A version of this article was previously published on the Learn Liberty blog.
Scott Sumner, over at EconLog, wrote that “America can run trade deficits forever.” Scott is correct, although for reasons that I’ll not here get into, I believe that Scott is incorrect to suggest that the running of perpetual and healthy U.S. trade – or current-account – deficits requires that Americans consistently earn good returns on their investments abroad; such consistent and healthy U.S. ‘trade deficits’ are possible even if Americans invest nothing abroad.
A hypothetical case: Squanderville and Thriftville
Commenting on Scott’s post, “Phil” disputes Scott’s conclusion. “Phil” does so by telling a tale of two hypothetical countries, Squanderville and Thriftville, in which citizens of the former country foolishly and frequently finance irresponsible consumption today by borrowing resources from citizens of the latter country. It’s easy to show that citizens of the borrowing country, Squanderville, run up trade deficits year after year with Thirftville and that Squandervillians will one day be impoverished by having to repay their creditors in Thriftville.
But contrary to what seems to be “Phil’s” implicit assumption (or belief), a country’s trade (or current-account) deficit is emphatically not necessarily debt for the citizens of that country. The fact that country D’s trade deficit can become additional debt for citizens of D is indisputable; that country D’s trade deficit is not necessarily additional debt for citizens of D is also indisputable despite the reality that very few people recognize this fact.
Below the fold is a slightly modified version of a comment that I left on EconLog in response to “Phil’s” comment:
The scenario you describe is possible. But it does not undermine the larger point made by Scott. The reason is that you implicitly assume throughout your tale that all of Squanderville’s trade deficit becomes Squanderville’s debt and that none, or too little, of that debt is used to finance the production of capital that will increase future output in Squanderville. Given the name of that mythical country, that is not a bad assumption.
But in reality any real country can run a trade (or current-account) deficit without incurring a smidgen of debt – such as, for example, when producers in country F simply hold some of the currency they earn by selling goods to denizens of country D, or when producers in country F use some of these earnings to buy shares of stock in businesses headquartered in country D, or when producers in country F use some of these earnings to build factories or retail outlets in country D.
When Ikea, for example, builds a store in Newark, New Jersey, the stock of capital in America increases as the U.S. trade ‘deficit’ thereby rises. It’s true that some higher proportion of capital in the U.S. is now owned by people whose passports are issued by a foreign government, but so what? From my perspective as an American I am no poorer because of this Swedish investment in America, and I am likely wealthier: I can now get more furniture at lower prices and, perhaps, I might even get a better job working at that Ikea store. Or perhaps my wage in my current job at Acme Furniture Retailer in Hackensack, NJ, might be bid up due to the resulting additional competition for workers such as myself.
There are other reasons why your tale fails to capture the full range of reasons why country D’s consistent trade deficits are not necessarily a problem for the people of country D, but I’ll not list them here. [One such reason is that some, and possibly even all, of the excess of D’s imports over its exports are inputs that producers in D use to expand and improve their outputs.]
In reality, country D’s consistent trade deficits in fact do not imply that country D is mortgaging its future to foreigners. Country D’s trade deficit might very well both be a signal that the people and economy of country D are growing stronger and more prosperous over the long run and is fuel for that stronger growth – for stronger growth in country D is what more capital investment in country D’s private economy causes regardless of the nationalities of the investors. (The trade deficits that the U.S. has run for most of its history are almost certainly generally of this happy sort. Witness, for example, the British investments that helped in the 19th century to finance the building of railways in America.)
Further, the fact that country D’s trade deficit, in any particular circumstance, might in fact be the result of such mortgaging as you describe in your tale is a reflection not of trade policy but of the high time preferences (or, if you prefer, the economic myopia) of citizens of country D. High time preferences (or economic myopia) among the citizens of D – whether expressed purely privately or through the agency of government borrowing – might indeed be a problem, but it is neither one that will plausibly be solved by trade restrictions nor one that even requires that the citizens of D trade with foreigners at all. Such profligacy as you correctly suggest is damaging over the long run is perfectly possible to play out exclusively within the borders of country D, without D running a trade deficit.
No accounting convention has caused more misunderstanding, and has served as an excuse for such a large amount of government mischief, as has the so-called “trade deficit” or current-account deficit. On this specific point, I wish to especially applaud Scott for this nice point that he makes in his post:
“Or we sell the Chinese “goods” such as houses in LA, that don’t count as US exports because they are not physically moved overseas.
Our balance of payments accounting doesn’t really correspond to what’s going on in the real world. If we sold the Chinese mobile homes, and put them on a ship to China, they’d count as exports. It sounds crazy, and it is, but that’s how the accounting is done.”
How this works in practice
What Scott means here is that dollars spent by non-Americans on real estate in America are conventionally recorded on the capital account and not on the current account. But this accounting convention has no economic significance. So, for example, if Mr. Lee in China earns $1 million selling cloth to Americans and then spends that $1 million on a home in Tucson, that transaction results in a $1 million increase in America’s current-account (“trade”) deficit – or, we might alternatively say, a $1 million increase in America’s capital-account surplus. “Oh my heavens!” then moan the punditocracy and politicians, “Woe is us, for we’re going further into debt to the Chinese – our economy is being torn asunder – our trade policies are flawed – the Chinese are being unfair – foreigners are killing us – we Americans are mortgaging our future and our children’s well-being to foreigners – raise tariffs!”
Yet as Scott correctly points out, if Mr. Lee had instead bought a $1 million American-made mobile home that was shipped to him in China, that American sale and Chinese purchase of a mobile home would have been recorded on the current account and the overall result of these transactions would have been no increase in America’s trade deficit. “Whew!” exclaim the punditocracy and politicians, “Isn’t that wonderful?!” Yet as Scott notes, there is no economic difference between these two transactions other than the fact that, given long-standing accounting conventions, the former transaction (Chinese purchase of a home in Tucson) is recorded on the capital account while the latter transaction (Chinese purchase of an American-made mobile home for export to China) is recorded on the current account.
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Edited by Russell Coates
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