I'll Try Again -- Why The Trade Deficit is Not a Debt

After spending gobs of electrons on this post about the US trade deficit explaining why it is not a debt, and is not even necessarily bad, I got a depressing number of comments and emails like this one:

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.

Aaaaargh.  It is depressing that we can get such economic ignorance, particularly in a self-righteous way.  The crappy media coverage of these issues has people convinced that it just has to be this big old debt out there someone is going to have to repay someday. 

OK, I will try again.  But in response to this specific post, it is only called "external debt" or "current account debt" rather than "deficit" by really, really sloppy media people who have no idea what they are talking about (unfortunately, there are a lot of these).  And a deficit is not a debt, though it can sometimes create a debt.

I try to be very respectful of my readers.  I never delete a comment, unless it is spam/bot stuff or in a few cases where commenters have asked me to.  So it is only with the deepest respect that I say the following:  Please do not bother to comment on this post if a) you do not understand the difference between the federal government deficit and the trade deficit and/or b) you do not understand the difference between an account deficit and a debt.  Seriously.  Just take my word for it that you need to educate yourself a bit first, and then feel free to leap into the debate.  (Update:  This was a poor tone to adopt, see here).

First, A Thought Experiment

This is not meant to constitute proof, but for those who are concerned that the trade deficit is potentially disastrous for our economy, I can only ask, When?  Because we have been running a substantial trade deficit as a nation for over a quarter of a century, and by all accounts, over that same time period, we have had just about the strongest economy in the world.  In fact, I would propose that the causation is more likely just the reverse.  Because we have had a strong economy, with extraordinary wealth creation, we have taken some of that wealth and spent it on goods from other nations.  And because we have the safest nation in the world in which to invest, demand for our local investments tends to shift exchange rates in a way that increase the trade deficit.

In the late 80's and early 90's, everyone was in a panic about Japan.  We were running a massive trade imbalance with Japan.  They were going to buy all of our real estate.  Their government was tipping the scales in their own favor.  They were purposefully depressing the yen to encourage exports.  Blah, blah, etc, etc.  And you know what happened?  They subsequently went into a decade and a half long recession they are only just now climbing out of, and we had one of the strongest economies in history. 

How do the Dollars Get Back?

With a couple of exceptions that don't really change our conclusions, dollars do follow a closed loop.  In other words, if we send them to China or India, they generally eventually come back.   The question is how.  To understand this, it is first important to understand that the balance of trade deficit only measures some monetary flows.  In particular, it looks at the balance between manufactured goods traveling between two countries.  If the US has a $20 billion trade deficit with China, it means that they shipped $20 billion more of manufactured goods to us than we shipped back to them.  It includes some but not all services.  It does not include goods or securities or investments purchased by foreigners that remain on US soil.

To understand how the dollars come back from China in a closed loop is to, in a sense, ask the question of what monetary flows are not included in the trade deficit.  If we have a trade deficit with China, there are a number of things it can do with its extra dollars:

  1. It can do nothing with them - just hold them in a big pile
  2. It can lend the money to people buying their products
  3. It can buy certain US services
  4. It can buy US goods, but not take them out of the US
  5. It can buy US public and private securities and real estate

Lets look at each in turn

1.  China can do nothing with them - just hold them in a big pile

Two words:  In-Sane.  By just holding them, they would effectively be sticking them in a mattress and foregoing any interest or investment income.  It's just not going to happen.  And don't say, well they could just put the dollars in a Chinese bank.  Fine, but the only way the Chinese bank is going to pay interest on dollars in the bank is if they turn around and invest the dollars in dollar-denominated investments.  One way or the other, the money, if it does not buy anything else, will get invested, which we will deal with in point 5.

I know there are paranoiacs that worry that the Chinese, despite the financial disincentives, will hold these dollars anyway in a big vault or something out of spite.  Gee, hurt me, hurt me.  Holding our dollars in a big mattress in Peking does nothing to hurt us.  And dumping them all on the market simultaneously may sound scary to conspiracy theorists, but in practice it would hurt them worse than it would hurt us, and the pain would be relatively short-lived  (just ask the Hunt brothers about this strategy).

