The Trade Deficit

Mr. Ewert is a recent graduate of Grove City College and is now working on a master’s degree in public policy at CBN University.

Unsound economic ideas, like cats, seem to have several lives. Errors which have been laid to rest in past decades and even centuries are often resurrected, and once dusted off and dressed in new apparel, they haunt humanity yet again.

One such spurious idea is the national “balance of trade” notion which was articulated by the mercantilist writers of the sixteenth, seventeenth, and eighteenth centuries. Although soundly refuted by Adam Smith and following classical economists, the concept has re-emerged and is today the focus of national attention.

The U.S. trade deficit, which has increased dramatically since 1983 and was a record $170 billion in 1986, is a leading concern of our nation’s politicians, labor leaders, businessmen, and media. We are solemnly warned that jobs are being lost as we are invaded with “cheap” foreign goods, American industry is losing a “trade war” and is threatened with extinction, and America is becoming a debtor nation. To sit by and do nothing about the trade deficit, according to a growing opinion, is tantamount to national suicide.

It is most often suggested that the solution to this “trade gap” is a policy of increased protectionism. To those who value liberty this is a serious threat on at least two accounts. First, import restrictions directly lessen the individual’s freedom to exchange, and correspondingly increase the government’s power over the affairs of its citizens. Second, and perhaps more importantly, individual freedom may be further attenuated because the impoverishment accompanying trade restrictions will likely cause people to invest more power in the civil authority. Such was the experience of America during the 1930s when the economic havoc created by the Smoot-Hawley tariff was instrumental in an unprecedented expansion of government power.

The balance of trade notion owes its modern existence to mercantilist writers. Prominent in the thinking of these early economists was the desirability of the natural acquisition of gold and the concomitant (or so they thought) increase in national power. A nation could best accrue specie, they reasoned, by exporting more goods than it imported. This was called “a favorable balance of trade.” The payment for the excess of exports over imports would take the form of a gold flow into the nation and this new money (which mercantilists confused with wealth) would stimulate the nation’s production and add to its power.

Two erroneous ideas pervaded mercantilist thought. First, trade was mistakenly seen as a contest in which one party inevitably bested the other. In each exchange there was a winner and a loser, and a nation “won” at trade if it exported more goods than it imported.

A second fundamental flaw in mercantilist thinking was its holistic approach to economic analysis. The nation was considered to be an entity in and of itself, separate from and more important than its individual citizens. Thus international trade was not analyzed from the perspective of the individual participants, but rather from the perspective of the nation, or more accurately, the state.

Mercantilism Refuted

Beginning with the publication of David Hume’s essay “Of the Balance of Trade” in 1752, the mercantilist arguments for the pursuit of a favorable balance of trade were soundly refuted. Hume pointed out that no nation could have a continuously “favorable” balance of trade because gold inflows would serve to increase domestic prices and consequently discourage exports while at the same time encouraging imports. The result would be an outflow of gold, and a nation’s balance of trade would tend toward equilibrium in the long ran.

Adam Smith and following classical economists, notably David Ricardo, refined the case for free trade and exploded other mercantilistic myths. The holistic approach to economic analysis was soundly rejected since, as Smith wrote, “What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom.”[1] The nation was seen as the sum of its citizens and thus “national gain” was simply the total of all individual gains. Furthermore each trade did not have a winner and a loser, but rather was a mutually advantageous exchange, undertaken only because each individual believed himself to be gaining. And if each individual gained in each trade, how could the nation suffer from a trade deficit?

The holistic thinking of the mercantilists has been readopted and modified by much of modern economic thought, and today’s emphasis on “national trade” has confused many people. To understand what a trade deficit is, we must start with the individual. After all, it is individuals and not nations who actually trade goods and services.

When an individual agrees to exchange one commodity for another, he does so only because he believes it to be to his advantage. This is true for both parties in any trade; it matters not whether the exchange takes place across the street, or across national boundaries.

Consider an American trading with a Japanese citizen (we could just as well take a New Yorker trading with a Californian). Suppose that the American values a Japanese television set more than a particular piece of machinery which he has produced, and at the same time, the Japanese values the piece of machinery more than the television. If such is the case, they will exchange. This, of course, is simple barter—goods are exchanged directly for goods—and there is no monetary intermediary. But notice that no one has a “deficit” in this transaction—both parties are satisfied that they have gained more than they have given up.

Of course, very few barter exchanges actually take place. It would be difficult for the person desiring the TV set to find a person in need of the particular machine tool which he had to offer in exchange. Rather, the exchange is facilitated by the use of money, which allows the machine tool manufacturer to sell his product to anyone who wants it and then use the money to purchase the specific good (in this case a TV) from the Japanese producer. The Japanese producer can convert these dollars into the American product (in this case a machine tool) which he desires.

