Professors Folsom and Gonzalez teach in the Department of Economics, San Jose State University. They are particularly indebted to Heather Folsom, who at age 10 posed the fundamental question that gave rise to this essay. They wish to thank Kirk Blackerby, Betty Chu, Mario Escobar, Anna K.N. Folsom, David Henderson, Franz Hirner, J. Paul Leigh, John Navas, Geoffrey Nunn, Michael Pogodzinski, Tim Sass, and David Saurman for their suggestions; Ralph Kozlow and Russell Scholl for explanations of international economic data; Ann Arlene Mar- quiss Folsom for her editing; and participants at the March 1989 National Social Science Association convention at Reno, Nevada, where they presented an earlier draft, for critical comments. The authors alone are responsible for the views expressed here.
Every U.S. trade deficit report brings forth myriad lamentations, routinely linking the deficit to the widely heralded notion that because foreigners allegedly now own more U.S. assets than we own foreign assets, the U.S. has become a “debtor” nation. Suppose this allegation is true and foreigners do own more stuff here than we own there. Does that situation really reflect debt that eventually we must repay?
Although recent data suggest that our trade deficit has begun to decline, it still is huge, and questions about its origins and consequences remain. What caused our trade deficit, and why haven’t we stopped it? Won’t foreign- owned assets cause us problems when exchange rates change? Isn’t Our trade deficit evidence of shameful profligacy? If foreigners own more here than we own abroad, how will we pay them a return on their assets? Could our trade deficit continue indefinitely—will it ever become a surplus? Wouldn’t a shift from trade deficit to surplus require the dollar’s foreign exchange value to fall even more than it has in the recent past? And what about the federal government’s budget deficit?
Deficits and Debt
A 10-year-old at dinner posed the first, fundamental question: “Even if we import more than we export, if the exports and imports are paid for, where does the debt come from?” The question implies the answer: Of course debt comes only if our trade deficit isn’t paid for. And we are paying for our net imports by selling all sorts of assets (real and financial, non-debt and debt) to foreigners. These asset sales need not put the U.S. in debt internationally, just as domestic asset sales need not put us in debt domestically. (Some examples: Selling your house doesn’t put you in debt. If you own a mortgage on someone else’s house, selling that mortgage won’t put you in debt, and won’t increase his debt, either. And kicking down all the “for sale” signs in your neighborhood, because you don’t want your neighborhood to be indebted to outsiders from other neighborhoods, makes no sense.)
Trade means exchange. If we export less to foreigners than they export to us, they must be getting something else from us to compensate. Our “current account” goods and services trade deficit is inevitably balanced by our foreign investment surplus. If our (broadly defined) exports are less than our imports, then foreign private individuals, firms, or governments must be accumulating more U.S. assets (either real or financial assets, short or long term) than U.S. individuals, firms, or governments are accumulating foreign assets.
Although conventional wisdom assumes that our trade deficit causes our foreign investment surplus, our trade deficit could just as well result from our foreign investment surplus. Actually, our trade deficit and investment surplus are determined simultaneously, as people choose to export, import, and invest at home or abroad. Incidentally, the dollar value of U.S.-owned assets abroad has increased in every year since at least 1960, although a decrease would mean merely that Americans preferred to invest at home. Our foreign investment surplus occurs because foreign-owned assets in the U.S. are increasing even more rapidly.
That we are financing our trade deficit by selling assets to foreigners may sound disastrous. But our trade deficit and foreign investment surplus reflect voluntary market transactions from which each party expects to benefit, or else the transaction wouldn’t occur. We have a trade deficit because we think we benefit from the transactions that generate it, and the foreigners with whom we trade think they benefit. Both sides generally do benefit.
Note that if we were running a trade surplus, for example by exporting more automobiles than we imported, we still would be selling assets—automobiles—to foreigners, again to the benefit of both sides. Also note that the automobile assets that we could be selling abroad, and the real and financial assets that we in fact are selling abroad, all use or represent scarce economic resources.