2.  China can lend the money to people buying their products

I suppose that for those who don't get the federal deficit and the trade deficit mixed up, this is what they assume is happening, that Americans are borrowing from the Chinese to finance manufactured goods purchases.  The only problem is that it is not happening, at least to a greater extent than any normal purchase-financing arrangements.  Take corporations such as Wal-mart, a huge buyer of Chinese stuff.  Is Wal-Mart going into debt to buy Chinese stuff?  No, and certainly not to the Chinese. 

Well, are individual Americans going into debt to buy Chinese.  Maybe, but the key point is that they are not going into debt because what they are buying is Chinese.  They are going into debt because Americans, for whatever reason good or bad, are saving less and choosing to buy more on credit.  This would be happening if what they were buying was Chinese or American made.  In other words, American consumers may have debt, but that debt would exist even if we had no trade deficit with China.  It is a personal choice people are making that has no relation to the source of goods.

3.  China can buy certain US services

Note that many US services are not included in the trade deficit calculations.  If Chinese companies engage McKinsey & Co. consultants in the US to figure out how to sell more stuff to Wal-mart, those payments for services are probably bringing dollars back to the US from China, but aren't included in the trade calculations.  This really is just a subset of point four:

4.  China can buy US goods, but not take them out of the US

Many, many of the dollars the Chinese end up with come back to us in this way.  As did many of the dollars the Japanese had in the eighties.  If a Chinese company uses dollars not to buy US goods and take them back to China, but buy them and consume them in the US, then this does not show up in the trade numbers.  Chinese and Japanese companies bring their US dollars to the US to build factories and infrastructure.  This is sometimes why it is said that the trade deficit is not a measure of differences in cash flows, but of a difference in where goods are consumed. 

If you flip the equation around, the Chinese have a wicked balance of stuff deficit.  They are sending a lot more manufactured goods to the US than they get back.  I could argue that Chinese workers are getting hosed, since they only get to enjoy a fraction of the goods they produce for themselves, since a large portion of the product of their labor is sent overseas for others to enjoy.  Hmmm, doesn't sound so bad that way.

5.  China can buy US public and private securities and real estate

Of course, what happens with a lot of the US dollars the Chinese find themselves with is that these dollars get invested in US investment vehicles, from real estate to government bonds to private equities.  There are several points that need to be made here:

a.  Just Because Chinese invest in US Government Bonds does not make them or the balance of trade responsible for this debt

As I intimated above, a lot of people get the US federal budget deficit confused with the trade deficit.  Making this confusion worse, the Chinese use a lot of the dollars they earn in trade to buy US Government Bonds that help finance the federal budget deficit.  Now, by buying a lot of government bonds, one might argue that the Chinese lower interest rates and make government borrowing easier, thus making the federal budget deficit worse since there is a ready source of debt financing. 

While there may be a link here, it is tenuous at best.  If the government was a private company, then its borrowing level might rationally fluctuate up and down based on interest rates and capital availability.  But the US Government is not this rational.  It runs a budget deficit primarily because legislators and bureaucrats alike have the incentive to spend other people's money to protect their jobs and power base.  This happens equally at 3% interest rates and 9% interest rates.  It happens equally if guys from Peking or Omaha are buying government bonds.  In fact, one could argue that Chinese reinvestment of their trade dollars in US securities actually marginally reduces the government debt by reducing interest costs.

This same argument holds equally true for Chinese investments in private debt.  Chinese dollars may increase borrowing slightly, but only because the influx of their cash reduces borrowing costs.

b.  Chinese Ownership of US Assets is GOOD

In the Japanese scare of the 1980's, everyone was freaked out that the Japanese were buying up American assets and real estate.  During that time, while I almost never play the race card, it was almost impossible not to come to the conclusion that some racism had to be involved in this fear.  America had welcomed, in fact, had prospered, via foreign investment for years.  For a century, the US has been the safest place for foreigners to put their money,something we should be proud of  -- A sign of strength, not weakness.

But suddenly, everything was different because the new buyers were Japanese.  Note the following:

Despite the notoriety of
Japanese investors, the British have the largest U.S. direct investment
holding"”with the Dutch not far behind"”as has been the case since
colonial times. In 1990 the United Kingdom held about 27 percent of
foreign direct investment in the United States, significantly greater
than Japan's 21 percent. The European Economic Community (EC)
collectively holds about 57 percent. Moreover, according to research by
Eric Rosengren, between 1978 and 1987, Japanese investors acquired only
94 U.S. companies, putting them fifth behind the British (640),
Canadians (435), Germans (150), and French (113).

