaux and rose at Liverpool; so that if I had not been so hasty, I could have bought at 40 francs and sold at 100 francs. I truly believed that on such a basis my profit would have been greater. But I learn from M. Mauguin that it is the loss that would have been more ruinous.
    13.15
    My second transaction had a very different result.
    13.16
    I had had some truffles shipped from Périgord which cost me 100 francs; they were destined for two distinguished English cabinet ministers for a very high price, which I proposed to turn into pounds sterling. Alas, I would have done better to eat them myself (I mean the truffles, not the English pounds or the Tories). All would not have been lost, as they were, for the ship that carried them off sank on its departure. The customs officer, who had noted on this occasion an export of 100 francs, never had any re-import to enter in this case.
    13.17
    Hence, M. Mauguin would say, France gained 100 francs; for it was, in fact, by this sum that the export, thanks to the shipwreck, exceeded the import. If the affair had turned out otherwise, if I had received 200 or 300 francs' worth of English pounds, then the balance of trade would have been unfavorable, and France would have been the loser.
    13.18
    From the point of view of science, it is sad to think that all the commercial transactions which end in loss according to the businessmen concerned show a profit according to that class of theorists who are always declaiming against theory.
    13.19
    But from the point of view of practical affairs, it is even sadder, for what is the result?
    13.20
    Suppose that M. Mauguin had the power (and to a certain extent he has, by his votes) to substitute his calculations and desires for the calculations and desires of businessmen and to give, in his words, "a good commercial and industrial organization to the country, a good impetus to domestic industry." What would he do?
    13.21
    M. Mauguin would suppress by law all transactions that consist in buying at a low domestic price in order to sell at a high price abroad and in converting the proceeds into commodities eagerly sought after at home; for it is precisely in these transactions that the imported value exceeds the exported value.
    13.22
    Conversely, he would tolerate, and, indeed, he would encourage, if necessary by subsidies (from taxes on the public), all enterprises based on the idea of buying dearly in France in order to sell cheaply abroad; in other words, exporting what is useful to us in order to import what is useless. Thus, he would leave us perfectly free, for example, to send off cheeses from Paris to Amsterdam, in order to bring back the latest fashions from Amsterdam to Paris; for in this traffic the balance of trade would always be in our favor.
    13.23
    Yet, it is sad and, I dare add, degrading that the legislator will not let the interested parties decide and act for themselves in these matters, at their peril and risk. At least then everyone bears the responsibility for his own acts; he who makes a mistake is punished and is set right. But when the legislator imposes and prohibits, should he make a monstrous error in judgment, that error must become the rule of conduct for the whole of a great nation. In France we love freedom very much, but we hardly understand it. Oh, let us try to understand it better! We shall not love it any the less.
    13.24
    M. Mauguin has stated with imperturbable aplomb that there is not a statesman in England who does not accept the doctrine of the balance of trade. After having calculated the loss which, according to him, results from the excess of our imports, he cried out: "If a similar picture were to be presented to the English, they would shudder, and there is not a member in the House of Commons who would not feel that his seat was threatened."
    13.25
    For my part, I affirm that if someone were to say to the House of Commons: "The total value of what is exported from the country exceeds the total value of what is imported," it is then that they would feel threatened; and I doubt that a single speaker could be found who would dare to add: "The difference represents a profit."
    13.26
    In England they are convinced that it is important for the nation to receive more than it gives. Moreover, they have observed that this is the attitude of all businessmen; and that is why they have taken the side of laissez faire and are committed to restoring free trade.

    http://www.econlib.org/library/Bastiat/basEss13.html