All Commentary
Tuesday, October 1, 1991

Thank the Japanese for Our Trade Deficits

Mr. Fargo is a railroad worker in Los Angeles and a parttime student at California State University, Los Angeles.

Most people believe that U.S. trade deficits are economically unhealthy, and that the Japanese are largely to blame. Yet our trade deficits actually are an unearned blessing for which we should be thankful. Trade deficits bring economic growth and health. When we blame the Japanese for our trade deficits, we are “blaming” them for creating millions of jobs for American workers; we are “blaming” them for increasing our standard of living.

Did you ever wonder why our standard of living is so high? What lies behind the immense difference between our way of life and that of the millions of people living, toiling, and dying in unabated poverty in Bangladesh, Ethiopia, and other Third World countries? Capital investment. To a large extent, investment in housing, hos pitals, schools, factories, farms, mines, machines, and transportation systems explains that immense difference.

Capital investment is the fuel of that dynamic engine called capitalism. It is the creator of unprecedented levels of consumption by the masses. And this accumulation of capital and its efficient use, which are inherent aspects of free market economies, are to a great extent responsible for the high standard of living the masses achieve in a free economy as compared with Third World or socialist economies. Even devout statists throughout the world are reluctantly beginning to realize this.

But how is capital accumulated? By savings that are then invested in productive facilities. And how do we rate when it comes to savings and investment in order to maintain our standard of living? About 10 percent of our gross national product (GNP) is invested, most of this just to replace capital equipment that has worn out or become obsolete. Meanwhile the Japanese invest 25 percent of their GNP in capital goods—two and a half times more than we do.

When it comes to net savings—savings above and beyond the mere replacement of capital goods—we fare even worse. Our net savings are 4 percent of disposable income as compared with 20 percent for the Japanese, Part of the problem lies with our own government. Although American households save over 6 percent of their disposable income, the Federal deficit consumes much of what otherwise would be invested in capital goods.

This lack of net savings could pose a real problem for our standard of living that relies upon capital accumulation. Our spendthrift habits and Federal deficits drastically reduce America’s ability to accumulate capital. But the Japanese (and others) have come to our rescue. Where we have neglected our own economic health, they have invested in it. In fact, the Japanese are using their hard-earned savings to bail us out of our own economic folly, They are helping us maintain our standard of living by pouring huge quantities of their savings into our economy. To a significant extent, they are fueling the capitalistic engine that maintains our lifestyle.

How do they get their investment over here? Do Japanese households fill shoe boxes full of yen and mail them to us? No, we don’t use or spend yen in this country. In order to invest in our economy, the Japanese first need to earn American dollars.

Picture a shipload of Toyotas coming across the ocean to be sold to American consumers for $100 million. Then picture the Japanese using this $100 million to buy American-made products and taking them back to Japan with them. That makes it an even trade—no trade deficit—but it also leaves the Japanese with no dollars to invest in the United States.

What if that ship unloaded the Toyotas here and then returned to Japan empty? After the Toyotas were sold, the Japanese would have $100 million in American banks that they could then invest in America. That also increases the U.S. trade deficit by $100 million. Net foreign investment flowing into America and our trade deficit are the two sides of the same coin—one necessitates the other.

Let’s say the Japanese use this $100 million to build a factory in Kentucky that will employ 1,000 U.S. workers. One thousand new jobs are created for Americans. Not only that, but these workers are using the latest in Japanese technology and Japanese management techniques, both of which often increase the productivity of American labor. $100 million in new capital investment, more advanced technology, more efficient management of capital and labor—all these tend to increase the productivity of U.S. labor and thus tend to raise the real level of wages of America’s working people. We should be thanking the Japanese for our trade deficit.

But the Japanese are doing even more. Instead of creating American jobs by buying $100 million in U.S. products to take back to Japan, the Japanese put additional Americans to work by building that $100 million factory here in the United States. Construction is generally more labor intensive than is manufacturing products for export. And, once the factory is built, it will employ 1,000 American workers indefinitely.

In reality, the picture is much more complex than this. For example, the Japanese firm selling the $100 million worth of Toyotas might not invest in America. But other Japanese firms may want to invest, so they trade yen for the 100 million U.S. dollars in order to invest them in America. Thus, the seller and the investor may be two different foreign individuals or corporations.

And the Japanese don’t have to build a factory in order to invest in the United States. Instead,they could leave the money in a New York bank account. The bank will readily lend it to Americans to build new homes, or to American firms to build new plants, equipment, and so forth. Or the Japanese might buy U.S. Treasury notes with the $100 million, thus freeing up $100 million in American savings that would have been used to purchase the Treasury notes and now is available for capital investment.