Although these individuals do not exchange directly, but through several intermediary buyers and sellers, the exchange is in principle the same as if they did. Ultimately the good produced by the American “pays” for the good received from the Japanese, and the Japanese good “pays” for the good received from the American. In other words, exports pay for imports.

But how then is a trade deficit possible? If in each exchange both parties are paying via goods and services, how can there ever be a national imbalance of trade? Why would foreigners agree to give up their products to us if they are not receiving American goods and services in exchange?

The answer is that they do not. Since each party trades only to gain, the difference between the value of the tangible or real goods which are given up by the “surplus” country and the value of the real goods which are received must be made up of other types of valuable goods. Each trade must balance; the deficit of real goods must be countervailed by a surplus of another type of exports.

And it is. The difference is made up of a net transfer of dollar claims from American individuals to foreign individuals. The trade deficit, which is more accurately called the merchandise trade deficit because it includes only the real goods traded, is possible only because on a net basis foreigners are willing to accept dollars in exchange for their goods and services, and temporarily hold these dollars. In other words, the U.S. currently is running a “surplus” of dollar exports with the rest of the world.

Why Value the Dollar?

Why are foreign individuals willing to accept paper assets in exchange for their real goods? The obvious answer is that they value the American dollar highly. This is true for a number of reasons.

First, the dollar has become, since the demise of the Bretton Woods agreement, the reserve currency of the world. It serves the function previously served by gold, allowing foreign central banks liquidity and the ability to inflate their currency.

Second, until recently, the real return on U.S. securities has been very attractive to foreign investors. Relatively high interest rates combined with the relatively low inflation of the dollar during the first several years of this decade (in comparison to other major currencies) has made dollar investments popular with foreigners. Foreign holdings in the U.S. are now over one trillion dollars and are growing at an annual rate of $100 billion.[2]

Third, the U.S. and thus the dollar, has become an international haven for “capital flight” from the less stable and less free countries of the world. Morgan Guaranty estimates that during the past ten years $188 billion has come into the U.S. from eighteen developing countries.[3]

Fourth, because of massive foreign loans during the 1970s, there is a substantial demand for dollars to service these debts. Countries such as Brazil and Mexico can only repay their dollar- denominated loans by running trade “surpluses” with the U.S. They obtain the necessary dollars the only way they can—by trading real goods for dollars on a net basis.

And fifth, because of widespread currency debauchment among foreign countries, the American dollar serves as a parallel money throughout Latin America, Southeast Asia and even parts of southern Europe.

These factors explain why on a net basis, foreigners are willing to “buy” our dollars with their goods. But the high demand for the dollar does not by itself explain the continuing U.S. trade deficits.

The other major factor enabling America’s consumption to exceed its production is the Federal Reserve’s policy of monetary inflation. In any inflation, the individuals who initially possess the newly created money gain the maximum benefit. This has been the case in the international arena where, because of dollar inflation, individual Americans have found themselves the initial recipients of new money.

Having increased nominal incomes, but not wishing to increase their individual “cash bal ances,” Americans have spent this new money for real goods, either domestic or foreign. New dollars spent on domestic goods tend to bid up domestic prices, and foreign goods (which have not yet been bid up) become more attractive to American consumers. Eventually dollars pour abroad in exchange for foreign goods. Inflation of this “world currency” has allowed Americans to bid goods and services away from other international buyers.

On net, Americans have been trading dollars for real goods because, for a number of reasons, they value the foreign goods more highly than their dollars. At the same time, on a net basis, foreigners are valuing the dollars they receive more highly than the real goods they are giving up. Can we say which party is getting the better deal? To do so would suggest that one is either irrational in its dealings or does not know its own best interests.

The questionable validity of seeing a trade deficit as “bad” and a trade surplus as “good” becomes apparent. If we can say that the U.S. is experiencing a trade deficit because it is losing dollars, we can just as accurately say that the Japanese are experiencing a trade deficit, as they are losing automobiles and television sets. Which are more valuable, dollars or real goods? This is purely subjective decision. While one person values dollars or dollar-de-nominated investments more highly, another person places a higher value on real goods.[4]

If an individual is not harmed by running a “trade deficit,” can a nation be? The answer is no. The economic gain or loss of a nation, as the classical economists recognized, is the gain or loss of its individual citizens. But what about charges that the trade deficit has led to unemployment and declining wage rates, the uncompetitiveness of American industry, and the debtor nation status of America?