This similarity is obscured under the definitions currently used in international “balance of payments” accounting. An American-made automobile sold abroad counts as an export and hence reduces our trade deficit (and foreign investment surplus), while a building constructed in the U.S. but sold to a foreigner counts as foreign investment in the U.S. and hence increases our trade deficit (by increasing our foreign investment sur plus). Yet there is no real difference between these transactions, other than that the automobile physically moves abroad while the building remains here.
Even though both sides benefit from their voluntary market transactions, there may be some different set of transactions, other than the ones actually agreed to and carried out, that would yield even greater benefits. We don’t make the Pollyanna claim that any particular set of voluntary market transactions generates the best of all possible worlds; the most advantageous trades may be overlooked. Voluntary market transactions simply make both sides better off than they would be without the transactions.
Those Profligate Americans
Despite many wails to the contrary, neither our many imports nor our net trade deficit show us to be frivolous and profligate. Most of our imports are consumer goods, but we also import many capital goods such as industrial machinery, trucks, and construction equipment. Moreover, many “consumer goods” imports such as automobiles and even home electronics could be considered capital goods because, just like a lathe or milling machine, they last and produce services for a long time. Even short-term imports such as food, flowers, or quickly broken toys can add to the stock of real capital in the United States. The more we import of anything, the more domestic resources we have available for production of other commodities, including real capital goods. Some of what we buy may be judged foolish, but purchases don’t become foolish merely because they are imported.
Won’t we have to pay back the foreign investments now being made in the U.S.? No. Foreigners are buying many kinds of real and financial assets. If they buy real estate, they own it now, so we won’t have to pay anything back. If they buy equities in businesses, they own those equities now, so again we have nothing to pay back. if they buy private debt, for example General Motors bonds, General Motors will have to pay neither more nor less than if the bondholders were Americans, if foreigners buy U.S. government debt, the U.S. government will have to pay neither more nor less than if the debt were owned by Americans. If foreigners hold U.S. bank accounts (denominated in either dollars or foreign money), the bank’s liabilities are no greater than if these accounts were owned by Americans. All of these assets pay a return (an implicit return in the case of non-inter- est bearing bank accounts) to whoever owns them, but there is nothing additional to be paid back, paid off, or paid out.
Admittedly, foreign willingness to lend to Americans may induce us to borrow more than we would otherwise. In this sense, some of our trade deficit is being financed by new borrowing. But new borrowing from foreigners should cause no more problems than would new domestic borrowing. If some Americans borrow and waste the proceeds, they become worse off (as do the lenders if the borrowers default), but whether the lenders are domestic or foreign makes no real difference. Of course, if exchange rates change, speculators who hold portfolios of net assets denominated on balance in moneys that unexpectedly depreciate, or net liabilities denominated on balance in moneys that unexpectedly appreciate, will lose, but those losses will be balanced by others’ gains.
(Even a growing international debt wouldn’t imply impoverishment because the proper measure of wealth is assets minus liabilities, not assets or liabilities alone. U.S. wealth continues to rise, because U.S. domestic saving—even after deducting all government budget deficits—remains positive.)
Where will the output come from to pay the returns on the assets in the U.S. now owned by foreigners? This is an irrelevant question, since, if a foreign-owned asset is productive, its return accrues to its foreign owner; if it isn’t productive, that is the foreign owner’s problem, not ours. And the foreign investment was accompanied by enormous inflows of resources (remember our huge trade deficit) resulting from exchanges to which we would not have agreed unless we expected to benefit, presumably by increasing our productive capacity or at least our economic welfare.
No other society coerced us to import more than we export and to accept huge volumes of foreign investment. We aren’t a pre-perestroika Eastern European nation “trading” with the Soviets. Voluntary foreign investments accompanied by resource inflows can pay their own returns. Foreign purchases of U.S. assets aren’t a zero-sum activity, since increases in foreign-owned assets require neither a decline in U.S.-owned assets nor a rise in U.S.-owed liabilities. Descriptions of the U.S. as a “debtor nation” are unwarranted.