The Japanese might also buy an existing hotel or office building. The purchase itself won’t add any new capital investment to our economy. But what does the previous owner do with the money he received from the Japanese? Somewhere along the line buying existing capital investments frees up money for new capital investments. In one way or another, just so long as the Japanese don’t buy anything to take back to Japan, just so long as they create or increase the U.S. trade deficit, new capital investment flows into a relatively capital-starved America.

Three-Way Trade

Let’s complicate this scenario in another direction to make it more realistic. The Japanese sell us $100 million in goods and in return accumulate $100 million in a bank account in New York. Since American dollars (or bank accounts) often are used as an international currency, the Japanese turn this New York bank account over to Saudi Arabia as payment for petroleum. Then the Saudis spend the $100 million buying American-made military hardware.

In these three transactions, all parties came out even in the end. Each of the three countries involved imported exactly $100 million worth of goods and exported $100 million worth of goods. None of them had a net trade deficit or a net trade surplus. But look a little closer. The above transactions produced a U.S. trade deficit with Japan of $100 million that was offset by a $100 million trade surplus with Saudi Arabia. So we bash Japan for our trade deficit with them while we praise Saudi Arabia for our trade surplus.

Such reactions are irrational. First, as we have seen, a trade deficit means an inflow of capital into an economy and thus should be welcomed rather than cursed—that is, unless we aim at economic self-destruction so we can move a little closer to the Third World. Second, we are denouncing the Japanese and praising the Saudis simply because of a pattern of trade that in itself has no net significance.

in the real world, trade often doesn’t come out even. For example, on net balance Japan exports far more than it imports. That means Japan is creating, or is at least partially responsible for, the net trade deficits of other countries, such as the United States. But this only means that large amounts of Japanese savings are being invested in other economies, such as ours. And after the Japanese have invested their hard-earned wealth into our spendthrift and savings-poor economy, we censure them. And sometimes we do even worse.

For example, let’s say the Japanese sell us $100 million in goods, then use those dollars to purchase petroleum from Saudi Arabia, and the Saudis invest that money in the United States. Of course, we should thank the Saudis for investing in America. Instead, we sneer at them. But given our distorted perspective, why do we then continue to bash the Japanese in the above example instead of the Saudis? After all, if the Saudis had purchased $100 million in goods from us, then everyone involved would have come out even—no net trade deficits or surpluses. But the Saudis didn’t buy anything with those U.S. dollars and thus left them invested in the American economy. Given our compulsion to bite the hand that feeds us capital investment, shouldn’t we then bash Saudi Arabia? Yet, we don’t because our books show a trade deficit with Japan but no trade deficit with Saudi Arabia. A more enlightened mind might see Saudi Arabia as the prime cause of the deficit.

Who is to “Blame”?

Instead of laying the entire “blame” on the Japanese, some experts insist this “destructive” trade deficit can be blamed partially on America’s lack of competitiveness within world markets. Thus, to some extent it’s really our own fault. Let’s face it, Japanese cars are a lot better buy for Americans than American cars are for Japanese consumers. Isn’t it obvious then that we are less competitive in world markets than the Japanese?

No. The exchange rate between the two currencies has something to do with what appears to be relative “competitiveness.” What if the Japanese yen suddenly became four times more expensive in terms of American dollars than it is now? Toyotas would then cost Americans $40,000 to $60,000 apiece—the Japanese car market in this country would quickly dry up. But with that exchange rate, American cars would be selling like hotcakes in Japan, and Japanese consumers would be wondering how Americans can produce cars so cheaply, how Americans can be so competitive in world markets relative to their own auto makers. And Japan would be running huge trade deficits while we would have large trade surpluses.

Yet, nothing has changed in this example except the exchange rate between the two currencies. Thus, we need to ask: What regulates exchange rates? Supply and demand for the respective currencies. Using only the two economies as a model, the Japanese supply of dollars is generated by selling goods to Americans. And the Japanese demand for dollars is generated because they want to buy goods from us and need dollars to do so. In addition, if they want to invest in America rather than their own economy, they also need dollars to do that. The market forces will tend to push the exchange rate between yen and dollars up or down until the demand for dollars is more or less equal to the supply of dollars.

For example, if for every $100 million in goods the Japanese sell to us, the Japanese invest $20 million in America, the exchange rate between the currencies will adjust to make Japanese goods sufficiently cheap (competitive) to Americans and American goods sufficiently expensive (uncompetitive) to the Japanese so that for every $100 million we buy from them, their consumers will buy only $80 million from us, leaving a $20 million trade deficit—which means $20 million of Japanese savings invested in the United States.