The Effect on Labor

it is popular to speak of the trade deficit as “exporting” American jobs. It is thought that when American consumers buy foreign goods produced with “cheap” labor they are disemploying or at least reducing the wages of American workers. The assumptions underlying this argument are specious.

The first erroneous assumption is that there is a fixed number of jobs in the world, and that the employment of a foreigner means the corresponding disemployment of an American. This is reminiscent of the mercantilist thought of past centuries which assumed a fixed amount of wealth in the world. The number of jobs, or more accurately the demand for labor, is not some quantity mysteriously mandated from above, but rather is completely dependent upon the price (wage rate and benefits) that workers demand for their labor. If the price of labor is held above the marginal productivity of labor, employers cannot profitably hire, and unemployment is the result. Unemployment has everything to do with the price of labor and nothing to do with the foreign goods we purchase.

Second, this argument overlooks the factors that determine wage rates. Wage rates in America are not comparatively high because we have more humane employers or a more benevolent government. They are higher because the marginal productivity of American workers is higher, and this is due primarily to capital investment. Nothing, aside from declining marginal productivity, threatens the level of wages. Therefore, the low level of foreign wages does not threaten the wage rates of Americans.

This does not deny that the wage rates in specific American industries may be affected by imports. If American consumers begin to purchase less expensive foreign steel instead of domestic steel, the wage rates within the American steel industry will tend to fall as producers cut costs to compete. But at the same time, unseen benefits are also occurring. The real wage rates of all Americans will rise Since the less expensive imports allow them to either buy more products containing steel, or buy the same amount of steel-related goods and more of other goods. Furthermore, since the division of labor is enhanced, both the productivity of labor and wage rates are generally improved.

The third faulty assumption in this argument is that when dollars are spent on foreign products (as opposed to domestic products) wealth and employment are lost forever to American industry. But the dollars received by foreigners do in fact return to demand American goods and services in one of two ways. They either will be invested in American capital and equities markets, or spent on American real goods and services. If the former, they serve to lower capital costs for American entrepreneurs and contribute to American employment by lifting the marginal productivity of some workers over institutional barriers. To the degree that dollars are redeemed for real American goods and services, they are “votes” for efficient American industries and contribute directly to employment. In either case, net jobs are not lost because of imports, but rather are diverted from less efficient industries to industries at which America has relatively lower production costs.

Does the trade deficit indicate that American industry is losing a “trade war” and is becoming uncompetitive? First of all, we must bear in mind that trade is never comparable to a war. In war the stronger triumphs at the weaker’s expense, but in trade the weaker gains as does the stronger. In war armies cross borders to harm and destroy people; in trade goods cross borders to please and enrich people. While losing a war denotes national weakness, imports signify no such thing but instead are a sign of a country’s relative inefficiency in the production of a particular good. It is certainly true that each time a consumer buys an imported good it reveals that a particular domestic industry is inefficient relative to a foreign producer. But this only means that America is the same as every other nation and has relative strengths and weaknesses of production.

Furthermore, imports only reveal the areas at which American industry is relatively inefficient; they are not the source of this inefficiency. The competitiveness of any industry depends on the costs it must pay for capital, labor, government, and resources. It is true that some traditionally competitive American industries may, for any number of reasons, become uncompetitive in relation to imports. But contrary to the beliefs of many politicians, trade restrictions do not improve an industry’s competitiveness and only end up punishing all consumers by forcing them to pay higher prices. In the long run, trade barriers only lower the real wages and living standards of all people.

Why Is the U.S. a “Debtor Nation”?

Another evil attributed to the trade deficit is America’s debtor status. It is true that the U.S. has been a “debtor nation” since 1985. This sounds ominous. But the word “debtor” is misleading in this case since there is no outstanding debt which must be paid by Americans to foreigners. The debtor status of the U.S. simply means that the dollar value of foreign investments in the U.S. surpasses the dollar value of assets owned by American individuals abroad,

This has come about because during the past several years Americans have freely chosen to relinquish ownership of dollars (and dollar assets) in return for real foreign goods.[5] This influx of foreign capital poses no threat to the well-being of the nation, and is actually beneficial. In 1986, while American individuals and corporations saved some $680 billion, the various levels of government borrowed $143 billion to finance deficits.[6] The foreign capital inflow of $144 billion (made possible by the trade deficit) in effect cancelled the capital consumption of government. It has temporarily allowed private investment to proceed as if there were no budget deficit.