Trade Deficit or Surplus?
As foreigners reap their returns from owning U.S. assets, our current trade deficit could be followed by a trade surplus if foreigners choose to consume their returns or invest them outside the U.S., but these choices and a resulting trade surplus aren’t inevitable. Capital that flowed in need not flow out again. Foreigners could continue to reinvest their returns here. Many U.S. assets are owned by foreigners who want not to repatriate profits but to accumulate even more assets in the U.S., where private ownership rights are relatively more secure than in their home countries.
Thus our trade deficit and foreign investment surplus could persist indefinitely. Real capital flows to wherever the expected real rate of return is highest, and apparently it has been and continues to be higher in the U.S. than elsewhere. Eventually, in a static world, the inflow of capital would reduce U.S. rates of return to equal those elsewhere, and the inflow would cease, but “cease” doesn’t mean “reverse.” In any case, the world isn’t static. Even if rates of return around the world eventually did equate, additional saving and investment would upset these equalities. The highest of the new rates of return would attract the new investment, creating new trade patterns in which the U.S, conceivably could have either a trade deficit and foreign investment surplus, or a trade surplus and foreign investment deficit.
A U.S. trade surplus will follow the current U.S. trade deficit only to the extent that foreigners consume or invest abroad their U.S. assets’ returns, instead of reinvesting them here. Even then, if foreigners move or sell title to their U.S. assets across national boundaries, our current trade deficit with one country could be followed by a trade surplus with another country—or by no trade surplus at all, if foreigners follow their capital and migrate here, or sell their U.S. assets to other foreigners who migrate here.
For a Trade Surplus, Must the Dollars Value Decline?
For the U.S. to develop a trade surplus (and foreign investment deficit), the value of the U.S. dollar relative to foreign money need not decline. A drop in the dollar’s international value does make our exports more competitive and our imports more expensive, but it also makes our assets more attractive to foreigners and foreign assets less attractive to us. The net effect on our trade deficit and foreign investment surplus is ambiguous. We could develop a trade surplus without the dollar falling at all, or even if the dollar’s value rose.
Recall that the U.S. trade deficit (imports into the U.S. minus exports from the U.S.) necessarily equals the U.S. foreign investment surplus (foreign investment inflow into the U.S. minus U.S. investment outflow abroad). A drop in the dollar’s international value encourages U.S. exports by making them cheaper to foreigners, and discourages U.S. imports by making them more expensive to us. If the dollar drops, the dollar value of our exports will certainly increase, but the dollar value of our imports will decrease only if we cut them enough to compensate for the higher dollar prices we pay. Thus a drop in the dollar’s value will reduce our trade deficit (measured in dollars) only if our exports increase enough to offset any increase in the dollar value of our imports. That is, a drop in the dollar’s value will reduce our trade deficit only if either our exports or our imports are sufficiently responsive to exchange rate changes. Otherwise, if a drop in the dollar’s value decreases our imports too little or increases our exports too little, then our trade deficit will increase instead of decrease. So much is well known, at least among those who have spent some time thinking about the effect on trade deficits of exchange rate changes.
When the Value of a Dollar Drops . . .
Less frequently considered is the effect of exchange rate changes on the components of our foreign investment surplus. A drop in the dollar’s value affects international investment flows as it affects exports and imports. A drop encourages foreign investments in the U.S. by making them cheaper to foreigners, and discourages U.S. investments abroad by making them more expensive to us.
It could be argued that foreign investment is relatively insensitive to exchange rate changes. For example, with a drop in the dollar’s international value, expected to be temporary, foreigners would be especially eager to buy U.S. assets but Americans would want to postpone asset sales until the dollar returned to a higher “normal” value. If these motivations offset each other, asset sales wouldn’t change.