But no one was complaining about the British, Canadians, Germans, or French.  Only the Japanese.  I have to come to the conclusion that there was some racism involved, with the same primal fears at work that caused us to ship US citizens of Japanese decent off to concentration camps in WWII but we did not do the same of citizens of German or Italian decent.  And in this case, it could not have been security concerns.  Since 1945, Japan is one of the most pacifistic nations in the world- we probably face a bigger security threat from Belgium than we do from Japan.

I get the same feeling today with the China panic that I did twenty years ago with Japan.  Its a race and a culture we don't understand well, so we get xenophobic.  People lament that China is a real security threat, and that certainly is true to an extent.  But ask yourself this - Is China more or less of a threat to hurt us if their economy, their financial prosperity, and most of their assets are tied to the US?  Is China more or less stable now that their people are not starving and they are rapidly developing the largest middle class in the world?

Conclusion

If you are still having trouble understanding, the problem may be that you insist on thinking of economics as zero-sum.  This is the fallacy of 18th century mercantilists, who saw the economy as a big fixed tank, and if more flowed overseas than flowed back, the tank level would fall until the country was bankrupt.  There are at least two key fallacies here:

  1. Wealth is not zero-sum.  It is created.  It is expanded.  Some can even be spent frivolously on big ass plasma TV's from China and we are still wealthier than we were decades ago.
  2. Trading has value in both directions.  As mentioned above, looking at only the currency side of trading misses a lot.  By definition, in a free trade, both sides believe the trade increases the value to themselves, or they would not have made the trade.  So trading per se, no matter what the currency flows, can only lead to wealth creation, not its destruction.

Postscript - New Mercantilism

Lamenting the trade deficit is always a precursor to interfering with free trade.  It is important to note that free trade has always led to prosperity, while protectionism has always led to stagnation. 

Several protectionists today are trying to make the argument that OK, that might have been true in the past, but today is different, and today, free trade is uniquely bad.  Economist Paul Craig Roberts made this argument, that, as Don Boudreaux summarizes it:

the American standard of living is threatened by the world's growing
prosperity, improved education, better governance, and greater fluidity
of capital and resources to move in search of higher returns

Boudreaux, a writer at the fabulous Cafe Hayek, does a good fisking of this argument, but I think I can demolish it even faster.  By this logic, California would be better off if the eastern part of the US was suddenly impoverished and made educationally backwards.  This is absurd.   Sure, the industrial east suffered some temporary dislocations as the south modernized and competed for factories.  But this was only temporarily.  As the south got richer, it wasn't a contest between regions for a fixed number of factories, the number of factories and jobs grew, so that all parts of the country had more. 

Is there anyone who thinks that half of the US would be better off
economically if the other half were turned into a third world nation?  Is there any company executive that thinks they could survive if half their market went away?  So why is half the world better off if the other half is impoverished?  If you are saying, gee, the only reason I can come up with is that zero-sum fallacy Coyote keeps talking about, go to the head of the class.

Update:  In comments and emails, my readership educates me that citizens of German and Italian decent were interned in WWII as well.  While I knew that Germans and Italian POW's were interned in large numbers in the US in WWII, I was not aware of internship of US citizens with German or Italian blood, though the programs for these nationals do seem more limited than the west coast movement of Americans of Japanese decent.   My first and second generation German immigrant family members never reported being harassed in any way, either publicly or privately, during the war and most all served either in the US military or war production industries.  I will still stick by my core point that investment in the US by Asian nationals is not treated the same as investment by European or Canadian nationals.

I have also gotten a number of emails and comments on the differences between various trade and current account deficit indicators.  I tried to avoid getting into all that, assuming, I think rightly, that it would just clutter up the argument and would not substantially affect the conclusion.  Just for the record, though, there are many different metrics, that range from narrow measures of manufactured goods flows to much broader measures of capital and services flow.  You can assume that 90% of the time, the media article you are reading about the deficit probably does not correctly describe the metric it is using.

 

  • http://dfriedman.typepad.com dave

    "Please do not bother to comment on this post if a) you do not understand the difference between the federal government deficit and the trade deficit and/or b) you do not understand the difference between an account deficit and a debt."

    What if we're honest enough to admit we don't understand the distinction?