While the trade deficit probably has been beneficial to the American economy, a major cause of the trade deficit, the inflation of the U.S. dollar, will have adverse effects. As the exchange markets respond to the increased quantity of dollars in circulation, the dollar de preciates in value. In the past, foreign dollar holders—both individuals and governments—have invested many of their dollar holdings in fixed-return securities. Their capital investments have kept U.S. interest rates below what they otherwise would have been.[7]

But the depreciation of the dollar has punished these holders of fixed-return securities. Becoming less willing to bear this loss, foreign investors are seeking other uses for their dollars. Such is happening today as foreign-held dollars are flowing into U.S. equity markets. Foreign holdings of U.S. equities increased by $5 billion in 1985, $23-$25 billion in 1986, and will increase by an estimated $35 billion in 1987.[8] The recent stock market boom is partially fueled by this foreign buying.

When the speculative boom in the stock market comes to an end, foreign dollar holders will likely use their dollars to buy real American goods and services. This will cause domestic prices to be bid up. Because a shrinking amount of foreign-held dollars will be available to finance U.S. capital demand, domestic interest rates also will rise. Interest rates will increase further as savers become aware of rising prices and take into account the future depreciation of their dollars. As the dollar depreciation continues, American goods and services will become more attractive to foreign consumers. And at the same time, because of the depreciating dollar, imported goods will become more expensive for American consumers. The trade balance will once again tend toward equilibrium.

Thus, the end of the trade deficit will likely be accompanied by high interest rates and inflated prices, and followed by a recession. But these undesirable consequences are not the result of the trade deficit per se, but of monetary inflation—the consequences of which have been forestalled for a time because of the unique position of the American dollar. The fruits of past monetary sins are at last revealed as the economic distortion becomes apparent. As foreigners convert their dollars into real goods and the inflow of foreign capital subsides, interest rates will rise and entrepreneurial “malinvestments” will be exposed.

If the trade deficit is a national problem, it is for two reasons. First, its eventual end will exact a price for the Federal Reserve’s past excesses, and individual Americans no longer will be able to consume more than they produce. And second, because of special interest groups and the mercantilist perspective of many politicians, the trade deficit threatens to lead to protectionist legislation. This is despite the fact that the actual threat posed by a trade deficit is minimal or non-existent. In the words of economist Herbert Stein, “There must be something more serious to worry about.”[9]

While the trade deficit itself is not threatening, government interference with international trade is. Any political efforts to rectify what is seen as “the trade problem” are certain to harm the economic interests of the vast majority of Americans. As far as the trade deficit is concerned, there is little doubt that any government cure will be worse than the imagined disease.

1.   Robert L. Heilbroner, The Essential Adam Smith (New York: W. W. Norton & Company, 1986), p. 266.

2.   Jaclyn Fierman, “The Selling Off of America,” Fortune. December 22, 1986, pp. 44-56.

3.   “Foreign Money Finds Haven in U.S.,” The Wall Street Journal. May 27, 1986, p. 2.

4.   In retrospect we see that foreign individuals who have chosen to accept and hold American dollars have been harmed by the subsequent inflation and depreciation of their dollar assets. But the fact that people sometimes misjudge the future and take actions contrary to their best interests does not suggest that the individual’s freedom should be lessened for his own good. Who could be a better judge of someone’s interests than the person himself?

5.   Americans can buy foreign goods or invest in American business, but they can not do both at the same time. To the degree that Americans are exchanging dollars for foreign consumer goods (obviously not all imports are goods for consumption), the trade deficit is an indication of our “present orientation.” It indicates a preference tot consumption over investment, or in other words, present enjoyment over future enjoyment. The trade deficit, however, does not cause this high time-preference, but is a symptom of it. Protectionist legislation would not change the time- preference of American consumers (i.e., stop people from consuming instead of investing), but only changes how time-preference is manifested (forcing consumer spending to shift from foreign to domestic goods). As Gary North writes: “Americans are increasingly willing to exchange their economic futures for present delights . . . What should the Federal government do about the short-sighted vision of American consumers? Is it the responsibility of the Federal government m pass legislation controlling people’s time perspective? . . . Those who want to invest in American business should be allowed to invest.” (Gary North, “Should American Business Give Up Smoking?” Biblical Economics Today, April/May 1987, p. 3)

6.   Herbert Stein, “Leave the Trade Deficit Alone,” The Wall Street Journal. March 11, 1987, p. 29.

7.   Lewis E. Lehman, “Trade War or Monetary Reform,” The Wall Street Journal. January 28, 1987, p. 26.

8.   Michael R. Sesit, “Overseas Holdings of U.S. Stocks Grow,” The Wall Street Journal. February 27, 1987, p. 13.

9.   Stein, p. 29.

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