Even a permanent drop in the dollar’s international value could have little effect on foreign investment, because the demand for an investment asset presumably depends on its expected rate of return, which—it often is supposed—is unaffected by a permanent change in exchange rates. A permanent drop in the dollar’s international value reduces the price of U.S. assets in terms of foreign money, but it also reduces the future income that will be earned by that asset in terms of foreign money.
However, if foreigners have any expectation that they will spend any of their future returns in the U.S., then a drop in the value of the dollar—even if expected to be permanent—does make U.S. assets more attractive to foreigners. And if the resulting increase in foreign demand raises the dollar price of U.S. assets, Americans are encouraged to sell (despite the decline in the dollar’s international value) if they expect to spend any of the proceeds of their asset sales in the United States. Only if Americans expected to spend all asset sale proceeds abroad would they be indifferent to the higher dollar prices for U.S. assets offered by foreigners when the dollar’s international value goes down.
Thus if the dollar’s international value drops, the dollar value of foreign purchases of U.S. assets will almost certainly increase, and the dollar value of our asset purchases abroad will decrease if we cut them enough to compensate for the higher dollar prices we pay. A drop in the dollar’s value will increase our foreign investment surplus, unless we cut our asset purchases abroad so little that their dollar value increases, and increases enough to offset foreigners’ increased asset purchases in the United States.
A drop in the dollar’s value will decrease our foreign investment surplus (and hence our trade deficit) only if foreigners increase the dollar value of their asset purchases here less than we increase the dollar value of our asset purchases abroad. A drop in the dollar’s value will reduce our trade deficit and foreign investment surplus only if either foreign purchases of U.S. assets or our purchases of assets abroad are sufficiently unresponsive to exchange rate changes. Otherwise, if a drop in the dollar’s value increases foreign purchases of U.S. assets too much, or decreases our purchases of assets abroad too much, then our trade deficit and foreign investment surplus will increase instead of decrease.
Those who forecast that the dollar’s international value will drop farther on the assumption that the trade deficit must end, and also those who advocate a further drop in order to force our trade deficit to end, are assuming not only that exports or imports are highly responsive to drops in the dollar’s value, but also that net foreign investment flows aren’t highly responsive to drops in the dollar’s value. When both trade and investment flows are considered, the effect of exchange rate changes on foreign trade deficits and foreign investment surpluses becomes much less obvious. Ultimately, the issue becomes an empirical question.
A drop in the dollar’s international value could reduce our trade deficit and foreign investment surplus, by making our exports more competitive and our imports more expensive. But a drop in the dollar’s international value could instead enlarge our trade deficit and foreign investment surplus, by stimulating foreign investment here and discouraging U.S. investment abroad. Although recent trade statistics suggest that the drop in the dollar’s international value since February 1985 is beginning to reduce our trade deficit and foreign investment surplus, an end to our trade deficit certainly doesn’t require the dollar’s value to drop more.
For example, without any drop in the dollar’s international value, our trade deficit could end and even become a surplus either because foreigners simply decide to buy more of our exports while investing less here, or because we decide to import less while investing more abroad. (Such decisions could result from changes in weather patterns and agricultural productivity, industrial productivity, new inventions and technologies, reliability of alternate suppliers, safety of investments in various countries, government domestic and trade policies, perceived goods’ quality, consumer tastes and preferences, and so forth.) Regardless whether we sell foreigners more commodities and fewer assets, or we buy from them fewer commodities and more assets, neither the demand for nor the supply of dollars on foreign exchange markets need change, so the dollar’s foreign exchange value need not change.
All parts of the U.S. use the same money, yet resources have flowed from New England to real investments in southern and southwestern states, and then have stopped flowing and even reversed direction. The fixed exchange rate between the New England dollar and the rest-of-the-U.S., dollar, constant for more than 200 years, has facilitated rather than impeded such resource movements within the U.S. by eliminating the risks of fluctuating exchange rates.
