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.


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)
    toll roads

    U.S. services:

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

    Foreign-made goods:

    household goods

    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.