Within the real world, of course, all these figures—the amount they buy from us, the amount we buy from them, and the amount they invest in America, in addition to the exchange rate—are fluctuating variables dependent upon various market forces. Also within the real world other factors have an effect on the exchange rate—factors such as tariffs, quotas, transportation costs, governmental influence on exchange rates, and Americans’ investing in the Japanese economy as well as their investing in ours. But the principle remains the same. The exchange rates will tend to adjust to make some economies less “competitive” and others more “competitive” in order to balance the supply and demand for various currencies that reflect the supply of and demand for both goods and investments that can be purchased with these various currencies.

Thus, the cause of our “uncompetitiveness” as well as the cause of our trade deficit is simply a high demand for dollars by foreigners who want to invest in the United States. We’ve got to be relatively “uncompetitive” in world markets precisely in order to create a trade deficit that then permits foreign capital to flow in. And as long as the demand to invest in America stays high among foreign investors, the exchange rates between the different currencies will automatically adjust to keep American goods relatively “uncompetitive” within world markets—regardless of how modern our machines and factories become or how high our labor productivity rises.

But this foreign investment also keeps millions of U.S. workers employed building more capital goods for America, rather than employing Americans to produce export goods for foreigners. And it is precisely capital goods invested in the United States that in the long run keep us economically strong and our standard of living high. Capitalism needs fuel.

From another point of view, we can say that America is highly competitive in world markets. We are highly competitive in attracting foreign capital. And capital investment is the real root of long-term economic growth and health. In attracting foreign capital we far surpass Japan—just look at the billions of dollars of their own capital we annually attract to our shores.

The Role of Tariffs

Another explanation offered for our trade deficit or the relative uncompetitiveness of our goods in Japanese markets goes like this: We allow the Japanese a more or less free hand in selling their products to Americans, but they have so many prohibitive tariffs and trade restrictions that Japanese consumers can buy relatively little from us. That’s why, we are told, we have a huge trade deficit with Japan.

What if Japan dropped all tariffs and trade barriers? This would certainly help the Japanese consumers and make trade more efficient for both economies. But would it reduce our trade deficit or make us more competitive in the world economy? No. As long as the quantity of dollars demanded by foreigners to invest in America remained the same, the exchange rates of the currencies would simply adjust, driving up the relative value of the American dollar in order to maintain our trade deficit and apparent “uncompetitiveness.”

This same analysis can be used to look at the period after World War II when the United States was the great exporter of capital investment. Europe and Japan were devastated by the war, and capital flowed from us to them. This mused large trade surpluses on our part that were offset by the net outflow of capital. And the currency exchange rates had to be such as to facilitate our capital outflow and trade surpluses. Of course, this also made American products appear highly competitive in world markets.

Since foreign demand for U.S. dollars to invest in America is the underlying cause of the trade deficit and our apparent “uncompetitiveness,” we might ask: Why do so many foreigners want to invest in America?

First, our huge Federal deficits and our low rate of savings have caused our economy to become relatively starved for capital, thus driving up the real rate of interest (nominal rate minus the inflation rate) or driving up the rate of return to capital in general. To a foreigner, that makes investments in America a good buy relative to the rate of return in other countries.

Second, the United States is a safe haven for investments. For example, even if a high rate of return were promised, would you sink your life’s savings into a farm machine factory in Iraq where next year it might be blown up or confiscated by Saddam Hnssein’s Baath Arab Socialist Party?

This is the same reason why the ruling elites of many Third World countries, whose economies are far more starved for capital than we are, pump their wealth into the capitalistic economies instead of their own. For example, China is desperate for capital, but Chinese Communist officials regularly stash hundreds of millions of dollars in Hong Kong and other capitalist countries. This is tragic because it drives the masses within China even deeper into poverty.

It has become somewhat of a pattern for the ruling elite of socialist or statist economies—whether it be Marcos, Hussein, or the former Communist rulers of Eastern Europe—to accumulate enormous private wealth, often by brutally exploiting their own working classes, and then to invest it in safe havens abroad such as the United States, thus further depriving their own people. Although this inflow of investment into the capitalist countries tends to impoverish the people of the statist/socialist countries, it certainly improves the standard of living of the workers and masses of the capitalist countries—and adds to our trade deficit in the process.

This inflow of capital does have a negative effect upon one segment of the American population, namely the wealthy capitalists. Large inflows of capital investment generate more competition in the capital markets, thus tending to drive down the relative returns to capital—just as other factors, such as our Federal deficit and our relative lack of savings, tend to drive up the returns to capital. But driving down the returns to capital tends to raise the returns to the working classes by means of higher wages. This becomes yet another way in which capital inflow; as reflected in our trade deficits, helps American workers.

