Saturday, March 12, 2005

Worrying about the trade deficit

Perhaps the biggest economic news Friday morning was that the U.S. trade deficit soared to its second-highest level ever. With that, inflation fears and higher oil prices, stocks took a bit of beating by the market's closing.

With impeccable timing, Dan Boudreaux explained Thursday how Warren Buffett misunderstands the trade gap, using simple scenarios to illustrate the underlying principles of trade. Many people, including "the world's greatest investor," fail to understand that there's intrinsically no difference between labor in one country versus labor in another. Let's say that my neighbor wants to support someone local by buying from him, which is his right; isn't it also my right to buy from whoever can supply a good or service for the cheapest price?

Does a family make their own shoes, or their own shirts, or build their own cars? Of course not. The principle of comparative advantage is independent of families, towns, states and provinces, and why not national borders too? Consider that when I purchase Florida oranges, well, that denies my fellow New York state residents a job growing oranges. When I buy Idaho potatoes or Midwest beef, that deprives my fellow New York state residents of those jobs. Such arguments are patently absurd, most people would agree. So why would the same people probably think "it deprives honest, hard-working Americans of jobs" when we import Chinese-made stuffed animals or Central American textiles? It doesn't "deprive Americans of jobs" any more than I can "deprive" fellow New Yorkers of jobs. What it does is push my fellow New Yorkers toward jobs where they have comparative advantage.

More importantly, when I buy Florida oranges and Midwest beef, it really doesn't matter if I sell something to them in return, only that I can afford what I buy from them. Likewise, it doesn't even matter that we export anything at all to our trading partners, just as long as we can afford to buy their imports. That both sides are equal is not a necessity of trade. It's important to remember what Adam Smith wrote in The Wealth of Nations, Book 4, Chapter 3, part 2:
Nothing, however, can be more absurd than this whole doctrine of the balance of trade, upon which, not only these restraints, but almost all the other regulations of commerce are founded. When two places trade with one another, this doctrine supposes that, if the balance be even, neither of them either loses or gains; but if it leans in any degree to one side, that one of them loses and the other gains in proportion to its declension from the exact equilibrium. Both suppositions are false. A trade which is forced by means of bounties and monopolies may be and commonly is disadvantageous to the country in whose favour it is meant to be established, as I shall endeavour to show hereafter. But that trade which, without force or constraint, is naturally and regularly carried on between any two places is always advantageous, though not always equally so, to both

By advantage or gain, I understand not the increase of the quantity of gold and silver, but that of the exchangeable value of the annual produce of the land and labour of the country, or the increase of the annual revenue of its inhabitants.
Wow, looks like Warren Buffett needs to read some Adam Smith. Buffett believes in forcing a zero gap in trade, i.e. we can import a dollar's worth of goods and services only if we export a dollar of goods and services. Notwithstanding that's bad economics, I question the logistics of how you can do that with any reasonable transparency -- what are we going to do, require a foreign ship to stay in port until one of our own ships starts unloading in Tokyo or elsewhere? Or would quotas be set where we'd plan to export, say, $25 billion to China, and thus export a maximum of $25 billion? Never mind the higher prices that protectionism brings: imagine all the inevitable and wasteful rent-seeking that would precipitate, as companies on both sides lobbied to get their share!

I've come to prefer calling it a trade gap, not a trade deficit, for two reasons. First, "deficit" has such a negative connotation for most people, and unnecessarily so when it comes to trade. Second, Buffett and most others think "deficit" is necessarily debt.

Some have stated that foreigners shouldn't get so many dollars from us, that we shouldn't "export our wealth." Again, there's no intrinsic difference in the labor. An American earning $1 can circulate it through the U.S. economy. However, what is to stop a Chinese textile worker, a Brazilian sugar harvester or a Belgian chocolatier from earning that $1, then spending the $1 on American goods or services? Or the foreigner could instead save that $1, which his major bank of country's central bank could invest in U.S. assets. Either way, the dollar can easily work its way back, in time, to the U.S. economy. After all, it does no good for foreigners to simply hold dollars, unless their central bank wishes to augment their reserve holdings. (Even so, China notably turns its U.S. dollar reserves, currently something like $450 billion, into U.S. Treasury securities.) Another example to think about is that most OPEC nations want to sell oil for only dollars. So China, Japan and anyone else can buy petroleum with the dollars they gained from trade surpluses with the U.S., and what will the Saudis, Yemenis et al do? They'll buy U.S. goods and services, they'll invest the money in U.S. securities, or they'll buy something from someone who wants dollars.

It's true that some of the trade gap is returned to the U.S. as interest-bearing investments, like bonds, but not all. As Boudreaux stated here, foreigners have some options for using their dollars. They may purchase stock or real estate, counting on the value to appreciate over time; maybe some of the stock pays dividends, but those aren't debt. The benefit most people don't realize is that after selling to Americans, foreigners can very easily take those acquired dollars and invest them somehow in the American economy; this means Americans don't have to supply that capital ourselves, and we thus have more money for consumption spending. So effectively, we have our cake and eat it too. This isn't indefinitely sustainable, of course, because at some point there won't be any more assets to buy -- or another possibility that I'll examine at the end, that a vast economy like the U.S. will have assets left, but foreigners won't have enough savings to buy them.

Donald Luskin once used the example of a runner. There are appropriate times for a runner to sprint, though he can't do so indefinitely. So it is with debt. John Stuart Mill said, "War is an ugly thing, but not the ugliest of things." I say, "Debt is an undesirable thing, but not the most undesirable of things." No one goes into debt strictly for the sake of being in debt, but because the interest payments are worthwhile. No sane person wants a mortgage of $X as an end in itself, but because that debt is preferable to having to wait to own the house.

The mainstream belief is that at some point, foreigners will decelerate their purchases of U.S. assets once they believe the U.S. can no longer afford the interest payments on the "current account deficit." When that happens, Americans are supposed to reduce consumption spending and start saving more. (Just over three years ago, Andy Xie of Morgan Stanley had a couple of wild predictions about that scenario, neither of which came true.) But a current account deficit is not all debt, as Boudreaux has explained, especially that it's often double-counted. When foreigners receive $X from selling us goods and services, then invest half of that in U.S. Treasury bonds, the actual debt is half of $X, not 1.5 times $X. I also point to the interest that the U.S. federal government pays on its debt, which is part of the current account deficit but certainly not debt.

Catherine Mann once noted that the U.S. current account (the trade gap, interest payments and unilateral transfers) is currently sustainable, but not forever so. She predicted, "At current exchange rates and assuming a resumption of sustained growth in the world economy, by 2005 the current account deficit will be about $600 billion — more than 5 percent of GDP." She made this in 2000, which was quite a nice mark to hit. Other economists, though, would just harp the "Unsustainable!" line and say that current account reversal would have to come "this year." If it didn't come to pass, they'd repeat the claim next year, and the year after that. It brings to mind a joke, "Economists have successfully forecasted ten of the last three recessions." Think of those who predicted the Red Sox would win the World Series in 1919, then 1920, and so on.

I personally believe sustainability's end is not when foreigners believe the U.S. can no longer afford the interest payments, but when foreigners can't afford to invest any more here. As long as the rest of the world's major economies are stagnant, I don't believe there will be a shortage of foreign investment in the U.S. economy. After all, most of the EuroZone is flat and Japan is back in recession, so where will foreigners want to invest their savings? Right here in the U.S. of A. Some of the Eastern European economies are starting to do well with liberalized tax reform, but they don't have the sheer quantity of available assets that the U.S. does, and the U.S. is still (overall) a safer nation in which to invest.



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