    Seriously, tho, I feel your pain. I don't have a problem admitting I don't know something but the confidence with which people go about thier opinions is often quite stunning.

    Given that I don't really have anything to add to this conversation, I will now stop commenting.

  • Doug G.

    I remember when you posted about the trade deficit last December, and I was probably as disappointed as you at the responses you received.

    I think zero-sum economics plays a big role here. We are "giving" our money to China by buying their products, so they must be gaining wealth at our expense. Nevermind that we are getting their products in return -- after all, a voluntary exchange cannot occur unless both parties are made better off by the exchange. Both parties are made wealthier by the trade, so the idea that we are in trouble because we have too much trade with China is preposterous.

    Unfortunately, zero-sum thinking is so widespread and so engrained in society that you are really fighting an uphill battle here.

    Personally, I think the most convincing argument is your statement: "Because we have had a strong economy, with extraordinary wealth creation, we have taken some of that wealth and spent it on goods from other nations."

  • steevo

    Japan, while in east asia, is not China. Part of your argument suffers from the problem of induction. you may be interested in listening to the following to understand why china is fundamentally different : http://cdn.itconversations.com/ITC.PopTech2005-OdedShenkar-2005.10.21.mp3

    also, do you really have no preference whatsoever on what type of government (communist v. democratic) holds all these u.s. treasuries? are there no distictions in your mind?

    also, since you like to look at history, any thoughts on the trends of countries' success once they move from a net-lending country to a net-borrowing country?

  • Lucido

    OK, let me give it a try.

    This deficit really means that although Americans are getting better returns investing outside the US, foreigners are investing in the US.

    Fine, but: this kind of deficit requires large-scale financing, so to prevent the US net debt from going up, US markets have to do worse than foreign markets.

    Do you see the contradiction? This is why it can't be sustained in the long term.

    Most likely, the effect will be inflation, and the dollar will fall.

  • BobH

    I think a better example of wealth being non-zero-sum is the Great Depression. If the US became poorer in the 1930s, someone must have become richer. Who?

    Conversely, when westen Europe's economies revived after WW2, who became poorer as a result?

  • Steve

    I always seem to post on items tangential to the point of the post, but I think that Italians and/or Germans were put in concentration camps during WWII. Maybe not, but I know I have heard many internment apologists (Malkin et al) claim this).

  • http://amateureconblog.blogspot.com Chris Meisenzahl

    Great post, thanks.

  • Sicilian

    You chide readers to educate themselves. I would suggest the same to your regarding the statement "to ship US citizens of Japanese decent off to concentration camps in WWII but we did not do the same of citizens of German or Italian decent" Wrong. US citizens of Italian descent were interned in Missoula, Crystal city, and force to relocate from coastal California communities during WWII. If anything the internment of US citizens other than Japanese shows the racism argument as serioulsy flawed.

  • Albatroz

    My apologies if I am saying something stupid. But what happens if foreigners start asking payement in euros or yuan? How would then the dollar loop function? Am I mistaken by thinking that what you say can only work as long as the US pays for its imports by printing dollars, and those paper dollars are seen by other countries as real money? Being an humble economist from backward Portugal, I shiver at the thought of the horrible things you are going to throw at me...

  • Paleo con

    Italian and German Americans were sent internment camps during WWII. Italians were forced to relocate inland from coastal California (2000 from Pittsburg, CA), sent to internment camps in Missoula, Montana and Crystal City, Texas. So the racism charge about internment is not that strong and no reparations were paid to Italian or Germans unlike the Japanese Americans. Obviously, you don't have your facts straight about who was interned.

  • http://amateureconblog.blogspot.com Christopher

    I'm with you on everything here except the comment about internment camps. I think that Germans and Italians were indeed put into camps in the U.S., albeit in much smaller numbers.

  • markm

    There were a lot more Germans than there were Japanese, so when you talk numbers, make it clear whether you are giving absolute numbers (so many thousand in camps) or relative to the size of the population, as well as whether the people affected were enemy subjects or American-born. AFAIK, nearly 100% of the west coast Japanese including second and third generation Americans were rounded up and sent off to camps, but in no place were all the German-Americans sent to camps - nor could we have afforded that big of a round-up.