Since our trade deficits in the long run are beneficial to the American public as workers and consumers, why do so many people depict them as a great evil? That’s a good question, and the answer probably involves more politics, psychology, and history than economics.

The most conspicuous answer may be politics. The essence of government is organized brute force. For example, tax collectors as loyal employees of government don’t take too kindly to those who resist governmental confiscation of sizable portions of their incomes. But governments need continually to justify the notion that some people (such as those in government) should initiate brute force (or threat thereof) as a means of relating to other persons (such as those outside of government). In short, government, like any other use of force in relating to other persons, needs legitimacy.

In some areas, such as collecting taxes for national defense, such legitimacy is relatively easily established. But as governments continually expand their regulation of the lives of their citizens, they become ever more desperate for legitimacy. So governments typically search for and magnify social problems—even to the point of artificially creating them—in order to justify the growing expansion of their power over the people and the product of the people’s labor.

To Some extent, the trade deficit, although inherently good for our economy, has been deemed a “problem” or a “crisis” by big government and its supporters. Thus, they have one more reason to expand the power of government over the otherwise voluntary interactions and social cooperation between persons of this country and other nations.

Piles of Gold

The trade deficit as “evil” also has historical roots, let’s go back in time to the Middle Ages in Europe. Picture a number of mutually antagonistic countries, each ruled by a king. These less-than-enlightened minds “knew” two things for certain.

First, they knew that a loyal citizen never invested his wealth in a foreign country. For example, an Englishman wouldn’t invest his wealth in France—that would be worse than throwing it into the ocean. It would be aiding and abetting a real or potential enemy or rival—economic treason! Furthermore, since he was an Englishman, the French authorities might simply confiscate his wealth.

Second, experts of the day believed that the wealth and status of a nation were largely a function of how much gold it possessed. Gold was a common, and prestigious, international medium of exchange.

So picture this pile of gold, the nation’s treasure, with the king’s throne sitting on top of the pile. The wealth and status of one’s nation depended upon how large this stock of gold became. Thus, every time a ship took a load of goods out of the country, sold them, and brought back gold (a trade surplus), the king’s pile of gold and the nation’s status grew a little. But if that ship brought goods into the country and in exchange took gold out (a trade deficit), the pile of gold shrunk a little.

Of course, a foreign ship might bring a load of oxcarts to England and sell them to the local citizens for gold. Then, instead of taking that gold out of England, let’s say they spent it in England in order to build an oxcart factory or develop a coal mine. This would create a trade deficit, but it wouldn’t reduce the nation’s stock of gold (money supply). But to the degree that people didn’t invest in foreign economies, this type of foreign investment wasn’t significant.

The wise men of the time concluded that trade surpluses in general were good because they increased the king’s stock of gold and elevated him and the nation a little in the eyes of the world, and trade deficits were evil because they reduced the size of the king’s pile of gold.

Another factor involved is a little more complex and wasn’t well understood at the time. With gold as a common medium of exchange, any net inflow of gold into an economy increased the money supply, causing some degree of price inflation that in the short run tended to generate at least the illusion of prosperity—much as when the Federal Reserve increases the money supply in modern times. Any net outflow of gold would have the opposite effect, reducing the supply of money within the economy, and causing a degree of price deflation and an economic recession in the short run.

I won’t go into the mechanics of this phenomenon, but modern economies are not on a gold standard, and thus the local supply of money is totally divorced from any trade deficits or surpluses. For example, if the Japanese sold us $100 million of goods and took back $100 million in gold bullion, it would have no effect on our money supply. In fact, today we wouldn’t even call it a trade deficit because gold is now considered just another commodity. And if the Japanese wanted to pack $100 million in American currency into a shipping container and take it back to Japan, we would simply print another $100 million to replace it in order to maintain the same supply of money.

Why do people, even experts, still cling to that bit of ancient economic “wisdom” regarding the detrimental effects of trade deficits even though every premise supporting such a notion has long ago vanished—and just the opposite is true? Gold is rarely used as an international currency, people all over the world routinely invest in foreign economies, and as Adam Smith pointed out over 200 years ago, the wealth of a nation is not a function of its stock of gold. Instead, the wealth of a nation is a function of the skills, habits, and technology of its workers and economic organizers, as well as a function of its factories, farms, mines, machines, retail establishments, transportation systems—in short, a function of the amount of capital investment.

Not only the wealth of a nation, but also the standard of living of its people, is to a large extent a function of capital investment. And a nation can increase its capital investment in two ways: by internal savings or by trade deficits that represent foreign investment flowing in. Thus, it is high time that we stand up, take off our hats, and thank the Japanese and other foreign investors for our trade deficits.