The nonhuman capital we have been discussing can move even if the owners of that capital stay put; human capital cannot move unless its owners migrate. Somehow that difference muddles our thinking and prevents us from seeing the similarities. Propositions that apply neither to labor nor non-labor resources we correctly reject for human capital but wrongly accept for nonhuman capital.
Not only foreign non-labor resources but also foreign people have come here. Do we need to “pay back” this labor inflow, by sending our children abroad against their will? No. Must we have extra children, in order to create a surplus to pay off our “immigration deficit?” No. Is our trade deficit an imaginary problem worried about by hallucinating minds? Yes.
Government Budget Deficits
What about our high government budget deficits and low (but still positive) saving rate? In years past, when almost all government debt was owned by Americans, government budget deficits seemed less threatening not only because they were smaller (and saving was relatively higher) than now, but also because “we owe it to our selves.” Now that foreigners own about 20 percent of U.S. government debt, that saying is less accurate and less comforting.
But even in years past, “we” and “ourselves” were different people. Regardless how much government debt is held domestically or by foreigners, government debt and the interest on that debt can be paid only by taxes or by defaulting—either outright, or by inflating the debt’s value away, or, in the case of foreign-held debt, by a drop in the dollar’s international value. Each of these alternatives would affect different people differently. Some will gain while others lose; nobody’s wealth is likely to be unaffected.
Foreign trade “deficits” and government budget deficits are entirely different concepts. Foreign trade deficits and investment surpluses result from voluntary market exchanges of goods, services, and assets; government budget deficits arise from government spending financed by fiscal and monetary policies that government coercion imposes on individuals in the society. And unlike foreign trade deficits financed by foreign investment surpluses, government budget deficits really do generate debt (either interest-paying bonds or non-interest-paying money) that will be financed by coercion (taxation or some sort of default). Compared with trade deficits, there is less assurance that government budget deficits are benign.
The U.S. government budget deficit and foreign trade deficit are often described as “twin deficits,” implying that the budget deficit’s adverse consequences are worsened by the foreign trade de-ficit-that is, by the foreign investment surplus that helps finance the budget deficit. But this view is seriously misleading because it forgets that the trade deficit results from voluntary market transactions, while the government budget deficit does not. Given the magnitude of the budget deficit, it isn’t more serious merely because foreigners finance part (or even all) of it, since, without a foreign trade deficit and investment surplus, gross investment in the U.S. would be less. (If anything, the government budget deficit’s consequences are alleviated, not worsened, by the trade deficit.) If the government budget deficit is too high, it is too high no matter whether it is financed by U.S. resi dents or by foreigners, no matter what the size of the foreign trade deficit. The trade deficit doesn’t compound the government budget deficit.
1. Incidentally, although asset ownership estimates state that foreigners own more assets here than we own abroad ($1,786.2 billion venus $1,253.7 billion at the end of 1988), this comparison is questionable because other data show the U.S. receiving $2.2 billion of net foreign income hi 1988. Unless Americans are consistently more sagacious investors than are foreigners, something is wrong—if they own so much more here than we own there, our net foreign income should be negative rather than positive. All these data are suspect, but the asset ownership data are especially suspect, because they undervalue U.S.-owned assets abroad by not fully allowing for appreciation since those assets were acquired, many of them long ago. “U.S. assets abroad are primarily direct investments that have been accumulated much earlier than foreign direct investment holdings in the U.S. and are recorded, for the most part, at their acquisition value, not at their current market price. ,As a consequence, the recorded value of foreign investment in the U.S. is less understated relative to its market value than is that of U.S.. investment abroad . . . It has been estimated by two State Department economists that U.S. foreign direct investment was undervalued by between $400 billion and $600 billion as of the end of 1987.” Mack Ott, “Trade Deficit Myths,” The Wall Street Journal, January 19,1990.