    Germans were sent to camps when there was evidence of their disloyalty. Not all of these were actually disloyal, and innocent family members might have been sent to the camps along with the suspected men, but that in no way compares to herding off everyone of a certain ethnicity residing in certain states, with or without evidence. What makes the difference even more striking is that there were indeed organizations of German-Americans with links back to an enemy government, and Hitler had quite plainly attempted to use these links to recruit spies and saboteurs in the USA, a number of whom had been caught. In spite of being able to read most Japanese codes, our counter-intelligence had caught just one Japanese-American spy, and he had been recruited after returning to Japan. The group that was factually least threatening was rounded up en-masse.

  • markm

    "My first and second generation German immigrant family members never reported being harassed in any way." Not quite the experience of my ancestors, who felt they had to anglicize the spelling of the family name during WWI. Maybe that was a difference between WWI and WWII; by WWII, they had no accents and a common English name that just happens to sound like the original Teutonic name, and any harassment they got was from being Jehovah's Witnesses and alleged pacifists[1] who wouldn't salute the flag, not from being recognized as German.

    [1] In the tiny bit of JW teachings I couldn't avoid as a child, it sure sounded like they were ready to join Jesus's army at the Battle of Amageddon - so they weren't pacificists, they just didn't want to accidentally wind up on the wrong side. As for the flag thing, the JW's claim "The Pledge of Allegiance" is tantamount to idol worship...

  • Ameteur

    While I agree fully with your view of the trade deficit and of the press, there is one angle in the trade imbalance that might be creating a problem:
    If the trade deficit is not compensated by a surplus in services, it becomes a Balance of Payments deficit.
    A BOP deficit might, and probably will, cause an increase in the net debt of the US residents to foreign residents, and therefore, to a permanent increase in the flow if interest to be paid abroad.
    The US used to have a huge financial services surplus. In the last years it has dissapeared, and even become a small deficit. If it becomes a larger deficit every year, I dont see how it will fail to cause some reduction in the US residents income and welfare.

  • Ameteur

    While I agree fully with your view of the trade deficit and of the press, there is one angle in the trade imbalance that might be creating a problem:
    If the trade deficit is not compensated by a surplus in services, it becomes a Balance of Paypents deficit.
    A BOP deficit might, and probably will, cause an increase in the net debt of the US residents to foreign residents, and therefore, to a permanent increase in the flow if interest to be paid abroad.
    The US used to have a huge financial services surplus. In the last years it has dissapeared, and even become a small deficit. If it becomes a larger deficit every year, I dont see how it will fail to cause some reduction in the US residents income and welfare.

  • Amateur

    Sorry for the double posting...

  • http://en.wikipedia.org/wiki/Jawahar_Mundlapati unknown

    I agree that wealth is not a zero-sum.
    Pls. educate me if motivation a zero-sum?

  • Andre Kooy

    A shame you only took 1 quote to comment upon.
    I am an educated economist and I know very well the differences between trade and government deficit.

    I repeat my post here, because it is still valid.

    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.

  • ReformerRay

    Last comment was in July. The issue is still relevant.

    Your are correct that:
    1. The trade deficit does not create debt. It sends financial assets overseas. I reduces the Net Asset position of the U.S.
    2. The growth of the U.S. economy is creating Net Wealth much faster than we are shipping assets overseas.

    It follows that as long as sentence #2 is true, the U.S. will be able to pay for our trade deficit with financial assets, without incuring debt.

    However, the capacity of the U.S. economy to continue to create financial assets faster than they are being sent overseas is not guaranteed.

    In 2005, foreign stock markets grew faster than the U.S. stock market. If that reality continues, the U.S. is in trouble. Only by maintianing a stock market growing in value faster than other overseas options, do we entice investors to keep money in the U.S. stock market.

    The trouble, for the U.S., of the large trade deficit, is that foreign sellers of goods to the U.S. use the receipt from their exports to increase their capacity to sell more exports cheaper. They are in a positive feed-back cycle.

    The capacity of U.S. firms to sell not only overseas, but in the U.S., is being destroyed daily by successful foreign producers.

    The U.S. could continue to participate successfully in international trade if it had the supporting conditions to gain control of the financial aspect of international trade. Current trends show London and Switzerland and tax havens around the world, including some oil exporting rulers, are cutting the U.S. off from that option.

    Wealth creation in the U.S. is at risk by continuing the trade deficiit.