2. More precisely, a drop in the dollar’s value will decrease our trade deficit if and only if the weighted sum of the elasticities of our export quantities plus the elasticities of the dollar prices we receive for our exports exceeds the weighted sum of the elasticities of our import quantities plus the elasticities of the dollar prices we pay for our imports, with each elasticity weighted by the dollar value of its (export or import) transaction. These elasticities are the percentage change in quantities or dollar prices with respect to a percentage change in the international value of the dollar. (If the trade deficit is dose to Zero, and if the elasticity of the dollar prices we receive for our exports is Zero while the elasticity of the dollar prices we pay for our imports is unity, this condition becomes simply that the weighted export and import quantity elasticities sum to more than one in absolute value.)
4. More precisely, a drop in the dollar’s value will decrease our foreign investment surplus if and only if the weighted sum of the elasticities of the quantities of our asset sales to foreigners plus the elasticities of the dollar prices we receive for selling these assets is less than the weighted sum of the elasticities of the quantities of our asset purchases abroad plus the elasticities of the dollar prices we pay for assets abroad, with each elasticity weighted by the dollar value of its (asset purchase or sale) transaction. (If the investment surplus is close to zero, and if the elasticity of the dollar prices we receive for our asset sales to foreigners is zero while the elasticity of the dollar prices we pay for our asset purchases abroad is unity, this condition becomes simply that the weighted quantity elasticities of our asset sales to foreigners plus our asset purchases abroad sam to less than one in absolute value.) These elasticities are the percentage change in quantities or dollar prices with respect to a percentage change in the international value of the dollar.
5. Some readers may remember some variant of the condition in note 2 (or note 4) above as a foreign exchange market stability condition, necessary and sufficient to make the elasticity to acquire and hold dollars, with respect to the international value of the dollar, negative. However, this is a stability condition only in models in which a money such as dollars is the only asset. In the present context, with exports, imports, non- money assets, and foreign money all trading against dollars, the stability condition would be that the weighted sum of the elasticities of the quantities of our exports and assets (other than dollars) sold to foreigners plus the elasticities of the dollar prices we receive for these sales exceeds the weighted sum of the elasticities of the quantities of our imports and assets (other than dollars) purchased abroad plus the elasticities of the dollar pikes we pay for these purchases, with each elasticity weighted by the dollar value of its (export, import, or asset purchase or sale) transaction.
If money were the only asset, it might be reasonable to suppose that any trade deficit eventually would end. As the residents of the trade surplus country received more and more of the trade deficit country’s money, eventually their demand for it would begin to become satiated and hence highly inelastic. Rather than continue accumulating trade deficit country money, trade surplus country residents would reduce their sales to the trade deficit country, or else increase their purchases from it, enough to end the trade imbalance. But this argument doesn’t apply to a world containing a variety of assets, for which the total demand isn’t likely to become satiated.
6. The opposite argument—that a large government budget deficit enlarges the foreign trade deficit and foreign investment surplus by raising U.S. interest rates—is plausible, However, the connection, if any, between budget deficits and interest rates depends on why the deficit is large—for example, whether an enlarged deficit results from an economic recession, a tax cat, an expansion of government Spending on transfer payments, or an expansion of government spending on goods and services. (A recession tends to lower interest rates; economic expansion tends to raise them.) Similarly, an attempt to reduce the budget deficit could either lower or raise interest rates, depending on whether the deficit were reduced by a tax increase, lower government spending on transfer payments, or lower government spending on goods and services. It also would depend on how people reacted to the deficit-reducing policy, specifically whether U.S. private saving, and foreign investment in the U.S., rose or fell Ultimately, interest rates are determined by the relative magnitudes of total saving (supply of loanable funds) and investment (demand for loanable funds), although many policy discussions seem to forget this fundamental.
Empirically, most deficit increases and decreases result from a combination of causes. Consequently, and not surprisingly, empirical studies generally don’t support a straightforward “larger deficits raise interest rates” hypothesis.